A key aspect of purchasing any asset – from heavy machinery in a manufacturing business to real estate, is depreciation. Simply put, it is the decrease in the monetary value of an asset over time due to wear and tear or obsolescence. All assets have a lifespan, and as the end draws near, so does its value.
Now at the end of their useful life, they still have some value left; this is residual value. The residual value of an asset is estimated at a fair market value and is a critical concept for accounting purposes.
But what is residual value? And how do you calculate it? Here's everything you need to know about the residual value and its importance.
Meaning of Residual Value
Residual value, also known as salvage value, is the estimated worth of an asset at the end of its useful life. It represents the amount an owner can expect to obtain when disposing of the asset. This value influences leasing agreements, depreciation schedules, asset valuations, purchasing decisions, resale strategies, and investment evaluations.
Importance of residual value
Let us take a deeper dive into why exactly residual value is so important:
1. Investment analysis: Investors, especially in real estate, use residual value to determine their investment return. Using residual value, you can determine how much the asset can generate when sold. This helps you make an informed decision about whether the property is worth investing or not.
2. Determining lease: Residual valueis a vital part of a lease agreement, especially regarding assets like vehicles and machinery. Lease payments are typically calculated by subtracting the residual value from the initial value and adding interest and taxes.
3. Loan calculation: Most financial institutions use the residual value of an asset to calculate its resale value. This can be the collateral whose residual value influences the interest rates and loan terms the lender offers.
Residual value calculation
There are plenty of calculators available online for you to get the residual value for a particular asset quickly. However, if you are taking important business or investment decisions, you should know what goes on behind the scenes of each calculation.
The residual value calculation process may differ in various industries. While some have a direct approach with a set depreciated value, others consider various market factors like technological advances and market trends.
The basic formula of residual value calculation is:
Residual value = Approximate salvage value - Asset disposal cost
Here,
1. Salvage value is the depreciated value of an asset after its lifespan or lease duration has ended.
2. Asset disposal cost refers to the additional cost incurred by you in disposing of the asset.
So, if a particular asset, say a car, has a salvage value of Rs. 30,000, and the cost of disposal is Rs. 5000, then the residual value will be:
Residual value = Rs. 30,000 - 5,000 = Rs. 25,000
Example of a residual value calculation
To better understand the calculation undertaken to find out the residual value, let us take the help of an example.
Suppose you bought a house which costs around Rs. 50 Lakhs, with a lease term of 20 years. Upon calculating, you realised that the estimated salvage value of the property would be 60%. This means that the property's value will be 60% of what it is today after the lease term ends.
The salvage value is estimated based on similar properties found in that area and predictions based on market conditions.
Now, if we take the cost incurred during its disposal to be yet another Rs. 2 Lakh, then the final residual value would be-
Salvage value = Rs. 50,00,000 x 0.60 = Rs. 30,00,000
Cost of disposal = Rs. 2,00,000
Residual value = Rs. 30,00,000 - 2,00,000 = Rs. 28,00,000
Hence, the final residual value of the property after 20 years would amount to Rs. 28 Lakhs. With this metric, the owner can decide how much rent they can charge from a potential tenant and whether it's profitable to keep or sell the property.
Factors affecting the residual value
Certain factors influence the residual value of an asset. These factors determine whether the final residual value will be high or low:
1. Lifespan: An asset's residual value primarily depends on its lifespan or valuable life. An asset with a longer service life usually has a lower residual value, whereas a shorter life results in a higher residual value.
2. Rate of usage: If a particular asset is subjected to regular use, it fetches a lower residual value. This happens because, with regular usage, the asset is more prone to wear and tear, which reduces its value over time.
3. Maintenance: A well-maintained asset often secures a better resale value than a poorly-maintained asset. Hence, with proper maintenance and care, an investment can fetch a high residual value after the end of its useful life.
4. Market trends: Current market trends and technological advancements play a significant role in the residual value of a machine or vehicle. Certain assets might turn obsolete by the end of their service life, which may fetch a lower residual value.
In a nutshell
Residual value is one of the easiest ways to quickly calculate the value an asset can fetch after the end of its service. This helps you make informed decisions to gain as much value as possible from buying an asset, whether you're looking for new equipment for your business or a new home for your family.
If you have done the necessary calculations and have decided to buy a particular property, opt for a home loan with Tata Capital. Tata Capital can help you finance your dream house in just a few days by offering attractive joint home loan interest rates and a smooth application process. Visit our official website today!
03 July 2023
5 mins read
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