Author: indiafreenotes

Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed-upon date in the future. In other words, an FRA is an agreement to exchange an interest rate commitment on a notional amount.

The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash-settled. The payment is based on the net difference between the interest rate of the contract and the floating rate in the market the reference rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials and the notional value of the contract.

In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).

Steps:

• Calculate the difference between the forward rate and the floating rate or reference rate.
• Multiply the rate differential by the notional amount of the contract and by the number of days in the contract. Divide the result by 360 (days).
• In the second part of the formula, divide the number of days in the contract by 360 and multiply the result by 1 + the reference rate. Then divide the value into 1.
• Multiply the result from the right side of the formula by the left side of the formula.

Uses and Risks

Many banks and large corporations will use FRAs to hedge future interest or exchange rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates. The development of swaps in the 1980s provided organisations with an alternative to FRAs for hedging and speculating.

In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate, referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the published reference rate is above the fixed, contracted rate, and the buyer pays to the seller if the published reference rate is below the fixed, contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs.

Forward Rate Agreement = R2 + (R2 – R1) x [T1 / (T2 – T1)]

Forward rate agreements typically involve two parties exchanging a fixed interest rate for a variable one. The party paying the fixed rate is referred to as the borrower, while the party paying the variable rate is referred to as the lender. The forward rate agreement could have the maturity as long as five years.

A borrower might enter into a forward rate agreement with the goal of locking in an interest rate if the borrower believes rates might rise in the future. In other words, a borrower might want to fix their borrowing costs today by entering into an FRA. The cash difference between the FRA and the reference rate or floating rate is settled on the value date or settlement date.

An interest rate future is a futures contract with an underlying instrument that pays interest. The contract is an agreement between the buyer and seller for the future delivery of any interest-bearing asset.

The interest rate futures contract allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.

These futures may also be cash-settled in which case, the one who holds the long position receives and one who holds the short position pays. These futures are thus used to hedge against or offset interest rate risks. Which means investors and financial institutions cover their risks against future interest rate fluctuations with these.

These futures can be short or long term in nature. Short term futures invest in underlying securities that mature within a year. Long term futures have a maturity period of more than one year.

Pricing for these futures is derived by a simple formula: 100 – the implied interest rate. So a futures price of 96 means that the implied interest rate for the security is 4 percent.

Since these futures trade in government securities, the default risk is nil. The prices depend only on the interest rates.

Interest rate futures in India

Interest rate futures in India are offered by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). One can open a demat account and trade in them. Government Bond or T-Bills are the underlying securities for these futures contracts. Exchange Traded Interest Rate Futures on NSE are standardized contracts based on 6-year, 10-year and 13-year Government of India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). All futures contracts which are traded on NSE are cash-settled.

Features of interest rate futures

• Expiration date: This is the final date future for the settlement of the contract which is pre-determined.
• Underlying asset: The underlying asset is the interest-bearing security on which the contract is based. In case of an interest rate futures contract, it is either a Government bond or a T-Bill.
• Size: This refers to the total amount of the contract. There is, however, a minimum requirement of Rs 2 lakh or 2,000 bonds if one wants to trade in these futures.
• Margin requirement: There is an initial amount required to enter into a futures contract. At the time of starting your trading, you will be required to pay an initial or upfront margin to your broker. This serves as a security deposit which the broker in turn has to submit to the exchange. For NSE, the minimum margin for a cash-settled interest rate futures contract is 1.5 percent of the contract’s value subject to a maximum of 2.8 percent on the first day of trading. For a 91-Days T-Bill futures contract the margin is 0.10 percent of the notional value of the futures contract on the first trading day. This becomes 0.05 of the notional value of futures contract after that.

Advantages of interest rate futures

• No security transaction tax: There is no security transaction tax on these futures, making them a cost-effective option.
• A suitable hedging mechanism: These futures act as a good hedging mechanism. They are also a useful risk management tool. As a borrower, you can hedge your risk in fluctuating interest rates by taking an opposite position in these futures.
• Transparency in trading: Since there is real-time dissemination of prices, trading is more transparent.

Interest rate options are options with an interest rate as the underlying. A call option on interest rates has a positive payoff when the current spot rate is greater than the exercise rate.

Call option payoff=Notional Amount × [Max (Current spot rate−Exercise rate, 0)]

On the other hand, a put option on interest rates has a positive payoff when the current spot rate is less than the exercise rate.

