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Chapter: Chapter 20: Leases and Retirement Obligations
True/False
1. The most common forms of off-balance-sheet debt are operating leases, securitized
receivables, and unfunded retirement obligations.
2. A profitable company has chosen to lease its assets. With respect to ROIC, capital
productivity, and operating profits, which of those measures are likely to artificially rise?
a) Operating profits and ROIC only.
b) Capital productivity and ROIC only.
c) Operating profits and invested capital only.
d) None of them are likely to artificially increase.
3. An analyst’s appropriate adjustments for operating leases would be to increase assets,
increase liabilities, and increase operating income.
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4. With respect to operating leases, adjusting the financial statements makes ROIC and free
cash flow independent of capital structure choices, specifically whether to lease, own, or
borrow.
5. Although a company’s ROIC will change following the adjustment for operating leases, its
valuation should not change.
6. When a firm uses operating leases, an analyst should determine the firm’s equity value by
subtracting traditional debt and the value of operating leases from enterprise value.
7. Apex Industries expects to earn $25 million in operating profit next year. The company pays
an operating tax rate of 30 percent. If the value of leased asset is $125 and the cost of debt is
10 percent, what is the approximate after-tax operating profit, adjusted for capitalized
operating leases?
a) $24
b) $25
c) $26
d) $27
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8. Summarize how to adjust the weighted average cost of capital (WACC) for the existence of
operating leases, and comment on the likely effect on the WACC.
Ans: [The analyst needs to estimate an adjusted debt–to-value ratio that includes capitalized
than the unadjusted WACC.]
Use the following information to answer the next two questions:
Operating assets = $3,000
Operating liabilities = $1,000
Book value of debt = Market value of debt = $1,500
Book value of equity = $500
Market value of equity = $900
Value of operating leases = $2,000
After-tax required return on unsecured debt = 6%
Required return on equity (CAPM) = 13%
After-tax required return on secured debt = 5%
Multiple Choice
9. What are (1) invested capital before adjustment for leases and (2) invested capital after
adjustment for leases?
a) Invested capital before adjustment for leases = $2,000; invested capital after adjustment for
leases = $4,000.
b) Invested capital before adjustment for leases = $4,000; invested capital after adjustment for
leases = $3,000.
c) Invested capital before adjustment for leases = $2,000; invested capital after adjustment for
leases = $3,000.
d) Invested capital before adjustment for leases = $4,000; invested capital after adjustment for
leases = $4,000.
10. What are (1) the WACC before adjustment for leases and (2) the WACC after adjustment for
leases?
a) WACC before adjustment for leases = 8.63 percent; WACC after adjustment for leases = 6.98
percent.
b) WACC before adjustment for leases = 6.63 percent; WACC after adjustment for leases = 6.98
percent.
c) WACC before adjustment for leases = 6.93 percent; WACC after adjustment for leases = 8.63
percent.
d) WACC before adjustment for leases = 8.63 percent; WACC after adjustment for leases = 8.98
percent.
11. When computing cash flows for a company with operating leases, an analyst should add
back the lease depreciation to NOPLAT.
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12. Since valuation is not affected by the treatment of operating leases, capitalizing operating
leases is not a useful activity for analysts.
13. In making adjustments for leases, an analyst will have to get the information on rental
expenses from the company’s footnotes and estimate the value of the asset.
14. Using the formula that incorporates the rental expense, asset life, and an appropriate
interest rate, compute the estimated value of a leased asset at the beginning of an accounting
period. The rental expense for the ensuing period is $2,500, the relevant cost of debt is 6.2
percent, and the asset’s life is 10 years.
a) $4,032.26
b) $15,432.10
c) $9,732.18
d) $40,572.58
15. The interest rate for operating lease adjustments is usually higher than the firm’s cost of
debt.
16. Analysts in the investment banking industry multiply rental expenses by 8 times to
approximate asset value. Although based on reasonable assumptions, the method is very
simple and can both overvalue and undervalue the leased assets.
17. In their study of operating leases, Lim, Mann, and Mihov found that use of more operating
leases led to agencies assigning companies lower credit ratings. These ratings and the use of
operating leases led to higher required yields on new public bond issuances.
18. Researchers at Ohio State University found that interest rates on unrated, unsecured debt
were explained better by credit statistics adjusted for operating leases.
19. Investors, lenders, and rating agencies tend to interpret operating leases the same as
traditional debt.
20. Using the present value of reported rental expenses systematically undervalues the asset,
since it ignores the residual value returned at the end of the lease contract.
21. Many companies securitized their accounts receivable before the financial crisis of 2008;
however, after the financial crisis, this practice largely stopped.
22. Which of the following adjustments for securitized receivables on the balance sheet are
appropriate for determining return on capital, free cash flow, and leverage consistently?
I. Increase short-term debt.
II. Decrease long-term debt.
III. Add back securitized receivables to the balance sheet.
IV. Treat the fees paid for securitizing receivables as interest.
a) I and III only.
b) III and IV only.
c) I, II, and IV only.
d) I, III, and IV only
23. Excess pension assets should be treated as operating assets, and unfunded pension
liabilities should be treated as a debt equivalent. With respect to taxes, valuations should be
done on a pretax basis.
24. If there is no line item for prepaid pension assets or unfunded pension liabilities on a firm’s
balance sheet, this means the firm’s pension plan is fully funded.
25. Since interest costs, expected returns on plan assets, and amortization of losses are part of
the compensation expenses for a firm, they should be considered to be a part of NOPLAT.
26. Classification of amortization of prior service cost and curtailment (or settlement) loss (or
gain) will depend on the purpose of analysis.
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valuation). To treat them as operating would double-count their effect. If you are benchmarking
your company’s financial performance against other companies, treat the expense as
operating.]
Multiple Choice
27. Given the following information, what are the (unadjusted) operating profits and operating
profits adjusted for pension liabilities and assets? (The amortized prior-year service cost and
the amortization of losses are both zero.)
Operating revenues = $1,000
Operating costs = $600
Pension interest cost = $700
Expected return on pension plan assets = $500
Pension service cost = $150
a) Unadjusted operating profits = $600; adjusted operating profits = $400.
b) Unadjusted operating profits = $400; adjusted operating profits = $600.
c) Unadjusted operating profits = $400; adjusted operating profits = $750.
d) Unadjusted operating profits = $600; adjusted operating profits = $750.
28. Over- or underfunded pension status must be incorporated into value as a nonoperating
asset or as a debt equivalent.
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29. Only expected returns (and not actual returns) on pension investments flow through the
income statement, and the rate of expected returns is selected at the discretion of company
management.
30. Which of the following company types is most likely to have operating leases as an off-
balance-sheet liability?
a) A financial services company.
b) A company with few fixed assets.
c) A company that uses large, easily transferable assets.
d) An established company whose age is greater than 20 years.