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  1. 033A company pays Rs 20 crore of rent a year. Moving to IFRS 16 puts a Rs 150 crore lease liability on its balance sheet. Before the change its EBITDA was Rs 100 crore and its enterprise value Rs 800 crore. What happens to EBITDA, enterprise value and EV/EBITDA?Accounting riddlesHardCredit SuisseSão Paulo · 2021

    Try it first

    After the change, where does EV/EBITDA land?

    Show the worked solution

    EBITDA rises to Rs 120 crore, enterprise value to Rs 950 crore, and EV/EBITDA eases from 8.0x to about 7.9x. Rent leaves operating costs and comes back as depreciation and interest, which sit below EBITDA, so EBITDA gains the full Rs 20 crore. The lease liability is debt-like, so it joins EV. The multiple barely moves because both sides change together, and it slips only because the lease enters at 7.5x.

    Why does EBITDA rise when nothing about the business changed?

    Think of a family that rents its flat. If you decide to treat the flat as bought with a loan, the monthly rent disappears from the household budget and reappears as loan interest plus wear and tear on the flat. The family pays the same cash; only the labels moved. Under the new standard, rent leaves operating costs and returns as depreciation and interest, both below EBITDA, so EBITDA rises by the whole Rs 20 crore.

    Move EBITDA and EV together and the multiple barely movesBefore: rent is an operating cost100EBITDA800EVEV / EBITDA = 8.0xAfter: lease on the balance sheet+20120EBITDA+150950EVEV / EBITDA = 7.9xMixed bases: wrongLease in EV, old EBITDA950 / 1009.5xNew EBITDA, old EV800 / 1206.7xSame business,three different multiplesThe lease enters at 150 / 20 = 7.5x, below the business's 8.0x,so the blended multiple slips from 8.0x to 7.92x7.9x
    Before the change EBITDA is Rs 100 crore and EV Rs 800 crore, 8.0x; after it EBITDA is Rs 120 crore and EV Rs 950 crore, 7.92x, while mixing the two bases gives a wrong 9.5x or 6.7x for the same business.

    Why must enterprise value move too?

    Enterprise value has to match the earnings line it is divided into. Once EBITDA no longer bears the rent, the claim that rent used to pay for, the lease liabilityThe present value of the rent a company has committed to pay over the lease term, carried on the balance sheet like a loan., must be counted like debt and added to EV, taking it from Rs 800 crore to Rs 950 crore. Move one side without the other and the multiple jumps to 9.5x or collapses to 6.7x, though the business is exactly the same. Those two numbers are what candidates produce when they mix bases.

    The relationship
    800+150100+20=950120≈7.92×15020=7.5×\frac{800 + 150}{100 + 20} = \frac{950}{120} \approx 7.92\times \qquad \frac{150}{20} = 7.5\times
    150the lease liability, added to enterprise value
    20the rent, added back to EBITDA
    7.5xthe multiple at which the lease itself enters
    What it says in wordsThe new multiple is a blend of the old 8.0x and the lease's own 7.5x, weighted by size, so it lands just below 8.0x.

    What does this mean for a comps table?

    Some peers report under standards that capitalise leases and some under rules that leave rent in operating costs. A comps table means something only if every company sits on the same basis, either all before lease capitalisation or all after. For a retailer or an airline with large leases the gap is far bigger than here, so the adjustment can move the valuation more than any view on growth. Indian companies report under an equivalent standard; confirm which rule each peer follows before you build the table.

    Where candidates lose it

    The losing move is adjusting one side. Candidates add the Rs 150 crore liability to EV and stop, report 9.5x, and conclude the company now looks expensive, when the business has not changed at all.

    The second miss is insisting the multiple stays exactly at 8.0x. It moves slightly, and the reason, that the lease is priced at 7.5x, is what separates an answer from a guess.

    What the interviewer asks next

    • What happens to net income in the first year of the lease, and why?
    • Which cash flow statement lines change, and does free cash flow change?
    • A peer reports under rules that keep rent in operating costs. How do you put it on the same basis?

    Asked at Credit Suisse, Investment Banking, São Paulo, 2021 (Wall Street Oasis): can you explain how changes in accounting principles, such as the transition from GAAP to IFRS, might impact the DCF valuation process