What is Residual Value?
The residual value, also known as salvage value, is the estimated value of a fixed asset at the end of its lease term or useful life. In lease situations, the lessor uses residual value as one of its primary methods for determining how much the lessee pays in periodic lease payments. As a general rule, the longer the useful life or lease period of an asset, the lower its residual value.
- The residual value of an asset is based on what a company expects to receive in exchange for selling or parting out the asset at the end of its lease term or useful life.
- Different industries and fields use and calculate residual value differently.
- Residual value will influence the total depreciable amount a company uses in its depreciation schedule.
- Generally, the useful life or lease period is inversely related to the residual value of an asset.
Understanding Residual Value
Residual value formulas differ across industries, but its general meaning - what remains - is constant. In capital budgeting projects, residual values reflect how much you can sell an asset for after the firm has finished using it or once the asset-generated cash flows can no longer be accurately predicted. For investments, the residual value is calculated as the difference between profits and the cost of capital. In accounting, owner's equity is the residual net assets after the deduction of liabilities. In the field of mathematics, specifically in regression analysis, the residual value is found by subtracting the predicted value from the observed or measured value.
Examples of 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, and it is based on past models and future predictions. Along with interest rate and tax, the residual value is an important factor in determining the car's monthly lease payments.
Additionally, consider the example of a business owner whose desk has 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 end 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. This software has an initial value of $10,000 and a useful life of five years. To calculate yearly amortization for accounting purposes, the owner needs the software's residual value, or what it is worth at the end of the five years.
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 five years to arrive at its yearly amortization, which is $2,000. If the residual value were $2,000, the yearly amortization would be $1,600 ($10,000 - $2,000 / 5 years).
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. The initial value minus the residual value is also referred to as the "depreciable base."