MODULE VALUATION CONCEPTS AND METHODS

CHAPTER 5: ASSET VALUATION

Objectives:
1. Determining Book Value
2. Adjusting Book Value
3. Factors in Asset Valuation

Determining Book Value:

1. In asset-based valuation, the value of a company is equal to the net assets

attributable to the equity shareholders. Asset values can be of many types:
Book Value, Net present value based on future cash flows to be derived from
the assets, and Replacement Value based on worth to be derived from the
future use of the asset.
2. Assets are capital items and the key resources of a firm that have the
potential to confer benefits over a long period of time. They represent the
infrastructure and productive assets a firm can use in producing and
delivering its products and services.
3. All countries have internal accounting standards and guidelines in regard to
accounting for assets. The classification and codification of assets are done
as per these standards, while, however, valu ing these assets and
determining the reliability of these values are areas still weak.
4. Determining Book value is centered around the balance sheet value of a
company as presented in the latest Annual Report.
5. In terms of book-value based valuation, the principle is that a company is
worth to its ordinary shareholders the value of its assets less the value of any
liabilities to third parties. This is also referred to as net asset value,
shareholders’ funds or the book value of the equity.

Adjusting Book Value:

In the books of accounts the assets are classified according to various groups,
the primary groups being fixed assets which have long-term value, current
assets with short-term value, and investments outside the business. Then come
the intangible assets.
Assets are valued at historical cost, i.e., the cost of acquisition. Costs incurred
towards upgradation are added and depreciation is applied for usage of the
assets. Thus, we have the gross block (origi nal cost) and the net block (gross
block - depreciation) available as book value in the accounting books.
The asset values in the books of accounts need to be adjusted to offer a closer
estimate of economic value than does the conventional book value.
MODULE VALUATION CONCEPTS AND METHODS
Tangible assets:
Tangible assets are valued at historical cost, and depreciation is applied for
diminution in value. Determining the depreciation to be charged is governed more
by accounting standards, company law and income tax rules, and not by any
technical estimation of the life of the asset. There are two methods by which
depreciation can be charged: the straight-line method and the written down value
method.
Therefore, the choice of depreciation method employed and the rate of
depreciation adopted can greatly influence the book value of an asset.
Land is not depreciated as it is not expected to wear out as in the case of
buildings and plant and machinery.
Current assets include inventories, cash and marketable securities.
Inventories are generally valued on the three commonly bases: FIFO (First-
In-First-Out), LIFO (Last-In-First-Out), and Weighted Average.
The method adopted will have a bearing on the cost of goods sold as well as
the closing stock. Under FIFO, the cost of goods sold will bear more of the cost
of materials bought during earlier periods, while the closing stock will reflect the
more recent or current replacement cost. In LIFO, the converse will hold good.
Under Weighted average method, both the cost of goods sold and closing
inventory will bear the average cost of materials purchased during the period.
Cash: While valuing cash should not pose any problem in the normal course,
problem will arise when it is deployed in short-term interest-bearing deposits or
treasury deposits. These are generally risk-free and there is no default risk.
Accounts Receivables are the sums owned by the customers to whom products
have been sold or services rendered on credit.
Intangible assets:
Intangible assets include expenditure on research and development (R&D),
brand values, intel lectual capital and goodwill.
R&D expenditure represents cash spent on a knowledge base which may
generate future revenues. Treatment of R&D expenses varies from country to
country.
Similarly, there is some argument for capitalizing expenditure on other forms of
knowledge, as in database systems within consultancy firms or expertise
provided by professional employees in
investment banks. This is known as intellectual capital and firms such as Scandia,
a Swedish insur ance company, have pioneered approaches to the valuation of
intellectual capital for inclusion in the balance sheet.
Another type of intangible asset over which there has been controversy is
capitalization of brand values in the balance sheet, as done by Coca-Cola or
Amazon.com. The methods for valuing brands are linked to forecast cash flows
related to the brands and hence to economic value. Therefore, capitalization of
brands will give a closer approximation to market value than would the exclusion
of the brands.
The difference between the price paid for a company and its book value is known
as goodwill. This is because goodwill is an intangible asset, which arises as a
MODULE VALUATION CONCEPTS AND METHODS
result of the fact that book values of companies typically do not reflect their
economic values, and hence the prices paid for companies, especially for high
value-added firms such as advertising agencies and consulting firms.
Off-balance sheet items:
Besides fixed assets and intangible assets, another possible area where the
value of the shareholders’ funds can mislead is its exclusion, by definition, of
what are known as off-balance sheet items. These can be leases, pension assets
or liabilities, employee-related liabilities and other contingent liabilities which may
be mentioned in the notes to the accounts.

Factors in Asset Valuation:

1. The factors to be considered for valuation of Assets are given below:

a. Type of Building/Plant/Equipment
b. Specifications/Ratings
c. Make and Model
d. Year of construction/installation
e. Service conditions
f. Extent of upkeep/maintenance
g. Upgradation, Retrofits, Modifications and Modernization of assets, if any
2. Capacity costs are non-linear and follow an exponential equation. ‘Factor
Estimating’ is an estab lished method of estimating the cost of a project, and
is widely used in Project Cost Estimation. If the cost of a given unit (C 1) is
known at one capacity (Q 1) and it is desired to estimate the cost at another
capacity (Q2), the cost at the second capacity (C 2) can be determined using
the following equations:
i. C2 = C1*(R)x
ii. R = (Q2/Q1)
This is popularly known as the 6/10 Rule. The exponent varies from 0.6 to 1, where
at 1 the rela tionship becomes linear.
3. Building and Civil Costs can be worked out from an ab initio estimation
based on technical specifications and current construction costs. The
Building Costs will include foundation costs (to the extent of about 15%).
4. Basis of Asset Valuation:
a. Replacement Cost/Value
b. Market Value = Replacement Cost – Depreciation
c. Agreed Value
5. Replacement Cost/Value is the Current Cost of a new asset of same kind –
Value of similar new property, and is based on current prices/quotes. However,
it is costly to determine, time consum ing, and is not always feasible.
Replacement cost factors:
a. Current F.O.B/F.O.R Cost of a new asset
MODULE VALUATION CONCEPTS AND METHODS
b. Price escalation
c. Foreign Currency rate
d. Duties & Taxes : Customs/Excise/S.Tax
e. Set off as Cenvat credit
f. Freight, Insurance, Handling, Inland transit
g. Erection costs

6. Market Value: It is the amount at which a property of the same age and
description can be bought or sold.
7. Estimating of replacement costs can be done by indexing the original
acquisition costs, or through an ab initio estimating from technical
specifications. Determination of market value requires estimating
depreciation or the life of an asset and the residual life of an asset.
8. Agreed Values are arrived at for properties whose Market Value cannot be
ascertained, such as Curios, Works of art, Manuscripts, and Obsolete
machinery. However, such valuations require Valuation certificate from
expert valuers.

For more knowledge, please follow the link provided;

https://www.youtube.com/watch?v=_LSMRLI23ZY
https://www.youtube.com/watch?v=lnk85DtMmig&t=10s
https://www.youtube.com/watch?v=3RXPFYwpLI4&t=16s