How current societies engage in civic life (society organizations) - Free Essay Example

Sample details Pages: 4 Words: 1196 Downloads: 9 Date added: 2018/12/14 Category Sociology Essay Type Research paper Level High school Did you like this example? Civic engagement in accordance with the American Psychological Association is individual as well as communal actions premeditated to recognize and address issues of community concern. It might be described as citizens working jointly to make an amendment or difference within the community. Civic engagement embraces communities functioning jointly in both political and non-political events. Don’t waste time! Our writers will create an original "How current societies engage in civic life (society organizations)" essay for you Create order The objective of civic engagement is to deal with community concerns and support the superiority of the community. Sociologists build up theories to enlighten social occurrences. A theory is an anticipated relationship involving two or more perceptions. In other terms, a theory is clarification for why or how an event occurs. An instance of a sociological theory is the effort of Robert Putnam on the reject of civic engagement. Putnam established that Americans participation in civic life (e.g., community organizations) has turned down over the preceding 40 to 60 years (Lichterman Potts, 2009). Despite the fact that there are an amount of factors that donate to this decline (Putnams theory is fairly complex), one of the well-known factors is the amplified utilization of television as a form amusement. Putnams theory proposes. This aspect of Putnams theory clearly demonstrates the essential purpose of sociological theory: it recommends a relationship linking two or further concepts. I n these circumstances, the concepts involve civic engagement as well as television watching.  The link is an inverse one as one goes up, the other goes down. Whats more, it is an explanation of one phenomenon with another: element of the explanation why civic engagement has turned down over the last numerous decades is for the reason that people are gazing at more television. Putnams theory obviously includes the key basics of a sociological theory. The Functionalist Perspective The Functionalist Perspective is a sociological theory which initially attempted to clarify social institutions as communal means to meet individual natural needs. Later it emerged to spotlight on the ways social establishment meet social requirements. Functionalist Perspective draws its motivation mainly from the opinions of Emile Durkheim. Durkheim was alarmed with the issue of how societies sustain internal permanence and endure over time. He wanted to explain social consistency and stability in the course of the concept of unity. In more prehistoric societies it was involuntary solidarity, everybody performing comparable tasks, which held society together. Durkheim anticipated that such societies have a tendency to be segmentary, being self-possessed of equivalent parts that are held mutually by shared values, ordinary symbols, or systems of interactions. In current, complex societies associates perform very dissimilar tasks, resultant in a well-built interdependence involving individuals (Elolia Adogame, 2012). Anchored in the symbol of an organism where many parts operate together to maintain the whole, Durkheim disputed that modern multifaceted societies are held mutually by organic unity (consider interdependent organs). The innermost concern of Functionalist Perspective is a persistence of the Durkheimian mission of explaining the noticeable stability and interior cohesion of culture that are essential to make sure their sustained survival over time. A lot of functionalists dispute that social societies are functionally incorporated to form a steady organization and that a transform in one organization will swift a change in other organizations. Societies are observed as logical, bounded and basically relational erect that task as organisms, with a variety of parts (social organizations) working mutually to sustain and replicate them. The different parts of society are implicit to work in an insensible, quasi-automatic manner towards the preservati on of the largely social stability. All social as well as cultural phenomena are thus observed as being functional within the sense of working jointly to attain this status and are efficiently considered to have an existence of their own. These mechanisms are subsequently primarily examined in provisions of the task they play. Durkheims strongly Functionalist Perspective of society was sustained by Radcliffe-Brown. Subsequently, Auguste Comte, Radcliffe-Brown assumed that the communal constituted a disconnect level of actuality distinctive from both the natural and the lifeless. Clarification of social phenomena thus had to be constructed in this social level, with people simply being transient inhabitant of moderately stable social responsibility (Elolia Adogame, 2012). As a result, in structural-functionalist consideration, people are not important in and of themselves although only in conditions of their? social position: their situation in patterns of social relationships. The social organization is thus a network of statuses linked by associated responsibilities. The Functionalist Perspective, originate from the thoughts of Karl Marx, who alleged society is a self-motivated entity continually undergoing alteration driven as a result of class conflict. Although functionalism recognizes society as a multifaceted system striving for stability, the conflict perspective on the other hand analysis social existence as competition. In accordance with the Functionalist Perspective, culture is fabricated of individuals contending for restricted resources (such as money, leisure, sexual associates, etc.). Competition over limited resources is at the compassion of all social relations. Competition, moderately than consensus, is feature of human associations. Broader social makeup and organizations (such as religions, government) replicate the competition for assets and the intrinsic inequality opposition entails; a number of people and associations have extra res ources (e.g. power and authority), and apply those assets to maintain their point of authority in society. For instance, Functionalist Perspective theorists may civic life movements as a result of studying how activists disputed the racially uneven distribution of biased power and financial resources. As within this example, conflict theorists normally see social modify as unexpected, even radical, moderately than incremental. Within the conflict perspective, modify comes about in the course of conflict involving competing interests, not agreement or version. Conflict theory, thus, gives sociologists an outline for explaining social change, thus addressing one of the tribulations with the functionalist standpoint. Functionalist Perspective is a hypothetical advance to accepting the connection linking humans and society. The fundamental notion of symbolic interactionism is that individual action and relations are comprehensible simply through the substitute of significant communic ation or symbols. Within this approach, humans are depicted as acting, as divergent to being performed upon. The main