Put payoff = Notional Amount × [Max (Exercise rate−Current spot rate,0)]

The adjusted book value approach represents the value of a business as a going concern when there is no expectation of any type of commercially transferable goodwill.

Adjusted book value is the measure of a company’s valuation after liabilities including off-balance sheet liabilities and assets adjusted to reflect true fair market value. The potential downside of using adjusted book value is that a business could be worth more than its stated assets and liabilities because it fails to value intangible assets, account for discounts, or factors in contingent liabilities. However, it’s not often accepted as an accurate picture of a profitable company’s operating value; however, it can be a way of capturing potential equity available in a firm.

Goodwill represents the benefits that a potential purchaser can obtain in an acquisition that is above and beyond the business’ net tangible assets. In other words, it is the premium that a buyer is willing to pay for a business, over and above its physical assets. Goodwill may include favourable branding, established products and service lines, customer relationships, and reputation within the industry, among others.

Adjusted book value approaches are generally used when there is no reasonable expectation of commercial goodwill.  Consider the following three scenarios:

• The company is an investment or real estate holding company;
• The company has active business operations that do not generate sufficient earnings to realize a reasonable return on the net assets; and/or
• The company is an operating business where all of the income is attributable to personal goodwill.

The Formula of Adjusted Book Value Approach

Below is a formula of how we calculate the adjusted net book value. We start with the shareholders’ equity on the financial statements, add any stub period after tax income/losses, adjust assets and liabilities to the fair market value as at the valuation date, and consider any disposition costs and income taxes arising from the notional sale. We then arrive at the adjusted net book value of the business.

Adjusted book value = Shareholders’ equity per Financial Statements +/- After-tax income (loss) for stub period +/- Adjustments of assets and liabilities to market value – Disposition costs on the sale of the assets – Taxes on the sale of the assets

Special Considerations

Adjusting the book value of a firm entails line-by-line analysis. Some are straightforward such as cash and short-term debt. These items are already carried at the fair market value on the balance sheet.

The value of receivables may have to be adjusted, depending on the age of the receivables. For example, receivables that are 180 days past due (and likely doubtful) will get a haircut in value compared to receivables under 30 days. Inventory can be subject to adjustment, depending on the inventory accounting method. If a firm employs the Last In, First Out (LIFO) method, the LIFO reserve must be added back.

Property, plant, and equipment (PP&E) is subject to large adjustments, particularly the land value, which is held on the balance sheet at historical cost. The value of the land would likely be far greater than the historical cost in most cases. Estimates for what buildings and equipment would fetch in the open market must be made.

The adjustment process becomes more complicated with things like intangible assets, contingent liabilities, deferred tax assets, or liabilities, and off-balance sheet (OBS) items. Also, minority interests, if present, will call for more adjustments to book value. The goal is to mark each asset and liability to fair market value. After the values of all the assets and liabilities are adjusted, the analyst must simply deduct the liabilities from the assets to derive the fair value of the firm.

There are three approaches used in valuing a business: the asset-based approach, the income approach, and the market approach. In a full business valuation, the valuation analyst must consider all approaches, and use their professional judgment to determine which of the three methods or combination of methods is most appropriate.  In a calculation engagement, the valuation analyst and the client agree on which approach or approaches will be used.

Asset-based approach: This method uses the fair market value of the assets of a business, less any related liabilities. In most cases, the analyst considers the value of the net assets in the context of a business that will continue to operate. If the business includes real estate or specialized equipment, separate appraisals for those assets may be needed.

The asset-based approach usually ignores the value of intangible assets, such as reputation, brand, customer relationships, and a well-trained workforce. As a result, it frequently results in the lowest value of the three methods and may be used to set a “floor” for the value of the business.

The asset approach may be applied when the benefits of operating a business do not outweigh the value that could be derived through the orderly liquidation of assets. Methods under this approach assume a controlling premise of value and include:

• Net Asset Value Method
• Adjusted Net Book Value Method
• Capitalization of Excess Income Method (also an income approach method)

The Net Asset Value Method

The Net Asset Value Method is based on the business’ assets less existing liabilities. This simplistic approach is used most commonly for a controlling interest and when valuing securities of businesses involved in the development and sale of real estate, investment holding companies, and certain natural resource companies.

Income approach:

The income approach determines the value of a business based on its ability to generate future income for the owners of the business. If the trajectory of future earnings will be stable, the analyst can use capitalization of benefits methodology. This method involves applying a fixed growth rate to a single measure of future income. If some variability is anticipated, the discounted future benefits method is generally used. This method involves building a two-stage model consisting of a forecast period and a terminal period.

