Residual Value: What It Is and How to Calculate It
Many people choose to lease items such as cars. When you lease a vehicle, you sign a contract, which outlines a payment plan for a fixed term. During the lease period, you pay a monthly or annual fee until the end of the agreement. When you research options and compare offers for different vehicles, you will likely encounter the phrase “residual value” frequently.
Residual value is the asset's estimated value at the end of the lease term or at the end of its projected useful lifespan. Essentially, it is either the value of the item when it is no longer needed or when its lease agreement comes to an end.
What Is Residual Value?
Residual value is a term used to describe the estimated value of an asset after a lease term has expired or the lessee no longer needs it. The residual value of the asset is calculated based on how much the company in charge of leasing or lending the asset believes it will be worth once the set term has elapsed.
In layman's terms, residual value means what is left of the value of the asset. In the case of a car, for example, the residual value would be the projected value of the vehicle after you have fulfilled your lease contract.
Understanding Residual Value
The technicalities of residual value may vary from one industry to another, but the core meaning of residual value remains the same. Understanding residual value is important for lenders and consumers or business owners who are looking to lease assets.
It’s worth noting that there are differences between the meanings of residual value in different scenarios. For investors, for example, the residual value relates to the difference between the cost of the capital and the profits generated.
For projects that involve capital budgeting, the residual value describes the anticipated sale price or exchange value once the asset is no longer used or required or its revenue becomes unclear.
Residual Value vs. Resale Value
Residual value is different from resale value. The two terms are very similar, but there is one key difference. Residual value is used to describe the estimated value of a car that has been leased, while resale value is the projected worth of a car that has been bought.
Examples of Residual Value
Looking at examples of residual value can help provide a better understanding of the meaning of the term and highlight why it is essential to consider before getting a car lease.
- Leasing a Car
A growing number of people are choosing to lease a new car as an alternative to buying a vehicle through a loan. Leasing is beneficial because it enables you to spread the cost and access a broader range of cars. The residual value of a hire vehicle is the projected value of the car at the end of the lease term.
This calculation is completed by the lender responsible for issuing the lease contract and is based on previous sales data and models and estimated valuations for the future. The vehicle’s residual value plays an integral role in calculating the cost of leasing the car.
- Leasing Equipment
Many firms choose to lease equipment because it is less expensive than buying it, and this method provides greater flexibility. When you lease, for example, tools or machinery for manufacturing, the residual value is calculated based on their projected lifespan.
To reduce risks, companies can purchase residual value insurance. This provides a guarantee that the assets will retain a certain value at the end of a contract or their useful life.
How to Calculate Residual Value
The methods used to calculate residual value may differ slightly depending on the industry, but most commonly, it is calculated by using the salvage value and the cost of disposing of the asset.
The salvage value of the asset is its projected worth. This is an estimate of the value based on trends, pricing models and the value of comparable items on the market. To calculate the residual value, you take the disposal cost away from the salvage value using this residual value formula:
Residual value = Estimated Salvage Value - Cost of Disposal
If, for example, a machine has an expected useful lifespan of eight years, the residual value will relate to the projected value of the asset after eight years of use. This is also known as salvage value. If the salvage value of a machine is estimated at $7,500, the residual value will be the salvage value minus any additional costs to dispose of the asset. If it costs $500 to take equipment to the dump, for example, the residual value would be $7,500 minus $500 for a total of $7,000.
How Residual Value Works
One of the best ways to understand how residual value works is to look at the example of a lease car. If you want to lease a vehicle, you will need to agree terms with a lender. This is how it works in practice:
- The lender will determine the price of the vehicle. This is calculated by taking away the value of a vehicle you’re exchanging or the down payment you are making from the overall value of the vehicle.
- The lender will calculate the residual value of the car based on the agreed lease term and the predetermined price of the car.
- The lender will calculate the projected vehicle depreciation by taking the residual value away from the starting price.
- The depreciation amount along with taxes, fees and any other additional charges will get divided by 12 to produce a monthly payment for the car.
To illustrate this, let’s take a concrete example. Vehicle A costs $30,000, and the customer would like to take out a lease term of one year. During the lease term (12 months), the lender estimates that the car will depreciate by 20%, which equates to $6,000.
This means that the car's residual value would be $24,000 ($30,000 - $6,000). The customer wanting a lease will pay $6,000 for the depreciation of the vehicle, plus additional charges, including taxes and fees. The total is then divided by 12 to produce a monthly fee of $500 plus taxes and fees.
Tips for Leasing a Car
If you plan to lease a car, it is always beneficial to look for a vehicle that has a high residual value. If depreciation rates are lower, this means that the car will more likely retain most of its value, meaning that your monthly payments will cost less.
Generally speaking, manufacturers offer good deals on vehicles with high residual value because they are often more attractive to drivers than buying used cars. Lenders tend to prefer low residual values because they can lease their vehicles at high prices without worrying about selling the car for a more competitive price at the end of the agreement to make their money back.
It is wise to look at the residual value of vehicles before you decide which car model you want to lease. If you don’t plan to purchase the vehicle at the end of your set lease term, look for an automobile with a high residual value, as this will most certainly lower your monthly payments.
If you instead wish to buy your preferred car after the contract ends, it’s best to opt for one with a low residual value. Your average monthly payments may turn out to be on a higher end, but the cost of purchasing the vehicle will be lower.
What Are the Benefits of Residual Value?
The benefits of residual value include:
- Calculating lease payments: residual value is one of the most important factors for lessors looking to determine how much a lessee will pay to lease an asset. In the case of leasing a car, the residual value will help in deciding how much the customer should pay to rent the vehicle.
- Calculating depreciation and amortization: residual values are essential for business accounting. The residual value of the asset will enable an accountant or a company owner to work out depreciation and amortization rates. If the residual value is $0, for example, and the initial value of the asset was $10,000, and the term was five years, the amortization rate would be $2,000 per year. If the residual value ends up being $2,000, the amortization rate would be $8,000 (starting value minus residual value) divided by five (the length of the term).
Summary
Residual value is a term used to describe the projected value of an asset at the end of its useful life or lease term. Commonly used when leasing vehicles, it plays an integral role in determining the monthly cost of leasing a car.
Further Reading:
FAQ
What does the residual value tell you?
Residual value tells you the estimated worth of an asset once its useful life has come to an end or a lease agreement term expires.
How do you determine residual value?
To calculate the residual value of, for example, manufacturing tools, you take the projected value of the asset and subtract from it the cost of disposal. In the case of a car, the residual value of vehicles is calculated based on market comparisons and sales data.
Why are the residual values important?
Residual values are crucial when leasing a vehicle because they determine how much you will pay for the car per month. The residual value will also determine how much the car will cost to buy if you want to purchase the vehicle at the end of the lease agreement. In general accounting, residual values help calculate both depreciation and amortization.
How often do residual values change?
Residual value can change frequently, and it is beneficial for companies that lease assets to calculate values every year. It is possible to take out residual value insurance to minimize risks.
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