1999
Aswath Damodaran
ABSTRACT
Most firm valuation models start with the after-tax operating income as a measure of the operating income on a
firm and reduce it by the reinvestment rate to arrive at the free cash flow to the firm. Implicitly, we assume
that the operating expenses do not include any financing expenses (such as interest expense on debt). While this
assumption, for the most part, is true, there is a significant exception. When a firm leases an asset, the accounting
treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease
expenses are treated as part of the operating expenses, but we will argue that they really represent financing
expenses. Consequently, the operating income, capital, profitability and cash flow measures for firms with operating
leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have significant
effects not just on valuation model inputs, but also on some multiples such as Value/EBITDA ratios that are widely
used in valuation.
Damodaran: (212) 998-0349 adamodar@stern.nyu.edu
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