Non‐cancellable Operating Leases and Operating Leverage

Published date01 September 2016
Date01 September 2016
AuthorFigen Gunes Dogan
Non-cancellable Operating Leases and
Operating Leverage
Figen Gunes Dogan
Faculty of Business Administration, Bilkent University, 06533 Ankara, Turkey
This paper explores the link between a rms non-cancellable operating lease
commitments and stock returns. Firms with more operating lease commitments
earn a signicant premium over rms with fewer commitments, and this premium is
countercyclical. Non-cancellable operating lease payments represent a major
claim on a rms cash ows. Firms with high levels of operating leases have higher
cash ow sensitivity to aggregate shocks and hence higher operating leverage. The
relationship between operating leases and stock returns is stronger in small rms
than in big rms.
Keywords: operating lease, operating leverage, cross section of expected returns
JEL classification: E22, G12
1 Introduction
Operating leases are the most common and important source of off-balance sheet
nancing, and operating lease use has increased substantially over the past several
According to Eisfeldt and Rampini (2009); leasing is of comparable
The author is grateful to Selale Tuzel for many comments and discussions. Furthermore, I
would like to thank two anonymous referees and Kursat Aydogan, Cem Demiroglu, John
Doukas (the Editor), Huseyin Gulen, Dong Lu, Armin Schwienbacher, and seminar
participants at the 2014 PFMC Conference, the 2015 MFA conference, and Koc University
for their helpful suggestions. Parts of this paper were written when the author was visiting
the University of Southern California.
Cornaggia et al. (2013) document that operating leases increased 745% as a proportion of
total debt from 1980 to 2007. The Financial Accounting Standards Board (FASB) in the US
and the International Accounting Standards Board (IASB) debated whether operating and
capital leases should be combined and presented on the balance sheet (The Wall Street
Journal, March 18 2014). The boards agreed to recognize certain operating leases on the
balance sheet. However, they failed to reach a consensus on how to recognise expenses on the
lessees income statement.
European Financial Management, Vol. 22, No. 4, 2016, 576612
© 2015 John Wiley & Sons, Ltd.
doi: 10.1111/eufm.12069
importance to long-term debt, and for small rms, leasing may be the largest source of
external nancing.
These authors report that the proportion of capital that rms lease in
merged CensusCompustat data is 16%, which is similar to the long-term debt-to-assets
ratio of 19%.
Operating lease payments represent a major claim on rmscash ows. Some of these
leases are short term; they may be reversible and provide exibility to the rm compared
to ownership. However, some operating leases are non-cancellable during the lease term
except in the event of bankruptcy. During the business cycle, rms cannot easily cancel
or adjust the terms of this type of lease contract with their lessors. This inexibility in
operating lease costs increases rm risk. Firms with relatively high levels of operating
lease commitment are more vulnerable to the business cycle than those with fewer
commitments. Consequently, shareholders require a higher rate of return for bearing this
risk, and expected stock returns of rms with higher levels of operating leases are greater
compared to those of rms with lower levels of operating leases.
In this paper, I show that a rms non-cancellable lease commitments are positively
and monotonically related to expected returns. I construct a measure of the rms
operating lease ratio by dividing minimum lease commitments by the rms total assets.
This ratio represents the level of non-cancellable operating lease use. The sample
includes US rms in the merged CRSPCompustat database that report their lease
commitments. On average, rms with high lease ratios have higher expected stock
returns than rms with low lease ratios: a difference of 11.0% per annum for equal-
weighted portfolios and 4.7% per annum for value-weighted portfolios.
Firms with high levels of operating leases are riskier, especially during recessions. The
return spread between high- and low-lease ratio rms is countercyclical and is about four
times as high during recessions as it is during expansions. To investigate the risk
mechanism behind expected returns, I show, rst, that operating lease commitments have
very limited comovement with sales. Second, the cash ows of rms with high levels of
operating leases are more sensitive to aggregate shocks than those of rms with lower
levels of operating leases. Third, I show that high-lease ratio rms have more volatile
stock returns and cash ow growth.
