Help Center

Tangible Personal Property Appraisal in a Bankruptcy Environment

Journal Issue: 
Column Name: 
Journal Article: 
There are many reasons to conduct a current appraisal of the tangible personal property (TPP) of an industrial or commercial debtor organization within a bankruptcy environment. The TPP may be the collateral for the outstanding secured debt. Or the TPP may be needed as collateral for debtor-in-possession (DIP) financing. Additionally, the TPP may present sale/leaseback, spin-off or other needed cash-generation opportunities. The actual TPP valuation approaches and methods used in the appraisal will depend on (1) the standard (or definition) of value and (2) the premise of value defined in the appraisal assignment. As part of a bankruptcy or reorganization analysis, it may be appropriate to value the debtor's TPP under various alternative standards and premises of value. This article will discuss the common approaches, methods and procedures for a TPP appraisal within a bankruptcy environment. The cost approach to TPP valuation considers the concept of replacement as an indicator of value. A prudent investor would pay no more for an asset than the amount for which that investor could replace the asset new, less any betterment. In the cost approach, an estimation of replacement cost new (RCN) is typically made. This RCN estimate is then adjusted for all forms of observed obsolescence in order to provide an indication of TPP value. In the market (or sales-comparison) approach, recent sales and listings of comparative TPP are gathered. Adjustments are applied to these transactional pricing data in order to account for differences in location, time of sale, physical characteristics, etc. between the subject TPP and the comparative TPP. The adjusted transactional data are analyzed in order to extract market-derived pricing indicators. The income approach quantifies the present worth of the expected future economic benefit (e.g., net income or net cash flow). The net income or net cash flow is projected over an appropriate period and is then capitalized at an appropriate capitalization rate or discount rate. The capitalization rate or discount rate should consider the time value of money, the effect of expected inflation and the risk inherent in the TPP ownership. When properly applied and documented, these three categories of analyses provide a well-substantiated TPP appraisal for various bankruptcy-related purposes. Cost-approach Methods The economic principle of substitution governs the cost approach. This principle indicates that a prudent investor would pay no more for a property than the cost of producing a substitute property with the same utility as the subject. This principle applies when the purchaser can either construct or buy a new substitute property with equivalent utility as the subject. The cost approach measures value by (1) estimating the current cost of the TPP and (2) subtracting deductions for various elements of depreciation including physical deterioration, functional obsolescence and external obsolescence, as follows: Current Cost of Replacement (or of Reproduction) New less Physical Deterioration less Functional Obsolescence less External Obsolescence results in a Value Indication RCN represents the amount of money in terms of current labor and materials in order to construct or to acquire new TPP of similar utility to the subject TPP. Similar utility refers to similar economic satisfaction. That is, the substitute TPP would be perceived by the investor or user as being equivalent to the subject TPP. The concept of RCN is not the same as the concept of "reproduction cost new." Reproduction cost new is the cost to reproduce the TPP in like kind—that is, to obtain a property that is nearly an exact duplicate of the subject. Normally, over time, TPP will become less than the perfect replacement for itself. While reproduction cost contemplates the construction of an exact replica of the subject TPP, replacement cost contemplates the cost to recreate the functionality or utility of the subject TPP. Therefore, when estimating the replacement cost, the form or appearance of the replacement asset may be very different from the original asset. The "costs" typically included in a cost approach analysis include all material, labor, overhead, developer's profit and entrepreneurial incentive (which is sometimes measured as a return on investment in the subject TPP). Adjustments are made to the replacement/reproduction cost estimate in order to account for losses in value resulting from (1) physical deterioration and (2) functional and external obsolescence as defined below: * Physical Deterioration is a loss in value of the TPP brought about by wear and tear, action of the elements, disintegration, use in service and all physical factors that reduce life and serviceability. * Functional Obsolescence is the loss in value of the TPP caused by the inability of the property to adequately perform the function for which it is utilized. Functional obsolescence is, therefore, internal to the property, and it is related to such factors as superadequacies, excess operating costs and inadequacies. * External Obsolescence is a loss in value of the TPP caused by external forces, such as changes in the supply/demand relationship, legislative enactments and other external factors, such as industry and local economic conditions, which impact on the value of the property. The next step in the valuation process involves estimating a remaining useful life (RUL) for the subject TPP—based on its existing age, quality and conditions. This RUL estimate