LESSON 3 Valuation of Machinery and Equipment

Assigned Reading 1.

UBC Real Estate Division. 2011. BUSI 452 Course Workbook. Vancouver: UBC Real Estate Division. Lesson 3: Valuation of Machinery and Equipment

2.

Gadd, J.L. 1987. "Machinery and Equipment". Canadian Appraiser. 31(2). pp. 30-33. (Included at the end of the lesson.)

Recommended Reading Selected recommended readings can be found under "Online Readings" on your Course Resources webpage. 1.

Miles, L.H. Dimensions of Value, IV Edition. 1997. Dallas, TX: MB Valuation Services Inc. Chapters 2 and 3

2.

Lenhoff, D.C. 2001. "Business Enterprise Value Debate: Still a Long Way to Reconciliation". In Lenhoff, D.C. (Ed.). 2001. Business Enterprise Value Anthology. Chicago: Appraisal Institute. pp 61-67.

3.

American Society of Appraisers. 2005. Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets (Second Edition). Washington, DC: American Society of Appraisers: www.appraisers.org

4.

Alico, J. 1988. Appraising Machinery and Equipment. McGraw-Hill.

5.

Budhbhatti, K. 1999. Valuation of Plant and Machinery: Theory and Practice. Karamsad, Gujarat, India: Kirit Budhbhatti.

6.

Manning, L. 2000. Valuing the Small Business. Scottsdale, AZ: Todd Publishing Inc. Chapters 5 and 6 of the book deal with the valuation of machinery and equipment.

7.

Sheeler, C.L. 2000. "Best Practices in Business Appraisals". Commercial Lending Review. 16(1). pp. 33-39.

8.

Rabianski, J.S. 1996. "Going-Concern Value, Market Value, and Intangible Value". Appraisal Journal. 64(2). pp. 183-194.

9.

Fineberg, M.I. 2001. "What is the Appropriate Market for Machinery and Equipment Fair Market Value Appraisals?" Canadian Appraiser. 45(1). pp. 38-42.

10.

Lynn, D.M. and Neyland, R.R. 1992. "The Role of Appraisal in Corporate Restructurings and Bankruptcies". Commercial Lending Review. 7(3). pp. 57-65.

11.

MacDonald, R.S. 2001. "Technology Tools Used in the Equipment Appraisal Process". The Secured Lender. 57(2). pp. 8-12, 96.

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Lesson 3

12.

Gross, J.A. 19 G 999. "Is Youur Appraiser Giving G You Enough E Valuee". The Secured Lender. 55(5). 5 ppp.56-60.

13.

6 Scchmidt, R.M.. 1997. "Valuing the Assetss of a Manufaacturing Comppany". Appraiisal Journal. 65(2). ppp. 120-123.

14.

Osborne, K.L. and Ingles, W.S. O W 2003. "W When Does a Capital Expennditure Increaase Market Vaalue?" Joournal of Prop perty Valuatioon and Taxatioon. 14(3). pp.. 32-37.

15.

Fowler, B.A. and a Fowler, E.C. E 1996. "C Coordinating Business B Valuuation Overlayy with Asset Based V Valuations". Bu usiness Valuaation Review. 14(4). pp. 171-3.

16.

MacDonald, R.S. M R 2000. "Gooing, Going, Gone: Orderlly Liquidationn Value and Auction A Valuee Uses annd Misuses". The Secured Lender. L 56(3)). pp. 74-78.

17.

Mobley, T.A. III, MAI. 19996. "Determiining and Alllocating Goingg Concern Vaalue Componnents". M Apppraisal Jourrnal. 65(4). ppp. 45-52.

18.

UBC Real Estaate Division. 2010. U 2 CPD 1118: Machineryy and Equipm ment Valuationn. Vancouver: UBC R Estate Div Real vision. Lesson 2: Valuation V of Machinery M andd Equipment – Case Studiees

Learning g Objective es Upon com mpletion of this lesson, the student s shouldd be able to: 1.

iddentify the diffferent types of o machinery and a equipmennt valuation assignments;

2.

deefine the diffeerent types of machinery annd equipment values; v

3.

m andd equipment vaaluation assignnment; exxplain how to approach a machinery

4.

iddentify the infformation resoources requireed and availabble to completee the various types of machhinery annd equipment assignments;

5.

exxplain how maachinery and equipment is valued using an income appproach;

6.

exxplain how maachinery and equipment is valued using a direct compparison approaach; and

7.

coomplete a sim mple machineryy and equipmeent valuation assignment ussing a cost appproach.

Photo courte esy of Benjamin Earwicher E

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Valuation of Machinery and Equipment

Instructor's Comments Throughout this lesson, machinery and equipment shall be referred to as M&E. The valuation of M&E is a specialty branch of the appraisal field. Those appraisers practising in this area tend to concentrate on these types of valuations and to develop the resources and databases necessary to become efficient and competent. Assignments in the M&E field also frequently demand expertise in business valuation and real estate appraisal. While not all appraisers will work on M&E assignments, it is important to have some knowledge about how to approach M&E appraisals, and the type of expertise that might be needed to complete the work. This lesson is offered principally as an introduction to machinery and equipment valuation. M&E appraisal assignments can differ from real property appraisals in many ways: •

A determination of market value is not always the aim of the assignment.

