What is the 'Residual Value'
The residual value of a fixed asset is an estimate of how much it will be worth at the end of its lease, or at the end of its useful life. The lessor uses residual value as one of its primary methods for determining how much the lessee pays in lease payments. As a general rule, the longer the useful life or lease period of an asset, the lower its residual value.
BREAKING DOWN 'Residual Value'If you lease a car for three years, its residual value is how much it is worth after three years. The residual value is determined by the bank that issues the lease before the lease begins. It is based on past models and future predictions. Along with interest rate and tax, residual value is an important factor in determining the car's monthly lease payments. In capital budgeting projects, residual values reflect how much you can sell the asset for after the firm has finished using it or once the asset-generated cash flows can no longer be accurately forecast.
Uses of Residual Value
An example for a business owner would be if his desk had a useful life of seven years. How much the desk is worth at the end of seven years (its fair market value as determined by agreement or appraisal) is its residual value, also known as salvage value. To manage asset-value risk, companies that have numerous expensive fixed assets, such as machine tools, vehicles or medical equipment, may purchase residual value insurance to guarantee the value of properly maintained assets at the ends of their useful lives.
Calculating Depreciation/Amortization Using Residual Value
Residual value also figures into a company's calculation of depreciation or amortization. Suppose a company acquires a new software program to track sales orders internally, and this software has an initial value of $10,000 and a useful life of 10 years. In order to calculate yearly amortization for accounting purposes, the owner needs the software's residual value, or what it is worth when those 10 years are up. Assume this value is zero and the company uses the straight-line method to amortize the software. Therefore, the company must subtract the residual value of zero from the $10,000 initial value and divide by the asset's useful life of 10 years to arrive at yearly amortization, which is $1,000.
For tangible assets, such as cars, computers and machinery, a business owner would use the same calculation, only instead of amortizing the asset over its useful life, he would depreciate it.