Cost Approach Flashcards
what is the cost approach
Depreciated replacement cost method
‘The current cost of replacing an asset with its modern equivalent asset less deductions for physical deterioration and all relevant forms of obsolescence and optimisation.’
when is DRC used
DRC is normally used in situations where there is no direct comparable alternative. - High speed scanner
The comparison therefore has to be made with a hypothetical substitute, also described as the modern equivalent asset (MEA).
The underlying theory is that the potential buyer in the exchange would not pay any more to acquire the asset being valued than the cost of acquiring an equivalent new one.
is DRC suitable to be used as a primary method of valuation?
The DRC method is conceptually unsuitable for use as the sole or primary valuation method for secured lending purposes but may in appropriate circumstances provide a useful cross-check to help inform where other methods have been applied
Assessing the replacement cost
The general principle is that the costs reflect those of a modern equivalent asset that offers an equivalent service potential to the actual asset.
In assessing the cost of the replacement asset, due account should be taken of all the costs that would be incurred by a potential buyer on the valuation date unless there is applicable direction to the contrary.
DRC - Applying valuation depreciation
A process of replicating how the market would view the asset.
Three principal types of depreciation allowance, or obsolescence, may be identified as:
a. physical deterioration
b. functional obsolescence and
c. economic obsolescence.
physical deterioration
The asset is valued in its existing condition, with the valuer fully taking into account any physical deterioration arising from a lack of maintenance or other causes, and the recognition that a lack of adequate maintenance can accelerate the rate of depreciation
functional obsolescence
Functional obsolescence arises where the design or specification of the asset no longer fulfils the function for which it was originally designed
may also arise because of advances in technology.
Economic obsolescence
This arises from the impact of changing economic conditions on the demand for goods or services produced by the asset.
A common example of economic obsolescence is where over-capacity in a particular market reduces the demand and therefore value for the actual asset.
Asset life
Depreciation of the replacement cost is often measured by comparing the remaining life of the subject asset at the valuation date with its expected total life.
The physical life is how long the asset, ignoring any potential for refurbishment or reconstruction, could be used before the asset would be completely worn out or beyond economic repair. The economic life is how long it is anticipated that the asset could generate returns or provide a financial benefit. The remaining life for valuation purposes will be the lower of the physical life and economic life where these do not coincide.
How you carry out the DRC on the high speed scanner
I worked out what the cost of the modern equivalent was. I believe this was in the region of £60,000.
Through market research I was able to form an opinion of total life of the machine. Considerations included technology advances. I considered it’s total life was 10 years.
The machine was 7 years old so had a maxmium of 3 years remaining.
Through my judgment I considered the residual value of the machine at the end of it’s life (residual value). I considered this would be approximately 5%.
A reducing balance deprication this led to a depreication rate of 25% which was 13% of it’s orginial value.
Leading to a value of £7,800.
Do you reduce any further?
Straight line depreication
Straight-line depreciation assumes the same amount is allocated for depreciation for each year of the estimated life.
The weakness of this method is the very simplistic assumption of the uniform erosion of the asset’s value over its total life
Reducing balance depreication
The reducing balance method of depreciation assumes a constant percentage rate of depreciation from the reducing base. The reduction of the balance at the end of each period by a fixed proportion of itself creates a sagging depreciating value curve over the life of the asset. This method effectively ‘compounds’ the total depreciation. This may match reasonable expectations of declining value over time better than the straight-line method
S-curve depreication
The S-curve is recommended where sufficient data is available for the valuer to be confident that the curve represents the likely reality. In some cases it presents the most realistic representation of an asset’s depreciation by assuming that depreciation is at a low rate in the early years, then accelerates in the middle years and reduces again in the final years. However, some assets, such as plant, may have a different depreciation pattern (high at first rather than low).
Although it is normally accepted that the S-curve realistically represents the pattern of depreciation over the life of most assets, the percentage for any given year will depend on decisions made as to the rates of depreciation at different times and when these change. In the absence of empirical evidence in support of these inputs, the exact pattern of the curve may depend on subjective inputs and may be no more relevant than the other methods discussed.
Comparison of depreciation method
The three methods outlined are all in common use. Of these, the straight-line approach has the advantage of simplicity. However, it does not represent the way in which asset values are normally reflected in the marketplace. The reducing balance method may also be open to similar criticism that it does not reflect market perceptions. The S-curve attempts a surrogate for market behaviour and is appropriate where there is empirical evidence available
DRC Final considerations
An essential final step is for the valuer to ensure that the resulting valuation conclusion is consistent with the underlying valuation objective – that is, to establish the price that would be paid in an exchange between a willing seller and willing buyer in an arm’s length transaction.
The valuer is advised to ‘stand back and look’ at the overall conclusion, taking particular care to check that the process of adjusting for valuation depreciation has not resulted in any factor being either double counted or ignored. An attribute of the actual asset may be identified that has not been reflected in the process of depreciating by comparison with the hypothetical modern equivalent.