•

The nature of the value being sought and the method(s) of valuation used are driven by the needs of the client, not necessarily by typical market considerations.

•

M&E appraisals are often completed as part of complete business valuations that typically combine the need for expertise in real property values and analysis of the financial well-being of the business.

•

Analysis of M&E values requires identification and classification of the items to be valued (which is not always an easy task), and then determination about the condition, and functioning of each item. The location of the item will, in most cases, make a difference in its value.

•

In a M&E assignment involving heavy or large machines, it is often difficult to know where to draw the line between where the machine ends and where the real property begins. For example, is the air conditioning that cools the employees, but is also needed to operate an engine production line within acceptable machined tolerances part of the building or part of the M&E?

•

M&E values can be very detailed requiring considerable inspection time and analysis, or completely summary in nature where a complex assembly process is valued as only one line on the report.

•

M&E values can also involve the valuation of chattels, including horses and livestock.

In spite of these factors, the Canadian Uniform Standards (CUSPAP) still apply to machinery and equipment appraisal assignments. CUSPAP discusses personal property as follows: Personal property: including tangible or intangible items that are not real property but that are included in the appraisal. May be omitted when not relevant to the assignment, otherwise competency in personal property appraisal is required when it is necessary to allocate the overall value. (CUSPAP section 7.23, 2010) Therefore, the most critical part of any machinery and equipment assignment is defining the purpose and function of the appraisal and defining the value being sought. Also, if remuneration is desired for the work, it is essential that the stated objectives of the valuation match the client's expectations. Often it becomes necessary to understand the client's underlying purpose for the appraisal (e.g., bank financing) and then discuss with him or her the options for completing the assignment before commencing. Because of this critical requirement, a large part of this introductory lesson is devoted to outlining the various types of machinery and equipment valuation assignments and the value definition that applies in those assignments. After, the resources and methods that are available to complete the appraisal will be discussed. Part of the lesson touches upon fundamentals in asset classification, record keeping, tax considerations, and 3.3

Lesson 3

what to do with/about financial statements. Machinery and equipment values for insurance and property tax purposes are also covered. As part of this lesson, simple examples on the income approach, the cost approach, and a direct comparison approach are demonstrated.

Reading Recommendations Several books and journals were relied upon in the creation of this lesson. These titles can be found in the list of recommended readings. Interested students are encouraged to read these supplementary materials – see the "Notes on Recommended Readings" at the end of this lesson. Along with this lesson, the assigned reading includes the Gadd article found at the end of this lesson. It is a good, short summary of what is involved in machinery and equipment valuations and how this field is similar to and different from real estate appraisal. Other comments and recommendations for reading can be found at the end of this lesson.

What is M&E? Machinery and equipment are items of personal property. This includes everything from the beds and televisions in a hotel room to automobiles, trucks and other mobile equipment, to manufacturing equipment in plants and generators in power dams. M&E also includes the following: • • • • • • • • •

Machine tools Hand tools Vehicles, boats Chemical equipment and tanks Furniture and supporting equipment Communication equipment and computers Farm equipment Oilfield equipment Restaurant equipment

M&E items are typically considered to be movable as opposed to buildings and structures (real property) that are considered immovable – though it sometimes takes a leap of faith to classify a power turbine as movable and a guardhouse as immovable. In addition, items such as machine foundations, equipment platforms, and large processing tanks sitting in the middle of the yard are generally considered and valued as part of M&E as opposed to structures and real property. In addition, M&E can include everything from the paper clips that form part of the office stocks to the horse that runs around the client's farm and the helicopter that is used by the client to get there. Alternatively, the M&E appraisal assignment can be limited to specific items identified by the client. The important lesson in completing M&E appraisals is to know or find out what needs to be valued – preferably before quoting on or accepting the assignment.

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Valuation of Machinery and Equipment

Types of M&E Appraisal Assignments The appraisal of machinery, equipment, and other business assets may be required for a wide range of purposes, including property tax assessment, income tax purposes, insurance claim or loss settlement, financing, allocation of purchase price, bankruptcy, expropriation, marriage breakdown, and dissolution of corporations or partnerships. Altogether, there are four broad categories of M&E assignments: • • • •

Sale or disposal Insurance values Taxation Business values and credit applications

Each category has a number of different options and these are presented in more detail below. Some of the definitions introduced throughout this lesson are summarized in Appendix 3.1 at the end of the lesson.

Sale or Disposal Just as with real property, one of the major reasons for valuing M&E is to determine the price it would obtain in the market. Therefore, the classic market value definition applies – generally with qualifications. Below, and in order of descending value, are the various forms of disposal assignments: •

Fair market value for continued use (purchase and sale of a business or property) where the M&E will continue to operate in place. (This type of valuation will be discussed under the section on business value below.)

•

Orderly sale or liquidation value where the M&E is to be removed and located in another place. This type of sale usually involves M&E that has a useful remaining economic life and is sold to a purchaser who intends to use the items in a productive capacity. The costs of relocating the M&E (i.e., disassembling, transporting, and reassembling) reduces the prices that are paid for these items. To the extent that it cannot be moved, the existing wiring, piping, electrical connections, foundations, and equipment platforms will not contribute to the value of the M&E being sold. Note that the wiring piping and equipment platforms left behind may retain some utility (and therefore value) if the sold M&E is to be replaced.

