VALUATION

AND
ASSET RETIREMENT
 Review of Lecture No. 4
 Economic comparison – continued
 Discounting method
 Present Worth Method
 Internal Rate of Return Method
 Benefit Cost Ratio Method

 Other Considerations in Economic Comparisons

 Inflation;
 Shadow pricing;
 Sensitivity Analysis;
 Multi Criteria Economic Analysis
Scope of Lecture No. 5
 Introduction
 Principles of valuation
 Value – definition, types
 Valuation procedures
 Depreciation – definition, methods
 Procedures
 Comparison of methods of depreciation
 Determination of hire rates
 Principles of Valuation
 Value of a good or a service may be assessed by the
extent to which it is exchangeable for some other
good or service.
 To an economist, something that cannot be
exchanged or something else has no real value.
 The value of almost all exchangeable goods is
interpreted in terms of money.
 Principles of Valuation (Contd..)

 The goods are given a price so that certain sums of

money may be exchanged for the goods.
 At any given time, the value of goods and services
can be compared simply by comparing the amount
of money for which they can be exchanged.
Principles of Valuation (Contd..)

 By comparing prices, the quantitative rates at

which goods can be exchanged can also be
calculated.

Note that price is not the same as value in this

context-prices differ daily (say through inflation)
but value may not differ correspondingly.
 Value –definition (investopedia)
 The worth of a good or service as determined by
people’s preferences and the tradeoffs they choose to
make given their scarce resources, or the value the
marketplaces on an item.
 Economic value is represented by the maximum
amount a consumer is willing to pay for an item in a
free market economy;
 In contrast, market value represents the minimum
amount a consumer will pay.
 Economic value thus often exceeds market value
 Value
 For value of a capital asset – there are different
values that may be considered.
 Market value – the price paid by a willing buyer to
a willing seller, where neither is under any
compulsion to buy or sell, e.g. a house sold in open
market.
 Value (contd…)

 Use value – the value to the owner, for example a

CBR machine has no use value to a medical doctor,
or a stethoscope has no use value to a civil engineer.
 The value of drinking water is very high for a thirsty
person;
 The value of a job is very high for an unemployed person –
you only can appreciate its value when you lose it!
 Scrap value – value of useful materials in a facility
e.g., a car that is irreparable can be sold as scrap –
for its steel, tires, engine parts, suspension parts etc.
 Value (contd…)
 Salvage (or resale) value – second-hand
value – asset to be used as per intended
design.
 Valuation Procedure
 Valuation of an asset requires that the
establishment of net cash flows arising
from the asset taking into consideration
the need or maintenance and regular
replacement.
 Valuation Procedure (Contd..)
 These net cash flows must then be
compared with those that will arise
assuming that the asset is not possessed.
 Valuation Procedure (Contd..)
 For example, a company owning a
bulldozer can establish it value by
forecasting the net cash flows arising out
of the existing b/dozer compared with
buying a new one immediately. Or hiring
one!
 Valuation Procedure (Contd..)
 For simplicity, the asset may be assumed
to be required perpetually, and that
operating, and replacement costs will be
similar.
 Example:
 A company has been operating a bulldozer for 3
years. Its estimated life is 8 years after which it will
be sold for $10,000. Replacement with a similar
bulldozer, will cost $60,000 and this an be resold for
a similar amount in 8 years. Operating costs for the
existing bulldozer is $5000 p.a while that of the
replacement is $ 3000 p.a What is the value of the
existing bulldozer if the cost of capital is 10% p.a.?
 Solution: Find difference between PW (new) and PW
(old)
The net cash flows for the OLD and NEW b/dozer are
as follows:
Year Existing b/dozer New b/dozer
0 - -60,000 +V0
1 -5000 -3,000
2 -5000 -3,000
3 -5000 -3,000
4 -5000 -3,000
5 -5000+ 10,000 - 60,000 -3,000
6 -3000 -3,000
7 -3000 -3,000
8 -3000 -3,000 + 10000 -
60000
9 -3000 -3,000
Year Existing b/dozer New b/dozer

11 -3000 -3000
12 -3000 -3000
13 -3000 – 60,000 + 10,000 -3000
14 -3000 -3000
15 -3000 -3000
16 -3000 -3000 + 10,000 –
60,000
17 -3000 -3000
18 -3000 -3000
19 -3000 -3000
If we have to buy a new bulldozer, we will
have to sell the old one and get an income
of V0. .

In order to compute the value for the old

bulldozer, it is necessary to equate the PW
of the two cashflows.

