![]() VALUATION WITH PRE AND POST TAX CASHFLOWS FREESince neither of these expense items are part of free cash flow, then you should not need to make any separate adjustments and the lease payments will be automatically excluded. If you have adjusted your forecasts to reflect IFRS 16, then the old operating lease expense will have been replaced by the depreciation of the right of use asset and interest on the lease liability. In practice, enterprise free cash flow calculations generally start with a profit measure such as EBITDA or NOPAT, with separate adjustment for working capital changes, capital expenditure and other items to derive free cash flow. Therefore, do not include lease payments in enterprise free cash flow unless they relate to elements of leases that are not subject to capitalisation, such as those related to short-term leases or certain variable lease payments. Here are the 4 steps you need … Step 1: Exclude the former operating leaseįor capitalised leases, the lease payments represent a repayment of finance and not an operating expense or operating cash out flow. The key thing to remember is to treat lease liabilities and the related flows as financing for all aspects of DCF analysis. But if done correctly you should find that there is no change to your DCF value. It means changing the cash flows, the discount rate applied to those cash flows, and also the adjustments to convert your DCF derived enterprise value to the implied equity value. Updating a discounted enterprise cash flow model for the effects of IFRS 16 is more challenging. If you use the discounted equity cash flow approach (including the dividend discount model) then IFRS 16 has little or no effect because both equity free cash flow and the cost of equity are unaffected by whether leases are capitalised or not. This is the most common and, in our view, the best approach to DCF. Just to be clear, we are talking about enterprise value based DCF models. We initially focus on lease accounting under IFRS 16. Getting your DCF model right is now much more important. However, capitalised leases will be a significant feature for a much wider range of companies post IFRS 16. The problem is that few companies had finance leases that were material enough to necessitate their separate treatment in DCF models. The issue with leasing in DCF analysis is not new because you are already dealing with finance leases in your current DCF model. Increase in capitalised leases makes separate consideration in DCF analysis more important Unless you are careful when adjusting for IFRS 16, your DCF model can go badly wrong. Both operating cash flow, as a component of enterprise free cash flow, and net debt are key components in an enterprise value based DCF analysis. The problem is that, under IFRS 16, cash flows are reclassified, which impacts the measurement of operating cash flow, and new debt appears on the balance sheet. However, IFRS 16 creates challenges for DCF modelling that do not arise from any of the other recent accounting changes Therefore, you would think that equity values produced by discounted cash flow models would be unaffected by the additional capitalisation of leases under IFRS 16. We all know that a change in financial reporting does not affect fundamental value (unless, of course, there are secondary effects such as an impact on tax cash flows). ![]()
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