•

Forced liquidation is where the M&E has to be sold in short order and therefore while the items are exposed to the market – usually by way of auction – sufficient time has not been allotted to satisfy the classic definition of market value.

•

Salvage value is the value generated where the M&E is purchased for its component parts. This type of sale is usually of M&E that is no longer entirely functional, or does not meet current performance standards, but the individual components have some value (i.e., selling a vehicle to an automobile salvage yard who then sells off the parts).

•

Scrap value is, as the name implies, the M&E that has no remaining economic life and is sold for the value of the underlying materials (i.e., scrap metal).

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Lesson 3

Establishing M&E Values

As with real estate appraisals, all approaches to value should be considered. Where there is a ready market for common M&E items (i.e., automobiles, office furniture), the direct comparison approach can and should be used to estimate a market value. Also, estimating any disposal value should incorporate a direct comparison, wherever possible. The applications of valuation methods are discussed in a latter section. For some M&E, it may be possible to employ the income approach where the subject equipment is leased or where there is a leasing market for similar equipment (i.e., automobiles, trucks, and forklifts). The income approach can also be applied in instances where the income from M&E can be segregated from other interests (i.e., part of the difference between rental rates for furnished apartments versus non-furnished apartments). However, for M&E valuations involving more complex machinery where no ready market has been established, the appraiser often has to rely on a cost approach as a method to estimate the value of these items. When valuing for sale or disposal, the costs of re-location often affect the value that can be obtained. For example, it may be fairly easy to ascertain the replacement cost of a bottling machine found in a brewery, determine the remaining economic life of the existing machine, and establish the inherent depreciation. However, the costs of disassembly, transport, and re-assembly at a new location are generally more difficult to determine. But these relocation costs will influence the price that a purchaser is willing to pay. When a machine is to be moved, the appraiser must either estimate these re-location costs, or complete a value of the M&E in-place with a note in the appraisal to that affect. A value in-place will be considerably less useful to a client who is looking to see the type of funds that can be generated from the disposal of assets.

Insurance Values Values for insurance purposes relate to the insurance policy in place (or being sought) or to the amount of an insurance claim. Typical insurance policies are either at full replacement value or depreciated replacement value. Full replacement value is a study of the cost of replacing the M&E with items of similar utility. While depreciated replacement value can either be at the current book value of the item (an accounting exercise, not an appraisal exercise) or the value of the item according to its cost new depreciated to reflect its utility and remaining economic life. Both types of policies could include or exclude the costs of installation. Insurance coverage could also be for items such as business interruption insurance where the appraiser has to determine both the cost of replacing the M&E plus the typical time to transport and complete the installation of the item as well as an estimate of the lost business revenue.

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Valuation of Machinery and Equipment

M&E Inventories

Another reason for completing an insurance appraisal or any other type of M&E appraisal is often to establish an inventory of all the M&E owned and/or leased by the client. While not strictly an appraisal function, these inventories are a useful service for clients. The valuation of inventory also has specific considerations including markdowns for items that are no longer in fashion, private brand labels that restrict the market for items, and shrinkage. We do not address the valuation of inventories in this introductory lesson on M&E.

Taxation Taxation and the Sale of a Business

There are three different types of valuation for taxation purposes. The first is the valuation of M&E arising as a part of a sale of a business or property. These types of values are needed because the M&E portion of the business value is depreciable and as such is typically treated differently (better) under income tax and transfer tax laws. It also typically means that the appraiser is under some pressure to enhance the M&E portion of the total value established in the sale of the business (such pressure should be resisted). Furthermore, the tax treatment of M&E under different jurisdictions can produce two different purchase prices for the same item. The process of valuing M&E for taxation purposes as part of a business sale is discussed under the business value section below. Corporate Financial Reporting

The second type of M&E value for financial/taxation purposes involves reporting of M&E values as part of the corporate balance sheet. This is generally an accounting function, whereby the values reported are based on acquisition costs less the depreciation applicable according to the age of the item and depreciation set in published government tables. Though not usually a market value analysis, corporate financial reporting assignments involve the data organizational skills, research capabilities, and classification know-how of the M&E appraiser. However, such assignments can also require the determination and quantification of extraordinary obsolescence by appraisers. Taxation of Personal Property

The third type of appraisal for taxation purposes occurs in jurisdictions where M&E is assessed and valued for property tax purposes. Many jurisdictions in the United States tax M&E, while in Canada only parts of Alberta have M&E taxation. While ostensibly (and generally) assessed under an ad valorem or market value standard, values of M&E for property tax purposes generally follow specific guidelines laid out in the tax legislation applicable in that jurisdiction, and/or accepted assessment practices; the application of which are deemed to produce market values. The usual assessment process is to determine and keep a record of the actual cost new of the items, then depreciate each item or each category of item according to depreciation tables and/or depreciation rules published by the taxing authority. Before undertaking a valuation of M&E for property tax purposes, the appraiser must become familiar with the tax legislation and know what has to be reported. In many jurisdictions, particular items of machinery and equipment are excluded from assessment and taxation. In other jurisdictions, the costs of transportation and installation are included (but only to a point). For example, in Alberta only those installation costs that would occur as if the item were to be installed in an Edmonton or Calgary location should be reported.

