Several situations warrant the disposal of assets, the most common being to offset loans. You’ll need to get an estimate of your asset to enable you to sell them within the market value. This is where Residual value comes in; it is the estimated amount asset owners would earn by selling their assets.
Residual value is used to determine the worth of an asset believed to have reached its use date. This evaluation is usually done when determining the value of an asset at the end of a lease.
What is Residual Value?
Residual value is an estimated amount an asset owner would earn after selling an asset. When taking out this estimation, the asset is considered to have reached the end of its useful life.
To properly evaluate an asset’s residual value, you must deduct the estimated cost of selling the asset. Generally, an asset’s residual value is calculated as its fair market value, determined by agreement or appraisal.
If you’re looking to lease an asset for a set duration, it is advisable to go for one with a high residual value. This is because if the asset retains more of its value, the depreciation amount will be lower, making your monthly payment lower.
However, if you plan to procure the asset at the end of the lease term, it is advisable to go for a lower-residual-value asset. This has a better long-term benefit even though you will pay higher monthly during the lease term. In the end, you will procure the asset at a lower price – usually the residual value and any purchase-option fees.
Note that there can be fluctuations between the residual value and its actual market value at the purchase time. This could be due to estimation inaccuracy of the asset’s value from the lessee at the end of the lease term.
Generally, purchasing an asset after a lease is advisable when the residual value is lesser than the market value. Reevaluate the purchase if the residual value is greater than the market value as your asset’s value will be lesser than it would cost to buy the asset.
There’s no harm in comparing the entire cost of leasing and then buying at the end of the lease to buying outrightly. Your comparison might help you save money.
How Residual Value Works in Canada
Residual value differs per institution in Canada as every lessee calculates residual value differently. It is also projected by the leasing institution holding the lease contract. A potential lessee uses a residual value as a significant determining factor when calculating your monthly lease payment.
Residual value evaluation is done depending on the asset. For example, if you’re in a car lease contract for five years, its residual value is the amount it is worth after five years. Your leasing institution determines the residual value based on the past models of the car and future predictions. Aside from residual value, factors like interest rates and tax are used to determine an asset’s monthly lease payment.
Since assets can be in any form, a company with numerous expensive fixed assets can manage asset-value risk by purchasing residual value insurance to guarantee assets’ value at the end of their use date.
How to Calculate Residual Value
Residual value is used to calculate an asset’s depreciation expense. And since the residual value is the end worth of an asset, it must be subtracted from the purchase amount to get the total amount, which will give the depreciation amount.
The amount is then divided by the asset’s useful life in years to determine the annual depreciation expense. There are several ways to calculate an asset’s residual value. Some of them include:
- No value
The no-value method is based on the assumption that the asset does not have any value at the end of its use date. Accountants mostly do a no-value residual value calculation as it simplifies the calculation of depreciation.
This is an efficient method for assets whose value is beneath the estimated level. Note that the final amount of depreciation is usually higher than when the residual value is considered with this method.
- Comparables
This is the most secure method to get the residual value of assets. This is done by comparing the calculated residual value to the value of comparable assets traded in a structured market.
- Policy
A company can have its policy regarding the residual value of all assets. For example, a company policy can state that all assets under a particular class should be deemed the same. This method is flawed as the derived value can be higher than the market value, thereby reducing the business’s depreciation expense.
Effects of Residual Value on Lease
Generally, how residual value works at the end of your lease depending largely on the kind of lease you have. Residual value can influence your lease depending on the type, and in some cases, you might owe your lender at the end of your lease. Let’s take a look at the types of leases and the effect of residual value on them.
- Closed-end Leases
With a closed-end lease, there is still the chance of returning the leased asset with no obligations other than to pay agreed fees. This is applicable if the asset’s worth is lesser than the residual value when the lease is still running.
- Open-ended Leases
When it comes to open-ended leases, you may be required to pay any differences between the asset’s residual value and its fair market value. That is if the asset’s worth is less than its residual value.
Regardless of which lease you’re on, you can choose to procure the asset if it pays more. Also, there are a few options available for you if you decide to get out of your lease before the agreed period is up. Some of the options include:
- Transferring your lease
You can transfer your lease to a third party if you decide to opt-out. Once you transfer your lease, the new party becomes responsible and in-charge of the contract requirements. This includes payments and asset conditions.
- Procure your lease
You can buy your lease before the end date; most lessees have this option available. If you decide to buy your lease early, you will have to pay the asset’s residual value and the lease’s outstanding balance. Note that you may also be required to pay any applicable taxes and interest.
- Get a new lease
Your chances of getting a new lease depend significantly on your credit score. You must possess good credit to be able to end an existing lease and start a new one. Bear in mind that if you’re applying for a new lease, your lessee will take the remaining balance of the lease, taxes, and the residual value of the asset into consideration before issuing you a new lease.
Conclusion
When it comes to asset leasing, getting the residual value is very crucial as it will help you know the worth of an asset and how much will be due monthly for payment. When considering leasing, it is essential to understand your asset’s projected value at the end of the lease alongside other lease terms.
Ensure to read the terms and conditions governing your lease before signing up your lease contract. Also, put into consideration residual value when searching for the most-suitable lease terms for you.
