Approximate Firm Valuation with Operating Leases

Operating leases are quite important in some industries. There are two possible errors that should be avoided when valuing a company with operating leases. First, one should not neglect the implied lease debt. Such neglect distorts the calculation of free cash flow, required rate of return on the equity under partial debt financing, WACC, and residual equity value in the discounted cash flow model. Second, lease expense and implied lease debt should not be forecasted as constant, historical fractions of sales revenue in the (non-steady-state) explicit forecast period. This paper outlines an approximate procedure for handling operating leases in the discounted cash flow model. This procedure avoids the two possible errors that were mentioned.