beliefs of symbolic interactionism are: Individuals act toward issues on the basis of the implications that issues have for them. As a result, these implications happen out of social relations. This perspective is as well based on phenomenological idea (Elolia Adogame, 2012). In accordance with symbolic interactionism, the aim world has no actuality for humans; simply personally defined objects have implication. There is no particular objective actuality; there are simply (possibly numerous, possibly contradictory)? understanding? of a situation. Implications are not things that are granted on humans and cultured by training; as an alternative, meanings can be changed through the imaginative capabilities of individuals, and those might manipulate the many meanings that outline their society. Individual society, thus, is a social invention. References Top of Form Lichterman, P., Potts, C. B. (2009).? The civic life of American religion. Stanford, Calif: Stanford University Press. Top of Form Elolia, S. K., Adogame, A. U. (2012).? Religion, conflict, and democracy in modern Africa: The role of civil society in political engagement. Eugene, Or: Pickwick Publications. Top of Form Joseph, P. (2007).? American literary regionalism in a global age. Baton Rouge: Louisiana State University Press. Bottom of Form Bottom of Form Bottom of Form

Power Of Ceo / Chairman - 1005 Words

Increased power of CEO/Chairman Most of the publicly owned companies are against combining the roles; they vote for an independent chairman to help control the board and balance the power. Shareholders do have the right to have the best representation of their interests and independence. In case of combined roles, the CEO sets the agenda for the board or, basically, himself, there is a conflict of interests and supervision. The percentage of firms that do vote for splitting these roles is constantly increasing. Since the corporations are required to have board to oversee the management and ensure that it reflects best interests of shareholders, the argument for separating the roles is constantly rising. Another argument is that combining†¦show more content†¦However, before splitting these roles up, each company has to decide which is best for them. Many companies consider if one person is skilled enough, can objectively run the company and represent shareholders interests, be responsible for company’s performance, and decide which is better for the long-term interest. In some companies it has been a routine meeting or even debate of keeping two different people in this position, mostly driven by shareholder activists. It was absolutely obvious to the board that one person can fulfill both roles and act quickly enough in taking corporate initiatives. On the other hand, issue with conflicts of interests, decision-making, and possible corruption has risen many times. Also, it makes more difficult to the board objectively evaluate the CEO/Chairman if one person hold the spot. By holding the roles in hands of tow different people, the two executives can focus better on the company rather than on its own benefits (compensation package or else), the CEO can better focus on daily operations while the chairman will be focusing in overseeing the regulations, board members, and, most importantly, strategic and succession planning. The trend of keeping rising on keeping these roles separate, the board can prioritize its independence from the CEO. More than 40% of the companies have followed the trend, however, the

The McDonaldization Free Essays

string(143) " This can be attributed to the fact that they do not pre-make their burgers and leave them under heat lamps to sit like McDonald’s does\." â€Å"McDonaldization† — as used by George Ritzer, author of The McDonaldization of Society — refers to the creation of â€Å"rationalized systems† to perform everyday functions such as food preparation, retail sales, banking, home construction, entertainment, news delivery and so on. He calls it McDonaldization because such methods were used to famous effect by Ray Kroc, who built McDonald’s into a fast-food empire — and because in many people’s minds McDonald’s represents the results, both good and bad, that occur when rationalized systems take over. But has this transition affected other businesses either positively or negatively? Why sure, thanks for asking! I think the best way to examine McDonaldization is to compare the analysis of McDonalds to its effects in the same industry. We will write a custom essay sample on The McDonaldization or any similar topic only for you Order Now The way I plan to do this is to see if the effects of McDonaldization have effect the Wendy†s franchise. The information that I know about this business comes from my brother working for this company for many years and partaking in a triple-cheeseburger or two in my short college career. The way that Wendy’s Old Fashioned Hamburgers does business and markets it’s product to consumers is due to the change in our society to where the consumer wants the biggest, fastest, and best product they can get for their money. This change in society can be attributed to a process known as McDonaldization. Although McDonaldization can be applied to many other parts of our society, this paper will focus on its impact on Wendy’s Old Fashioned Hamburgers. My belief is that the process of McDonaldization, where the ideology of McDonald’s has come to dominate the world, has caused Wendy’s Old Fashioned Hamburgers to emulate McDonald’s style of running a franchised restaurant chain in terms of efficiency, calculability, and control. However, since McDonald’s has become the embodiment of â€Å"fast-food† in our society, Wendy’s Old Fashioned Hamburgers has had to change their focus to giving the consumer a higher quality product in a relatively fast amount of time. So, Wendy’s still caters to a McDonaldized society in terms of giving them a meal as fast as possible but making quality their number one priority to give people a viable option from McDonald’s. In addition, as mentioned before, I have used my brother who managed to keep a job at Wendy’s for a short period and observations I gathered while at McDonald’s as further information for this paper. First, before I discuss the impact of McDonaldization on Wendy’s Old Fashioned Hamburgers, I will define what McDonaldization is. McDonaldization is the process by which the principles of fast-food restaurants are coming to dominate more and more sectors of American society, as well as, of the rest of the world. George Ritzer created this concept of McDonaldization as a continuation of Max Weber’s theories on bureaucracies (I hope). Max Weber defines a bureaucracy as a large hierarchical organization that is governed by formal rules and regulations and has a clear specification of work tasks. Its three main characteristics are that it has a division of labor, hierarchy of authority, and an impartial and impersonal application of rules and policies (see what I got from Sociological Theory). Thus, from that definition of a bureaucracy, one would conclude that both McDonald’s and Wendy’s Old Fashioned Hamburgers are bureaucracies. The fact that both restaurants are bureaucracies is supported by the fact that each assigns workers to a specific job where each worker individually contributes to