On Operating Lease-Adjusted Betas

After some thought, I think I’ve figured out how operating lease-adjusted betas work.  Basically, betas are a closed world, and all forms of leveraging are attempts to distribute the betas in a group around a mean, using techniques including looking at the various forms of leverage.  The higher the proportion of fixed payments a company has, the riskier it is.  I could treat operating leases straight as debt, or discount it, or not treat them at all.  I suspect the best approach would be to discount operating leases a bit, and to discount future aircraft purchases even more, based on the idea that aircraft purchases might be a bit easier to escape than operating leases on existing assets.

Further, these adjustments to beta don’t need to touch cost of capital.  Cost of capital and the FCFF are related in the sense that COC dictates what percentage of the free cash flow satisfies “debt” holders, and which proportion “equity” holders.  So it would be fine to use a COC that includes operating leases or aircraft purchases, but only if I could completely and accurately separate those out of operating income.  I can’t do that, and trying would introduce an addition point of possible error.  More points of error will just tend to lead to higher aggregate error, I suspect, so it’s a bit of a fool’s errand until operating leases are capitalized in 2019.

Return on Capital and Length of Leases

In return on capital calculations, the formula is generally operating income (annual) divided by total capital invested, to form a return on capital.  This figure can be used for various things, such as determining whether a company is making good investments by comparing the return on capital to a cost of capital.  The total capital can also be adjusted to include operating leases, by calculating a present payment of all future expenses on an operating lease, as described by Damodaran.  However, this number is also easily altered by adjusting the length of operating leases, disconnected from the true value or returns of a company.

Continue reading “Return on Capital and Length of Leases”