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Valuation by Cost and Income Approaches

 
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amibrahim



Joined: 03 Sep 2008
Posts: 370

PostPosted: Tue Mar 27, 2012 11:32 am    Post subject: Valuation by Cost and Income Approaches Reply with quote

 

Valuation by Cost and Income  Approaches

(IVS 9th Edition June 2010) Cost Approach is an approach to estimating value based on the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction. Depreciated Replacement Cost (DRC) is the current cost of replacing an asset with its modern equivalent asset less deduction for physical deterioration and all relevant form of obsolescence and optimization. 

Often the asset being valued will be less attractive than the cost of a modern equivalent because of age or obsolescence; where this is the case, adjustments will need to be made to the cost of the modern equivalent. This adjustment figure is known as the DRC. (IVS 9th Edition) 

(IVS) Optimization is the process of considering physical deterioration and functional/technical obsolescence in a property asset and determining the most economic means to replicate the asset’s service potential. The cost of upgrading and remediation are contingent liabilities to be estimated and disclosed in conjunction with optimization process. The DRC calculation while non-market will be based on criteria that envisage a transaction between rational, informed parties. 

DRC Method: Calculate the sum of MVEU (Market value of land in its existing use) of the land and the DRC of the improvement (less allowance for physical deterioration and all relevant forms of obsolescence’s) as the DRC Estimate. For reporting, assess the land at its market value (Highest and Best Use = HABU). Report the difference between the sum of DRC estimate and the land value at its market value as the Value of Improvement. When the market value of the land exceeds the DRC Estimate, the DRC Estimate is redundant and the valuer shall report Market Value only. (Guidance Note 8: IVS) 

(IVS 9th Edition) For a private sector entity with specialized assets that relies on one or more cash generating operations for its viability, the adoption of DRC Estimate must be subject to the test of adequate profitability of the assets held by the entity. For public sector entity with no or limited free cash flows, the above test of adequate profitability is replaced by a test of adequate service potential. Service potential is measured as the level productivity capacity that would have to be replaced if the entity were deprived of the asset.  

Method of assessing remaining service potential when non-cash-generating public assets are impaired is by Restoration Cost Approach and Service Units Approach,  both based on the lower of Depreciated Reproduction / Replacement Cost of the asset before impairment (Say “LDRC”).

 

(IPSAS-21) Restoration Cost Approach: Recoverable Service Amount = LDRC (-) the estimated restoration cost of the asset.

 

Service Units Approach: Higher of LDRC after the event occurred and value-in-use of the asset in its current stage. (IPSAS-21) 

Example (Restoration Cost Approach: In 1984, the city of Moorland built an office building a cost of CU 50 Million. The building was expected to provide service for 40 years. In 2003, after 19 years of use, fire caused severe structural problem. Due to safety reasons, the office building is closed and structural repairs costing CU 35.5 million are to be made to restore the office building to an occupiable condition. The replacement cost of a new office building is CU 100 million. 

Evaluation of Impairment: Impairment is indicated because the office building has sustained physical damage due to fire. Impairment loss using a Restoration Cost Approach would be determined as follows:

 

a) Acquisition Cost, 1984                                                                                5,00,00,000

a1) Accumulated depreciation, 2003 (a x 19 / 40)                                          2,37,50,000

b) Carrying Amount, 2003 ( a – a1)                                                                2,62,50,000

c) Replacement cost of a new building                                                       10,00,00,000

d) Accumulated depreciation (c x 19 / 40)                                                      4,75,00,000

d1) Depreciated Replacement cost (c - d)                                                     5,25,00,000

 d2) Less Restoration cost                                                                             3,55,00,000

e) Recoverable Service Amount (d1 – d2)                                                            1,70,00,000

    Impairment loss    (b – e)                                                                            92,50,000                

 

Example (Service Unit Approach): In 1988, Orange City Council constructed a 20 storey office building for use by the council in downtown Orlong at the cost of CU 80 million. The building was expected to have a useful life of 40 years. In 2003, National Safety Regulations required the top 4 stories of high rise building should be left unoccupied for the foreseeable future. The building has a fair value less costs to sell (FVLCTS) of CU 45 million in 2003 after regulations came into force. The current replacement cost of a similar 20 storey building is CU 85 million. Impairment is indicated because the extent of use of the office building has changed from 20 floors to 16 floors as a result of New National Safety Regulations. The reduction in the extent of use is significant and the occupation of the building is expected to remain at the reduced level (16 floors) for the foreseeable future. Impairment loss using the Service Units Approach would be determined as follows:

 

a) Acquisition cost                                                                                          8,00,00,000

a1) Accumulated depreciation (a x 15 / 40)                                                    3,00,00,000

b) Carrying Amount, 2003 ( a – a1)                                                                5,00,00,000

c) Replacement Cost (20 Storey building)                                                     8,50,00,000

c1) Accumulated depreciation ( c x 15 / 40)                                                   3,18,75,000

d) DRC before adjustment for remaining service units (c – c1)                    5,31,25,000

e) Value-in-use of the building after regulation came into force (d x 16/20) 4,25,00,000

f) FVLCTS of the building after regulation came into force                            4,50,00,000

g) Recoverable Service Amount (Higher of  e & f)                                  4,50,00,000

                          Impairment  (b – g)                                                                 50,00,000

                             

 


DRC VALUATION as per GN No. 8

DRC VALUATION I (Opinion of A. M. Ibrahim based on GN No. 8 ADDENDUM Example, HABU is considered in line with Chennai Building Rules) 

Illustration of a) the methodology to determine a DRC valuation based on the Market value for Existing Use of the land (Column “A”) and the apportionment of the DRC conclusion for reporting purposes on the market value of the land (Column “B”) 

  • Improvement: 10,000 sqm of Industrial Building abutting a 9.00 m wide road (Green & Orange Industry up to 200HP)
  • Extent of land: 3 Acres; Existing Land Use: Industrial & Market value of land per acre: Rupee 1,50,00,000/=. Therefore, Market Value Rupee 4,50,00,000/= (Say “L”) 
  • The Land Use conversion to Residential Use (Special Building Maximum Height G+3 = 15.25 M) is permissible with special permission from the Local Municipal Authority, which is legally & physically possible, financially feasible & maximally productive for the site (Highest and Best Use = HABU)
  • Market value of land can be assessed @ Rupee 2,25,00,000 per acre after conversion. Therefore, HABU Market value Rupee 6,75,00,000/= (Say “M”)

 

Description

A

Existing use of land (Rupee)

B

HABU of land (Rupee)

Replacement Cost (Say “D”)

6,50,00,000

6,50,00,000

Physical deterioration (Say “P”)

1,62,50,000

1,62,50,000

Functional obsolescence (Say “Q”)

(Knowledge of business requirements to estimate functional/technical obsolescence)

1,30,00,000

1,30,00,000

Economic obsolescence (Say “R”)

(Knowledge of future industrial requirements to estimate economic / external obsolescence)

65,00,000

2,90,00,000

 extent of additional economic obsolescence

Depreciation plus all relevant form of  obsolescence & optimization (P+Q+R) Say “S”

3,57,50,000

5,82,50,000

DRC of Improvements (D – S) Say “T”

2,92,50,000

67,50,000

Market Value for existing use of land (Say “L”)

4,50,00,000

 

Market Value of land under HABU (Say “M”)

 

6,75,00,000

D R C Estimate (L + T) ( Say “N”)

7,42,50,000

7,42,50,000

Conclusion

D R C:                                                            7,42,50,000

Apportionment between

Buildings / Improvement Elements:                 67,50,000

Land Element                                                6,75,00,000

 

DRC VALUATION as per GN No. 8

DRC VALUATION II (Opinion of A. M. Ibrahim based on GN No. 8 Addendum Example, Chennai Building Rule is considered)

 

Illustration of (a) the methodology to determine a DRC calculation based on the Market value for Existing Use of the land (Column “A”) and (b) the adopted Market Value based on the Market Value of Land(Column “B”)

  • Improvement: 10,000 sqm of Industrial Building abutting a 10.00 m wide road, (Green & Orange Industry  up to 200HP)
  • Extent of land: 3 Acres; Existing Land Use: Industrial & Market value of existing land per acre: Rupee 1,50,00,000/=. Therefore, Market Value in its existing use Rupee 4,50,00,000/= (Say “L”)

 

  • The Land Use conversion to Residential (Special Building or Group Development Maximum Height G+3 = 15.25 M) is permissible with special permission from the Local Municipal Authority, which is legally & physically possible, financially feasible & maximally productive for the site (Highest and Best Use = HABU)
  • Market value of land can be assessed @ Rupee 2,75,00,000 per acre after conversion. Therefore, HABU Market value Rupee 8,25,00,000/= (Say “M”)


Last edited by amibrahim on Wed Mar 28, 2012 11:35 am; edited 9 times in total
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amibrahim



Joined: 03 Sep 2008
Posts: 370

PostPosted: Tue Mar 27, 2012 11:37 am    Post subject: Valuation by Cost and Income Approaches Reply with quote

 

Description

A

Existing use of land (Rupee)

B

HABU of land (Rupee)

Replacement Cost (Say “D”)

