Illustration
4: Adjusting Operating Income for Operating
Leases: Starbucks in 2006
Starbucks
has been a retail/restaurant success story
for much of the last decade. As we succumb
to the allure of its cappuccinos, lattes and
music offerings, it is worth examining how
it has funded its growth. It has hundreds
of stores that are leased, with the leases
being treated as operating leases. For the
most recent financial year, Starbucks has
operating lease expenses of $498.8 million.
Table 7 presents the operating lease commitments
for the firm over the next five years and
the lump sum of commitments beyond that point
in time.
In
2006, Starbucks had a pre-tax cost of debt
of 6.85%. To compute the present value of
the commitments, you have to make a judgment
on the lump sum commitment in year 6. Based
upon the average annual lease commitment over
the first five years ($477 million), we arrive
at an annuity of 3 years:
Approximate
life of annuity (for year 6 lump sum)21
= $ 1487/477 = 3 years. The present value
of the commitments is estimated in Table 8:
The
present value of operating leases is treated
as the equivalent of debt and is added on
to the conventional debt of the firm. Starbucks
has conventional interest-bearing debt of
$703 million on its balance sheet. The cumulated
debt for the firm is:
To
adjust the operating income for Starbucks,
we first use the full adjustment. To compute
depreciation on the leased asset, we assume
straight line depreciation over the lease
life (8 years) on the value of the leased
asset.23
Starbucks'
stated operating income of $894 million is
adjusted as follows:
The
approximate adjustment is also estimated,
where we add the imputed interest expense
using the pre-tax cost of debt.
21
The value is rounded up to the nearest integer.
22
The present value is computed in two steps.
In step 1, we compute the present value of
the annuity of $495.57 million over 3 years,
using the 6.85% cost of debt. In step 2, we
discount this present value back 5 years (the
annuity formula brings the present value back
to the beginning of year 6) to today.
23
The lease life is computed by adding the estimated
annuity life of 8 years for the lump-sum to
the initial 5 years.
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