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MF
35,10
Pricing and net profit
of operating lease
Enrico Moretto
Dipartimento di Economia, Facoltà di Economia,
828 Università degli Studi dell’Insubria, Varese, Italy, and
Giulio Tagliavini
Università Degli Studi di Parma, Parma, Italy
Abstract
Purpose – The purpose of this paper is to investigate how asset risk (i.e. the risk that the value of
the leased asset loses unexpectedly most of its value at the end of the contract) is measured and
hedged.
Design/methodology/approach – The evaluation of the lease contract is achieved by applying the
theory of option pricing as the lessor is the writer of a call option on the leased asset. A sensitivity
analysis on some parameters is performed.
Findings – The paper disentangles the components of the profit of a lease contract and allows to
choose the optimal final purchase price. This lets the lessor hedge against asset risk.
Research limitations/implications – The paper’s result can be extended by considering more
complex options (such as American or exotic ones) into the lease contract.
Practical implications – Results in the paper allow for a more flexible and efficient management of
lease contracts where both parties benefit under an economic and a financial point of view.
Originality/value – This is believed to be the first paper that applies derivative evaluation to the
analysis of lease contracts.
Keywords Assets management, Leasing, Pricing, Profit, Hedging
Paper type Research paper

Managerial Finance
Vol. 35 No. 10, 2009
pp. 828-840
# Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074350910984700
1. Introduction
Over time many of the problems concerning leasing contracts (i.e. the agreement
between two parts in which the first – lessor – owns or buys an asset and leases it to
the second – lessee – keeping the full property of the good itself and allowing the lessee
to buy it when the contract expires) have been studied. In an early phase, up to the mid
1980s, financial analysts and mathematicians concentrated their attention on the
relationship between cost and effective yield. The framework was complicated by
diversified effects of fiscal policy that were difficult to assess.
Recent studies use different concepts. Moreover, the widespread diffusion of
electronic spreadsheets as an instrument in financial decisions offers a chance to
ground the activity of problem-solving on a rational basis. Among the different
problems still under scrutiny, a branch of current business literature emphasises the
importance of risk assessment in optimising contracts’ structure. There are, however,
no entirely satisfactory models to solve this problem yet.
The (final value) asset risk concerns the lessor when the final value of the leased
good is significatively different than the one set in the contract. The lessor becomes the
writer of a European call option embedded in the contract. Contracts that look like
This article has been jointly written by the authors. In order to acknowledge specific
contributions, Giulio Tagliavini wrote Sections 1 and 4 while Enrico Moretto wrote Section 2
and the appendices. Section 3 was written in common by the two authors.
The authors thank Erio Castagnoli and Paola Modesti for their useful advice.
being profitable may end up in a loss for the lessor. In fact, a final value larger than the Pricing and
fixed buying price obliges the lessor to sell at a smaller price while, in the opposite
case, the lessee does not buy the good, leaving it to the lessor that needs to sell it for a
net profit of
small value. At a first, but eventually wrong, glance, to avoid such an effect lessor operating lease
should keep the final price low.
Thus, competition in the leasing sector has recently led companies to face and
accept higher levels of asset risk. This can be noted in both increased final purchase
price and down payment and in an extended duration of contracts. So-called 829
‘‘operating’’ leases, which are riskier by definition, are becoming increasingly common.
This paper develops a basic model for evaluating leasing contracts in order to
formalize some business intuitions that reveal how a properly managed leasing can
fairly solve this instance of the risk/return problem.

2. Notation and evaluation formula

2.1 Basic framework
In a leasing contract the lessor buys (or owns) an asset and rents it to the lessee, keeping
the property of the good itself till contract’s end (time tn ). The value at a generic time t,
denoted with V(t), of such an asset obviously changes through time, following
recognizable patterns that usually incorporates both a deterministic depreciation and
some random factors. The contract has a fixed structure based on an initial (i.e. at time 0)
down payment A ¼   V ð0Þ;   0, n periodical fixed payments C and a final purchase
price[1], P ¼   V ð0Þ; 0    1  , in tn . As the lessee has the right to buy the asset
in tn at price P, but he is not obliged to, there is some degree of flexibility for the lessee,
this, obviously, negatively reflects on the overall value of the contract for the lessor as he
carries the risk to be asked to sell the asset at a given price regardless to its market value
or to receive it back in case the good’s price at expiration is low.
The evaluation formula (on the lessor side) at time t0 ¼ 0 for the contract is the net
present value (NPV) GðkÞ of all cash-flows[2],

