COMM 309 — Business Finance | Chapter 16: Leasing
COMM 309 — Business Finance
CHAPTER 16: Leasing
Comprehensive Exam Preparation Notes
Leasing is treated in this course as a capital budgeting decision — a comparison of cash flows from
leasing versus buying a needed asset, evaluated using DCF methods. The asset-based financing and
leasing industry is the largest provider of debt financing to Canadian businesses after traditional bank
lenders. The Canadian Finance and Leasing Association (CFLA) estimates Canadian asset-based
financing assets exceeded $314 billion in 2013. Note: Chapter 16 notes begin at section 16.3. Sections
16.1 and 16.2 provide institutional/accounting background; the exam-tested material is concentrated in
16.3 and 16.4.
📌 Essential Background: Operating vs. Financial (Capital) Leases
LEASE DEFINITION (CFLA): An agreement where the owner (lessor) conveys the right to use an
asset to the user (lessee) in return for specified payments over an agreed period.
OPERATING LEASE — some benefits of ownership remain with the lessor:
• Lessor responsible for maintenance, insurance, property taxes (full-service lease).
• Does NOT appear on the lessee's balance sheet — OFF-BALANCE-SHEET financing.
• Full lease payment is tax deductible for the lessee (as rental expense).
• Lessor claims CCA (depreciation) on the asset.
• Covers less than 75% of asset economic life; PV of payments < 90% of asset cost.
FINANCIAL (CAPITAL / FULL PAYOUT) LEASE — essentially all ownership benefits transfer to
lessee:
• Lessee responsible for maintenance and insurance.
• APPEARS on lessee's balance sheet as both an asset AND a liability (PV of payments).
• Lessee claims CCA (depreciation) on the asset.
• Only the INTEREST portion of the lease payment is tax deductible (like a loan).
• Covers ≥75% of asset economic life OR PV of payments ≥90% of asset cost.
• Lessee has a fixed purchase option.
SALE AND LEASEBACK (SLB): Owner sells asset (usually to insurance company/pension fund)
then leases it back — retains use, receives one-time cash inflow. Less popular in Canada since
1989 tax changes restricted CCA deductions on SLB assets.
LEVERAGED LEASE: Three-party deal — lessee, lessor, and external lender. Lessor contributes
only 20–50% of purchase price; lender finances the rest. Not popular in Canada because CRA
restricts CCA deductions to the party at risk.
📌 Accounting Treatment Summary (Key for Exam Ratio Questions)
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, COMM 309 — Business Finance | Chapter 16: Leasing
LESSEE — Operating Lease: Asset NOT on balance sheet. Expense full lease payment as
rental expense (reduces NI). CFO reduced by full payment. Lessor claims CCA.
LESSEE — Financial Lease: Asset AND liability ON balance sheet (PV of payments). Expense
INTEREST portion only. Depreciation expense claimed by lessee. CFO reduced by interest only;
CFF reduced by principal repayment.
FINANCIAL vs. OPERATING (comparing the same lease classified differently):
• Net income: HIGHER under operating in early years (interest declines over time for financial
lease; operating expense stays constant).
• CFO: HIGHER under financial lease (only interest subtracted from CFO, not full payment).
• CFF: HIGHER under operating lease (no principal repayment component).
• TOTAL cash flow: IDENTICAL under both — only the classification changes.
• Balance sheet: Financial lease makes firm appear LARGER and MORE LEVERAGED.
• Ratios under financial lease: Lower current ratio, higher debt/leverage ratio, lower asset
turnover, lower ROA, lower ROE (at least in early years), higher P/E (lower EPS).
• In efficient markets: classification should NOT affect firm value — total cash flows are the
same. Analysts see through operating lease off-balance-sheet classification (required footnote
disclosure).
• IFRS trend: Moving toward capitalizing operating leases on the balance sheet — limiting off-
balance-sheet financing.
16.3 Evaluating the Lease Decision
Leasing is an alternative to purchasing an asset. To decide whether to lease or buy, a firm compares
the incremental cash flows of leasing relative to buying. Since leasing is a form of debt financing (it
creates a legal obligation to make periodic payments to the lessor), it can be evaluated using the same
DCF / IRR framework used in capital budgeting.
The Four Key Cash Flow Differences: Lease vs. Buy
When a firm leases an asset instead of buying it, there are exactly four categories of cash flow that
change:
# Cash Flow Difference Direction Details
1 Initial purchase cost INFLOW The firm saves the full purchase price of the asset at time
avoided (+) 0 — it does not have to pay upfront. This is the largest
positive cash flow from leasing.
2 Forgone salvage value OUTFLOW If it is an operating lease (or if title is not transferred via a
(−) financial lease), the firm cannot sell the asset at the end
of its life. The forgone salvage value is a cost of leasing.
Discounted at the after-tax borrowing rate back to time 0.