may influence the allowances for each form of obsolescence. The concept of physical deterioration is easily understood. However, in order to quantify the loss in value due to physical deterioration, the analyst should segregate the two components of this concept. The first component is service life. As TPP is placed in service and begins to age, its service life is impaired or reduced. Therefore, there is a reduction in value due to the fact that the TPP has a decreasing remaining life throughout its service. The second component is serviceability. Serviceability refers to the utility of the TPP in its use. In quantifying functional obsolescence, some of this type of obsolescence (e.g., excess capital and/or capacity costs) is eliminated by using a replacement (vs. reproduction) cost new valuation method. Further adjustments for functional obsolescence may be made by (1) quantifying excess operating costs and capitalizing them over the remaining useful life of the TPP or (2) identifying functional inadequacies and assigning an appropriate economic penalty. External obsolescence is a loss in value due to external forces unrelated to the TPP itself. If a property-specific income analysis is conducted, then the value indicator—after deducting for physical deterioration and functional obsolescence—may indicate any remaining economic obsolescence. It is sometimes difficult to assign an economic income stream to individual TPP pieces. Therefore, it is sometimes difficult to quantify TPP external obsolescence on an individual asset-by-asset basis. Accordingly, the quantification of external obsolescence is sometimes made on a collective basis (i.e., such as is possible in the analysis of an overall going-concern business). For example, if a discounted net cash flow analysis of an overall going-concern business indicates that the value of the operating business entity is less than the depreciated replacement cost of the component TPP, then external obsolescence may exist. In that case, all TPP components may be devalued to the level of economic support indicated by the income capitalization analysis. Market Approach Methods The underlying theory of the market (or sales comparison) approach is that a prudent investor can go to the marketplace and purchase TPP that can be assembled to provide similar output. The market approach is applied in the secondary TPP market in order to establish value through an analysis of recent sales or asking prices of comparative property. In the market approach, recent sales and offering prices of similar TPP are analyzed in order to arrive at an indication of the most probable selling price of the subject. The basic procedure is to gather data, determine the parameters to be compared, and apply the results to the subject. Depending on the premise of value sought, one method of estimating a value indication by the market approach is to (1) estimate the cost to purchase the subject TPP in the appropriate secondary market and (2) then add sales tax, freight, installation and connection costs. While applying the market approach, it is sometimes possible to arrive at estimations of value based on sales of identical TPP that has exchanged hands in the appropriate secondary marketplace. However, while it is fairly common to see secondary market prices for units based on like model numbers, unique configurations of the specific TPP often make it difficult to obtain data on sales of assembled comparable (or nearly identical) units. Therefore, in practice, investigation and analyses of the sales of similar, or "guideline," TPP in the appropriate secondary marketplace often leads to the value estimate. In addition to the configuration of the comparable, or the "guideline," TPP, the following list presents some of the parameters that should also be considered for purposes of assessing comparability: * age of the unit * condition of the unit * upgrades or other deviations from standard model specifications * location of sale * market conditions * motivation for sale * quantity of units sold * time of sale * type and terms of sale * price of each sale. Each parameter has its own importance, and its estimation is dependent on the type of data available. Depending on the standard and premise of value sought, factors that add value-in-use may be identified and included in the value estimate. For most TPP, these factors include activities such as freight, installation, connections, test-batch loading and debugging, and any other indirect costs required to commission and hand over the TPP to the end-user. The systematic application of the market approach includes these procedures: 1. Research the appropriate secondary or exchange market to obtain information on sale transactions, listings and offers to purchase or sell comparative TPP. 2. Verify that the information and data are factually accurate and that the exchange or sale transactions reflect arm's-length market considerations. 3. Collect additional information regarding current market conditions and industry economics. Information may include the conditions at the time of the comparative property sales as well as at the time of the subject valuation. 4. Note and quantify the relevant parameters of comparison of the comparative TPP sales to the subject property, such as age, condition, quantity sold, time of sale, type of sale, terms of sale, etc. 5. Using these comparison elements, adjust the sale price of the comparative sale transactions in order to approximate the status of the subject. 