X
n
C min½P; V ðtn Þ
GðkÞ ¼ A þ tj þ  V ð0Þ
j¼1 ð1 þ kÞ ð1 þ kÞtn
ð1Þ
min½V ð0Þ; V ðtn Þ
¼ C  ðn; kÞ þ  ð1  ÞV ð0Þ
ð1 þ kÞtn

where k is the (constant[3]) cost of capital, i.e.P the rate the lessor could alternatively
invest the amount ð1  ÞV ð0Þ in[4], ðn; kÞ ¼ nj¼1 1=ð1 þ kÞtj .
The lessor obviously aims at an adequate return for the invested capital and needs
to take into proper account all uncertainty related to the contract itself. He needs to and
should properly manage overall risk as an integral part of the leasing contract
structure.
Similarly to all other financing possibilities, leasing, too, is the reimbursement over
time of some loaned capital at a rate which both parties agree as fair. Under this point
of view, down payment V ð0Þ and final purchase price V ð0Þ are paid to reimburse
lessor’s outstanding capital while payments C also repay accrued interest. Obviously,
the greater V ð0Þ and V ð0Þ, the lower C will be. If y is the required rate of return for
the lessor and if the lessee decides to keep the asset at time tn , C is a decreasing
MF function in ,
35,10
1    =ð1 þ yÞtn
CðÞ ¼ V ð0Þ  : ð2Þ
ðn; yÞ

We now focus on the influence of  on G(k) so, from now on, the NPV of the leasing will be
830 explicitly dependent on  too, i.e. we write Gðk; Þ. By substituting (2) in (1) we get
" #
V ð0Þ ðn; kÞ min½V ð0Þ; V ðtn Þ
Gðk; Þ ¼ ðn; k; yÞð1  Þ  tn þ ; ð3Þ
ðn; yÞ ð1 þ yÞ ð1 þ kÞtn

where ðn; k; yÞ ¼ ðn; kÞ  ðn; yÞ > 0 when y > k.

2.2 The impact of asset risk

In the following we will deal with only with the asset risk, expressed in (3) by the term
min½V ð0Þ; V ðtn Þ. The lessee will exercise the option to buy if V ð0Þ < V ðtn Þ, i.e. if
he can buy the asset at a lower price than the market one. This opportunity resembles
the financial structure of a (plain vanilla) European option[5] with strike price V ð0Þ.
By exploiting well-known pricing techniques, we can give a fair value to such an
option, analyse the impact of the asset risk in the overall contract and eventually
suggest an optimal strategy, for the lessor, in defining .
A first, naı̈ve, approach for the lessor is to reduce , making it as close as possible
to 0. This choice leads both to a reduction of asset risk and to larger values for CðÞ,
making the contract less appealing to the lessee. There is, though, an ‘‘optimal’’
strategy in fixing . In fact if V ð0Þ  V ðtn Þ, i.e. when   V ðtn Þ=V ð0Þ, (3) becomes
( " #)
V ð0Þ ðn; yÞ ðn; kÞ
Gðk; Þ ¼ ðn; k; yÞð1  Þ þ   ;
ðn; yÞ ð1 þ kÞtn ð1 þ yÞtn

a linear function in , increasing when ðn; k; yÞ ¼ ðn; yÞ=ð1 þ kÞtn  ðn; kÞ=
ð1 þ yÞtn > 0. It can be shown that ðn; k; yÞ > 0 when y > k. In the opposite case,
V ð0Þ > V ðtn Þ, (3) is
" #
V ð0Þ ðn; kÞ V ðtn Þ
Gðk; Þ ¼ ðn; k; yÞð1  Þ  þ ;
ðn; yÞ ð1 þ yÞtn ð1 þ kÞtn