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Lesson 3

In addition to the correct reporting of M&E values, these types of property tax assignments tend to be lucrative for the client as some big businesses have a tendency to forget to write off M&E that has been sold or retired and as a result such companies often end up paying taxes on items that they no longer use or own.

Business Values and Credit Applications Business Values

The value of the entire business is the value of all tangible (real and personal property) and intangible assets (i.e., goodwill, patents, licences) of that business. This business enterprise value is generally demonstrated in a sale of the business. However, the sales of businesses may involve a complex swapping of shares, future considerations, a spin-off of certain assets, tax write-off considerations, or leasebacks of a portion of the operation and may have more to do with the value of trained employees as opposed to any physical assets. Apart from considering the financial details of transactions involving sales and mergers of businesses, business enterprise values are generally established through the review of financial statements including Profit and Loss Statements and Corporate Balance Sheets. Appraisers may be called upon to develop an opinion of the investment value, use value, or some other type of value for a business. However, most appraisals of a business relate to a determination of market value. Unless the M&E appraiser is qualified to provide opinions of the market value for the business enterprise, it is advisable to put a condition to that affect in the Statement of Limiting Conditions (i.e., "The appraiser is not qualified to provide opinions of the market value of the business carried on in respect of the machinery and equipment that are the subject of this appraisal"). Going Concern Values – M&E

A going concern is an established and operating business with a foreseeable future life. The going concern value of a business refers to the total value of all elements of the business. M&E is one component of the tangible property value. This final category of M&E appraisal assignments generally requires a determination of a value-in-use, or going concern value of the M&E. The notion of value-in-use to the non-appraiser can represent anything from the concept of opportunity costs (from the field of economics), to the book value listed on the corporate balance sheet (accounting). The M&E appraisal profession establishes a value-in-use as an estimate of the value of an operational item in respect of its remaining economic life, typically as installed. In Valuing Machinery and Equipment, the American Society of Appraisers defines value-in-use as follows: Fair market value for continued use is the estimated amount, expressed in terms of money, that may reasonably be expected for a property in an exchange between a willing buyer and a willing seller, with equity to both, neither under any compulsion to buy or sell, and both fully aware of all relevant facts, including installation, as of a specific date and assuming that the business earnings support the value reported. This amount includes all direct and indirect costs, such as installation and other assemblage costs to make the property fully operational. In his book, Dimensions of Value, Miles describes market value in use as follows: A judgement of worth of a property, utilized in manufacturing or production operation, to its owners. It is the value of the property to its owner/user which is based on the productive contribution of the property to the entity.

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Valuation of Machinery and Equipment

Comment: This "In-Use" concept can generally be justified when: • • • • •

the property is fulfilling a reasonable, identifiable economic demand for the service it provides or houses; the property improvements have a reasonable remaining economic life; there is responsible ownership and competent management; diversion of the property to an alternate use would not be economically feasible; and continuation of the present use is assumed.

This value concept is applicable for marketing property on a going concern basis, or for allocation of purchase price after acquisition.1 When encountering the sale of a business it may be difficult to separate the market value of the tangible assets (land, building, and M&E) from the total value of the business, and then further delineate the value attributable to the real property and that attributable to M&E and other personal property. However, these value distinctions are generally the goal of business appraisal assignments. Also, the separate valuation of M&E is often a requirement under governmental regulations when businesses are bought and sold. Business value assignments must be performed in compliance with appropriate CUSPAP standards. Therefore, only qualified appraisers or a team of qualified appraisers should undertake an assignment requiring opinion values for the business enterprise, the real property, the M&E, other personal property, and the intangible property. When an appraiser cannot effectively separate the market value of the real and personal property from the business enterprise value, it is necessary to state that the appraiser has not been able to establish separate values for the tangible assets. M&E Values in Company Mergers and the Purchase or Sale of a Business

For some businesses, the physical assets represent a large and integral part of the ongoing value of the business, (i.e., hotels and motels, restaurants, bowling alleys, manufacturing enterprises, athletic clubs, or landfills). Other businesses do not have many tangible real property or personal property assets and the major portion of their business value lies in the intangible assets (i.e., an appraisal or consulting firm). Where a M&E appraiser is not qualified to estimate business values, the ability to review financial statements, combined with knowledge of the financial health of the industry are critical in the assumption of whether the business has a viable future, and a going concern value can be established. Also, reviewing financial data can often indicate whether external depreciation should be considered in the valuation of M&E. Therefore, an important part of completing a going concern value of the M&E is an examination of the financial statements for the past few years to determine if the business has been financially successful. Should this test be satisfied, the machinery and equipment may be valued on a going concern basis. If the business is losing money, or if there is some question as to the financial viability of the business, then the machinery and equipment should not be valued on a going concern basis without first obtaining an opinion of the value of the business from a qualified appraiser. A going concern value relies upon a determination of remaining economic life of the M&E. When there is some question as to the financial viability the remaining economic life, the value of the M&E cannot be determined and a going concern value cannot be established. In such circumstances the appraiser should advise the client that a going concern value could not be determined, but a liquidation value of the M&E could be considered.

