What it means
Most leases end in one of three ways: hand the asset back, extend the lease, or buy the asset outright. A fixed price purchase option makes that third route predictable, because the number was settled when the contract was signed rather than argued over at the end.
The alternative is a fair market value option, where the buyout price is whatever the asset is worth on the day. That protects the lessor from underpricing but leaves the lessee exposed to a strong second hand market, which is precisely the risk a fixed price removes.
The option is genuinely optional, and that asymmetry is where its value lies. If the asset is worth more than the agreed price the lessee buys and keeps the difference; if it is worth less, the lessee simply walks away and the lessor is left with equipment worth less than it hoped.
Lessors price that risk into the rentals. A very low option price, sometimes a nominal $1, usually means noticeably higher monthly payments and normally makes the arrangement a finance lease for accounting purposes, because the lessee is effectively buying the asset in instalments.
Accounting treatment turns on whether exercise is reasonably certain. If it is, the purchase price must be built into the lease liability from the outset, which changes both the balance sheet and the pattern of expense, so the option is never a purely commercial detail.
In practice
Real-world examples.
Example
A haulage firm leases twenty trailers with a fixed option of $6,000 each. Second hand trailer prices rise sharply during the term, so the firm buys all twenty for $120,000 against a market value of roughly $9,000 each, capturing about $60,000 of value it would have lost under a fair market value option.
Example
A dental practice leases an imaging unit with a $1 buyout at the end of a six year term. The monthly payment is noticeably higher than on a comparable fair market value lease, and the accountant records the arrangement as a finance lease because ownership is effectively certain from day one.
Example
A print shop leases a press with a fixed option of $40,000, then watches a new generation of machines halve the value of the model it holds. It returns the press at the end of the term and the lessor absorbs the loss it had implicitly underwritten when it set the price.
Formula
Calculation
Total cost of ownership through the option = (monthly rental x number of months) + fixed option price
Gain from exercising = market value at the end of the term - fixed option price
A construction company leases a $120,000 excavator for five years at $2,100 a month, with a fixed price purchase option set at 10% of the original cost, that is $12,000.
Rentals total 60 x $2,100 = $126,000. Exercising the option brings the full cost of owning the machine outright to $126,000 + $12,000 = $138,000.
Whether to exercise depends on the machine's value at the end of the term. If comparable five year old excavators sell for $20,000, exercising is worth $20,000 - $12,000 = $8,000. If the market has weakened and they fetch only $9,000, the company hands the machine back and saves $12,000 - $9,000 = $3,000 against buying it.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Marlbrook Cold Storage, an invented food logistics business, needed six refrigerated trailers costing $90,000 each and compared two five year lease offers on identical equipment.
Offer A charged $1,500 per trailer per month with a fair market value buyout. Offer B charged $1,620 per month with a fixed price purchase option of $18,000 per trailer. Across five years Offer A cost 60 x $1,500 x 6 = $540,000 and Offer B cost 60 x $1,620 x 6 = $583,200, a premium of $43,200 for the certainty.
When the leases matured in this fictional scenario, refrigerated trailers of that age were selling for about $26,000. Marlbrook exercised its option on all six for 6 x $18,000 = $108,000, some $48,000 below the market value of 6 x $26,000 = $156,000, comfortably recovering the $43,200 it had paid in higher rentals. Had the second hand market fallen instead, the company would simply have handed the trailers back and treated the premium as the cost of insurance.
Watch out
Common mistakes.
- Comparing lease quotes on the monthly payment alone and ignoring what the buyout will cost or be worth at the end.
- Treating the option as an obligation, when the lessee can always walk away if the asset is worth less than the agreed price.
- Overlooking the accounting consequence, since an option reasonably certain to be exercised must be included in the lease liability from day one.
Questions
People also ask.
Is a $1 buyout a fixed price purchase option?
Yes, it is the extreme version, and it almost always signals a finance lease because the lessee will certainly exercise it.
How is the fixed price usually set?
Often as a percentage of the original cost, commonly somewhere between 10% and 20% for equipment, based on the lessor's estimate of residual value.
What is the main downside for the lessee?
Slightly higher rentals, because the lessor is giving up any upside on the asset's residual value and charges for that in the monthly payment.
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