3 After-tax lease OUTFLOW Regular lease payments must be made. For
payments (−) OPERATING leases: full payment is tax deductible →
after-tax payment = PMT × (1 − T). For FINANCIAL
leases: only interest portion is deductible (same as a
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COMM 309 — Business Finance
CHAPTER 16: Leasing
Comprehensive Exam Preparation Notes
Leasing is treated in this course as a capital budgeting decision — a comparison of cash flows from
leasing versus buying a needed asset, evaluated using DCF methods. The asset-based financing and
leasing industry is the largest provider of debt financing to Canadian businesses after traditional bank
lenders. The Canadian Finance and Leasing Association (CFLA) estimates Canadian asset-based
financing assets exceeded $314 billion in 2013. Note: Chapter 16 notes begin at section 16.3. Sections
16.1 and 16.2 provide institutional/accounting background; the exam-tested material is concentrated in
16.3 and 16.4.
📌 Essential Background: Operating vs. Financial (Capital) Leases
LEASE DEFINITION (CFLA): An agreement where the owner (lessor) conveys the right to use an
asset to the user (lessee) in return for specified payments over an agreed period.
OPERATING LEASE — some benefits of ownership remain with the lessor:
• Lessor responsible for maintenance, insurance, property taxes (full-service lease).
• Does NOT appear on the lessee's balance sheet — OFF-BALANCE-SHEET financing.
• Full lease payment is tax deductible for the lessee (as rental expense).
• Lessor claims CCA (depreciation) on the asset.
• Covers less than 75% of asset economic life; PV of payments < 90% of asset cost.
FINANCIAL (CAPITAL / FULL PAYOUT) LEASE — essentially all ownership benefits transfer to
lessee:
• Lessee responsible for maintenance and insurance.
• APPEARS on lessee's balance sheet as both an asset AND a liability (PV of payments).
• Lessee claims CCA (depreciation) on the asset.
• Only the INTEREST portion of the lease payment is tax deductible (like a loan).
• Covers ≥75% of asset economic life OR PV of payments ≥90% of asset cost.
• Lessee has a fixed purchase option.
SALE AND LEASEBACK (SLB): Owner sells asset (usually to insurance company/pension fund)
then leases it back — retains use, receives one-time cash inflow. Less popular in Canada since
1989 tax changes restricted CCA deductions on SLB assets.
LEVERAGED LEASE: Three-party deal — lessee, lessor, and external lender. Lessor contributes
only 20–50% of purchase price; lender finances the rest. Not popular in Canada because CRA
restricts CCA deductions to the party at risk.
📌 Accounting Treatment Summary (Key for Exam Ratio Questions)
Page 1
, COMM 309 — Business Finance | Chapter 16: Leasing
LESSEE — Operating Lease: Asset NOT on balance sheet. Expense full lease payment as
rental expense (reduces NI). CFO reduced by full payment. Lessor claims CCA.
LESSEE — Financial Lease: Asset AND liability ON balance sheet (PV of payments). Expense
INTEREST portion only. Depreciation expense claimed by lessee. CFO reduced by interest only;
CFF reduced by principal repayment.
FINANCIAL vs. OPERATING (comparing the same lease classified differently):
• Net income: HIGHER under operating in early years (interest declines over time for financial
lease; operating expense stays constant).
• CFO: HIGHER under financial lease (only interest subtracted from CFO, not full payment).
• CFF: HIGHER under operating lease (no principal repayment component).
• TOTAL cash flow: IDENTICAL under both — only the classification changes.
• Balance sheet: Financial lease makes firm appear LARGER and MORE LEVERAGED.
• Ratios under financial lease: Lower current ratio, higher debt/leverage ratio, lower asset
turnover, lower ROA, lower ROE (at least in early years), higher P/E (lower EPS).
• In efficient markets: classification should NOT affect firm value — total cash flows are the
same. Analysts see through operating lease off-balance-sheet classification (required footnote
disclosure).
• IFRS trend: Moving toward capitalizing operating leases on the balance sheet — limiting off-
balance-sheet financing.
16.3 Evaluating the Lease Decision
Leasing is an alternative to purchasing an asset. To decide whether to lease or buy, a firm compares
the incremental cash flows of leasing relative to buying. Since leasing is a form of debt financing (it
creates a legal obligation to make periodic payments to the lessor), it can be evaluated using the same
DCF / IRR framework used in capital budgeting.
The Four Key Cash Flow Differences: Lease vs. Buy
When a firm leases an asset instead of buying it, there are exactly four categories of cash flow that
change:
# Cash Flow Difference Direction Details
1 Initial purchase cost INFLOW The firm saves the full purchase price of the asset at time
avoided (+) 0 — it does not have to pay upfront. This is the largest
positive cash flow from leasing.
2 Forgone salvage value OUTFLOW If it is an operating lease (or if title is not transferred via a
(−) financial lease), the firm cannot sell the asset at the end
of its life. The forgone salvage value is a cost of leasing.
Discounted at the after-tax borrowing rate back to time 0.
3 After-tax lease OUTFLOW Regular lease payments must be made. For
payments (−) OPERATING leases: full payment is tax deductible →
after-tax payment = PMT × (1 − T). For FINANCIAL
leases: only interest portion is deductible (same as a
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