Valuing a Company with Operating Leases  449
When reconciling cash flow to investors, treat embedded interest on op-
erating leases and the change in the operating lease liability as a flow to debt 
holders. Again, note in Exhibit 22.5 how the summation of these two accounts 
matches the cash-based lease payment. Financing and its associated taxes 
should not be part of free cash flow.
Incorporating Operating Leases into Financial Projections
To forecast right-of-use assets, use the forecasting process introduced in Chap-
ter 13. Link right-of-use assets to sales or a quantity-based measure, such as 
the number of units sold. In the airline industry, units are represented by num-
ber of available seat-miles. Make sure the mix of purchased and leased assets 
is consistent with the amount of capacity necessary to conduct operations.
Set the operating lease liability as a percentage of the right-of-use asset. 
While this estimation method is far from precise, flows to and from financing 
do not affect an enterprise-based valuation. Instead, financing affects valua-
tion only through the target capital structure set in the weighted average cost 
of capital. If helpful, you can model the combination of operating leases and 
debt to the target capital structure, but it is not required.
EXHIBIT 22.5  FlightCo: Free Cash Flow and Its Reconciliation
$ million
Year 1
Year 2
Year 3
EBITA,1 unadjusted
25.0
25.0
25.0
Operating lease interest
1.4
1.0
0.6
EBITA, adjusted for lease interest
26.4
26.0
25.6
Operating taxes at 20%
(5.3)
(5.2)
(5.1)
NOPAT2
21.1
20.8
20.5
Decrease (increase) in inventory
–
–
15.0
Decrease (increase) in right-of-use assets
8.6
9.0
9.4
Free cash flow
29.7
29.8
44.9
Interest tax shield at 20%
0.3
0.3
0.2
Cash flow available for investors
30.1
30.1
45.1
Reconciliation of free cash flow
Interest, debt
0.4
0.3
0.3
Interest, operating leases
1.4
1.0
0.6
Decrease (increase) in debt
1.2
1.6
5.0
Decrease (increase) in operating leases
7.6
8.0
11.4
Flows to debt holders
10.6
10.9
17.3
Dividends
19.5
19.1
27.8
Cash flow to investors
30.1
30.1
45.1
1 Earnings before interest, taxes, and amortization.
2 Net operating profit after taxes.

450  Leases
Estimating the Cost of Capital
To discount free cash flow, use the weighted average cost of capital inclusive 
of the value of operating leases. Exhibit 22.6 presents the weighted average 
cost of capital for FlightCo.
We assume the company will maintain its current capital structure of 40 
percent adjusted debt to value. Total debt equals the sum of the operating 
lease liability of $27.1 million and traditional debt of $7.8 million, divided 
by enterprise value, estimated at $87.4 million. When estimating enterprise 
value, include operating leases as well. For FlightCo, the mix of operating 
leases and debt will change over time, but we set the combination to be stable 
at 40 percent of enterprise value. Since operating leases and interest expense 
are tax deductible, reduce the cost of capital for operating leases and debt by 
the company’s marginal tax rate.
In the calculations for this example, the cost of equity is provided. In prac-
tice, the cost of equity must be estimated using beta. Following the principles 
of Chapter 15, start by estimating an industry unlevered beta. Unlever each 
company’s beta using a debt-to-equity ratio adjusted for operating leases. 
Next, to determine the target company’s beta, relever the unlevered beta to 
the target company’s capital structure, again inclusive of leases.
Moving from Enterprise Value to Equity Value
To calculate enterprise value, discount free cash flow at the weighted average 
cost of capital, both inclusive of leases. Exhibit 22.7 shows the enterprise DCF 
valuation for FlightCo.
Since free cash flow excludes future payments related to existing operat-
ing leases, the value of operating leases must be deducted from enterprise 
value to determine intrinsic equity value. For FlightCo, enterprise value is 
estimated at $87.4 million. Deducting the present value of the operating lease 
liability ($27.1 million) and debt of $7.8 million leads to an equity value of 
$52.4 million.
EXHIBIT 22.6  FlightCo: Weighted Average Cost of Capital (WACC)
%
Source of 
capital
Value,
$ million
Proportion
of total
capital
Cost of
capital
Marginal
tax rate
After-tax
cost of
capital
Contribution
to weighted
average
Operating leases1
27.1
31.0
5.0
20.0
4.0
1.2
Debt
7.8
9.0
5.0
20.0
4.0
0.4
Equity
52.4
60.0
12.0
12.0
7.2
WACC
87.4
100.0
8.8
1 The present value of operating leases, found in the liabilities section of the balance sheet.