the overall success of the restaurant by doing his or her job. For example, workers at each restaurant could be assigned to working the grill, making fries, working the front register, or taking orders at the drive-thru window. Both restaurants have a hierarchy of authority from worker, crew chief, shift manager, salary manager to owner of the store. Also, each restaurant enforces an impartial and impersonal application of rules and policies. Both McDonald’s and Wendy’s have standard, impersonal greetings at the register and at the drive-thru window. The exception when this impersonal attitude towards the customer is changed is when a worker knows the customer outside the restaurant. In this case, the worker will probably ask their acquaintance how they are doing or what they are up to. The worker might even throw in an extra cheeseburger that a regular customer might not get. Despite this exception where standardization is broken, both these restaurants have become bureaucracies because they are the most efficient means of managing large groups of people. That leaves one to wonder why the process of McDonaldization has been so successful for both companies. The first reason is that it offers efficiency where consumers know that it means the quickest way to get from one point to another. In the case of McDonald’s, it offers the best available way to get from being hungry to being full. This is so important in today’s society because so many people are in a rush to get from one place to another. Therefore, the quick, efficient setup of McDonald’s allows consumers to eat a fast-food meal without having to leave their car. On the other hand, Wendy’s strives for as efficient service as possible without affecting the quality of their product. This is because McDonald’s already has imprinted on people’s minds throughout the many years of its existence that they will get the same burger each visit in the quickest amount of time. They reinforce this idea on the minds of consumers through advertising and other clever tools. For example, on every McDonald’s sign is a tally of how many people in the world have eaten there, which is currently at 99 billion served. The use of this sign reinforces to people that McDonald’s is an icon in our society and many people will equate that large number with McDonald’s being the best restaurant. As a result, Wendy’s has tried to make quality their number one priority but with no serious deficiencies in the speed of their product. This can be attributed to the fact that they do not pre-make their burgers and leave them under heat lamps to sit like McDonald’s does. You read "The McDonaldization" in category "Essay examples" Instead, they have their staff assembled to make the burger as the customer orders it. This is an especially important benefit because many people like to â€Å"customize† their burger and the process that Wendy’s uses allow them to do that. This allows them to target another group of society, which McDonald’s product doesn’t appeal to. For example, older people who would rather sit down and have a quality meal would most likely rather go to Wendy’s Old Fashioned Hamburgers. Even, the name of Wendy’s Old Fashioned Hamburgers suggests that their style is more like how things used to be done many decades ago in terms of making quality the number one priority for a restaurant. Therefore, they would provide an alternative for people who were not interested in getting a burger that has been slopped together and sitting under a heat lamp for an hour. This would be reflected in which demographic of people each restaurant targeted. McDonald’s traditionally has targeted families as their key demographic but recently they have shifted to make their product more appealing to teenagers as well. This can best be demonstrated in their new style commercials that use many young adults and refers to McDonald’s as â€Å"Mickey D’s† as a hip place to hang out. So, for young people who are in a rush to get from place to place, McDonald’s provides a fast, cheap meal that they can eat on the run. On the other hand, Wendy’s Old Fashioned Hamburgers targets people who aren’t in such a rush and would rather sit down and eat a slow, relaxing meal (is this ageism). They still cater to those who are in a rush by offering a drive-thru. However, they know that most of their business will come from people looking for a quality alternative to McDonald’s. Another aspect of McDonaldization that has made both companies successful is calculability. This is where each restaurant puts an emphasis on quantitative aspects of products sold like portion size and cost. For example, McDonald’s has burgers like the â€Å"Quarter Pounder† and â€Å"Big Mac† while Wendy’s Old Fashioned Hamburger has burgers like the â€Å"Double Bacon Cheeseburger†. This use of descriptive adjectives suggests to the consumer that they are getting the most amount of food for their money. Both McDonald’s and Wendy’s have the option to â€Å"Supersize† or â€Å"Biggiesize† an order. This makes the companies successful in our society because of our belief that bigger is better. Finally, both companies use control, especially through the substitution of non-human for human technology. For both companies that means using soft drink machines that automatically shuts off when the glass is full, french-fry machines that rings and lifts itself out of the oil when the fries are done, and the preprogrammed cash registers that eliminate the need for the cashier to calculate any prices. The main reason that this is done is because,† [people are] The great source of uncertainty, unpredictability and inefficiency in any rationalizing system. Thus, by increasing control, through increased mechanization, both companies maintain a better control over the entire organization. Also, this leads to employees not having to think about their job because the tasks they are asked to do are very repetitive. In conclusion, it is obvious that both restaurants have adopted a style of running their restaurants that makes them successful. McDonald’s style is to give the public the same burger that they have always had so that they can come to depend that they will get the same meal as they did last time. They have been a pioneer in the fast-food industry and the model that other restaurants try to imitate. On the other hand, Wendy’s style is to make a quality product that reminds people of the â€Å"good old days†. They have been directly influenced by McDonald’s in terms of how to run their fast-food restaurant to maximize speed and efficiency. However, since Wendy’s Old Fashioned Hamburgers would not have a chance of competing with McDonald’s at their own game, they have developed their own niche in the market of making a quality product efficiently. What concerns me is the way these companies are phasing out the roles of their employees to the point where they are doing nothing but mindless, repetitive tasks. To me, the consequence of this will be that someday all human workers will be replaced because it is more efficient for machines to do the work. So, although McDonaldization has made both these companies very successful, there is a very serious potential downside that could have an effect on everyone. Now there is no doubt that this text can be read on a number of different levels, some of which