In both methods, it is crucial that the valuation adjust projected earnings to reflect only the net income that a hypothetical buyer will experience. These adjustments are known as normalization adjustments.

Once the future income stream is determined, the valuation analyst applies a discount rate to the future earnings stream. This discount rate must be developed and applied carefully, as small changes in the discount rate can produce significant changes in value.

Expected returns on an investment are discounted or capitalized at an appropriate rate of return to reflect investor risks and hazards. From a theoretical perspective, enterprise value is based either on historical earnings or future cash flows.

Methods under this approach include:

• Capitalization of Excess Income Method
• Capitalized Economic Income Method
• Discounted Cash Flow Method

Market approach:

The market approach is a method of determining the value of a business based on the selling price of comparable businesses. The analyst can use either data on publicly traded companies, or data on the sale of comparable privately owned companies. This method generally relies on pricing multiples, usually of revenue or some measure of profit to arrive an indication of value.

This is done through the use of ratios that relate the stock prices of the public companies to their earnings, cash flows, or other measures. By analyzing the financial statements of analogous companies and then comparing their performances with those of a subject company, the appraiser can judge what price ratios are appropriate to use in estimating the market value of the closely-held entity.

Methods under the market approach include:

• Dividend-Paying Capacity Method
• Guideline Merged & Acquired Company Method
• Guideline Publicly-Traded Company Method
• Transaction Database Method

The main purpose of equity valuation is to estimate a value for a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case and equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day.

There are a number of different methods of value a company with one of the primary ways being the comparable (or comparables) approach. Before we explore what this valuation method entails, let’s compare it to other valuation methods.

Comparable company analysis starts with establishing a peer group consisting of similar companies of similar size in the same industry or region. Investors are then able to compare a particular company to its competitors on a relative basis. This information can be used to determine a company’s enterprise value (EV) and to calculate other ratios used to compare a company to those in its peer group.

Steps in Performing Comparable Company Analysis

1. Find the right comparable companies

This is the first and probably the hardest (or most subjective) step in performing a ratio analysis of public companies.  The very first thing an analyst should do is look up the company you are trying to value on CapIQ or Bloomberg so you can get a detailed description and industry classification of the business.

The next step is to search either of those databases for companies that operate in the same industry and that have similar characteristics. The closer the match, the better.

The analyst will run a screen based on criteria that include:

• Industry classification
• Geography
• Size (revenue, assets, employees)
• Growth rate
• Margins and profitability

2. Gather financial information

Once you’ve found the list of companies that you feel are most relevant to the company you’re trying to value it’s time to gather their financial information.

Once again, you will probably be working with Bloomberg Terminal or Capital IQ and you can easily use either of them to import financial information directly into Excel.

The information you need will vary widely by industry and the company’s stage in the business lifecycle.  For mature businesses, you will look at metrics like EBITDA and EPS, but for earlier stage companies you may look at Gross Profit or Revenue.

If you don’t have access to an expensive tool like Bloomberg or Capital IQ you can manually gather this information from annual and quarterly reports, but it will be much more time-consuming.

3. Set up the comps table

In Excel, you now need to create a table that lists all the relevant information about the companies you’re going to analyze.

The main information in comparable company analysis includes:

• Company name
• Share price
• Market capitalization
• Net debt
• Enterprise value
• Revenue
• EBITDA
• EPS
• Analyst estimates

4. Calculate the comparable ratios

With a combination of historical financials and analyst estimates populated in the comps table, it’s time to start calculating the various ratios that will be used to value the company in question.

The main ratios included in a comparable company analysis are:

• EV/Revenue
• EV/Gross Profit
• EV/EBITDA
• P/E
• P/NAV
• P/B

Relative vs. Comparable Company Analysis

There are many ways to value a company. The most common approaches are based on cash flows and relative performance compared to peers. Models that are based on cash, such as the discounted cash flow (DCF) model, can help analysts calculate an intrinsic value based on future cash flows. This value is then compared to the actual market value. If the intrinsic value is higher than the market value, the stock is undervalued. If the intrinsic value is lower than the market value, the stock is overvalued.

In addition to intrinsic valuation, analysts like to confirm cash flow valuation with relative comparisons, and these relative comparisons allow the analyst to develop an industry benchmark or average.