6. Compute any direct and indirect expenses, such as sale taxes, freight, installation, etc. that would be required to make the subject function at the appropriate premise of value. Make appropriate adjustments to these costs in order to reflect the age of the TPP already in service. 7. Add the adjusted direct and indirect expenses to the adjusted sale price in order to derive an indication of value. The Income Approach The income approach provides a systematic framework for estimating TPP value—particularly rental TPP—based on income capitalization or on the present value of future "economic income" to be derived from the use, forbearance, license or rental of the subject. Under the income approach, economic income can be measured as: 1. gross or net rental income, 2. gross or net license income, and 3. gross or net operating cash flow. Quantifying the appropriate (1) direct capitalization rate or (2) present value discount rate is an important procedure in the income approach. The appropriate capitalization rate or present value discount rate should reflect a fair return on the investment in the subject TPP and should consider: 1. the opportunity cost of capital, 2. the time value of money, and 3. the risk of investment in the subject TPP. In the income approach, the estimate of the subject's remaining useful life is an important analytical component. Clearly, the economic income projection should not extend beyond the expected remaining useful life of the subject TPP. The service life of TPP is the period of time extending from the date of the installation of the property to the retirement from service of the property. Many factors affect useful life. Some of these factors (and the type of useful life measurement they affect) are: 1. usage (physical), 2. age when acquired (physical), 3. maintenance and downtime (physical), 4. technological improvements (functional), 5. progress in arts (economic), 6. economical changes (economic), 7. regulatory and other prohibitory laws (economic), and 8. other causes. In its simplest form, the income approach is the present worth of the future economic benefit of TPP ownership. The different valuation methods are broadly classified as those (1) that rely on direct capitalization, and (2) methods that rely on yield capitalization. In the direct-capitalization methods, an appropriate measure of economic income is estimated for one period (future to the valuation date) and then divided by an appropriate measure of a rate of return on that investment. The direct capitalization method lends itself to the analysis of TPP that will generate economic income for an infinite (or, at least, a very long) period of time. In the yield-capitalization methods, the appropriate measure of economic income is first projected for a discrete period of time. The economic income projection is converted to a present value by the use of a present value discount factor—that is, the required rate of return over the expected term of the economic income projection. Due to the finite life expectation of TPP, the yield-capitalization methods more readily apply to the valuation of such property. The first step in the yield-capitalization method is the estimation of remaining useful life. Typically, TPP remaining useful life is the shortest of its remaining physical, functional, technological or economic life. In other words, the economic income stream would be projected over the shortest of the TPP remaining life estimates. The second step is the analysis of the amount of economic income expected by the TPP owner. It is noteworthy that this process analyzes the amount of economic income related to the direct property ownership only. The amount of economic income expected by the TPP owner may be measured as the rental income that could be earned from the rental of the subject TPP in an arm's-length rental/lease transaction. For leased TPP, the expected rental income is directly influenced by the amount of rent that the TPP user (i.e., the lessee) actually pays to the owner (i.e., the lessor). If the subject TPP is owner-used, then the analysis is slightly more complicated. In this case, the analyst would estimate the amount of market-derived rental income that the property owner (i.e., the lessor) would receive from the property user (i.e., the lessee) if the TPP were to be the subject of an arm's-length rental/lease transaction. The analysis includes a search of the marketplace for rental income data with regard to comparative leased TPP. Of course, the selected comparative rental property may not be identical to the subject. The comparative rental property may be larger/smaller, newer/older, used in different industries, located in different geographic areas and so forth. However, all of these differences between the subject and the comparative leased property generally can be accommodated through a series of incremental or decremental adjustments to the comparative rental data. These adjustments (to make the comparable—or the guideline—TPP more comparative to the subject) are the basis for the rental transaction "adjustment grid." These adjustments would consider such factors as age, size, capacity, power plant, power source, etc. In order to estimate the prospective economic income associated with owner-operated TPP, the property's expected operating income is analyzed. The prospective income and expense of the TPP are estimated after researching and analyzing 1. the income and expense history of the subject, 2. the income and expense histories of comparative TPP, 3. recently signed rental agreements, proposed rental agreements, and asking rents for the subject and for comparative properties, 4. actual rental levels for the subject and for comparative properties, 