are far more satisfactory than others. Ritzer is clearly an accessible and engaging writer. For an undergraduate audience, which is unfamiliar with the language, and indeed, critical project of radical social theory, this text provides a worthy, and indeed somewhat enjoyable introduction. Keep in mind, though, that those four principles are not necessarily pursued from the point of view of the consumer. Efficiency, for example, may entail the placing of great inconveniences upon a consumer for the sake of efficient management. Calculability may involve hiding certain information from the consumer. Predictability and control may involve a company’s ability to predict and control consumer behavior, not the consumer’s ability to predict what kind of product or control what kind of service he gets. Ritzer calls such breakdowns â€Å"the irrationality of rationalization. † Even so, there is a great perception among American consumers in particular that McDonaldized systems succeed from their own point of view based on those criteria: the systems are perceived to be more efficient, the benefits calculable, the goods and services predictable. But it’s rare that the consumer will ever feel himself to be more in control. McDonaldized systems take away a great deal of consumer autonomy (which I love), making decisions and implementing processes on a mass-market scale with little room for individual involvement on the part of a single customer or even a single store or plant manager. The benefit of control is one that accrues exclusively to the company. Regardless of who benefits or to what extent, the universal result is homogenization. Rationalized systems have a pronounced tendency to squash-individual tastes, niche markets, small-scale enterprise and personalized customer service. Differences are leveled, wrinkles smoothed, knots cut off — convenience at the expense of character. An overwhelming normlessness develops, along with a decrease in responsiveness among the people of our society that are involved. The system that seeks to mimic a machine becomes a machine, incapable of making exceptions or taking risks. McDonaldization is taking over our society. In the future, our wishes of fast, more efficient services will be fulfilled; but whom in the world will we ever talk too? How to cite The McDonaldization, Essay examples

Damodaran on Capital and Operating Leases free essay sample

Dealing with Operating Leases in Valuation Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 [emailprotected] nyu. edu Abstract Most firm valuation models start with the after-tax operating income as a measure of the operating income on a firm and reduce it by the reinvestment rate to arrive at the free cash flow to the firm. Implicitly, we assume that the operating expenses do not include any financing expenses (such as interest expense on debt). While this assumption, for the most part, is true, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease expenses are treated as part of the operating expenses, but we will argue that they really represent financing expenses. Consequently, the operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have significant effects not just on valuation model inputs, but also on some multiples such as Value/EBITDA ratios that are widely used in valuation. The operating income is a key input into every firm valuation model, and it is often obtained from an accounting income statement. In using this measure of earnings, we implicitly assume that operating expenses include only those expenses designed to create revenue in the current period, and that they do not include any financing expenses. For the most part, accounting statements separate out financing expenses such as interest expense and show them after operating income. There is one significant exception to this rule, and that is created by the accounting treatment of operating lease expenses, which are categorized as operating expenses to arrive at operating income. We will make the argument in this paper that these expenses are really financing expenses, and that ignoring this misclassification can create significant problems in measuring and comparing profitability. We also suggest two ways in which we can recategorize operating lease expenses as financing expenses. The Accounting Treatment of Leases Firms often have a choice between buying assets and leasing them. When, in fact, assets are leased, the treatment of the lease expenses can vary depending upon how leases are categorized and this can have a significant effect on measures of operating income and book value of capital. In this part of the paper, we will begin by looking at the accounting treatment of leases and how it affects operating earnings, capital and profitability. Operating versus Financial Leases: Basis for Categorization An operating or service lease is usually signed for a period much shorter than the actual life of the asset, and the present value of lease payments are generally much lower than the actual price of the asset. At the end of the life of the lease, the equipment reverts back to the lessor, who will either offer to sell it to the lessee or lease it to somebody else. The lessee usually has the option to cancel the lease and return equipment to the lessor. Thus, the ownership of the asset in an operating lease clearly resides with the lessor, with the lessee bearing little or no risk if the asset becomes obsolete. An example of operating leases would be the store spaces that are leased out by specialty retailing firms like the Gap. A financial or capital lease generally lasts for the life of the asset, with the present value of lease payments covering the price of the asset. A financial lease generally cannot be canceled, and the lease can be renewed at the end of its life at a reduced rate or the asset acquired at a favorable price. In many cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these obligations up to the lessee; the lessee consequently reduces the lease payments, leading to what are called net leases. In summary, a financial lease imposes substantial risk on the shoulders of the lessee. While the differences between operating and financial leases are obvious, some lease arrangements do not fit neatly into one or another of these extremes; rather, they share some features of both types of leases. These leases are called combination leases. Accounting For Leases The effects of leasing an asset on accounting statements will depend on how the lease is categorized by the Internal Revenue Service (for tax purposes) and by generally accepted accounting standards (for measurement purposes). Since leasing an asset rather than buying it substitutes lease payments as a tax deduction for the payments that would have been claimed as tax deductions by the firm if had owned the asset (depreciation and interest expenses on debt), the IRS is wary of lease rrangements designed purely to speed up tax deductions. Some of the issues the IRS considers in deciding whether lease payments are tax deductible include the following: †¢ Are the lease payments on the asset spread out over the life of the asset or are they accelerated over a much shorter period? †¢ Can the lessee continue to use the asset after the life of the lease at preferential rates or nominal amounts? †¢ Can the lesse e buy the asset at the end of the life of the lease at a price well below market? If lease payments are made over a period much shorter than the asset’s life and the lessee is allowed either to continue leasing the asset at a nominal amount or to buy the asset at a price below market, the IRS may view the lease as a loan and prohibit the lessee from deducting the lease payments in the year(s) in which they are made. Lease arrangements also allow firms to take assets off the balance sheet and reduce their leverage, at least in cosmetic terms; in other words, leases are sometimes a source of off-balance sheet financing. Consequently, the Financial Accounting Standards Board (FASB) has specified that firms must treat leases as capital leases if any one of the following four conditions hold: 1. The life of the lease is at least 75% of the asset’s life. 2. The ownership of the asset is transferred to the lessee at the end of the life of the lease. 