Effect
on Returns
Converting
operating leases from operating to financial
expenses will generally affect both the operating
income and invested capital at firms. The
direction of the effect is ambiguous:
The
effect of the conversion will depend entirely
on the relationship between the firm's pre-lease
adjustment return on capital and the ratio
of the lease adjustment to earnings to the
present value of lease commitments.
The
lease effect on return on capital will largely
depend upon:
a.
The length and magnitude of the lease commitments:
Larger lease commitments over longer periods
will generate a high debt value for leases
and reduce reported return on capital.
b.
The level of the pre-lease return on capital:
Firms with higher pre-lease return on capital
will see a much bigger drop in return on capital
from the lease conversion than firms with
lower returns on capital. In fact, firms that
generate returns on capital that are lower
than the after-tax cost of debt may actually
see an increase in reported return on capital
with the lease conversion.
As
noted in the last section the returns on equity
for firms should not be affected by this conversion,
since neither net income nor book value of
equity should be changed as a result of it.
To
measure the impact of converting operating
leases to debt on return on capital, we estimate
the pre-adjustment and post-adjustment return
on capital for all firms in the US, as well
as returns in three sectors that have significant
lease commitments - airlines, restaurants
and retailing. The results are reported in
figure 5:
Across
all firms, the after-tax return on capital
drops from 10.74% to 8.80%, when we capitalize
leases and adjust both invested capital and
operating income. The drop is much more dramatic
for retail firms, the primary users of operating
leases, where the return on capital is almost
halved (from 19.74% to 10.95%) and for restaurants,
where the drop is not as dramatic but is still
large (from 14.58% to 10.62%). For airlines,
the drop is smaller but that may be reflective
of the fact that their unadjusted return on
capital is low (only 8.79%) to begin with.
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