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Calculating the Depreciation Component

Most of the people are unable to realize that their vehicle is going to depreciate at some rate. Regardless of how you pay for your vehicle, whether you take on a lease, a loan, or pay cash, your car will lose a certain amount of value every year. This lost value is factored into the cost of your lease.

In order to calculate the depreciation component of the lease payment, subtract the end value of the leased car from the initial balance on the lease to get the total amount of depreciation. Later divide this number by the number of months of the lease.

Here is the formula for calculating the lease component:

Initial balance on the lease – End value of the lease Depreciation Component = ---------------------------------------------------------------------- Number of months in the lease

Let us show you where these numbers come from.

a. Initial Balance on the Lease

To find the total value of the initial balance, add up everything included in the lease that will increase the balance. The initial balance starts with the price you pay for the car. So the price of the car matters a lot in a lease payment. Now add everything else in this price including accessories, service agreements, and dealer’s delivery and handling charges. These may sound like arranging a loan for buying a car.

Another different item on the lease is the “acquisition fee”. This is a fee charged by the leasing company for initiating a lease. This fee is just like an origination fee on a mortgage. In simple words, it is an extra money for the leasing company that is non-negotiable. You have to pay it.

Accountants try to make lease sound extra complicated with special names for different values on a lease. For example, the sum total of all the charges that are added to the initial balance on the lease is called “Capitalization cost” or the “Gross capitalization cost”

Add all these terms to get the gross capitalization cost:

Gross Capitalization Cost = Negotiated price of the car + Lease Acquisition Fee + Delivery and Handling + Total Accessories (If Any) + Total Service Agreements

In the next step add up everything in the lease that would reduce the balance on the lease. Factors that might reduce the balance include lease rebates, cash as down payment to reduce the lease payment, and any equity of a trade-in.

The accounting name for all those items that reduce the balance on the lease is “Capitalization Cost Reduction”

Capitalization Cost Reduction = Lease Rebates + Cash Down + Trade Equity

Now you can calculate the initial balance on the lease as the sum of everything that increases the balance, minus sum of everything that reduces the balance. In accounting terms, the initial balance is calculated as the “Gross capitalized cost” minus the “Capitalized cost reduction”.

The accounting term for initial balance is then called “Adjusted capitalization cost”, the “Net capitalization cost” or just the “Capitalization cost”. This is the final version of your initial balance used to calculate your lease payment.

Adjusted Capitalized Cost = Gross Capitalization Cost – Capitalization Cost Reduction

a. End Value of the Lease

In a lease agreement, you only pay for the amount of the vehicle that you use. This amount is calculated as the difference in the value at the beginning of the lease and the value at the end of the lease.

This value at the end of the lease is projected by the company. Basically, the leasing company estimates what the car will be worth after the lease term and number of miles you drive. This is done by different financial companies whose business is to determine the future value of the car. Leasing companies take these numbers as the end value of their leases.

“Residual Value” is the accounting term used for the end value of a lease. In other words, the residual value for a lease the value that the company expects the car to be worth at wholesale auction at the end of the lease.

Most of the leasing companies express the residual values of leases as a percentage of the MSRP of the car. For example, a residual value can be expressed as 55% of MSRP. But it must be kept in mind that the residual value is a percentage of a car’s MSRP, not the negotiated price of a car.

The residual value is based upon the expected future value of the car while the future value depends on the terms of the lease and the number of miles you plan to drive. This residual value will be higher for a 24-month lease than for a 39-month lease because the value of the car would be worth more after two years than after three years.

Similarly, the residual value will be higher for a 10,000 mile-per-year lease than a 15,000 mile-per-year lease because a car driven lesser miles will have more worth than a car driven 45,000 miles.

The residual values are determined by the leasing companies on the basis of lease months and miles to be driven. Though you can choose different terms for mileage or months, for a given set of terms, the residual values are not negotiable.

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