In the late 1990s, car leasing was very popular in the United States.  A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car.  If the customer decided to keep the car, the customer would pay a price to the manufacturer, the “residual value,” computed as 60% of the new car price.  The manufacturer would then sell the returned cars at auction.  In 1999, the manufacturer lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value).Why was the manufacturer losing money on this program?What should the manufacturer do to stop losing money (while still leasing cars)?

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Asked Jan 26, 2020
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In the late 1990s, car leasing was very popular in the United States.  A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car.  If the customer decided to keep the car, the customer would pay a price to the manufacturer, the “residual value,” computed as 60% of the new car price.  The manufacturer would then sell the returned cars at auction.  In 1999, the manufacturer lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value).

  • Why was the manufacturer losing money on this program?
  • What should the manufacturer do to stop losing money (while still leasing cars)?
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Expert Answer

Step 1

The car leasing was a popular business in the US economy in the 1990s where the consumers were allowed to lease the car for two years. After the two years, the consumers had the option to either keep the car or not. When the consumer decides to keep the car, the consumer needs to pay a price to the manufacturer of the car which is known as the residual value of the car. The residual value of the car was calculated to be 60 percent of the price of the new car. When the consumer decides not to keep the cars, they would be returned to the manufacturer and the manufacturer would sell those cars at auction. When this happens, the manufacturer faces a loss of $480 on each returned car which was generally less than the residual value of the car.

Step 2

The manufacturers were losing huge amount of money in this leasing program because of the calculation of the residual value and the auction value. The residual value of the car when the consumer decides to keep the car had to be decided based on the market value anticipation. The manufacturers but decided to fix the price as 60 percent of the value of the new car. The value of the car depends...

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