3. There is a â€Å"bargain purchase† option, whereby the purchase price is below expected market value, increasing the likelihood that ownership in the asset will be transferred to the lessee at the end of the lease. 4. The present value of the lease payments exceeds 90% of the initial value of the asset. All other leases are treated as operating leases. Effect on Expenses, Income and Taxes If, under the above criteria, a lease qualifies as an operating lease, the lease payments are operating expenses which are tax deductible. Thus, although lease payments reduce income, they also provide a tax benefit. The after-tax impact of the lease payment on income can be written as: After-tax Effect of Lease on Net Income = Lease Payment (1 t) where t is the marginal tax rate on income. Note the similarity in the impact, on after-tax income, of lease payments and interest payments. Both create a cash outflow while creating a concurrent tax benefit, which is proportional to the marginal tax rate. The effect of a capital lease on operating and net income is different than that of an operating lease because capital leases are treated similarly to assets that are bought by the firm; that is, the firm is allowed to claim depreciation on the asset and an imputed interest payment on the lease as tax deductions rather than the lease payment itself. The imputed interest payment is computed by assuming that the lease payment is a debt payment and by apportioning it between interest and principal repaid. Thus, a five-year capital lease with lease payments of $ 1 million a year for a firm with a cost of debt of 10% will have the interest payments and depreciation imputed to it shown in Table 1. Table 1: Lease Payments, Imputed Interest and Depreciation Year Lease Payment 1 2 3 4 5 $ $ $ $ $ $ 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 3,790,787 Interest Expense $ 379,079 $ 316,987 $ 248,685 $ 173,554 $ 90,909 Imputed Reduction in Lease Liability Lease Liability Depreciation $ 620,921 $ 3,169,865 $ 758,157 $ 683,013 $ 2,486,852 $ 758,157 $ 751,315 $ 1,735,537 $ 758,157 $ 826,446 $ 909,091 $ 758,157 $ 909,091 $ (0) $ 758,157 Total Tax Deduction $ 1,137,236 $ 1,075,144 $ 1,006,843 $ 931,711 $ 849,066 The lease liability is estimated by taking the present value of $ 1 million a year for five years at a discount rate of 10% (the pre-tax cost of debt), assuming that the payments are made at the end of each year. Present Value of Lease Liabilities = $ 1 million (PV of Annuity, 10%, 5 years) = $ 3,790,787 The imputed interest expense each year is computed by calculating the interest on the remaining lease liability: In year 1, the lease liability = $ 3,790,787 * . 0 = $ 379,079 The balance of the lease payment in that year is considered a reduction in the lease liability: In year 1, reduction in lease liability = $ 1,000,000 $379,079 = $ 620,921 The lease liability is also depreciated over the life of the asset, using straight line depreciation in this example. If the imputed interest expenses and depreciation, which comprise the tax deductible flows arising from the lease, are aggregated over the five years, the total tax deductions amount to $ 5 million, which is also the sum of the lease payments. The only difference is in timing –– the capital lease leads to greater deductions earlier and less later on. Effect on Balance Sheet The effect of leased assets on the balance sheet will depend on whether the lease is classified as an operating lease or a capital lease. In an operating lease, the leased asset is not shown on the balance sheet; in such cases, leases are a source of off-balance sheet financing. In a capital lease, the leased asset is shown as an asset on the balance sheet, with a corresponding liability capturing the present value of the expected lease payments. Given the discretion, many firms prefer the first approach, since it hides the potential liability to the firm and understates its effective financial leverage. What prevents firms from constructing lease arrangements to evade these requirements? The lessor and the lessee have very different incentives, since the arrangements that would provide the favorable â€Å"operating lease† definition to the lessee are the same ones under which the lessor cannot claim depreciation, interest, or other tax benefits on the lease. In spite of this conflict of interest, the line between operating and capital leases remains a thin one, and firms constantly figure out ways to cross the line. These conditions for classifying operating and capital leases apply in most countries; France and Japan are major exceptions –– in these countries, all leases are treated as operating leases. Effect on Financial Ratios The effect of leases on the financial ratios of a firm depends on whether the lease is classified as an operating or a capital lease. Table 2 summarizes types of profitability, solvency, and leverage ratios and the effects of operating and capital leases on each. The effects are misleading, in a way, because they do not consider what would have happened if the firm had bought the asset rather than lease it. ) Table 2: Effects of Operating and Capitalized Leases Ratio Return on Capital Effect of Capitalized Lease †¢ †¢ Decreases EBIT through depreciation †¢ †¢ Capital increases through †¢ present value of operating lease †¢ ROC is lower Return on Equity †¢ Net income lowered by after-tax †¢ Net income lowered by lease expense after-tax interest expense †¢ BV of Equity Unaffected epreciation †¢ ROE effect depends on whether †¢ BV of Equity unaffected lease expense (imputed interest †¢ ROE effect depends on + depreciation) whether lease expense (imputed interest + depreciation) Interest Coverage †¢ EBIT(1-t) decreases †¢ EBIT(1-t) decreases †¢ Interest Exp. unaffected †¢ Interest Exp. ncreases †¢ Coverage ratio generally higher †¢ Coverage Ratio generally lower Debt Ratio †¢ Debt is unaffected †¢ Debt increases (to †¢ Debt Ratio is lower account for capitalized leases) †¢ Debt Ratio is higher Since the level of financial ratios, and subsequent predictions, can vary depending on whether leases are treated as operating or capital leases, it may make sense to convert op erating leases into capitalized leases when comparing these ratios across firms. In Summary †¦ When a lease arrangement qualifies as an operating lease, there are profound consequences for the reported