1

Miles, L.H., Dimensions of Value, VI Edition, p. 50.

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Lesson 3

Another consideration in a value-in-use analysis is that even out-of-date M&E is often assigned a residual or minimum value as long as the items are in use. This value is generally a percentage of original costs (i.e., 10%). These values are typically arbitrary and do not reflect liquidation values. M&E Values for Credit Applications

The appraiser should be aware of the type of value that the lender wants when establishing a value of M&E as security for credit or loan applications from a bank. First, the bank is not interested in becoming the owner of any machinery and equipment. Their primary interest is to determine how capable the borrower is of paying back the loan. To a great extent, this means a review of the business value and the financial history of the client. Typically a bank will have their own experts review the financial data and provide this opinion. The second component of an application for credit is how committed the borrower is to the project (i.e., do they have any of their own money wrapped up in the business). If the bank is looking at this type of response, then the value of the M&E as a going concern should be established. However, most applications for credit concerning the valuation of M&E are done for the security offered by the value of the M&E. For this type of analysis, the appraiser should establish the forced liquidation value of the M&E. However, in these situations the appraiser must know whether it is a fire sale of the business with the M&E items in place or a sale of the M&E as removed (usually in situations where the mortgage for the real property is held by a different lender). Establishing the Business Value of M&E

There are three approaches to estimating value-in-use of the M&E in the sale of a business: • •

•

Where the business has sold, attempt to arrive at a rational apportionment of the sales price between the various components of the business (i.e., real estate, M&E, labour, and management). Determine the replacement cost new of the M&E, correct for any functional changes and obsolescence, determine the remaining economic life, and complete the value by applying the appropriate depreciation. Compare prices paid in the market for similar items in place.

These valuation methods are discussed in greater detail below. Depreciation in Appraisal Versus Accounting

The valuation concept of depreciation differs from the accounting concept of depreciation. Depreciation in the valuation of machinery and equipment is the estimated loss in value of an asset compared to the new asset. This depreciation is the measure of loss in value, caused by a combination of physical deterioration, functional obsolescence, and economic (or external) obsolescence. Depreciation for accounting purposes may be thought of as a mathematical procedure for recovering the original cost of an asset in declining installments over a specified period. "It is important for an appraiser to understand that the accounting depreciation process is one of cost allocation only. It is not a method of valuation."2 The appraiser should have a basic understanding of accounting terms and their relation to valuation concepts. In addition to cost, price, and depreciation, the appraiser will encounter other accounting and financial terms.

2

Quote from Valuing Machinery and Equipment published by the American Society of Appraisers.

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Valuation of Machinery and Equipment

Capital Cost Allowance

Depending on the methods used, the accountant either capitalizes or expenses the costs incurred or prices paid for certain items. The items that are capitalized are considered as fixed assets. The costs of fixed assets are recovered through accounting depreciation. This is in accordance with the generally accepted accounting principles (GAAP). Items that are expensed are considered to be wasting assets. The life of an asset on a company's books is also an accounting concept. The depreciation taken should reflect the company's estimate of the assets expected useful life. Most companies will choose to keep their books in accordance with the income tax department's idea of depreciation. Depreciation measures will vary from operation to operation depending on decisions made between the accountants and management. Canada Revenue Agency (CRA) provides for the following annual tax rates on a declining balance basis for depreciation on machinery and equipment and other assets as follows: • • • •

Class 10: 30% CCA rate for vehicles, computers, trailers, trucks Class 8: 20% CCA rate for furniture, stationary machinery, office equipment Class 3: 5% CCA rate for buildings acquired before 1988 Class 1: 4% CCA rate for buildings acquired after 1987, plumbing, heating, cooling systems

Even though these are the rates for income tax purposes, corporations may take a lower or a higher rate for internal purposes than the tax department allows. Appraisers must be aware of these considerations and make suitable adjustments where required.

Steps In M&E Valuation The process of valuing M&E has five steps, described in more detail below: 1. Determine the purpose and use of the valuation 2. Determine the scope of the report 3. Discuss with the client the type(s) of valuation reports that could be completed and ensure that the proposed work will meet his or her expectations 4. Check availability of resources and gather the necessary information 5. Complete the valuation assignment

Step 1: Determine the Purpose and Use of the Valuation One of the simplest mistakes made by an M&E appraiser is assuming that the client knows the type of value that they need. For example, the client may request a market value for taxation purposes expecting a value for corporate financial reporting instead of a property tax value or a value as part of the sale of a business. Once the appraiser understands the nature of the client's request, he or she is in a much better position to provide the services required.

Step 2: Determine the Scope of the Report Scope refers to the information to be included in the report and the level of detail required – is it a micro approach covering all the M&E in detail or is it a macro approach where whole processes are valued as one item? Are there any M&E items to be excluded?

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Lesson 3

Step 3: Define the Type of Value to be Reported Discuss the valuation assignment with the client and provide them with options that seem appropriate to meet the client's needs. After explaining the options, come to an agreement with the client on the nature of the assignment including: • • •

Type of value to be established. Should the value include the support structures and installation costs? Value in-place or as moved.