The most common valuation measures used in comparable company analysis are enterprise value to sales (EV/S), price to earnings (P/E), price to book (P/B), and price to sales (P/S). If the company’s valuation ratio is higher than the peer average, the company is overvalued. If the valuation ratio is lower than the peer average, the company is undervalued. Used together, intrinsic and relative valuation models provide a ballpark measure of valuation that can be used to help analysts gauge the true value of a company.

Valuation and Transaction Metrics Used in Comps

Comps can also be based on transaction multiples. Transactions are recent acquisitions in the same industry. Analysts compare multiples based on the purchase price of the company rather than the stock. If all companies in a particular industry are selling for an average of 1.5 times market value or 10 times earnings, it gives the analyst a way to use the same number to back into the value of a peer company based on these benchmarks.

How to read about company:

Company Information:

• This includes Company Name, Ticker, and Price. The ticker is a unique symbol given to the company to identify publicly listed companies.
• You may take Bloomberg, Reuter’s tickers as well. Also, note that the prices that we take here are the most recent prices.
• We make the table so that these prices are linked to the database, where they would get updated automatically.

Size of the company:

• This includes Market Capitalization and Enterprise Value.
• We normally sort the table based on Market Capitalization. Market Capitalization also provides us pseudo for the size of the company.
• Enterprise Value is the current Market-based valuation of the firm.
• We may not want to compare a small market capitalization company with a large one.

Valuation Multiples:

• It should include 2 to 3 appropriate valuation tools for comparison
• We should ideally show one year of historical multiple and two years of forwarding multiples (estimated)
• Choosing an appropriate valuation tool is the key to successfully valuing the company.
• Operating Metrics
• It may include fundamental ratios like Revenue, growth, ROE, etc
• It is important to understand the fundamentals of the company at once.
• To make this comp more meaningful, you may include Profit Margins, ROE, Net Margin, Leverage, etc.

Summary:

• It is a simple mean, median, low, and high of the above metrics
• Mean, and Median provides core insights to the fair valuation
• If a company’s multiple is above the mean/median, we tend to infer that the company may be overvalued
• Likewise, if the multiple is below the mean/median, we may infer that it is undervalued.
• High and Low also help us understand the outliers and a case to remove those if they are too far away from the Mean/Median.

Net realizable value (NRV) is a valuation method, common in inventory accounting that considers the total amount of money an asset might generate upon its sale, less a reasonable estimate of the costs, fees, and taxes associated with that sale or disposal.

Net realizable value (NRV) is the value for which an asset can be sold, minus the estimated costs of selling or discarding the asset. The NRV is commonly used in the estimation of the value of ending inventory or accounts receivable.

The net realizable value is an essential measure in inventory accounting under the Generally Accepted Accounting Principles (GAAP) and the International Financing Reporting Standards (IFRS). The calculation of NRV is critical because it prevents the overstatement of the assets’ valuation.

NRV and Lower Cost or Market Method

Net realizable value is an important metric that is used in the lower cost or market method of accounting reporting. Under the market method reporting approach, the company’s inventory must be reported on the balance sheet at a lower value than either the historical cost or the market value. If the market value of the inventory is unknown, the net realizable value can be used as an approximation of the market value.

How to Calculate the NRV

The calculation of the NRV can be broken down into the following steps:

• Determine the market value or expected selling price of an asset.
• Find all costs associated with the completion and the sale of an asset (cost of production, advertising, transportation).
• Calculate the difference between the market value (expected selling price of an asset) and the costs associated with the completion and sale of an asset. It is a net realizable value of an asset.

Realizable Value = Expected Selling Price – Total productions and Selling costs

Replacement Value

The term replacement cost or replacement value refers to the amount that an entity would have to pay to replace an asset at the present time, according to its current worth.

In the insurance industry, “Replacement cost” or “replacement cost value” is one of several methods of determining the value of an insured item. Replacement cost is the actual cost to replace an item or structure at its pre-loss condition. This may not be the “market value” of the item, and is typically distinguished from the “actual cash value” payment which includes a deduction for depreciation. For insurance policies for property insurance, a contractual stipulation that the lost asset must be actually repaired or replaced before the replacement cost can be paid is common. This prevents over insurance, which contributes to arson and insurance fraud. Replacement cost policies emerged in the mid-20th century; prior to that concern about over insurance restricted their availability.

If insurance carriers honestly determine replacement cost, it becomes a “win-win” for both for the carriers and the customers. However, when a replacement cost determination is made by the carrier (and, perhaps, its third party expert) that exceeds the actual cost of replacement; the customer is likely to be paying for more insurance than necessary. To the extent that the carrier has knowingly or carelessly sold excessive (i.e. unnecessary) insurance, such a practice may constitute consumer fraud.