5. maintenance expenses for the subject and comparative properties, 6. published operating data, 7. market expectations, and 8. projected replacement allowances for property components that wear out and must be replaced. These data are most easily available for TPP types that are typically leased, such as mainframe computers, railroad rolling stock, commercial aircraft, etc. The third step is to estimate an appropriate present-value discount rate that provides a fair, risk-adjusted return on the subject TPP over its remaining useful life. The yield capitalization rate (also called the present value discount rate) may be estimated by converting the direct capitalization rate, as follows: yield capitalization rate = direct capitalization rate + expected long-term income growth rate. Valuation Procedures Within each valuation method, there are numerous individual procedures. The most common procedures are described below. The first phase of procedures is common to all valuation methods. Part of the second phase is also common to all valuation methods, especially data related to confirmation of the original cost and the date when the subject TPP was put into service. The remainder of the second phase and the third phase are unique to specific valuation methods. Ideally, Phases I and II of the procedures should be followed in as much detail as possible. However, there may be instances where property security, legal objections, natural calamities and other such reasons may preclude the thoroughness in the collection of data, information and relevant documents. Phase I: Inventory and Inspection Procedures The first phase of any TPP valuation involves (1) obtaining the TPP listing, (2) confirming the presence of the property within the confines of the subject business and (3) inspecting the condition of the subject TPP. Step 1: Listing. The analyst will often create a de novo listing of the subject TPP, based on his or her inventory and inspection procedures. However, when available, the TPP owner's detailed fixed-asset listing regarding the subject should be obtained for comparative purposes. Step 2: Availability. The following tests of inclusion and exclusion should also be performed: 1. Verify that all of the TPP included on the list is, in fact, available for inspection and inventory. 2. If there are TPP pieces included on the fixed-asset listing that are not available for inspection (i.e., they are not physically located at the owner's facility), then they should be removed from the listing. 3. Verify that all of the TPP available for inspection (i.e., physically at the subject facility) is, in fact, included in the property owner's detailed fixed asset listing. 4. If there are TPP pieces observed during the inventory and inspection that are excluded from (or not in) the detailed fixed asset listing, then they should be added to the TPP listing. 5. The result of these verification, inclusion/exclusion and inventory procedures should be an accurate, updated and verifiable TPP inventory listing. Step 3: Inventory. The data on the detailed TPP listing should be verified through individual physical inventory, as follows: 1. Verify and confirm the asset listing number. 2. Verify and confirm company identification number or bar code. 3. Verify and confirm manufacturer and country of origin. 4. Verify and confirm general category of TPP. 5. Verify and confirm specific type of TPP. 6. Verify and confirm model number of TPP. 7. Verify and confirm serial number of the TPP. 8. Note the date of manufacture of the TPP. 9. Note the location of the TPP, including building address, room number and end-user name. 10. Check the capacity of the subject TPP against model specifications. 11. Note any and all internal upgrades or enhancements to the subject TPP against model standards. 12. Note any and all appurtenances and other external peripherals attached to the subject TPP. 13. Check if any of the appurtenances have been identified and noted separately in the property owner's detailed fixed-asset listing. 14. Verify and confirm the last physical inventory date. 15. Confirm, if possible, the date the subject TPP was put into service. Step 4: Property Inspection. Ideally, as part of the property inventory, each TPP piece will be inspected, as follows: 1. Note the condition of the TPP: check for physical deterioration, wear and tear, etc. 2. Check for adequacy of work environment: Is the power supply easily accessible? Are power cords and other connections stretched? Is power-surge protection utilized? Is there exposure to heat or other energy sources? 3. Verify and note the usage of the TPP: * percent of time per period (8-hour day, 24-hour day, week) of continuous use; and * number of personnel using the personal property during a given period. 4. A copy of any maintenance agreement for the subject TPP should be reviewed. The maintenance log for the TPP should be reviewed for the following items: * note number of complaints; * quantify the severity of complaints; * check if all complaints have been rectified; and * not recommendations for recurring problems. Phase II: Data Collection and Analysis Procedures Usually, the property owner's fixed-asset listing will contain certain information such as the original cost, date the TPP was placed into service and accumulated (accounting) depreciation. The first two steps of this phase are common to all valuation approaches. Step 1: Data Collection—Specific. Certain data on the detailed fixed-asset listing should be verified with the property owner's accounting department (if possible), including the following: 1. Verify and confirm the original property cost against the actual purchase order. 