Option 2: Capitalize Using Actual Terms
The mechanics of this adjustment affect income differently than treatment as a capitalized lease; instead of calculating the depreciation expense, the pre-tax cost of debt is applied to the capitalized amount to ascertain the implied interest expense. This amount is then added back to income, leaving only the depreciation expense to flow through NOPAT.
As in the
treatment as a capitalized lease, this adjustment brings the cost of
equity into the lease treatment through the application of the cost of
capital to the capitalized amount. This option will also produce a
declining cost of ownership over time as the number of years to maturity
declines.
This treatment, however, does require very detailed information about each operating lease as it is tracked over its life. Management will have an incentive to enter into shorter lease agreements. Consequently, the leasing function must be centralized and management must be particularly mindful of the tradeoffs between shorter leases (and smaller commitments) and the increased risk associated with renewing the lease more often.