Equipment Appraisers Association BASIC COST APPROACH PRESENTED TO: Equipment Appraisers Association Of America January 24, 2014

Presented By Douglas R. Krieser, ASA FRICS Valcon Partners, Ltd. 371 E. Prairie Street, Suite B Crystal Lake, Illinois 60014   P:   815-477-1000 F:   815-477-1001 E-mail:   dougk@valconpartners.com Web Site:   www.valconpartners.com

Disclaimer This is NOT a comprehensive review of the Cost Approach Methodology. The information presented cannot be taken as “the definitive way” to perform a Cost Approach.

Review of Approaches to Value There are 3 approaches to value: Cost Approach Market Approach Income Approach

Applicable Definitions Replacement Cost New: The current cost of a similar new property having the nearest equivalent utility as the property being appraised, as of a specific date. Reproduction Cost New: The current cost of producing a new replica of a property with the same, or closely similar materials, as of a specific date.

Applicable Definitions Actual Age/Chronological Age: The number of years that have elapsed since the item or property was originally built or placed in service for the first time. Effective Age: The apparent age of a property in comparison with a new property of like kind; that is, the age indicated by the actual condition of the property. The Effective Age varies with the amount of use, regularity and extent of maintenance, wear and tear, etc. For this reason, the Effective Age for a given asset may be more than, less than, or equal to the Actual Age.

Applicable Definitions Normal Useful Life (NUL):The physical life, usually in terms of years, that a new property will actually be used before it is retired from service. A property’s normal useful life relates to how long similar properties actually tend to be used (given minimal maintenance and no rebuilds), as opposed to the more theoretical economic life calculation of how long a property can profitably be used. (NOTE: Parenthetical comment added) Remaining Useful Life (RUL): The estimated period during which a property of a certain effective age is expected to actually be used before it is retired from service.

Applicable Definitions Depreciation: Mathematical formula measure of a tangible asset’s loss of value over time to prop­erly match revenues against the appropriated asset’s lost value (estimated expense). The actual loss in value or worth of a property from all causes including those resulting from physical deterioration, functional obsolescence, and economic obsolescence. Depreciation may be curable or incurable. The estimated loss in value of an asset.

Applicable Definitions Physical Depreciation: A form of depreciation where the loss in value or usefulness of a property is due to the using up or expiration of its useful life caused by wear and tear, deterioration, exposure to various elements, physical stresses, and similar factors. Physical depreciation may be curable (or partially curable), by replacement or rebuilding, to some percentage of its full physical life. If curable, the remaining life would go no lower than a core or re-buildable life. Cure or partial cure may then change the Effective Age of the property.

Applicable Definitions Functional Obsolescence: A form of depreciation in which the loss in value or usefulness of a property is caused by inefficiencies or inadequacies inherent in the property itself, when compared to a more efficient or less costly replacement property that new technology and changes in design, materials, or process that result in inadequacy, overcapacity, excess construction, lack of functional utility, excess operating costs, etc. has developed. Symptoms suggest­ing the presence of functional obsolescence are excess operating cost, excess construction (excess capital cost), over-capacity, inadequacy, lack of utility, or similar conditions.

Applicable Definitions Economic Obsolescence: A form of depreciation where the loss in value or usefulness of a property is caused by factors external to the property. These may include such things as the economics of the industry; availability of financing; loss of material and/or labor sources; passage of new legislation; changes in ordinances; increased cost of raw materials, labor or utilities (with­out an offsetting increase in product price); reduced demand for the product; increased competition; inflation or high interest rates; or similar factors.

Basic Cost Approach Formula In its simplest form, the cost approach formula is as follows: REPLACEMENT COST NEW (Preferred RCN and NOT Repro cost – custom equipment is an exception!) LESS PHYSICAL DEPRECIATION LESS FUNCTIONAL OBSOLESCENCE LESS ECONOMIC OBSOLESCENCE EQUALS FAIR MARKET VALUE (may be in use or in exchange depending on costs associated with RCN)

Cost Approach Components REPLACEMENT OR REPRODUCTION COST Data can be gathered from: Dealers or manufacturers (BEST) (have customer contact them) Engineering studies/firms Engineers at plant (for custom equipment) Used equipment dealers Trending historic cost info Your Own Estimate (WORST – unless you KNOW the equipment well!)

Trending Discussion You can ONLY trend HISTORIC COSTS NOT ORIGINAL COSTS: Historical Cost: The initial capitalized cost of an asset at the time it was first put into service Original Cost: The initial capitalized cost of the asset in the hands of its present owner.