6,50,00,000

6,50,00,000

Physical deterioration (Say “P”)

1,62,50,000

1,62,50,000

Functional obsolescence (Say “Q”)

(Knowledge of business requirements to estimate functional/technical obsolescence)

1,30,00,000

1,30,00,000

Economic obsolescence (Say “R”)

(Knowledge of future industrial requirements to estimate economic / external obsolescence)

65,00,000

3,57,50,000

 extent of additional economic obsolescence

Depreciation plus all relevant form of  obsolescence & optimization (P+Q+R) Say “S”

3,57,50,000

6,50,00,000

DRC of Improvements (D – S) Say “T”

2,92,50,000

0

Market Value for existing use of land (Say “L”)

4,50,00,000

 

Market Value of land under HABU (Say “M”)

 

8,25,00,000

D R C Estimate (L + T) ( Say “N”)

7,42,50,000

8,25,00,000

Conclusion

D R C:                                                            8,25,00,000

Apportionment between

Buildings / Improvement Elements:                 0

Land Element                                                8,25,00,000

 

Note: Sufficient knowledge is required from valuer to determine the impact of economic / external obsolescence on the value of improvement under HABU is materially higher than the land value at its current use.

 (IVS 9th Edition) Income Approach considers the income that an asset will generate over its remaining useful life and estimates value through a capitalization process. The process applies an appropriate yield or discount rate, to the projected income stream to arrive at a capital value. The income stream may be derived under a contract or contracts or be non-contractual, eg, the profit generated from either the use of or holding of the asset.  

Two commonly used methods that fall under the income approach are Income capitalization, where an all risks yield is applied to a fixed income stream, or discounted cash flow (DCF) where the cash flows for future periods are discounted to a present value.

The income approach can be applied to liabilities by considering the cash flows required to service a liability until it is discharged. (IVS 9) 

Example:  Rent Capitalization & DCF Approaches Valuation

 An investment of Rupee Seventy Five Lakh is invested in a new residential property G+2 in Zambazaar Area of Chennai, which is in a continuous building area – Primary Residential Use Zone, abutting a < 9.0 m road, the property is in its highest and best use (HABU). The net annual rental income is Rupee Two Lakh.

 All risks Yield: 8.5% (20 Years Gilt Yield)

 Income Capitalization Method:

 Capital Value: Net Income / 8.5% = Rupee 23,52,941/= or say 23, 53,000/= which is value in perpetuity.

 

Capitalization for 20 Years: Net Income * Years Purchase (1 + i)n - 1 / i(1+i)n ie, (1+0.085)20 -1 / 0.085(1+ 0.085)20, which is 2,00,000 * 9.46 = 18,92,000/=

 

DCF Method with 20 year cash flows: Net Present Value: npv (rate, net_inflow) + Initial Investment: = (8,5%_sum of present value for 20 years)+Investment is Rupee (56,07,333) and Present Value: =pv(rate, Year_number, Yearly_net inflows) + Investment: Rupee is (93,92,667).

 

The DCF is Rupee 18,92,672/= which can be arrived by summing up discounting 8.5% compound interest factor (SPPWF) Single payment present worth factor  formula 1 / 1 + i) n or by multiplying net annual income with  Uniform series present worth factor (USPWF) formula :  (1 + i )n  - 1 / i (1 + i )n 

 Valuation arrived by Income and Comparable approaches is cross checked with Land & Building Method (Cost Approach). Market Value of land in its existing Use (MVEU) is to be considered. It appears Indian Accounting Standards are in line with International Accounting Standards therefore, IVS may be relevant to Indian Valuation Practice.    

 

 

 

 



Last edited by amibrahim on Sat Mar 31, 2012 11:27 am; edited 10 times in total
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amibrahim



Joined: 03 Sep 2008
Posts: 370

PostPosted: Tue Mar 27, 2012 11:45 am    Post subject: Glossary Reply with quote


 

Glossary: (SOURCE: IPSAS – 21) International Public Sector Accounting Standards

 

Cash-generating-assets are assets held to generate a commercial return,

 

Non-cash-generating assets are assets other than cash generating assets,

 

Recoverable Service Amount is the higher of non-cash-generating asset’s fair value less costs to sell and its value-in-use,

 

Value-in-Use of a non-cash-generating asset is the present value of the asset’s remaining service potential,

 

Carrying Amount is the amount at which an asset is recognized in the statement of financial position after deducting any accumulated depreciation and accumulated impairment losses thereon,

 

An impairment loss of a non-cash generating asset is the amount by which the carrying amount of an asset exceeds its recoverable service amount.

 E-mail: mamibrahim1@gmail.com

 

 

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