a linear decreasing function in . For y > k, noting that, in this case, Gðk; 0Þ ¼
V ð0Þðn; k; yÞð1  Þ=ðn; yÞ > 0, a likely shape for Gðk; Þ is shown in Figure 1[6] .
Therefore an optimal and (strictly) positive level for  that maximizes Gðk; Þ exists.
In the opposite situation, y < k, Gðk; Þ is a decreasing function in  and, moreover,
Gðk; 0Þ ¼ V ð0Þðn; k; yÞð1  Þ=ðn; yÞ < 0, making the leasing unprofitable for every
possible value of .
A final remark: NPV is here a decreasing function with respect to . The greater the
, the smaller the capital invested in the operation. As NPV returns a monetary value
rather than a rate of return, larger Gðk; Þ comes from larger stakes of capital invested
in a profitable operation. Under this point of view (i.e. we do not consider lessee’s
default risk) the down payment should be kept to a minimum level.
 Pricing and
net profit of
operating lease

831

Figure 1.
Net present value of a
leasing contract for
different values of the
final purchase price

To proceed with our analysis, we now need to define how to determine the final value
V ðtn Þ of the asset. Consistently with financial literature, we exploit two approaches:
the first deterministic (section 2.3), the latter stochastic (section 2.4).

2.3 Deterministic evolution

Following Dixit and Pyndyck (1994), we now define[7] V ðtÞ ¼ V ð0Þ  et ;  > 0, as
the expression of asset depreciation. Parameter  stands for the constant
instantaneous depreciation rate. By substituting this into (3) we end up with
" #
ðn; k; yÞð1  Þ  ðn; kÞ=ð1 þ yÞtn minð; etn Þ
Gðk; Þ ¼ V ð0Þ þ
ðn; yÞ ð1 þ kÞtn

or, equivalently:
8  
> ðn; k; yÞð1  Þ þ   ðn; k; yÞ
>
> V ð0Þ for   etn
>
> ðn; yÞ
>
< 2 3
ðn; k; yÞð1  Þ þ etn ðn; yÞ=
Gðk; Þ ¼ t
6 ð1 þ kÞ n  ðn; kÞ=ð1 þ yÞ n 7t
>
>
>
> V ð0Þ6
4
7
5 for  > etn :
>
> ðn; yÞ
:

Once again, when y > k Gðk; 0Þ is positive and Gðk; Þ shows the same features of the
general case in the previous section: there exists a maximum, that depends on , for
 ¼ eatn . This level depends on the depreciation factor . When y < k the maximum
is achieved for   ¼ 0 but Gðk; 0Þ < 0, so the contract carries no profit.
Figure 2 shows that, other values being equal, the greater the depreciation, the
lower both the maximum profit for the lessor and the optimal purchase level   .
MF
35,10

832

Figure 2.
Net present value of a
leasing contract for
different values of the
depreciation rate in the
deterministic setting

2.4 Stochastic evolution

A more detailed dynamics for V ðt Þ is

dV ðtÞ ¼ V ðt Þdt þ V ðtÞdwðtÞ ð4Þ

that is a special case, known as geometric brownian motion with drift, of the stochastic
differential equations. The term dwðt Þ is a brownian motion, while  denotes the
(constant) volatility of the relative value process. This equation has been widely
used in many fields. In finance it has been exploited by Black and Scholes (1973) and
supplied[8] a closed-form expression to determine the fair price of an European call
option written on an underlying asset whose price’s dynamics is as in (4) and with a
pay-off at expiration max½V ðtn Þ  V ð0Þ; 0. The value of such an option at time 0 is:
 