earnings, book value of debt and capital, and return ratios of that firm. In general, †¢ †¢ †¢ both the operating and net income of the firm will be lowered the debt and capital for the firm will be understated the return on equity and capital will be much higher Effect of Operating Lease Decreases EBIT through lease expense Capital does not reflect leases ROC is higher when a lease is treated as an operating lease rather than a capital lease. The Financial View of Operating Lease In finance, our view of all leases, operating as well as capital, is colored by whether the lease payment represents a commitment similar to interest payments on debt. If the answer is in the affirmative, leasing becomes an alternative to borrowing and buying the assets, and lease payments becomes financial expenses rather than operating expenses. This can have significant implications for the measurements of income, debt and overall profitability. In this section, we will explore two ways of adjusting valuation inputs for operating leases. The Capital Adjustment If operating lease expenses are to be considered financing expenses, it stands to reason that the present value of commitments to make such payments in the future has to be treated as debt. Accounting standards in the United States require that operating lease commitments for the next five years be reported as part of the footnotes to financial statements, and that any commitments beyond that period be umulated and reported with the commitments five years from now. To convert operating lease commitments into an equivalent debt amount requires that we discount these commitments back to the present. Again, consistency requires that we use a pre-tax cost of debt for the discounting, since the commitments are pre-tax and the lease expenses are being treated as financing expenses. The cost of debt can, however, vary depending upon whether debt is secured or unsecured. Since the claims of lessees are similar to the claims of unsecured debt holders, as opposed to secured debt holders, the firms cost of unsecured debt should be used in discounting lease commitments. To compute the â€Å"debt† value of operating leases, the present value of actual lease commitments is computed over time. The cumulation of all lease commitments after the fifth year into that years amount does create a discounting problem. One simple approximation that works is to use the average lease commitment over the first four years as an approximate annuity in converting the final cumulated amount into annual amounts. Thus, a firm that has average lease commitments of $ 2 million for the next 4 years, and shows a cumulated commitment of $ 12 million in year 5, can be considered to have annual lease payments of $ 2 million a year for 6 years starting in year 5 for present value purposes. The book value of equity should be unaffected by either adjustment, but the book value of capital will then be the sum of the debt, including converted operating leases, and the book value of equity. Illustration 1: The Home Depot Capital Estimation with Operating Income Recategorized The Home Depot, as a retail firm which leases most of its store spaces, has considerable lease commitments outstanding. We begin by reporting the operating lease commitments that the Home Depot reports in its last annual report (February 28, 1998), and computing the capitalized value of these operating lease commitments: To compute the present value of the operating lease expenses, we use the pre-tax cost of borrowing for the Home Depot of 6. 25%. Year Operating Lease Expense Present Value at 6. 25% 1 2 3 4 5 Yr 6 -15 $ $ $ $ $ $ 294 $ 291 $ 264 $ 245 $ 236 $ 270 $ $ 277 258 220 192 174 1,450 2,571 PV of Operating Lease Expenses The operating lease expenses after year 5 are treated as an annuity. The present value of operating leases can be treated as the equivalent of debt. The following table summarizes the book value of capital, when operating lease expenses are capitalized, at the Home Depot: Home Depot Book Value of Capital + Present Value of Operating Leases = Adjusted Book Value of Capital $8,513 $2,571 $11,084 The capitalization of operating leases increases the book value of capital substantially. There is no effect on the book value of equity. The Income Adjustment If operating lease expenses represent fixed commitments for the future, then they have to be treated as financing expenses rather than operating expenses. This will have a significant impact on operating income, since it is defined to be net of just operating expenses. Thus, the operating income for a firm will always increase when operating lease expenses are re-categorized as financing expenses. To obtain the adjusted operating ncome, the operating income will be increased by the imputed interest expense on the capitalized debt. Adjusted Pre-tax Operating Income = EBIT + Imputed Interest Expense on Capitalized Lease Moving operating leases from the operating expense to the financing expense column, by itself, should have no effect on the net income. If we decide to treat operating leases as capital leases, and estimate imput ed interest and depreciation on it, there can be timing effects on net income, with the net income in earlier years being lower and in later years being higher as a result of the recategorization. Net Income comples = Net Income + Operating Lease Expenses – Imputed Interest Expense on Capitalized Lease – Depreciation on Capitalized Lease Asset If we make the simplifying assumption that the operating lease expense is equal to the sum of the imputed interest expense and the depreciation, then the net income will be unaffected by this categorization. Illustration 2: The Home Depot Income Estimation with Operating Leases Recategorized We will estimate the adjusted operating and net income for the Home Depot, using the information on operating leases provided in illustration 1. We use the apitalized value of operating leases of $2,571 million computed in the previous illustration to adjust the operating income. We compute the inputed interest expense, using Home Depot’s pre-tax cost of debt of 6. 25% and debt value of operating leases: Imputed Interest Expense = $2,571 million * . 0625 = $ 161 million In the following table, we adjust the operating income, aft er-tax operating income and net income at Home Depot for operating lease expenses. Adjusted Operating Income Home Depot Operating Income + Imputed Interest Expense on Operating Leases = Adjusted Operating Income $2,016 $161 $2,177 Note that the adjusted operating income is higher than the reported operating income. The after-tax adjusted operating income is computed in the table below for the Home Depot. Adjusted After-tax Operating Income Operating Income (1-t) + Imputed Interest Expense (1- t) = Adjusted After-tax Operating Income $1,311 $104 $1,415 The imputed interest expense added back here is the after-tax expense, obtained by multiplying the pre-tax interest expense by (1- marginal tax rate). Alternatively, the adjusted operating income could have been multiplied by (1-t) to arrive at the same estimate of after-tax operating income. The net income of $1,228 million of the Home Depot is unaffected by the capitalization of operating lease expenses, because we assume that the operating lease expense is equal to the sum of depreciation