Operating & Capital Leases
Big 5 Sporting Good’s reasons for leasing its stores:
1. To conserve cash: By taking a lease rather than paying the entire cost of an asset upfront, Big 5 only pay relatively small monthly payments.
2. Tax deductible: Store leases payment are structured to be a deductible expense. However, if one purchases the asset, one has to capitalize and depreciate the asset which slows the recovery of costs.
3. Better Asset to Liability ratio: Recording liability is not required for the future payments under operating lease. Not only that, cash does not have to be paid up front. This will most likely improve asset to liability ratios.
4. Lower start-up costs: One store only requires investment of approximately $0.6 million in fixtures, and $0.4 million in net working capital. Leasing makes fast expansion possible.
For capital leases in 2010, Big 5 recorded (1) principal lease payments $2,284, (2) …show more content…
This means the debt ratio increased. Under an operating lease, debt equity ratio was 0.62. After capitalizing lease, debt-equity ratio goes up to 2.18. A capitalized lease would make Big 5’s performance look worse. Capitalized leases will also have a negative impact on the ROA. This will lower the ROA as it records the full value of the assets in the accounting records.
Enterprise Value Assessment
Using the Free Cash Flow evaluation, we do not agree with Deutsche Bank. Free Cash Flow of 2011 is discounted by WACC (10.95%), giving enterprise value of $5,316,401. Enterprise value is then divided by shares outstanding (21,832) which results in $24/share.
However, if the operating leases are capitalized in the balance sheet, the share price goes up to $38/share. This is due to the increased debt which then increased the value.
In summary, the benefits of not capitalizing on the lease outweighs the benefits of an increase in share
Big 5 Sporting Good’s reasons for leasing its stores:
1. To conserve cash: By taking a lease rather than paying the entire cost of an asset upfront, Big 5 only pay relatively small monthly payments.
2. Tax deductible: Store leases payment are structured to be a deductible expense. However, if one purchases the asset, one has to capitalize and depreciate the asset which slows the recovery of costs.
3. Better Asset to Liability ratio: Recording liability is not required for the future payments under operating lease. Not only that, cash does not have to be paid up front. This will most likely improve asset to liability ratios.
4. Lower start-up costs: One store only requires investment of approximately $0.6 million in fixtures, and $0.4 million in net working capital. Leasing makes fast expansion possible.
For capital leases in 2010, Big 5 recorded (1) principal lease payments $2,284, (2) …show more content…
This means the debt ratio increased. Under an operating lease, debt equity ratio was 0.62. After capitalizing lease, debt-equity ratio goes up to 2.18. A capitalized lease would make Big 5’s performance look worse. Capitalized leases will also have a negative impact on the ROA. This will lower the ROA as it records the full value of the assets in the accounting records.
Enterprise Value Assessment
Using the Free Cash Flow evaluation, we do not agree with Deutsche Bank. Free Cash Flow of 2011 is discounted by WACC (10.95%), giving enterprise value of $5,316,401. Enterprise value is then divided by shares outstanding (21,832) which results in $24/share.
However, if the operating leases are capitalized in the balance sheet, the share price goes up to $38/share. This is due to the increased debt which then increased the value.
In summary, the benefits of not capitalizing on the lease outweighs the benefits of an increase in share