Leases with purchase options and double moral hazard

K. Y., Derek CHAU, Michael Arthur FIRTH, Bin SRINIDHI

Research output: Journal PublicationsJournal Article (refereed)

4 Citations (Scopus)

Abstract

The purpose of this paper is to explain why leases have a purchase option and how the exercise price of this option is determined. We follow Demski and Sappington's (1991) approach by using a double moral hazard setting. One limitation of their model is that the agent has unlimited liability. The agent has to have enough wealth and the obligation to buy the firm when the principal decides to exercise the put option. In our paper, this problem is resolved by using a call option, which is a feature of many lease contracts. We show that leases with a purchase option can completely resolve the double moral hazard problem even if all the variables in the model are unverifiable. It is the threat of being the residual claimant that induces the lessor to provide an efficient level of effort. On the other hand, it is the opportunity of being the residual claimant that induces the lessee to maintain the asset efficiently. Finally, the model predicts that certain leased assets are not properly accounted for under the current accounting standards for leasing.
Original languageEnglish
Pages (from-to)1390-1401
Number of pages12
JournalJournal of Business Finance and Accounting
Volume33
Issue number9-10
DOIs
Publication statusPublished - 1 Nov 2006

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Lease
Purchase
Double moral hazard
Assets
Exercise
Wealth
Obligation
Call option
Put option
Accounting standards
Threat
Leasing
Liability

Keywords

  • eases with purchase options; double moral hazard

Cite this

CHAU, K. Y., Derek ; FIRTH, Michael Arthur ; SRINIDHI, Bin. / Leases with purchase options and double moral hazard. In: Journal of Business Finance and Accounting. 2006 ; Vol. 33, No. 9-10. pp. 1390-1401.
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Leases with purchase options and double moral hazard. / CHAU, K. Y., Derek; FIRTH, Michael Arthur; SRINIDHI, Bin.

In: Journal of Business Finance and Accounting, Vol. 33, No. 9-10, 01.11.2006, p. 1390-1401.

Research output: Journal PublicationsJournal Article (refereed)

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AB - The purpose of this paper is to explain why leases have a purchase option and how the exercise price of this option is determined. We follow Demski and Sappington's (1991) approach by using a double moral hazard setting. One limitation of their model is that the agent has unlimited liability. The agent has to have enough wealth and the obligation to buy the firm when the principal decides to exercise the put option. In our paper, this problem is resolved by using a call option, which is a feature of many lease contracts. We show that leases with a purchase option can completely resolve the double moral hazard problem even if all the variables in the model are unverifiable. It is the threat of being the residual claimant that induces the lessor to provide an efficient level of effort. On the other hand, it is the opportunity of being the residual claimant that induces the lessee to maintain the asset efficiently. Finally, the model predicts that certain leased assets are not properly accounted for under the current accounting standards for leasing.

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