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Leases with Purchase Options and Double Moral Hazard

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  • Derek K.Y. Chau
  • Michael Firth
  • Bin Srinidhi

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.

Suggested Citation

  • Derek K.Y. Chau & Michael Firth & Bin Srinidhi, 2006. "Leases with Purchase Options and Double Moral Hazard," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 33(9‐10), pages 1390-1401, November.
    • Handle: RePEc:bla:jbfnac:v:33:y:2006:i:9-10:p:1390-1401
    DOI: 10.1111/j.1468-5957.2006.00606.x
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    References listed on IDEAS

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    2. Franks, Julian R & Hodges, Stewart D, 1987. "Lease Valuation When Taxable Earnings Are a Scarce Resource," Journal of Finance, American Finance Association, vol. 42(4), pages 987-1005, September.
    3. Russell Cooper & Thomas W. Ross, 1985. "Product Warranties and Double Moral Hazard," RAND Journal of Economics, The RAND Corporation, vol. 16(1), pages 103-113, Spring.
    4. John R. Graham & Michael L. Lemmon & James S. Schallheim, 1998. "Debt, Leases, Taxes, and the Endogeneity of Corporate Tax Status," Journal of Finance, American Finance Association, vol. 53(1), pages 131-162, February.
    5. Long, Michael S., 1977. "Leasing and the Cost of Capital," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 579-586, November.
    6. Smith, Clifford W, Jr & Wakeman, L MacDonald, 1985. "Determinants of Corporate Leasing Policy," Journal of Finance, American Finance Association, vol. 40(3), pages 895-908, July.
    7. Joel S. Demski & David E.M. Sappington, 1991. "Resolving Double Moral Hazard Problems with Buyout Agreements," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 232-240, Summer.
    8. Ang, James & Peterson, Pamela P, 1984. "The Leasing Puzzle," Journal of Finance, American Finance Association, vol. 39(4), pages 1055-1065, September.
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