ð0;  Þ ¼ V ð0Þ N ½d1 ðÞ  ertn  N ½d2 ðÞ ; ð5Þ
  pffiffiffiffi pffiffiffiffi
with d1 ðÞ ¼ r þ 1=22 tn  ln = tn , d2 ðÞ ¼ d1 ðÞ   tn , N ðÞ the cumulate
of a standardized normal distribution and r is the (instantaneous) risk-less rate of
return on ½0; tn .
Recalling footnote 5, the value of the option embedded in a leasing contract is, for
the lessor, V ð0Þ  ð0;  Þ ¼ V ð0Þf1  N ½d1 ðÞ þ ertn  N ½d2 ðÞg. Therefore by
plugging this into (3) we get (see Figure 3):
" ( )
ðn; k; yÞð1  Þ rtn ðn; kÞ
Gðk; Þ ¼ V ð0Þ þ 1 þ  e N ½d2 ðÞ  þ
ðn; yÞ ðn; yÞð1 þ yÞtn ð6Þ
N ½d1 ðÞ:

The first thing to note in (6) is that parameter  does not appear. In this context, the
depreciation rate is not relevant at all. Second, if  ¼ 0, the NPV is (see Appendix 1)
Gðk; 0Þ ¼ V ð0Þ  ðn; k; yÞð1  Þ=ðn; yÞ, positive when y > k. A condition for the
 Pricing and
net profit of
operating lease

833

Figure 3.
Net present value of a
leasing contract for
different values of the
final purchase price in the
stochastic setting

existence of an optimal strictly positive value  that maximizes Gðk; Þ derives

from determining when ½@=@Gðk; Þ¼0 > 0. Recalling Appendix 1, lim!þ1
Gðk; Þ ¼ 1 and, therefore, Gðk; Þ is increasing in  ¼ 0 but needs to become
decreasing at some point. This condition is equivalent (Appendix 1) to

ðn; yÞð1 þ yÞtn > ðn; kÞertn ð7Þ

and it can be shown that when y > k, (7) is satisfied.

The fact that Gðk; 0Þ ¼ V ð0Þ  ðn; k; yÞð1  Þ=ðn; yÞ indicates that the choice of
fixing a small final purchase level is a way to eliminate both volatility and asset risks;
in fact this expression does not involve  and  at all. Our results indicate, on the other
hand, that some (hopefully optimal) portion of asset risk should be accepted as it leads
to larger NPV.
Quantitative finance offers some useful tools, the so-called greeks (Hull, 1993), to
deal with variations in the parameters of Black and Scholes’ formula. The most
relevant here is Vega, the first derivative of the price of an European option with
respect to the volatility of the underlying asset. Such a derivative in our case is

@ V ð0Þ  

G¼ n½d1 ðÞd2 ðÞ ertn þ 1 þ ertn tn ;

@ 
always negative[9]. This shows how a positive variation of the volatility reduces the
NPV, pinpointing that the effect of volatility affects only the lessor’s side. This effect is
depicted in Figure 4, where the graph of Gðk; Þ is shown for different values of .
Lastly, Figure 5 clearly shows how volatility influences the optimum purchase price.
For higher levels of volatility, the optimal level of purchase price reduces to 0. In
Appendix 2 an analytical explanation is reported.
MF
35,10

834

Figure 4.
Net present value of a
leasing contract for
different values of  for
different values of the
final purchase price

Figure 5.
Optimal values for  for
different levels of 

As a last point of this section, we briefly address the influence of the down payment for
the NPV. From (6) it is trivial to note that the larger the , the smaller the Gðk; Þ.
Therefore this value should be kept to a minimum. This suggestion, though, does not
consider lessee default risk, i.e. the chance the lessor will not receive a full
reimbursement of his outstanding capital.
3. Some operative remarks Pricing and
3.1 Pricing and profitability
Another way, mostly similar to what has been presented so far, to deal with financial
net profit of
profitability is to apply the internal rate of return (IRR)[10] instead of the NPV operating lease
technique. As we saw above, the required return rate y is the internal rate for the
lessor if there is certainty that the lessee will exercise the embedded option to
purchase. But what if the lessee lets the option expire and does not buy the asset? In
this case, the IRR can be different than the required one and becomes dependent on : 835
we therefore denote it with xðÞ. To determine it we, numerically, solve the following
equation:

½ðn; xðÞÞ  ðn; yÞð1  Þ

þ 1  N ½d1 ðÞ
ðn; yÞ
( )
rtn ðn; xðÞÞ
þ e  N ½d2 ðÞ  ¼ 0;
ðn; yÞð1 þ yÞtn

obtained by setting (6) equal to 0. Rearranging the terms to isolate xðÞ we get

ðn; yÞfN ½d1 ðÞ  ertn  N ½d2 ðÞ   g

ðn; xðÞÞ ¼ :
1    ð=ð1 þ yÞtn Þ

This equation has always a single solution, due to the fact that ðn; xðÞÞ is a
monotonic decreasing function with respect to xðÞ; therefore, for suitable values of the
right-hand side, there is only a value for xðÞ. A likely plot of xðÞ vs  is shown in
Figure 6.
It can be finally shown, again numerically, that the maximum for both NPV and
internal rate is achieved for the same optimal level   .

Figure 6.
Internal rate of return of a
leasing contract for
different values of the
final purchase price in the
stochastic setting
MF The lessor can also decide the level of  based on the choice of a pre-specified internal
rate. To achieve this, the above equation has to be solved, once again analytically, with
35,10 respect to . Unfortunately in this case the equation can have two solutions or no
solution at all for different values of , as can be seen in Figure 6. The lessor, therefore,
has to be very careful in using numerical methods to solve the equation and should
check the obtained level of .
836 3.2 Asset risk management
So far we have shown how the profit for the lessor from a leasing depends on both final
purchase price and volatility of the value of the asset. The lessor can accept this risk
that, we remind, is on his side only, if fairly remunerated. We propose a formula to
correct the rate of return y that now depends on both  and  so that we denote it with
yð; Þ, with

@ @
yð0; 0Þ ¼ y0 > 0; yð; Þ  0 and yð; Þ  0:
@ @

A possible expression is yð; Þ ¼ y0 þ q  þ q maxð  0 ; 0Þ with q > 0, q > 0

and 0 a target volatility level; when the volatility is greater than 0 the lessor
requires an adequate rate y to compensate increased volatility risk. To prevent the
leasing from being unappealing for the lessee, parameters q and q have to be chosen
carefully.
Our analysis is here mainly graphical. According to this we cannot disentangle the
effect of the single factors so we separately represent the NPV of the leasing for
different levels of  and . We first study the effect of q on yð; Þ by plotting the NPV
for different values of q itself and 0 ¼ 0:7 (see Figure 7).
For larger values of q both the maximum value for the NPV and the optimal level
 increase. This is explained by noting that for higher levels of the remuneration rate,

Figure 7.
Net present value of a
leasing for different
values of q
the larger the duration of the contract, the larger the final outcome, as outstanding Pricing and
capital is rewarded more.
Secondly, we analyse the impact of  on NPV. To give another example, we
net profit of
set  ¼ 0:2, q ¼ 0:05, q ¼ 0:03 and two trigger levels for : 0 ¼ 0:7 and operating lease
0 ¼ 1. By plugging yð; Þ into (6) we get an expression whose graph is shown in
Figure 8.
The result is clear: unprofitable leases can become profitable if the lessor inserts a
correction for volatility. It is also worth noting that the three NPVs share the same 837
pattern for small values of .

4. Conclusions
This paper carries a contribution to the analysis of a relevant problem, the asset
risk, in leasing contracts. Quantitative techniques enable us to establish how the
lessor should optimally determine the final purchase price as it is shown that
this value significatively impacts the profit and the internal rate of the financing
operation.
On the basis that both parties act according to the economic principle and
prefer ‘‘more to less’’, so that the lessor designs the contract to maximise his profit and
the lessee evaluates and chooses which lease to accept under market conditions and
exercise the embedded purchase option only if the purchase price is smaller than the
market value of the asset, the result is that, once determined a priori the level of
variability the asset price will be subject to during the duration of the contract, there
exists a purchase price that maximizes the NPV of the operation for the lessor.
In conclusion, this article shows how quantitative finance offers reliable tools
capable to manage various kinds of risk, such as asset one. An analysis of the impact
other sources of risk into a leasing contract is left for further research.