The risks associated with holding non-cancellable operating leases are mentioned in
the business press. For example, when UAL Corp., parent of United Airlines, led for
Chapter 11 in December 2002, it had US$ 25.2 billion of assets, US$ 22.2 billion of
liabilities and US$ 24.5 billion in non-cancellable operating lease commitments. A UAL
spokeswoman acknowledges the companys high lease costs were a factor in UALs
Similarly, US Airways led for Chapter 11 in August 2002. Its chief
executive ofcer, David Siegel, explained,
Graham et al. (1998) report that operating leases constitute 42% of xed claims, whereas
capital leases and debt are 6% and 52% of xed claims, respectively, in the 19811992
Compustat data.
Jonathan Weil, How Leases Play a Shadowy Role in Accounting,The Wall Street Journal,
September 22, 2004.
US Airways to Complete Restructuring Plan in Chapter 11 Reorganization,PRNewswire,
August 12, 2002.
© 2015 John Wiley & Sons, Ltd.
Non-cancellable Operating Leases 577
While US Airways was able to successfully negotiate cost savings from many of its
employee groups, the company determined that it was unlikely to conclude consensual
negotiations with certain vendors, aircraft lessors and nanciers in a timeframe necessary to
complete an out-of-court restructuring. Siegel cited as factors the large number of lessors
and nanciers and the companys inability to reject surplus aircraft leases and return excess
aircraft outside of Chapter 11.
The inexibility of the rms lease obligations creates cyclicality in the rms cash
ows, which is related to the concept of operating leverage.
For shareholders, lease
expense is a form of leverage that makes equity riskier. Danthine and Donaldson (2002)
propose a general equilibrium model with labour-induced operating leverage.
model with xed labour costs generates operating leverage and provides a better match to
the observed equity premium. Tuzel and Zhang (2013) show that rms have lower
industry-adjusted average returns in areas where wages strongly comove with aggregate
shocks. The idea of labour-induced operating leverage, that is, wageslimited
comovement with revenues affecting rm risk, can be extended to operating leases.
During recessions revenues fall but lease commitments do not fall by as much as
revenues. These precommitted lease payments transfer the risk to shareholders.
Therefore, in the setting of this paper, the operating leverage mechanism is created by the
rms non-cancellable leasing contracts.
The rmsnancing and leasing decisions are possibly related. Debt and leases have
been studied as both substitutes and complements.
Chen et al. (2014) argue that rms
with more inexible operating costs endogenously choose lower nancial leverage
ex ante to reduce the likelihood of default in future bad states. Supporting the substitute
argument, I nd that rms that use higher levels of operating leases have lower nancial
leverage. To investigate whether a rmsnancial leverage has an impact on the
relationship between its operating leases and stock returns, I control for nancial
leverage in the FamaMacbeth (1974) regressions and perform portfolio sorts with
unlevered returns. Both results conrm that the lease premium is independent of nancial
leverage effects.
This paper makes the following contributions. A large body of literature on asset
pricing links rm characteristics to stock returns in the cross-section. Fama and French
(2008) provide a survey of this literature. To this literature, my paper adds the rm-level
lease rate as a variable that constitutes part of a rms operating leverage risk and
establishes a link to expected stock returns.
Second, this paper contributes to the literature related to operating leverage. While the
role of operating leverage on rm risk is studied in the theoretical works of Rubinstein
(1973) and Lev (1974); there is limited supporting empirical evidence on the relationship
between the rms operating leverage and stock returns. The difculty in measuring
operating leverage is deciding on which costs are xed, and on the degree and duration of
the inexibility of costs. Novy-Marx (2011) uses a measure of operating leverage the
See Lev (1974); Mandelker and Rhee (1984); Carlson et al. (2004) and Novy-Marx (2011).
See Gourio (2007); Chen et al. (2011); Favilukis and Lin (2013) and Donangelo (2014) for
examples of labour induced operating leverage studies.
See Ang and Peterson (1984), Lewis and Schallheim (1992), Graham et al. (1998); Lasfer
and Levis (1998) and Eisfeldt and Rampini (2009).
© 2015 John Wiley & Sons, Ltd.
578 Figen Gunes Dogan

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