and imputed interest expenses. The Profitability Adjustment The conversion of operating lease expenses into financing expenses increases operating income and capital, and thus affects any profitability measure using one or both of these numbers. The most directly affected estimate is the return on capital, which is the operating income divided by the book value of capital. Return on Capital = (EBIT + Operating Lease Expense) (1 -tax rate) Operating Lease Expense (Book Value of Debt + + Book Value of Equity) kd The effect on return on capital will be determined by the present value of operating lease commitments over time (PVOL) and the method used to compute depreciation on the asset created. The return on capital can then be estimated as follows: (EBIT + Operating Lease Expense Depreciation ) (1 tax rate) PVOL (Book Value of Debt + PVOL + Book Value of Equity) Return on Capital = If we assume that the difference between operating lease expenses and the imputed interest expense is equal to the depreciation on the asset created by operating leases, this computation can be simplified further: Return on Capital = (EBIT + Imputed Interest Expense on Capitalized Leases) (1 tax rate) (Book Value of Debt + PVOL + Book Value of Equity) Whether return on capital will increase or decrease in this case will depend upon whether the unadjusted pre-tax return on capital is greater than the pre-tax cost of debt. Thus, If Unadjusted Pre-tax ROC Pre-tax cost of debt Unadjusted Pre-tax ROC Pre-tax cost of debt ROC will decrease ROC will increase The comparison can also be made entirely in after-tax terms. With our assumption that the operating lease expense is equal to the sum of the imputed interest expense and the depreciation on the capitalized lease asset, the return on equity should be unaffected by whether we capitalize operating leases or not. Illustration 3: The Home Depot Profitability Estimation with Operating Income recategorized The following table summarizes the adjusted operating income and capital at the Home Depot. Home Depot After-tax Operating Income BV of Capital Beginning BV of Capital Ending BV of Capital Average ROC (based on average) ROC (based on beginning) $1,311 $7,205 $8,513 $7,864 16. 67% 18. 20% Home Depot (Adjusted) $1,415 $9,776 $11,084 $10,430 13. 56% 14. 47% Note that the return on capital drops when operating leases are capitalized because the return on capital is well in excess of the cost of debt of 6. 5%. The return on equity will be unaffected since neither the net income nor the book value of equity will be affected by the recategorization of operating lease expenses. The Free Cash Flow Adjustment In valuation, it is the free cash flows to the firm, defined as the cash flows left over after reinvestment needs have been met, that are discounted at the cost of capital to arrive at firm val ue. When operating lease expenses are treated as financing expenses, not only is operating income affected but so is the net capital expenditure. To be consistent with our treatment of operating leases as financing expenses in the course of acquiring an asset, we need to consider changes in the present value of operating lease expenses over time as the equivalent of capital expenditures. The net capital expenditures on operating leases is determined by the increase in the present value of the operating lease commitments over time. Net Cap Ext = (PVOLt PVOLt-1) Thus, firms with increasing operating lease expenses over time will have a net capital expenditure reflecting this growth. The final effect on free cash flow to firm of treating operating lease expenses as financing expenses will depend upon two factors – †¢ The reclassification of operating expense as financing expenses will increase the free cash flow to the firm because the imputed interest expense on the capitalized operating leases has to be added back to the operating income. †¢ Any increase in the present value of operating lease expenses over time will have a negative effect on cash flows because it will be treated as an additional capital expenditures. There is no effect on free cash flow to equity of reclassifying operating lease expenses as financing expenses. This is because the increase in capital expenditures created by the change in the present value of operating lease expenses will be exactly offset by the increase in net debt created by this reclassification. Illustration 4: The Home Depot Free Cash Flow Estimation with Operating Income recategorized The following table summarizes free cash flows to the firm at the Home Depot with operating leases reclassified as financing expenses: Home Depot Operating Income (1-t) $1,311 Home Depot (with Operating Lease Adjustment) $1,415 Depreciation Capital Expenditures Change in Working Capital FCFF 283 1,396 474 ($277) $ 283 1,453 474 ($230) The adjusted operating income is computed in illustration 2. The present value of operating leases at the Home Depot increased from $2,514 million to $2,571 million ove the year. The difference of $ 57 million is added on to the net capital exp enditures. The free cash flows to the firm are more positive (less negative) if operating lease expenses are treated as financing expenses, because the imputed interest expense is now treated as a financing expense. The table below summarizes the effect of capitalizing the operating lease expenses on the free cash flow to equity: Home Depot Net Income + Depreciation Capital Expenditures Change in Working Capital + Net Debt Issued = FCFE $1,228 $283 $1,396 $474 -25 ($384) Home Depot with adjustment $1,228 $283 $1,453 $474 $32 ($384) The increase in capital expenditures of $57 million, attributable to the increase in the present value of operating leases, also shows up as an increase to net debt issued, leaving the ultimate FCFE unaffected. Intuitively, this makes sense, since reclassifying an operating expense as a financing expense should not affect the FCFE, which is after financing expenses. The Effect on Discounted Cash Flow Value Looking back at the last three sections, converting operating lease expenses into financing expenses affects firm cash flows by changing both the operating income and the net capital expenditures, and the cost of capital by altering the debt ratio. It can also affect expected growth in the operating income to the extent that it has an impact on both the reinvestment rate and the expected return on capital. Once firm value has been estimated with the modified inputs, the debt that is netted out to arrive at the market value of equity should include the debt value of operating leases. Converting operating lease expenses into financing expenses should have no impact on equity valuation. The free cash flows to equity are after both operating and financing expenses, and are thus unaffected by recategorizing operating lease expenses, especially since there is no tax effect from the recategorization. The cost of equity is not affected by the treatment of the present value of operating lease expenses as debt. Illustration 5: The Home Depot DCF Value with Operating Income recategorized Converting operating lease expenses affects both cash flows and discount rates. In the following illustration, we will value Home Depot twice, once with the unadjusted operating income and cost of capital and one with the adjusted operating income and cost of capital. We will begin by summarizing the estimates for cost of capital and operating leases with and without the operating lease adjustments: Current Revenues Operating Income (1-t) $24,156 $1,310 Adjusted $24,156 $1,415 Depreciation Capital Expenditures Change in Working Capital FCFF $283 $1,396 $474 ($277) $283 $1,453 $474 ($230) Market Value of Equity = Debt Outstanding = Debt/Capital Ratio = Cost of Equity Cost of Debt Cost of Capital 51379 1205 2. 