John Deere has a new S690 combine harvester that sells for $300,000. Realizing that many of its customers can’t afford this amount upfront, Deere’s financing subsidiary offers a level payment lease option for a ten year term, with no salvage value (so that the customer could keep it or sell it at that point). Deere’s cost of capital is 8%. Deere’s CFO calculates that a level payment lease can be calculated using the payment function in Excel ( = PMT(rate, time, PV). She finds that in Excel, =PMT(8%,10,300000), this produces an equal annual payment of $44,709 for ten years
A customer then asks if he could take this lease, but also have a cancellation option that would allow him to return the S690 combine harvester to Deere at the end of 5 years. You are asked to analyze the value of this option to the customer. You believe that if the S690 was returned at the end of 5 years, it would have a value of $100,000. You know the customer considers his discount rate to be 8%, the volatility of combine harvester values is also 8% annually, and that 5 year risk free rates are currently 3.5%.
From the standpoint of John Deere, what is this cancellation option worth today?
Ignore taxes for this problem.