Capital Leases in an equipment-heavy deal

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by a searcher from Queen's University
in Toronto, ON, Canada

2yrs ago

Capital Leases in an equipment-heavy deal

Hello,

I'm looking at buying a small parking lot maintenance business in Canada.

The business has capital leases that the seller isn't looking to pay-off as part of the stock transaction.

However, the seller is adding back the principal and interest payments on the lease to get to SDE.

Would I be correct in thinking that these should not be added back to SDE since they are real cash expenses required to operate the business?

I am thinking, alternatively, that if the seller paid off the capital leases in full at the time of closing, then the interest and principal expenses on those leases would then cease when I take over. In this scenario, the seller would then be reasonable in adding-back the lease payments to SDE because the business is truely being sold on a debt-free basis.

Any help would be greatly appreciated.

1 Like

71 Views

reply by a searcher 2yrs ago
from Duke University in Tulsa, OK, USA

Eric, the answer to your question will be very specific to the individual business. I am not familiar with how the lease is structured but depreciation and interest do get added back which he would have if he purchased it with a loan and depreciated over the applicable period 5-7 years. Then on a deal by deal basis look at the equipment and decide what the useful life is. Perhaps he has a 7 year loan and depreciation cycle but the equipment if properly maintained will last for 20 plus years.

I looked at many asset heavy businesses myself when I was searching. You need to consider why the seller is reinvesting so much money into the equipment. Is his business expanding so his equipment expense is unusually large? What is a reasonable annual budget for replacing equipment at normal operations under the current volume of business? What is the average equipment life in the industry (hint call the equipment manufacturer and ask them about the machinery)? These are just some of the questions you need to ask, and clearly understand to properly evaluate the deal.

Also, since the equipment expense can be quite large many asset heavy businesses get evaluated based on EBIT and 5x is the equivalent of 4x EBITDA in most cases. If 5x EBIT and 4x EBITDA produce vastly different valuations I would be very cautious.