In this 3-part video series, we cover the conversion of operating leases to capital leases, a process known as the “lease capitalization”. In the final video, we apply the Capital, Income, Profitability, and FCF Adjustments to a real world company, CVS, and learn how these adjustments can impact the enterprise value multiples when conducting a comparable companies analysis or DCF.

The big reason why bankers capitalize leases centers on comparing one company to another. If Company A owns operating leases, off-balance sheet financing, and Company B owns capital leases, comparing EBITDA or EBIT multiples will be unfair. By adjusting the operating expense of an operating lease and calculating the imputed interest and depreciation associated with the present value of the liability, multiples of EBIT and EBITDA will more accurately reflect the true financial state of the company.

Definitions:

Operating Lease – Agreement which is signed for a period much shorter than the actual life of the asset while the PV of lease payments are generally much lower than the actual price of the asset.

Capital Lease – Agreement which generally lasts the entire life of the asset with the PV of lease payments covering the price of the asset. Oftentimes cannot be cancelled and has an option to buy the asset at a favorable price.

Great reading materials for topic of lease capitalization;
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