All of these items should then be set forth when establishing the parameters and scope of the report.

Step 4: Check Availability of Resources and Gather Information The existence of good client records makes a big difference in the amount of work that needs to be completed. An appraisal assignment going in cold will involve a lot more time and effort than one where the client has an up-to-date database on all the M&E. Before quoting a price on a job, first determine what type of information is available. Second, determine what kind of support the client can provide. For complex production machinery, it is critical that the appraiser has access to a company engineer or operations expert. Without this assistance, it may not be possible to evaluate the functionality and expected remaining economic life of the M&E. Finally, the appraiser should have their own data library and access to publications, auction houses, and experts in the field to assist in the value analysis.

Step 5: Complete the M&E Assignment Once all the valuation parameters have been settled, the appraiser is ready to begin the valuation analysis.

Valuation of M&E The valuation of M&E requires up to seven steps: 1. 2. 3. 4. 5. 6. 7.

Identify and list the machinery and equipment Classify M&E accounts and classes Rating of equipment Direct comparison approach Income approach Cost approach Reconciliation and final estimate of value

Step 1: Identify and List the Machinery and Equipment Once the scope and purpose of the appraisal has been defined, the appraiser begins with identifying and listing all the M&E to be valued. The two main approaches used are macro identification and micro identification. Macro identification is the study of the entire manufacturing process by identifying major components contributing to the design capacity of the plant. Valuing a manufacturing process inventoried in this way often entails comparison with the known costs to acquire and install a similar manufacturing line. 3.12

Valuation of Machinery and Equipment

Micro identification is the process of finding the individual characteristics of the equipment. It focuses on the listing of individual machines and identifies the specifics of the equipment. Of prime importance in micro identification is the brand name, model number, size, serial number (very important), type of power, production capacity, weight and dimensions (if practical), condition, and age. Other identifying features that could be noted include: • • • • •

speed; age; operating costs; energy consumption; and warranty and/or service contracts.

Valuing assets inventoried in this way often entails relating the cost of other similar equipment, and adding the additional costs to make the equipment operational: i.e., installation costs, power feeds, plant piping, foundations. Where there is a large quantity of similar assets (e.g., a fleet of vehicles) the appraiser may include sampling and desktop analysis techniques to establish the condition and expected remaining economic lives of all the items in that class. Sampling and desktop analysis are statistical methods that look at a representative, random sample of a population and translate the findings to the entire population. As long as the sample is selected appropriately, these techniques are acceptable as a method to value large inventories or other tangible assets without actually inspecting each item. The appraiser should remember that these methods result in abbreviated results from what is normally required by professional standards. Thus, the appraiser must be satisfied that use of these abbreviated methods will not result in a false or misleading appraisal. The appraisal report should note any departure from the CUSPAP standards by stating these as critical assumptions or limiting conditions.

Step 2: Classify M&E Accounts and Classes Once the inventory is established the items should be classified into various accounts and classes that describe the machinery, equipment, furniture, and fixtures included in the appraisal. All machinery and equipment falls more or less into the hundreds of different classification codes published by the government – the Standard Industrial Classifications (SIC). Other classification codes can be used, but appraisers are increasingly following the SIC codes that are also used by accountants and the Canadian government. In addition to establishing the SIC classifications, the appraiser should also group all items by type such as: production machinery, general plant equipment, office furniture and fixtures, and other groups that fit best with the company's accounting programs. It is recommended that appraisers, as far as possible, follow the groupings used by the company to ensure that the client and others using the report can better understand the appraisal report. In addition, it is important that the appraisal report can be easily reconciled to the company's accounting records so that the client knows where numbers and results are coming from. If the company does not keep such records, appraisers should attempt to use classes that follow the type of M&E found at the business. The following is a list of classes that may be used for this purpose. Typical Machinery and Equipment Classes Production machinery Support equipment Motor controls and Switchgear Electrical wiring Process piping Foundations and structural supports Material handling and storage equipment General plant equipment Rolling stock

Laboratory and test equipment Office furniture, fixtures and equipment Computer equipment Tools Special tooling Patterns and templates Special classes Inventory Installation in progress 3.13

Lesson 3

Appraisals for certain industries may require additional special classes, such as aircraft, bottles and cases (beverage industry), screens (printing), cores and moulds (foundry), and trays and pans (bakery). At other times, it may be necessary to augment the aforementioned classes to account for the following situations: • • •

leased equipment; not inspected or away from premises; and non-operating assets.

Inventories

Inventories of product and of M&E (spare parts) are often included as part of an M&E valuation. Some companies will have an inventory count done by the staff, whereas others will use the services of persons who are experienced in the identification and accounting of inventory on hand. Care should be taken with respect to inventory numbers provided by the client as they may include work in progress, raw materials, finished goods, and slow moving or out-of-date stock.

Step 3: Rating of Equipment The next step is to determine the condition of the M&E. Some texts recommend that a rating system should be used based on a physical examination of the machinery or equipment to determine the estimated amount of physical deterioration. In carrying out this analysis the following ratings are suggested (Manning, 2000; Gadd, 1987): •

Very Good: An item of equipment receiving this rating would have to be in excellent condition and be capable of being used to its fully specified capacity based on its design purpose. In addition, this equipment would not require any abnormal maintenance both at the time of the inspection or for the foreseeable future.

