Residual Risk and the Valuation of Leases under Uncertainty and Limited Information

For a variety of tax, accounting, and economic reasons, leasing has become an enormously popular method of financing the acquisition of capital assets. In particular, for power generation assets, the use of leasing products (including synthetic and leveraged leases) has grown substantially in recent years. However, the long-lived nature of most power generation assets, together with their often unique physical and economic characteristics, makes estimation of their residual values challenging. In an environment where uncertainties are commonplace and in which capital structures are often highly leveraged, even small changes in residual values can have a significant impact on the profitability of financial institutions and other investors. This article outlines a framework for analyzing the uncertainty in residual values for assets, such as power generation facilities, for which few data points exist.