Note that there is a repeating pattern of

cashflows as shown.
The present worth of the new B/dozer:

PW of operating costs:
P = A(P|A,10%,8) = -3,000(5.3349)=-$16,005

Similarly, resale value after 8 years:

= S(P|F,10%,8) = 10,000(0.4665) = $4665

Therefore, the series of payments every 8 years

to perpetuity:

= -60,000 – 16005 + 4665 = -71,340 every 8

years.
 In general, A is made every t years as
shown in the CFD below
A A A A A A A

0 t 2t 3t 4t (n-1)t nt

Present worth of the series to infinity,  is:

A A A
P  ..............  ......(1)
1  i  1  i 
t 2t
1  i 
Multiply both sides by 1  i  t

A A
P1  i   A 
t
 .....................  ........(2)
1  i t
1  i 

Subtraction (1) from (2)

P1  i   P  A
t

A  P 1  i   1)  t

 A
P
1  i   1
t

Therefore, the PW of $71,340 every 8 years

commencing with an initial payment of $ 71,340
at year 0
 71340
Pw   71,340
1.1
1
8

 133,722
*Pw of uniform in series every t years to perpetually.
 For the old bulldozer, the Cash Flow Diagram
(CFD) can be reduced to

5,000 133,722

0 1 2 3 4 5

10,0000

For the old (existing) bulldozer, the series of

payments and receipts from the end of year 6
onwards will be similar to those of the hypothetical
asset, including the capital cost of $ 60,000 at the end
of year 5
PW of cash flow:
= -133,722(P/F,10%,5) – 5,000(P/A,10%,5) +
10,000(P/F,10%,5)

= -133,722 x 0.6209 – 5000 x 3.7908 + 10,000 x

0.6209 = -95,772

Value of existing bulldozer

- 95,772 – (-133,722) = 37,949

That is, if we sell the existing bulldozer for 37,949,

and buy a new bulldozer, we will have made no
loss! i.e. V0 = 37,949
DEPRECIATION
Definitions - Investopedia
 1. A method of allocating the cost of a
tangible asset over its useful life.
Businesses depreciate long-term assets
for both tax and accounting purposes.
 2. A decrease in an asset's value caused

by unfavorable market conditions, use,

etc.
 Definition (continued…)

Depreciation is decrease in value of an

asset due to:
 Deterioration;
 Wear and tear;
 Obsolescence; or
 Depletion of resources.
 The purpose of determining the amount of
depreciation

 Accounting for legal and taxation reasons.

 Ensuring that the cost of an asset is recovered over
its life.
 For example, in operating equipment, say as truck,
a cost associated with depreciation has to be
recovered to replace the equipment once it is
retired.
 Estimation of Depreciation
 It is difficult to estimate the exact rate and extent of
depreciation of an asset as this depends on the extent
of use; and resale market value.
 In practice, depreciation are accounting entries into
books.
 Depreciation plans may take advantage of taxation,
as depreciation is considered as a cost, may be used
to off-set amount of taxation (or delay tax payments).
 Calculating depreciation
 Three main empirical methods:
 Writing off fixed similar value every year;
 Writing off a greater proportion in the early
years; and
 Writing off a smaller proportion in the early
years.
 Depreciation Methods:
 I: Straight – line Depreciation Method
 II: Declining Balance Depreciation Method:
 III: Sum-of-years-digits (SOYD) Depreciation
 IV: Sinking Fund Method
Straight – line Depreciation Method:

 Depreciates fixed similar value every year

 Annual Straight line depreciation =
initial cost – estimated salvage value
estimated life in years
if
 P = Initial capital cost
 L = asset salvage or resale value
 N = estimated life of an asset in years
 Straight – line Depreciation Method
(Contd…)
 Then Book value, defined as current proportion of
the initial cost of an asset after depreciation, is:
 Book value =

P  k P  L  / n
Where k = number of years that the asset has been depreciated.
 Declining Balance Depreciation
Method:
 Writes off at a greater rate in early years.
 Other names:

 Diminishing balance;
 Matheson formula; or
 Constant percentage
 Declining Balance Depreciation
Method (Contd..)
 Fixed percentage of the book value written off
annually;
 Book value at year 0 = P
 Book value at year 1 = P(1-d)1
 Book value at year 2 = P(1-d)2
 Book value at year k = P(1-d)k
 Where d is the fixed percentage depreciated at the
end of asset life, book value is equal to salvage value
after n years.
 Declining Balance Depreciation
Method (Contd..)
 Thus:
L  P 1 
It follows from above that:
d n

d  1 n L  P
d is normally expressed as a percentage.
 Sum-of-years-digits (SOYD)
Depreciation:
 This method depreciates greater proportion in early
years.