Replacement cost coverage is designed so the policy holder will not have to spend more money to get a similar new item and that the insurance company does not pay for intangibles. For example: when a television is covered by a replacement cost value policy, the cost of a similar television which can be purchased today determines the compensation amount for that item.[3] This kind of policy is more expensive than an Actual Cash Value policy, where the policyholder will not be compensated for the depreciation of an item that was destroyed. The total amount paid by an insurance company on a claim may also involve other factors such as co-insurance or deductibles. One of the champions of the replacement cost method was the Dutch professor in Business economics Théodore Limperg.

As part of the process of determining what asset is in need of replacement and what the value of the asset is, companies use a process called net present value. To make a decision about an expensive asset purchase, companies first decide on a discount rate, which is an assumption about a minimum rate of return on any company investment.

A business then considers the cash outflow for the purchase and the cash inflows generated based on the increased productivity of using a new and more productive asset. The cash inflows and outflow are adjusted to present value using the discount rate, and if the net total of all present values is a positive amount, the company makes the purchase.

Budget

While arriving at the replacement cost of expensive assets, well-managed firms create a capital expenditure budget to plan for both future acquisitions of assets and how the firm will generate cash inflows to pay for the new assets.

Budgeting on the purchase of assets is vital as it needs replacing assets to run the company. For example, a manufacturer has budgeted for equipment and machine replacement, and retailer budgets that update each store look.

A business valuation is a general process of determining the economic value of a whole business or company unit. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings. Owners will often turn to professional business evaluators for an objective estimate of the value of the business.

The value of a company could be different for sellers and buyers, so valuation is integral part of the negotiation process. It is also crucial for the effective management of a company, for identifying its value-generating units, and formulating strategies for growth. Initial public offerings, portfolio management, and tax assessment are also areas that involve a lot of corporate valuation.

There are different valuation methodologies, yielding different results and used in different situations. The three main methods are discounted cash flow analysis (DCF), trading multiples, and precedent transactions. An experienced financial analyst knows how to use these methods in combinations in order to reach conclusive valuations.

A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons.

The cost approach is a real estate valuation method that estimates the price a buyer should pay for a piece of property is equal the cost to build an equivalent building. In the cost approach, the property’s value is equal to the cost of land, plus total costs of construction, less depreciation. It yields the most accurate market value for when a property is new than through alternative methods.

The cost approach is one of three valuation methods for real estate; the others being the income approach and the comparable approach.

The cost approach is based on the logic that informed buyers will not pay more for a property than it will cost them to build to a similar property from scratch and with the same level of utility. The cost approach is appropriate for unique properties, such as churches or schools with unique components. Also, for a new property, it is easy to estimate the cost of construction since the improvements were recently built.

The formula for calculating the cost approach is as follows:

Property Value = Replacement/Reproduction Cost – Depreciation + Land Value

Since the cost approach is not based on comparable properties or the property’s ability to generate revenues, the method considers the amount that will be incurred to build a property today, assuming that the existing structure is to be destroyed and rebuilt afresh. Hence, it takes into account the value of the land where the property is built, less any loss in value.

Steps in the Cost Approach Method

The following is the process of the cost approach method of real estate valuation:

1. Estimate the reproduction or replacement cost of the structure

The step involves estimating the current cost of building the structure from scratch and the site improvements. The cost can be estimated using the following two methods:

Replacement method

The replacement method estimates the cost of constructing a building with the same utility as the structure being evaluated, using the current construction materials, standards, designs, and layouts.

Reproduction method

The reproduction method estimates the cost of constructing a duplicate of the property, using similar materials and construction practices. It also uses the designs, standards, and layouts that were in place at the time the property was constructed.

The older and more historic a property is, the higher the difference between the replacement and reproduction costs. Building a duplicate property of a historical building is more expensive than duplicating a modern home because it will cost more to buy materials and undertake site improvements.

For a newly built property, there is no major difference between the replacement and reproduction costs. For example, assume that the reproduction/replacement cost is estimated to be $1 million.

2. Estimate the depreciation of the improvements

Depreciation is the loss in value of the building and or its improvements, and it causes the difference between the value of improvements and the current contributing value of the improvements. When estimating the depreciation of the property, you should consider the physical, functional, and economic depreciation.

Physical depreciation refers to the wear and tear that occurs as the building ages, while functional depreciation occurs with the changes in consumer tastes and preferences over a period of time.