Trending Discussion Trending may be the easiest method to use, BUT it has the most limitations, some of which are as follows: Only “Historic” costs can be trended and asset records often include used costs, discounts, allocated costs, “ghost assets” (which can skew the values up or down significantly) The data included on most fixed asset records is vague at best and may or may not provide enough information on the assets (to do a proper trend analysis) The results can vary significantly depending on the source of, make up of specificity, and reliability of the trends utilized

Trending Discussion Trending may be the easiest method to use, BUT it has the most limitations, some of which are as follows: Trending MAY be good in aggregate but may or may not arrive at a reasonable result for any individual item Trending an entire fixed asset listing will not typically provide enough reliable data to allow the values to be segregated by building or area (which is critical depending on the PURPOSE of the appraisal). (Typically) The older the asset being trended, the bigger the probability that the resulting trended cost will be either much higher or much lower than the “true” RCN today.

Trending Discussion

When is Trending a Reasonable Tool? Trending CAN BE a reasonable tool for:   Trending the historic costs of “newer” equipment (depending on the source of the trends etc.). Estimating the Reproduction Costs for customized equipment when there is no other way to estimate the cost to replace the item. Where practical, use independent, verifiable sources (i.e. manufacturers, dealers, engineers, etc.).

Custom or Specialized Equipment Make sure you are accounting for ALL material and labor costs Estimate costs as if SOMEONE ELSE builds the unit Typically exclude excessive engineering and/or prototype costs

Custom or Specialized Equipment One form of functional obsolescence is EXCESS CAPITAL COST (Repro Cost – RCN)…it may cost MORE to build a unit “as is” today than to replace its operational capacity. Reproduction Costs “best used” for unique or customized equipment.

Cost Approach Components PHYSICAL DETERIORATION/DEPRECIATION Physical deterioration Observation based on experience Age/Life Analysis Cost to cure analysis NOTE: is NOT the same as accounting depreciation!

Cost Approach Components Cost to Cure: The cost to fix physical deterioration or obsolescence. NOTE: Any depreciable factor cannot exceed the cost to remediate the problem. Curable depreciation: Any form of depreciation that is economically feasible to remedy. The resulting increases in utility and value are equal to, or greater than the expenditure to cure.

Age-Life Analysis An easy formula to use is: OR NUL = EA + RUL % Depreciation = (Effective Age/Normal useful Life) = EA/NUL OR % Good = (Remaining Useful Life/ Normal useful Life) = RUL/NUL NUL = EA + RUL

Effective Age Notes EA may be equal to, less than or greater than actual age depending on: Atmosphere/surroundings/conditions it exists in Maintenance (or lack thereof) Use (or lack thereof)

How Can You Estimate NUL? Dealers or manufacturers Engineering studies/firms Articles on various industries/equipment Engineers at plant Used equipment dealers Marshall and Swift ASA NUL study Specialty guides Your Own Estimate

Cost Approach Components FUNCTIONAL OBSOLESCENCE This is typically due to technological change WITHIN the asset or product itself. Examples include: Lack of utility Excess capacity Excess construction Change in design, materials or process Efficiency Technological change Excess operating costs

Cost Approach Components How can you compensate for Functional Obsolescence? Reduce RUL Ask dealers/manufacturers how much more efficient (as a percentage or production, energy usage etc.) the newer model is and use that as an estimate (as a percentage) Estimate excess operating costs over the RUL (beyond scope of presentation) Inutility calculation (can be used for functional OR Economic depending on reason for reduced utility) – BEYOND SCOPE OF THIS PRESENTATION.

Cost Approach Components ECONOMIC OBSOLESCENCE This is typically due to technological change EXTERNAL to the asset or product itself. Examples include: Management concepts or ability Availability of raw materials Availability of labor supply Market accessibility or acceptability Governmental regulations Earning power Competition

Cost Approach Components Notes on Economic Obsolescence: Typically NOT Curable! CAN be VERY volatile. Can change over time (up or down). VERY dependent on what is going on SPECIFICALLY on the valuation date. May make an asset TOTALLY obsolete (to current or future potential owner) May cause a value of an asset to be negative

Cost Approach Components How can you compensate for Economic Obsolescence? Reduce RUL Estimate excess penalty costs over the RUL (BEYOND THE SCOPE OF THIS PRESENTATION) Inutility calculation (can be used for functional OR Economic depending on reason for reduced utility)

Cost Approach Components

Market Based Obsolescence Factor There is a method to estimate obsolescence (typically Economic or a combo Functional/Economic factor) which utilizes known market data to estimate the obsolescence for items which do not have market data available. This method utilizes comparing the results of the cost approach and market approach for a known series of assets and utilizing that relationship to estimate the obsolescence for an item where no market data exists. A remaining obsolescence factor (ROF) or an aggregate obsolescence factor can be quantified by a compar­ison between the results obtained through the use of a cost indicator of value prior to the deduction for obsolescence and results obtained through the use of the sales comparison approach. This is a market-derived obsolescence analysis.