•

Good: In general, this rating would be given to equipment which has been subject to modifications or repair and is being used on a regular basis, based on their fully specialized utilization. Consideration would also be given to the age of the machines.

•

Fair: This term describes items of equipment which are being used in the operation at some point below their potential capacity due to age or a change in application which would require repairs or replacement in the immediate or foreseeable future in order to raise the level of utilization at or near their original specifications.

•

Poor: This term is used to describe items of equipment that are in a state of repair that would require extensive repairs or replacement of major components in the immediate future.

•

Scrap: This term would be given to those items which have reached the end of their useful life and would require considerable expenditures of monies to put them into working order or machinery and equipment that is technologically or functionally obsolete.

In practice, particularly with a small inventory, some appraisers will only value the very good and good items of equipment with the remainder of the equipment valued on a group basis by category.

3.14

Valuation of Machinery and Equipment

Step 4: The Direct Comparison Approach Once the M&E has been identified, classified, categorized and rated, the appraiser is ready to apply the various valuation approaches. Like real property appraisal, all approaches to value should be considered. However, it is not usual to have the data necessary to complete each of the three approaches, and the appraiser has to decide which approaches can be applied to each type of M&E. Wherever possible, it is preferable to use at least two approaches, if for no other reason than to verify the depreciation estimates (Gadd, 1987). The direct comparison approach seldom applies to all of the items to be valued. However, where the necessary sales data is available, values for M&E should be established using the direct comparison approach. The approach works the same way with M&E as it does with real property. The values of machinery, fixtures, and equipment are established by comparison to the sales or asking prices of similar M&E in a similar market on or about the valuation date. The greater the comparability of the M&E, the more confidence can be placed upon the value conclusions. The Sales Comparison Process

Though only a few items of used M&E (such as vehicles) are actively traded in the marketplace, it is often possible to gather information on liquidation prices for other types of M&E from auctions. Therefore, most of the comparable price information available either comes from the sale of new equipment or, at the other end of the value scale, from the liquidation or forced liquidation values achieved at auctions or in the sale of a business. The nature of the sales comparison research that should be undertaken depends upon the nature of the existing equipment and the valuation assignment. If the assignment is to establish a going concern value, and if the subject equipment is new (and has most of its economic life remaining), then looking to the market for current prices makes sense as a point of value comparison. If the assignment is to establish disposal value, or if the subject M&E is near the end of its economic life, then the sales comparison process must consider used sale prices from auctions or other sources. The comparability of the subject M&E against new M&E is often made more difficult because of changes in technology and functionality. While it may be easy to establish the price of the latest equipment as new, the new M&E often has different functionality than the equipment being appraised. In many instances the M&E being appraised is no longer being manufactured. In any case, the typical direct comparison approach, involves establishing a point of reference price, then adjusting it for differences, such as condition, age, functionality of the equipment, location, installation costs, type of sale, and time of sale. These are the same kinds of adjustments that take place in a replacement cost approach, and therefore, except in cases where there is an active market for used M&E, the analysis undertaken in a direct comparison approach is similar to that undertaken in the cost approach [i.e., a value reference point is established – replacement cost new – and then adjusted (depreciated) to reflect the circumstances pertaining to the M&E being valued].

3.15

Lesson 3

Retail Versus Wholesale Sales Values

Following from the various definitions of sales value, the appraiser must be aware of the type of information being used to generate values. If the purpose of the appraisal is the orderly disposition of the items or continued operation of the business, then the retail market evidence should be used. If the client wants to establish the value in exchange and it is unlikely that they will take the time to advertise and sell the M&E, then the wholesale market is more representative of the probable value (i.e., forced liquidation). Fortunately, for items like automobiles both wholesale and retail values are quoted in the "Blue Book" based on the model age and condition of the car. This information highlights how important it is to understand what you are valuing and how to find comparables that are actually equivalent and offer reasonable evidence of value of the subject. Valuation Benchmarks – Direct Comparison Approach

One of the difficulties in using the direct comparison approach is the lack of common market benchmarks when determining values. With real property values, measures such as the per square foot of building, or cubic foot of warehouse are commonly referred to. However, there are few instances where M&E items enjoy the same benchmark interpretations. The first is the hotel and motel industry where the furniture, fixtures and equipment (FF&E) command ranges of value depending upon the quality of the hotel and the age of the items. For example, a motel may sell for $19,000 per room plus the value of the FF&E at $3,500 as new with a typical economic life of five years. For this type of property, a vendor would expect to assign $2,800 per room for one year old FF&E (80% of $3,500). Similarly, the value of the FF&E in a five star hotel may be in the range of $16,000 per room. However, in both examples, a bank using FF&E as security on an operating loan would be fortunate to realize $1,000 per room for the furniture on the basis of its disposal value. The other area where there is a common benchmark for M&E values is for leasehold improvements in offices and retail space. To the extent that they are removable, leasehold improvements are generally classified as M&E. The value of the leasehold improvements is generally referred to as an amount per square foot. A store owner could spend $20 to $80 per square foot improving space for specific retail purposes. On a continued use basis those leasehold improvements have a reasonably specific life expectancy and as a result a value-in-use can be determined. However, retail leasehold improvements have very little value to another store format and therefore the value in exchange is limited, if any. The value of the leasehold improvements in offices tends to carry more general appeal. Therefore, there is a difference in the rents commanded for newly finished space as opposed to unfinished space. In these instances, the premium in rent can be analyzed as a method of valuing the leasehold improvements. Leasehold improvements generally include the cost to build-out the premises which are needed for the operation of the subject business. Some of these improvements are detailed as follows: • • • • • •