Economic depreciation results from external negative trends, such as the collapse of major employers, recession, and new negative developments (such as the construction of a sewer treatment plant in the neighborhood). In this case, let us assume that the accrued depreciation is $150,000.

3. Estimate the market value of land

The next step is to estimate the value of the land on which the property is being built. The most appropriate method of estimating the land value is the direct comparison method, where the current price of land is obtained from the value of recently sold plots of land. It is the market value that you would pay for the land today if it was vacant. In this case, let us assume that the market value of the land is $750,000.

4. Deduct accrued depreciation from the reproduction/replacement cost

After obtaining the total value of depreciation of the improvements, deduct the figure from the estimated reproduction or replacement cost obtained in step one. In our case, it is calculated as follows:

Replacement/Reproduction Cost                                      $1,000 000

Less: Accrued Depreciation                                                  $150,000

Depreciated Cost of the Structure                                       $850,000

5. Add the depreciated cost of the structure to the estimated value of the land

The final step is to add the depreciated cost of the structure and improvements to the estimated value of the land. The figure is obtained as follows:

Replacement/Reproduction Cost                                      $1,000,000

Less: Accrued Depreciation                                                  $150,000

Depreciated Cost of the Structure                                       $850,000

Add: Estimated Value of the Land                                        $750,000

Total Value of the Real Estate Property                            $1,600,000

Limitations of the Cost Approach

One of the limitations of the cost approach is that it assumes that the buyer is in a position to find a vacant plot of land where to build an identical property, and that is not always the case. If there is no vacant land, the estimated value of the property will be inaccurate.

Also, an area can be fully developed, and local authorities can be restrictive on new developments, and so it will be impractical to estimate land values in that area.

Another limitation is that it will be difficult to estimate the depreciation of older properties because there are many factors to take into account. For example, construction materials used during the construction of older property may no longer be available or in use. Estimating the value of such a property allows a lot of room for subjectivity.

There are two main types of cost approach appraisals:

Reproduction method:

This version considers what a replica of the property would cost to be built and gives attention to the use of original materials.

Replacement method:

In this case, it is assumed that the new structure has the same function but with newer materials, utilizing current construction methods and updated design.

Another earnings-based method is excess earnings. This method discounts company earnings based on two capitalization rates: a rate of return on tangible assets and a rate attributable to company goodwill. The method is often described as a hybrid method because it takes into account the company’s asset values as well as discounts expected cash flows.

The following equation represents the valuation based upon the two rates of return:

V = Ea / R a + Eg / Cg

Where,

V = The value of the business

E a = The earnings attributable to a return on assets

Ra = The appropriate rate of capitalization for earnings attributable to net tangible assets

E g = The earnings in excess of those attributable to a return on assets

Cg = The appropriate rate of capitalization for earnings attributable to goodwill In its most common form,

The value is calculated as follows:

V = E A*Ra / Cg + A

Where:

V = The value of the small business

E = The adjusted earnings of the firm

A = The net tangible assets of the firm

Ra = The appropriate rate of capitalization for earnings attributable to net tangible assets

Cg = The appropriate rate of capitalization of Goodwill

The excess earnings method was developed by the U.S. Treasury Department in 1920 to estimate lost goodwill suffered by breweries and distilleries as a result of Prohibition. The method was never intended to be a business valuation tool, but it became popular because of its simplicity.

Appraisers using the excess earnings method follow these basic steps:

• Estimate the value of the company’s net tangible assets.
• Multiply that value by a fair rate of return to calculate earnings attributable to the company’s tangible assets.
• Estimate the company’s total normalized earnings.
• Subtract earnings on tangible assets from total earnings to arrive at excess earnings that is, earnings above a fair return on the company’s net tangible asset value.
• Divide excess earnings by an appropriate capitalization rate to calculate the value of goodwill and other intangible assets.
• Combine the tangible and intangible asset values to determine the company’s overall value.

A typical procedure to establish the business value with the method is:

• Start with the business net tangible assets, obtained from its recast financial statements by subtracting adjusted liabilities from the tangible assets.
• Estimate the business earnings attributable to the net tangible assets. This is done by multiplying the net tangible assets by a reasonable rate of return, expressed as a percentage.
• Determine the excess earnings as the difference between the total business earnings and those attributable to the net tangible assets. These excess earnings reflect the business goodwill.
• Capitalize the excess earnings by dividing their value by an appropriate capitalization rate.
• Add the capitalized excess earnings value to the value of the business net tangible assets, to establish the overall business value.