Finance Lease vs Operating Lease: EBIT higher or lower?

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youreskimofriend

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Hey,
If I remember correctly, EBIT should be higher under the finance lease, right? Schweser says so on several occasions
“In a finance lease, rent expense is replaced by depreciation expense and interest expense. Since EBIT is calculated before interest and taxes, EBIT is higher with a finance lease.”
I have a question in front of me (ID 87570), where I need to capitalize operating leases. I would think this is the same as adjust them as if they were finance leases, right? But in the solution it turns out that EBIT is lower now. The old EBIT was 88, rent is (PV x interest rate) 24, and depreciation is 30. So the new EBIT is actually lower with 82.
I thought the increase in EBIT through not paying rent should offset the depreciation because the rent is split up into depreciation and interest but in this example the rent is the same as interest.
Can anybody help?
Thanks!
 
EBIT is higher under finance leases. Primarily because you don’t expense the lease payment, you only take a dep charge and a interest charge.
 
2 components of expense in finance lease: depreciation and interest. When taken together, they total more than just the rental expense (in the early years). However, only depreciation is deducted before arriving at EBIT. And depreciation alone is less than the total rental expense.
 
pokhim wrote:
EBIT is higher under finance leases. Primarily because you don’t expense the lease payment, you only take a dep charge and a interest charge.
Click to expand...
 
Yes, thanks, I realize that normally the finance lease should have a higher EBIT. Thats what the book says. But I am still confused because the only example I ever encountered where I actually had to calculate the new EBIT, it turned out to be lower not higher:
MAC reported the following data:
Rent expense:24 mio
Depreciation: 17mio
EBIT: 88 mio
Interest expense: 22 mio
Total assets: 500 mio
Long term debt: 150 mio
Capital lease obligations: 100 mio
Total equity: 250 mio.
MAC also reported that the present value of its operating leases at the beginning of the year was $240 million at 10% interest rate. The term on the leases was 8 years. What are the effects on the leverage (liabilities / total capital) and times interest earned if an analyst chooses to capitalize the leases using a straight-line depreciation assumption? Leverage measures:
A) increase to 65% from 50% and times interest earned decreases to 1.78 times from 4 times
B) increase to 65% from 50% and times interest earned decreases to 1.33 times from 4 times
C) remain unchanged and times interest earned decreases to 1.23 times from 4 times
Correct answer: A
The income statement is affected in the following way:
Reported EBIT: 88
+ rent: 24
= EBIT excl. cost of operating leases: 112
- depreciation of operating leases: 30 (240/8)
=adjusted EBIT: 82
Interest expense will increase by $24 million ($240 million × 0.10) to $46 million. Therefore times interest earned decreases to 1.78 times (82 / 46). Recall that when capitalizing operating leases interest expense is calculated as the present value of the lease obligations multiplied by implied interest rate.
So why is EBIT lower after the lease has been capitalized? The only answer I can think of is - capitalizing operating leases is not the same as adjusting operating leases as if they were finance leases. But how would the adjustment that ends up with a higher EBIT be different?
 
This question is messed up. We don’t know whether Long term debt of 150 mio includes Capital lease obligations of 100 mio and whether depreciaiton includes this 100 of capital lease of not. The losest I got to the answer was 1,7 times innteres earned.
Generally speadking under capital lease EBIT should be higher than under operating lease and so does CFO.
 
Sorry, I left out the solution for the leverage part:
Total assets: 710 (500 + 240 - 30)
Value of operating leases: 240
Long term debt: 150 (unchanged)
Capital lease obligations 100 (unchanged)
Total equity: 250 (unchanged)
Therefore, the leverage measure is 0.66 ((240 + 150 + 100) / (240 + 150 + 100 +250))
Yes, indeed a very messed up question. No idea what to make of this decrease in EBIT…
 
That’s why developing a proper CFA level 2 mock test is complex, costly and time consuming task. If thats not the case, the more you do the more you get confused.
 
EBIT is lower (interest expense + depreciation > lease payments) in the early stages of the lease but becomes higher as interest expense decreases (depreciation stays the same).
 
qorghdud wrote:
EBIT NI is lower (interest expense + depreciation > lease payments) in the early stages of the lease but becomes higher as interest expense decreases (depreciation stays the same).
Click to expand...
 
Ya, I agree with Xander. EBIT doesn’t include interest, so its just the depreciation component that is factored in to EBIT.
Depreciation will always be lower than the operating lease payments, so lower depreciation in EBIT compared to operating lease expense means higher EBIT.
**ASSUMING STRAIGHT LINE**
Typo in the question/answer maybe?
 
Just want to find out, if we use accelerated depreciation method to reflect the economic reality eg. production capability of the asset/lease is known to drop drastically in the first few years at a decreasing rate, will the depreciation always be lower than the operating lease payments? Or we just don’t care, just straight-line no matter what in real world?
 
Ah yes, if you use accelerated depreciation EBIT could be different. I should have pointed it out before that my answer assumed straightline depreciation.
In the case of accelerated just calculate what the depreciation would be the first year and see if it is higher than the operating lease payments.
 
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