3.16

Good quality floor and ceiling finishing Custom ornamental metal work Electrical supply including panels and hook up of various equipment Plumbing and coring Mechanical Security gate

• • • • •

Millwork/counters with front fascia and countertops Signs and menu boards Hot water tank Built-in seating Other similar costs

Valuation of Machinery and Equipment

Direct Comparison Approach Example

The following sales analysis is a simple example of the application of the direct sales comparison approach in the valuation of a diesel-electric locomotive. The subject M&E is a 5-year old diesel-electric locomotive that the owner wants to sell as of April, 2011. The locomotive is a 3,300 horsepower model and has 32,600 operating hours. A locomotive typically has a 5-year operating life and is expected to run between 5,500 and 6,500 hours per year. For the past 5 years, the standard freight locomotive had 3,300 horsepower – up from the previous standard of 3,000 Hp. The advantage of higher horsepower is the same number of locomotives can haul more rail cars. At the end of its economic life, a standard used locomotive has a typical salvage value of $30,000. The market for railroad locomotives has just recently undergone a significant change in technology with the introduction of new locomotives burning 15% less fuel. These new efficient locomotives cost 10% more than the older models, but offer significant savings in operating costs over the lifetime of the product. At a fuel cost of $1.00 per litre, the current value of the expected savings over a 15 year period is $155,000.

There is a small but regular market for used locomotives. However, care must be taken in interpreting the results as a number of sales occur as a result of bankruptcies. Discussions with people in the industry indicate that the typical difference in price in a bankrupt sale and a market sale is 5% (due to motivation). The following table shows the results of recent research on sales values of comparable M&E. Sale of Locomotives No.

Hp

Age (yrs)

Hours

Price

Sale Date

1

3,000

8

46,700

$330,000

Jan-10

Sold at auction due to bankruptcy

2

3,000

8

44,670

$350,000

Jan-10

Sold at auction due to bankruptcy

3

3,300

7

34,190

$403,500

Jan-10

Sold at auction due to bankruptcy

4

1,800

10

61,430

$276,700

Jul-09

Yard engine

5

3,300

5

31,990

$489,000

Sep-09

6

3,300

6

38,770

$426,600

Nov-09

7

3,000

11

58,420

$251,500

Mar-10

New

3,300

0

0

$1,700,000

Comments

Fuel efficient model

3.17

Lesson 3

The first task in the sales price comparison process is to establish appropriate point or points of comparison. In this instance, as with a lot of M&E, the critical number is the remaining economic life. Working between 5,500 and 6,500 hours per year for 15 years, a typical locomotive has a 90,000 hour operating life. Given the above information, we can determine the following points of comparison: • • •

•

The expected remaining economic life. The price paid per hour of remaining economic life. The average number of hours per year the locomotive has worked – a surrogate measure that tells us something about the current condition of the locomotive, as physical inspection of all these items is not possible. The price of a new locomotive in comparison to older units.

The table below shows this information. Sale of Locomotives – Points of Comparison

Price

Remaining Economic Life (Hours)

Price per Hour of Remaining Economic Life

Sale Date

No.

Hp

Age (yrs)

1

3,000

8

46,700

5,838

$330,000

43,300

$7.62

Jan-10

2

3,000

8

44,670

5,584

$350,000

45,330

$7.72

Jan-10

3

3,300

7

34,190

6,838

$403,500

55,810

$7.23

Jan-10

4

1,800

10

61,430

6,143

$276,700

28,570

$6.53

Jul-09

5

3,300

5

31,990

6,398

$489,000

58,010

$8.43

Sep-09

6

3,300

6

38,770

6,462

$426,600

51,230

$8.33

Nov-09

7

3,000

11

58,420

5,311

$251,500

31,580

$7.96

Mar-10

90,000

$18.89

Hours

Hours/Yr

New

3,300

0

0

Sub

3,300

5

32,600

$1,700,000 6,520

57,400

There are other points of analysis that can be completed. The new engine should be put on equal terms with the other 3,300 Hp engines in terms of functionality and price given the expected savings in fuel efficiency. New Engine cost Less expected fuel savings Comparable replacement cost new

$1,700,000 $155,000 $1,545,000

To bring all sales to a level value, we must adjust the price derived from the three auction sales by 5% and make adjustments for time of sale for all sales. As the desired sales trending information was not available time of sale, adjustments were made using the Electrical Equipment Quarterly Cost Indexes (1926=100) from Marshall & Swift Valuation Service Manual as a proxy for time adjustments. Further adjustments are also required for above average usage/condition and horsepower differences. Locomotives that have below average use (hours per year