29% 9. 80% 4. 06% 9. 67% 51379 3776 6. 85% 9. 80% 4. 06% 9. 41% To do the valuation, we will assume that revenues, operating income and depreciation will grow at 15% a year for the next 5 years and 5% thereafter. Capital expenditures and capitalized leases are assumed to grow 5% a year for the next 5 years. After year 5, we will assume that capital expenditures (not counting capital leases) after year 5 will be 150% of depreciation, and that capitalized leases will continue to grow at 5% a year. In the following table, we summarize the expected cash flows to the firm on an annual basis for the next 5 years and the terminal year (year 6) with unadjusted operating income. We also compute the present value of the cash flows at the unadjusted cost of capital: Base 1 2 3 4 5 Terminal Year Revenues EBIT(1-t) + $24,156 $1,310 $283 $27,779 $1,507 $325 $31,946 $1,733 $374 $36,738 $1,993 $430 $42,249 $2,292 $495 $48,586 $2,636 $569 $51,016 $2,767 $598 Depreciation Cap Ex Change in WC FCFF Terminal Value PV $70 $195 $321 $449 ($277) $77 $235 $424 $649 $ $916 41,475 $26,722 $1,936 $1,396 $474 $ $1,466 290 $ $1,539 333 $ $1,616 383 $ $1,697 441 $ $1,782 507 $897 $532 Summing up the present values of the cash flows gives us an estimate for the value of the firm, and netting out the unadjusted debt gives us the value of equity: Value of Firm = Value of Debt = Value of Equity = $27,757 $1,205 $26,552 In the following table, we estimate the value of the firm using the adjusted cash flows to the firm and the adjusted cost of capital: Base Revenues EBIT(1-t) + Deprec’n Cap Ex ? WC FCFF Terminal Value PV Capitalized Leases $2,571 $62 $2,700 $199 $2,835 $337 $2,976 $477 $3,125 $24,156 $1,415 $283 $1,453 $474 ($230) 1 $27,779 $1,627 $325 $1,594 $290 $68 2 $31,946 $1,871 $374 $1,674 $333 $238 3 $36,738 $2,152 $430 $1,758 $383 $441 4 $42,249 $2,475 $495 $1,846 $441 $683 5 Terminal Year $48,586 $2,846 $569 $1,938 $507 $970 $45,218 $29,465 $3,281 $3,445 $51,016 $2,988 $598 $1,061 $532 $1,993 Change in Cap Leases $129 $135 $142 $149 $156 $164 The change in the capitalized leases from year to year is added on to capital expenditures each year. The value of the firm and the value of the equity can then be estimated, using the adjusted value of debt outstanding: Value of Firm = Value of Debt = Value of Equity = $30,540 $3,776 $26,764 Note that the value of the firm increases but so does the value of the debt. The value of equity is very close to the value of equity estimated using the unadjusted operating income and the unadjusted cost of capital. This should not be surprising. As long as the debt ratio stays stable, and the operating leases are fairly valued, treating operating leases as debt should have a neutral effect on the value of the equity in the firm. Under what conditions will the two values diverge significantly? If the present value of the operating leases increases at a rate different from other capital expenditures, the value of the firm computed using the adjusted cashflows and cost of capital will change because the debt ratio will change. Under those conditions, the value obtained using the adjusted estimates will be more precise. The value of the equity will be unaffected by the treatment of operating leases as debt, as long as the leverage is not expected to change over the valuation period. If it is, there will be an effect, because only because the cost of equity will change as the leverage changes. The Adjustment to Multiples Much the same analysis applies when we look at the impact of capitalizing operating lease expenses on widely used multiples. If the multiple is an equity multiple, such as price/earnings or price/book value, there should be no effect from recategorizing operating lease expenses. If the multiple, however, is a firm value multiple, there can be significant shifts in the value once operating lease expenses are recategorized, because of the effects on both operating income and capital. As an example, the Value/EBITDA multiple with operating lease expenses recategorized would be: Value MV of Equity + MV of Debt PV of Operating Leases + = EBITDA EBITDA + Operating Lease Expenses Whether the Value/EBITDA multiple will increase or decrease will depend, again, on whether the unadjusted Value/EBITDA is greater than or lesser than the ratio of the present value of operating lease expenses to the annual operating lease expense. With the value/sales multiple, converting operating leases to equivalent debt value will always increase the multiple, since the firm value will increase to include the present value of operating leases while the denominator will remain unchanged. The implications for analysis where firm value multiples are compared across companies can be profound in any of the following scenarios: †¢ When some firms lease assets and other firms buy them, converting operating leases to equivalent debt will make the firm value multiples more comparable. †¢ When some firms treat leases as capital leases, while other firms qualify for operating leases, there can be significant changes in how companies rank on firm value multiples after operating leases are converted into equivalent debt. †¢ Even if all firms treat all leases as operating leases, there can be significant differences across firms in how large these lease commitments are as a percent of operating expenses. In these cases, again, the conversion of operating lease expenses to debt will give more realistic assessments of where these firms stand. Illustration 6: The Home Depot Multiples with Operating Income recategorized In the following table, we summarize the firm value multiples for the Home Depot with and without the operating lease adjustments: Home Depot Market Value of Equity Value of Debt $51,379 $1,205 Home Depot (with adjustments) $51,379 $3,776 EBITDA EBIT EBIT(1-t) $2,299 $2,016 $1,310 $2,593 $2,177 $1,415 Value/EBITDA Value/EBIT Value/EBIT(1-t) 22. 87 26. 08 40. 13 21. 27 25. 34 38. 98 Note that the adjusted value multiples are consistently lower than the unadjusted multiples when operating leases are capitalized. Conclusion Firm valuation can be impacted by how we deal with operating leases. While the accounting distinction between capital and operating leases may seem reasonable, there seems to be no reason, from a financial standpoint, to maintain that distinction when it omes to estimating operating income, capital and profitability. Operating lease expenses need to be reclassified as financial expenses and this will affect our estimates of operating income. The present value of future operating lease expenses need to be treated like debt, and this will have an impact on assessments of capital and leverage for firms. Finally, in estimating free cash flows for valuation purposes, expected increases in operating lease c ommitments over time have to be shown as capital expenditures.