Leases with Purchase Options and Double Moral Hazard |
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| Authors: | Derek KY Chau Michael Firth Bin Srinidhi |
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| Institution: | The first author is from the University of Toronto at Scarborough. The second author is from Lingnan University. The third author is from the State University of New York, Albany. They acknowledge the helpful comments of Jevons Lee, Zhaoyang Gu, Son Ku Kim, an anonymous referee and workshop participants at the Hong Kong University of Science and Technology, Lingnan University, and the Hong Kong Polytechnic University. |
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| Abstract: | 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. |
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| Keywords: | leases with purchase options double moral hazard |
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