Figure 8.
Net present value of a
leasing for different
volatility levels
MF Notes
35,10 1. The final purchase price ranges between 0    0:35 but it is customary fixed at
 ¼ 0:01 or  ¼ 0:02. The rest of the paper will debunk this custom.
2. Here, for sake of brevity and clarity, we ignore other side costs and fees, that can arise
for the lessor, and fiscal charges.
3. We consider k constant throughout the duration of the contract for sake of simplicity; we
838 could have dealt with a non-flat term structure for the evaluation rates but we claim that
this does would not significatively improve our analysis.
4. This is the effective amount of money the lessor invests in the leasing.
5. To be precise the pay-off of an European call option is max½V ðtn Þ  V ð0Þ; 0. The pay-off
min½V ð0Þ; V ðtn Þ we are dealing with can be easily rewritten as
V ðtn Þ  max½V ðtn Þ  V ð0Þ; 0 so, denoting with ð0;  Þ the price of the European call
option with V ð0Þ as strike price, the value in 0 of min½V ð0Þ; V ðtn Þ is V ð0Þ  ð0;  Þ.
Finally note that such an option is, at time 0, deeply ‘‘in-the-money’’ (Hull, 1993) as it would
be exercised if this were possible.
6. In this and all the following example we use these values: V ð0Þ ¼ 10; 000,  ¼ 0:1,
k ¼ 0:05, y ¼ 0:1, tn ¼ 3 years, V ð3Þ ¼ 1; 000, ð36; 0:1Þ ¼ 31:186 and ð36; 0:05Þ ¼
33:421. This yields Gð0:05; 0Þ ¼ 645.
7. This expression derives from the solution of the differential equation

dV ðt Þ ¼ V ðt Þdt

with V ð0Þ as initial value.

8. Most empirical financial literature provides evidence that this model fails to determine
the market price of an option. We claim this does not affect our result as, as supported
by Heston (1993), Black and Scholes’ formula yields more accurate prices for long term
contracts, as it is in a leasing one.
9. The only term that can be negative in the derivative is d2 ðÞ but, for small values of , the
term lnð1=Þ is large enough to prevent d2 ðÞ from being negative (see Appendix 1).
10. The criterion of choice known as ‘‘internal rate of return’’ (IRR) is widely known and
often used. It has been criticised (for example by Brealey and Myers (1994)) as it can
lead to incoherent financial decisions. It is in fact possible to construct examples of
financial operations with no IRR or with more than one of such rates. Practitioners are
widely using this criterion, although Berkovitch and Israel (2003) note that it is
becoming less common. Our analysis here is intended to exemplify practical aspects
rather than theory, so our results should be interpreted taking account of the weakness
of the criterion itself.

References
Berkovitch, E. and Israel, R. (2003), ‘‘Why the NPV criterion does not maximize NPV’’, Review of
Financial Studies, Vol. 17 No. 1, pp. 239-55.
Black, F. and Scholes, M. (1973), ‘‘The pricing of options and corporate liabilities’’, Journal of
Political Economy, Vol. 81, pp. 637-54.
Brealey, R.A. and Myers, S.C. (1994), Principles of Corporate Finance, 4th ed., McGraw-Hill,
New York, NY.
Caretta, A. and Fiordelisi, F. (2000), ‘‘Il leasing operativo’’, Bancaria Editrice.
Dixit, A.K. and Pindyck, R.S. (1994), Investment Under Uncertainty, Princeton University Press,
Princeton, NJ.
Heston, S.L. (1993), ‘‘A closed-form solution for options with stochastic volatility with Pricing and
applications to bond and currency options’’, Review of Financial Studies, Vol. 6 No. 2,
pp. 327-43.
net profit of
Hull, J.C. (1993), Options, Futures and Other Derivative Securities, Prentice Hall, Englewood
operating lease
Cliffs, NJ.

Further reading
839
Tagliavini, G. (1998), ‘‘La valutazione del rischio di credito e del rischio bene’’, in Alessandro, C. and
Giacomo, D.L. (Eds), Alessandro Carretta e Giacomo De Laurentis, Egea, Milan, pp. 513-30.

