Effect of capital lease

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saurya_s

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Hi all,
Can somebody elaborate on effect of capital lease on:
1. Interest coverage ratio
2. Net Income
3. Return on Equity
 
interest coverage ratio will increase because operating income will be higher (in cap leases you deduct depreciation while operating you deduct rent expense)
Net Income will be lower in the earlier years of the lease however in the later years it will increase. (total NI under operating and capital leases are the same, just allocated over different periods)
ROE will descrease because of lower NI in the beginning of the lease
 
Interest coverage= EBIT/Interest expense
Under capital lease, you capitalize the asset hence:
-total assets increase (remember after it will at net of accumulated depreciation)
- total equity increase for the same amount of total assets
In the income statement:
- You report the depreciation expense for the year
- and the interest expenses also
Therefore
Net Income decrease
interest coverage decrease
however at the end of the leasing the situation reverse
 
Wouldn’t interest coverage ratios be lower for a capital lease. (Assuming the % change in EBIT is smaller than the % change in interest expense)
 
Nope
Capital lease: lower interest coverage because interest expenses are created from the capital lease
Operating lease: Higher interest coverage
 
operating income is higher under cap leases,
I just check with the book to confirm and is says that cap leases lead to a higher interest coverage ratio
 
getterdone Wrote:
——————————————————-
> operating income is higher under cap leases,
>
> I just check with the book to confirm and is says
> that cap leases lead to a higher interest coverage
> ratio
In stalla says lower interest coverage ratio under capital lease. :-)
 
forget it guys, i just read that its an increase in ebit which is operating profit, however you are right interst coverage will decrease because of interest exxpense
my bad guys
 
Under a capital lease, the periodic payment goes toward principal and interest. Depreciation also gets deducted. Not only EBIT goes lower down when compared to an operating lease, but you also have higher IE in the denominator of EBIT/IE. At least at the beginning of the lease.
As you approach the end-term of the lease and you completed the depreciation and EBIT increases, you also have lower IE because of the constant repayment (higher and higher repayment of principal), so the ratio becomes higher.
 
map1, operating income is larger because the interest expense gets charged after EBIT.
the operating lease rent expense will be higher than depreciation therefore cap leases will have higher EBIT
 
From CFAI book pag. 523:
“In general, firms with operatig leases report higher profitability, interest coverage (as interest expense is lower), ROE and ROA”.
 
I am confused now. Can somebody clarify the conclusion?
 
saurya_s Wrote:
——————————————————-
> I am confused now. Can somebody clarify the
> conclusion?
Under Capital lease you have:
-Lower Net Income
- Lower Interest coverage
- Lower ROE
 
In the early years of the capital lease, the NI is lower, but it increases as we approach the end-term of the lease (lower expenses in relation to the lease). As NI gets higher, RE gets higher, E gets higher, ROE gets higher.
Return ratios always follow the profit ratios: they move in the same direction. When the profit ratio grown, both ROA and ROE grow, when profit ratio regresses, so does ROA and ROE (NI effect).
 
map1 Wrote:
——————————————————-
> In the early years of the capital lease, the NI is
> lower, but it increases as we approach the
> end-term of the lease (lower expenses in relation
> to the lease). As NI gets higher, RE gets higher,
> E gets higher, ROE gets higher.
>
> Return ratios always follow the profit ratios:
> they move in the same direction. When the profit
> ratio grown, both ROA and ROE grow, when profit
> ratio regresses, so does ROA and ROE (NI effect).
This is also true because at the end of the lease the total costs of capital lease (Interest + depreciation) is equal to the total rent expenses paid under operating lease. Hence, there are only differences at the early stage of the lease, but during the years the situation reverse and at the end of the leasing the total cash flow will be the same
 
Hmmm… not really. Over time, a capital lease payment (which is exactly the same in value with an operating lease payment) goes toward interest and repayment of principal, and IE gets lower and lower, which makes CFO higher (meaning the company will have higher CFOs) becaue the IE becomes lower and lower. In the same time, the principal repayment is higher and higher, CFIs of the company are lower and lower (because a larger amount is outflow for repayment of principal). Not really connected with depreciation, which is a noncash expense.
 
strangedays, do you have Stalla’s PassMaster? Check L1-02934.
 
map1 Wrote:
——————————————————-
> strangedays, do you have Stalla’s PassMaster?
> Check L1-02934.
Nope I dont have it…why?
 
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