 Example:
 If an asset has 5 years estimated life, then depreciation
in the first to the fifth year will be as follows:
 Sum-of-years-digits (SOYD)
Depreciation (contd..)
 1st Year: 5
P  L
1 2  3  4  5

 2nd Year: 4
P  L
1 2  3  4  5
 3rd Year:
3 P  L 
15
 5th Year: 1
P  L 
15
 Sum-of-years-digits (SOYD)
Depreciation (contd..)
 Depreciation for any one particular year, k:
n  k  1
Dk  P  L
nn  1/ 2
 Where:
 Dk = depreciation cost required;
 P = initial capital cost;
 L = salvage or resale value
 N = total life of asset
 K = sequential year number
Sum-of-years-digits (SOYD)
Depreciation (contd..)
 Book value is given by the formula:

BVk  P  L 
n  k n  k  1
L
nn  1
 Sinking Fund Method
 Assumes a deposit of a uniform series at
a given rate of interest
 The amount deposited accumulates to the

amount of depreciation at the end of asset

life.
 Sinking Fund Method (Contd..)
 Example:
 If initial cost is Tshs 10,000,000
 Salvage is Tshs. 2,000,000 after 8 years
 Interest is 10% p.a

 Then end-of-year payments:

 (10000-2000) (A/F, 10%,8)
 = 8000 (0.0874) = ₤ 699.20
Sinking Fund Method (Contd..)
 Total amount of accumulated imaginary payments
+ interest at the end of k:

P  L A / F , i%, nF / A, i%, k 

 Is the loss of value after k years.
Sinking Fund Method (Contd..)
 Thus, book value:

BVk  P  P  L A / F , i %, n F / A, i %k 

Graphical Comparisons:
Example:
 An asset has cost Tshs. 10,000,000 and is estimated

to last for 8 years when the salvage value is

expected to be Tshs. 2,000,000.
Graphical Comparisons (Contd..)

 Compute and plot book values against age of the

asset using:
 Straight-line method of depreciation;
 Sum-of-years-digits method;
 Declining balance method; and
 Sinking fund method (at i = 10%)
 Use the same axes.
Initial Value 10,000,000 Tshs
Salvage
value 2,000,000 Tshs
Useful life 8 Years
Year Straight Line Declining Balance Sum of Digits Sinking Fund i=

d= 0.1822346 A= 699,552.14 10%

Depreciatio
Depreciation Book Value Depreciation Book Value n Book Value Depreciation Book Value

(Total)

0 - 10,000,000 - 10,000,000 - 10,000,000 - 10,000,000

1 1000000 9,000,000 1,822,346 8,177,654 1,777,778 8,222,222 699,552 9,300,448

2 1000000 8,000,000 1,490,251 6,687,403 1,555,556 6,666,667 1,469,059 8,530,941

3 1000000 7,000,000 1,218,676 5,468,727 1,333,333 5,333,333 2,315,518 7,684,482

4 1000000 6,000,000 996,591 4,472,136 1,111,111 4,222,222 3,246,621 6,753,379

5 1000000 5,000,000 814,978 3,657,158 888,889 3,333,333 4,270,836 5,729,164

6 1000000 4,000,000 666,461 2,990,698 666,667 2,666,667 5,397,471 4,602,529

7 1000000 3,000,000 545,008 2,445,689 444,444 2,222,222 6,636,771 3,363,229

8 1000000 2,000,000 445,689 2,000,000 222,222 2,000,000 8,000,000 2,000,000

 Comparison of Book Valuas by Depreciation Method

12,000,000
10,000,000
8,000,000 Straight
Book Value

Declining
6,000,000
Sums
4,000,000 Sinking
2,000,000
-
0 1 2 3 4 5 6 7 8 9
Years
 HIRE RATE
CONSIDERATIONS
 Hire Rate Considerations
 Capital investment in construction plant has to be
recovered through hiring.
 This should apply whether the equipment is
owned or hired from external sources.
 It is therefore necessary to compute hire rates that
are sufficient to recover the investment, operating
capital and make profit.
Hire Rate Considerations (Contd..)

 Consider the following scenario for equipment

investment:
 A contractor has bought a piece of heavy
construction equipment for Tshs. 750 Million Tshs.
The equipment will last for 12 years with the
operating costs expected to be as follows:
 Year Operating Costs Number of
(Million Tshs) working Hours per
day
1 45 8
2 55 8
3 60 7
* Major rehabilitation

4 65 7
5 70 6
6 70 6
7 75 + 150* 6
8 60 8
9 70 8
10 70 8
Hire Rate Considerations (Contd..)

 The Equipment can only be utilised when it is

available.
 The following terms are applicable in equipment
management:
 Availability: The percentage of time when a piece of
equipment is in good working condition and ready for
work based on maximum number of hours possible.
Hire Rate Considerations (Contd..)

 Utilisation: The percentage of time when the equipment

is actually working compared to maximum number of
hours possible.
 Target: In order to maximise utilisation it is first
important to maximise number of available hours: 8 – 10
hours for equipment utilisation 1500 hrs – 1800 hrs
per annum.
 Hire Rate Considerations (Contd..)

 Compute the hourly hire rate if the expected return

on the investment is:
 15% per annum.
 Compute the hire rates if the envisaged inflation is
about 6% per annum and that the tabulated figures are
in constant prices.
 Compute the maximum hire rate if situation in b
applies but also that the figures in the Table (except for
capital costs) have a margin of error of ± 10%.
Summary of Lecture No. 5.
 Introduction
 Principles of valuation
 Value – definition, types
 Valuation procedures
 Depreciation – definition, methods
 Procedures
 Comparison of methods of depreciation
 Determination of hire rates
 Asante sana.