Market Based Obsolescence Factor In order for this methodology to be used effectively, replace­ment cost new/reproduction cost new data and fair market value data for a sample of assets similar to the subject assets must be gathered or otherwise calculated (i.e., by trending). Such a comparison is necessary to reconcile any potential differences between the cost ap­proach and actual market data obtained from comparable sales trans­actions. The most accurate and supportable results of this process will be realized if the analysis breaks the assets down into various asset-specific categories (i.e., production equipment, packaging equipment, conveyors, maintenance equipment, etc.) and develops remaining obsolescence factors for each of the various categories. However, it is also possible to use this technique to develop plant-wide or pro­cess-wide factors, as long as the sample used is significant and con­tains a relevant sample of assets used in the process or plant. The former method is preferred and is necessary for facilities that have a variety of different types of equipment, while the latter can be used when the process or facility has assets that are similar in nature or when the assets are all part of a continuous process.

Market Based Obsolescence Factor EXAMPLE: Subject: ABC Company can seamer, model 100, which was built in 1990 and is in good condition Physical Deterioration Est: 70% RCN (Per MFG): $400,000

Market Based Obsolescence Factor EXAMPLE: Market Indication of Value: $66,000 Functional Obsolescence: NA per MFG Economic Obsolescence: ???????

Market Based Obsolescence Factor EXAMPLE: Using the cost approach, we have the following result:

Market Based Obsolescence Factor EXAMPLE: In order quantify the remaining obsolescence, use the following formula: ROF= RCNLD−FMV RCNLD

Market Based Obsolescence Factor ROF= RCNLD−FMV RCNLD Where: ROF = Remaining Obsolescence Factor FMV = Fair Market Value RCNLD = Replacement Cost New Less known or estimated Depreciation

Market Based Obsolescence Factor EXAMPLE: Using the formula in the current example gives us the following:   ROF= $120,000−$66,000 $120,000 ROF= $54,000 $120,000 ROF = 45%

EXAMPLE: How Is This Data Useful? Subject: ABC Company can seamer, model 120, which was built in 1993 and is in good condition Physical Deterioration Est: 65% RCN (Per MFG): $420,000

Using the cost approach, we have the following result: How Is This Data Useful? EXAMPLE: Using the cost approach, we have the following result:

Another Example Your job is to appraise the FMV a 2013 caterpillar 324E L Crawler Excavator. Your client tells you he paid $350K. You search the market and cannot find any comps due to the unit being relatively new, so you have to perform a cost approach. Assuming you use a 20 year NUL, the total depreciation in year one would be 5% of $350K or $17,500.

Another Example As such, your initial cost approach results would be: $350,000 (RCN) Minus $ 17,500 (1 year depreciation) $332,500

Another Example

Another Example Assuming the $215,000 unit is essentially the same as your subject (just older) you can estimate the FMV of the comparable (using the cost approach) as follows: $350,000 (RCN) Minus $ 52,500 (3 years depreciation) $297,500

Another Example The difference (Obsolescence) can be calculated as follows: 𝑅𝑂𝐹= $297,500−$215,000 $297,500 𝑅𝑂𝐹= $82,500 $297,500 ROF = 28%

Another Example This can be used to value our Subject as follows: $350,000 (RCN) Minus $ 17,500 (1 year depreciation) $332,500 Minus $ 92,200 (28% Econ Obs.) $240,300 CONCLUDED FMV

Bringing It All Together Assignment: To appraise a production line that produces products for the automotive industry. Within this line there is a custom built machine. Premise of value: Fair Market Value Installed (as part of the entire production line)

Bringing It All Together Custom Machine Cost: $250,000 (installed – 5 years ago) Trending this cost using accepted trends arrives at REPRODUCTION COST of $275,000 (installed) Discussions with Engineer at client indicate engineering and design costs: $50,000

Bringing It All Together RCN today (discussed with Engineer and machine builder): $210,000 (installed) New Unit would be 10% more energy efficient (discussed with Engineer and machine builder). Salvage Value (discussed with Engineer and machine builder): $15,000 Physical Useful Life: 15 years

Bringing It All Together Using the data, physical deterioration is 5/15 = 33% (67% “good”) Engineering and Company Management indicate that the product line in which the machine is used will be discontinued in 3 years.

Bringing It All Together Since the product line will be discontinued in 3 years, the ACTUAL percent good is either: 3/15 = 20% (RUL/NUL) OR 3/(3+5) = 38% (RUL/( EA + RUL)) Remember NUL = EA + RUL (stated previously)?

Bringing It All Together Based upon this, we get the following: $210,000 X 38% $ 79,800

Bringing It All Together Based upon our discussions, there is also a 10% Functional Obsolescence so: $210,000 X 38% $ 79,800 X 90% $ 71,820

Bringing It All Together Based upon our discussions, there is also a 10% Functional Obsolescence so: $ 210,000 X 38% $ 79,800 X 90% $ 71,820 X 75% $ 53,865

Disclaimer This is NOT a comprehensive review of the Cost Approach Methodology. However, hopefully this will give you some tools that will assist you if you find yourself needing to perform a cost approach

QUESTIONS?