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This paper applies a "real" option literature based model to valuing the option element of a non- cancelable lease without an early exercise provision. The model is applied to a common lease type - the closed-end automobile lease. The findings show that the value of the option inherent in an automobile lease is approximately two to six percent of the original asset cost. The analysis discusses ways in which the option value can be captured through the lease contract terms. Management decision makers can use these concepts in evaluating lease/purchase decisions. The analysis in this paper utilizes the commonly encountered automobile lease versus purchase decision to illustrate application of the model. The findings show that within certain parameters of initial price, depreciation, and residual value variability, the additional value of the option inherent in an automobile lease is approximately two to six percent of the original asset cost. The results also demonstrate that the initial relative option value is negatively related to the expected depreciation rate of the asset. The analysis provides examples of the terms of a negotiated lease contract necessary to encompass the option value through the capitalized cost, interest rate, and/or the residual value. The remainder of the discussion is organized in the following manner. The first section presents the background to real option theory and its application to an automobile lease. The second portion develops a model that is applicable to a variety of lease versus purchase decisions. The third section quantifies model parameters in the context of the automobile lease-purchase decision. Finally, the paper provides some future research directions and conclusions.

Valuation Of The Embedded Option In A Non-Cancelable Lease: Theory And Application