Chapter 20 Exam Prep Leases And Retirement Obligations

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.

Response: []

Multiple Choice

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.

Response: [A company that chooses to lease its assets will have artificially low operating profits because rental expenses include an implicit interest expense. The company is likely to have artificially high capital productivity because the assets do not appear on the lessee’s balance sheet. Although these two effects counteract one another, the net effect is an artificial boost in ROIC because the reduction in operating profit by rental expense is typically smaller than the reduction in invested capital caused by omitting assets.]

True/False

3. An analyst’s appropriate adjustments for operating leases would be to increase assets, increase liabilities, and increase operating income.

Response: []

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.

Response: []

5. Although a company’s ROIC will change following the adjustment for operating leases, its valuation should not change.

Response: [A drop in ROIC will be accompanied by a corresponding drop in the cost of capital and increase in debt equivalents. The net effect will leave the equity valuation unchanged.]

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.

Response: []

Multiple Choice

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

Response: [Adjusted NOPLAT = Operating profit + Lease interest – Operating taxes = ($25 + $12.5) * (1 – 0.3) = $26.25]

Short Answer

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.

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.

Response: [Invested capital before adjustment for leases = Operating assets – Operating liabilities = $3,000 – $1,000 = $2,000; invested capital after adjustment for leases = Operating assets + Operating leases – Operating liabilities = $3,000 + $2,000 – $1,000 = $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.

Response: [WACC (unadjusted) = ($900/$2,400) * 13% + ($1,500/$2,400) * 6% = 8.63%; WACC (adjusted) = ($900/$4,400) * 13% + ($1,500/$4,400) * 6% + ($2,000/$4,400) * 5% = 6.98%]

True/False

11. When computing cash flows for a company with operating leases, an analyst should add back the lease depreciation to NOPLAT.

Response: [To build adjusted free cash flow, do not add lease depreciation back to NOPLAT to compute gross cash flow. Although depreciation is a noncash charge for the lessor, it is a cash charge for the lessee.]

12. Since valuation is not affected by the treatment of operating leases, capitalizing operating leases is not a useful activity for analysts.

Response: [Capitalizing operating leases is a critical step in competitive benchmarking. Companies that use more operating leases will have higher raw ROICs, leading to misperceptions of their relative performance. Thus, even if you choose not to adjust the valuation for operating leases because this will not affect your final figures, always benchmark performance with adjusted numbers.

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.

Response: [Rental expenses are usually not explicitly shown as a separate line item on the income statement, and the value of the asset is usually not disclosed.]

Multiple Choice

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

Response: [Asset value = $2,500/(0.062 + 1/10) = $2,500/0.162 = $15,432.10]

True/False

15. The interest rate for operating lease adjustments is usually higher than the firm’s cost of debt.

Response: [The interest rate for operating lease adjustments is usually lower than the firm’s cost of debt. This is because that interest expense is secured with the leased assets.]

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.

Response: [As the cost of debt or asset life deviates from these values, the 8-times multiplier could lead to incorrect assessments.]

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.

Response: []

18. Researchers at Ohio State University found that interest rates on unrated, unsecured debt were explained better by credit statistics adjusted for operating leases.

Response: []

19. Investors, lenders, and rating agencies tend to interpret operating leases the same as traditional debt.

Response: []

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.

Response: []

21. Many companies securitized their accounts receivable before the financial crisis of 2008; however, after the financial crisis, this practice largely stopped.

Response: [Due to liberal accounting policies, if a firm sold its receivables, they were taken off of the balance sheet. This improved closely scrutinized operating metrics like operating cash flow and ROIC. After the financial crisis, accounting policies became stricter, and securitized receivables were classified as secured borrowing. Coupled with tighter credit policies from banks, this substantially reduced the receivables securitization programs.]

Multiple Choice

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

Response: []

True/False

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.

Response: [Excess pension assets should be treated as nonoperating, and unfunded pension liabilities should be treated as a debt equivalent. With respect to taxes, valuations should be done on an after-tax 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.

Response: [This does not mean that the plan is fully funded. Many firms will consolidate prepaid pension assets into accounts like "other long-term assets." Unfunded pension liabilities are often included in "other long-term liabilities." This points to the importance of reading the pension footnote to find the true nature of pension obligations and to remove nonoperating assets or liabilities from accounts on the balance sheet that might be deemed part of invested capital.]

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.

Response: [Interest costs, expected returns on plan assets, and amortization of losses are related to the performance of the plan assets, not the operations of the business. Therefore, they should not be included in wages and benefits to determine NOPLAT.]

26. Classification of amortization of prior service cost and curtailment (or settlement) loss (or gain) will depend on the purpose of analysis.

Response: [Classification of amortization of prior service cost and curtailment (or settlement) loss (or gain) will depend on the purpose of your analysis. If these two line items are used to forecast future cash flows, treat them as nonoperating, since the expense represents a past action and is already incorporated into the present value of benefits (and consequently 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.

Response: [Unadjusted operating profits = Revenues – Operating costs = $1,000 – 600 = $400; Adjusted operating profits = Revenues – Operating costs + Net periodic cost – Pension service cost = $1,000 – 600 + ($150 + $700 – $500) – $150 = $600]

True/False

28. Over- or underfunded pension status must be incorporated into value as a nonoperating asset or as a debt equivalent.

Response: [To incorporate pensions for a company with net excess assets, increase enterprise value by the product of (1 – marginal tax rate on pensions) times net pension assets, as excess pension assets will lead to fewer required contributions in the future. To value companies with net unfunded liabilities, reduce enterprise value by the product of (1 – marginal tax rate) times net pension liabilities.]

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.

Response: []

Multiple Choice

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.

Response: [Operating leases tend to be most prevalent in industries such as airlines and hospitals that use large, easily transferable assets.]