Appendix 1
Ð dðÞ 2 pffiffiffiffiffi
We first recall that N ½dðÞ ¼ 1 eð1=2Þx = 2dx and set ð@=@zÞN ð zÞ ¼ nð zÞ as the derivative
pffiffiffiffiffi ð1=2Þz2
of pthe cumulative function so that nð zÞ ¼ 1=
ffiffiffiffiffi ð1=2Þd pffiffiffiffiffiffiffiffiffi e
2 and, finally, ð@=@ÞN ½dðÞ ¼
2
ðÞ ð1=2Þd 2 ðÞ
1= 2e  ð@=@ÞdðÞ ¼ e = 2tn . Algebraic results used in the paper are
as follows: lim!0þ N ½d1 ðÞ ¼ lim!0þ N ½d2 ðÞ ¼ 1, lim!þ1 N ½d1 ðÞ ¼ lim!þ1
N ½d2 ðÞ ¼ 0, lim!0þ d1 ðÞ ¼ lim!0þ d2 ðÞ ¼ 1 so that lim!0þ Gðk; Þ ¼ V ð0Þ  ðn; k; yÞ
ð1  Þ=ðn; yÞ and lim!þ1 Gðk; Þ ¼ 1. lim!þ0þ d2 ðÞ ¼ þ1.
To evaluate the derivative of Gðk; Þ with respect to  we get
(( )
@ rtn ðn; kÞ
Gðk; Þ ¼ V ð0Þ e N ½d2 ðÞ 
@ ðn; yÞð1 þ yÞtn

@ @
þertn N ½d2 ðÞ  N ½d1 ðÞ ;
@ @

or, equivalently,
(( )
@ rtn ðn; kÞ
Gðk; Þ ¼ V ð0Þ e N ½d2 ðÞ 
@ ðn; yÞð1 þ yÞtn
2 2
)
ertn eð1=2Þd2 ðÞ eð1=2Þd1 ðÞ
 pffiffiffiffiffiffiffiffiffi þ pffiffiffiffiffiffiffiffiffi
2tn  2tn 

(( )
@ rtn ðn; kÞ
Gðk; Þ ¼ V ð0Þ e N ½d2 ðÞ 
@ ðn; yÞð1 þ yÞtn
2 2
)
e½ð1=2Þd2 ðÞþrtn  eð1=2Þd1 ðÞ
 pffiffiffiffiffiffiffiffiffi þ pffiffiffiffiffiffiffiffiffi :
2tn  2tn 

To determine the value of ð@=@ÞGðk; 0Þ we exploit the above limits to end up with
" #
@ rtn ðn; kÞ
Gðk; 0Þ ¼ V ð0Þ e  ;
@ ðn; yÞð1 þ yÞtn
ðn;kÞ
that is positive when ertn  ðn;yÞð1þyÞ tn > 0 or, equivalently,

ðn; yÞð1 þ yÞtn > ðn; kÞertn :

MF Appendix 2
It is interesting to analyse the behaviour of Gðk; Þ for ‘‘extreme’’ cases of the
35,10 volatility parameter . As lim!0þ N ½d1 ðÞ ¼ lim!0þ N ½d2 ðÞ ¼ 1, lim!þ1 N ½d1 ðÞ ¼ 1 and
lim!þ1 N ½d2 ðÞ ¼ 0, we get
( " #)
ðn; k; yÞð1  Þ ðn; kÞ
limþ Gðk; Þ ¼ V ð0Þ þ  ertn 
!0 ðn; yÞ ðn; yÞð1 þ yÞtn
840 and
" #
ðn; k; yÞð1  Þ ðn; kÞ
lim Gðk; Þ ¼ V ð0Þ  :
!þ1 ðn; yÞ ðn; yÞð1 þ yÞtn

In the first case the shape of the NPV is linear, with a positive intercept for y > k and increasing
when ðn; yÞð1 þ yÞtn > ðn; kÞertn . In the second Gðk; Þ is always decreasing. This shows that
higher volatility levels reduces and eventually eliminates the positive ‘‘final purchase value’’
effect.

Corresponding author
Enrico Moretto can be contacted at: enrico.moretto@uninsubria.it

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