Understanding Residual Value In Lease Financing - From The Business Owners Perspective!
The business owner or financial manager needs to investigate and understand thoroughly
the concept of a ' residual value ' in any lease financing negotiation. These residual values may represent an additional significant profit to the lessor in the transaction. Naturally one can assume that additional profit to the lessor may mean loss of additional profit to the borrower!The residual value may also represent a significant portion of the lenders over all ' return ' on the transaction. Again, lessor return often equates to borrower shortfall.
So what is that residual value? At the end of the term of a lease there are pre - negotiated options that any savvy borrower should both negotiate and understand. If a customer enters into what is known as a ' true operating lease ' then the lessee has the option to return the equipment to the lessor ( or maybe it is the manufacturer itself ) when the lease transaction has terminated. We reference the manufacturer above given that many sizable corporations have finance arms that finance equipment for their customers.
When the equipment is returned the lessor re-sells the equipment, or in some cases actually rents or leases out the equipment again, obviously on a ' previously used ' basis. In the construction or aircraft industry assets can be used as long as 10- 20 years!
Borrowers need to understand that the potential profit the lender/lessor realizes on a transaction hinges significantly on the final value of the asset at the end of the term.
Let's use a simple example. If a customer purchases something for a value of 100.00 and wants to lease it the lessor will perhaps estimate that the equipment will be worth 10% of its original value, or in our case, $ 10.00 at the end of the term of the lease. He will often base his rate on the expected recovery. Naturally the lender could receive more or less at the end of the lease term - he bases his price and interest rate accordingly.
Borrowers therefore might want to significantly investigate the residual value being contemplated in these type of operating lease transactions, and, in some cases, invoke their right to buy the equipment at the end of the lease. It could in fact be resold for a profit if the company has a strong sense the asset will maintain its value. Again, think aircraft and construction equipment in the example we used.
Naturally lease companies want to earn as high a reasonable return as possible. Given that they are usually conservative in their residual estimates it behooves the business owner to try and maximize on the asset itself, either via negotiating a lower interest rate, or, as in our example, invoking a right to purchase the asset at the end of the lease.
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