2. Verify and confirm the original property cost against the paid invoice amount. 3. Note purchase order date. 4. Note invoice date. 5. Verify and confirm date when the subject TPP was received in the property owner's warehouse. 6. Verify and confirm date when the subject TPP was placed into service. 7. Verify and confirm any sales taxes that were paid per the invoice. 8. Verify and confirm any freight, insurance or other delivery expenses on the invoice. Step 2: Data Collection—General. For each TPP piece, the following cost items are estimated either (1) on the basis of the analyst's individual experience or (2) by consulting with the property owner's operations and/or maintenance departments: 1. Installation costs—set-up costs on the basis of the normal amount of time required for various set-up activities including unpacking and checking, making necessary power and other internal and/or external connections. 2. Special requirements expenditures—expenditures required specifically for the TPP to work efficiently, such as high power source and wiring, dust-free air equipment, installation and so on. 3. Commissioning expenses—start-up expenses on the basis of the normal amount of time required for various start-up activities including, for example, loading necessary systems and applications software, debugging and hand-over to the end-user. The remaining steps in this phase are specific to each individual valuation method. Step 3: Data Collection—Search (for depreciated replacement cost method only). For each category of property (usually on the basis of SIC code) in the property owner's fixed-asset listing, the appropriate price, production and cost indices should be researched. Common sources of such indexes include the Statistical Abstracts of the United States, the Marshall & Swift Valuation Guides, etc. An index—for price, cost, materials, wages, production, and so on—is a device for showing the relative changes in the price or cost of specific items or groups of items over a period of time. Step 3: Data Collection—Search (for sales comparison method only). For a given TPP piece in the fixed-asset listing, transaction pricing data with regard to actual sales of "similar" seasoned TPP are researched. For valuation purposes, "similar" property will have these same characteristics: 1. manufacturer and country of origin, 2. general category of TPP, 3. specific type of TPP, 4. model number of TPP, and 5. date of manufacture of TPP (a difference in the year of manufacture, a minor deviation, should be noted and considered in the final analysis). If sufficiently similar "comparable" TPP are not found, the analyst will search for "guideline" (or "indirect comparable") TPP sale transactions. For valuation purposes, a "guideline" TPP piece is one that performs the same functions as that of the subject. The main difference between the "guideline" property and the subject property is often the property manufacturer. Using specifications of comparative models produced by different manufacturers, a "guideline" TPP piece usually can be identified. The following information with regard to each "comparable" or "guideline" sale transaction should be verified or otherwise confirmed: 1. actual market price of comparable/guideline TPP sale transaction, 2. time (month and year) of sales transaction, 3. location of sale transaction, 4. condition of the comparable/guideline TPP, 5. any upgrade or deviation from model's standard specification, 6. any appurtenances of the comparable/guideline TPP included/excluded in the sale, and 7. any special terms and conditions of the sale. A search for comparable, or guideline, sale transactions can be conducted by: 1. researching publicly available data, 2. licensing/renting/buying privately developed databases, and 3. gathering information from reputable and knowledgeable used equipment dealers/brokers. Step 3: Data Collection—Search (for rental yield capitalization method only). For each TPP piece in the detailed fixed asset listing, transactional data with regard to the actual rental or lease of comparable TPP are researched. If directly comparable rental transactions are not found, then the rental or lease of guideline TPP is researched. For each rental or lease of comparable or guideline TPP, the terms and conditions of the rental/lease agreement should be verified or otherwise confirmed, including: 1. term of the agreement, 2. rent payable for each period of the term, 3. inclusion of any penalty clause, with amount of penalty, and 4. inclusion of any purchase clause, with the purchase price. For each rental transaction, the following data should be confirmed or otherwise verified: 1. rental history, 2. maintenance history including maintenance expenses, 3. general and administrative expenses, and 4. marketing and advertising expenses. Also, the following elements included in the build-up of the appropriate rental income capitalization rate should be confirmed or otherwise verified: 1. prevailing risk-free rate of return, 2. amount of additional TPP-specific risk premium, and 3. expected inflation rate. Step 4: Data Analyses (for depreciated replacement cost method only). Using the cost or production index for the subject industry, cost "inflation" trending factors are developed for each TPP vintage group. The TPP cost new is estimated by multiplying the historical cost by the appropriate age-dependent cost trending factors developed earlier. Next, the TPP average age is estimated. Based on (1) property-specific statistical studies or (2) published information regarding the effective life of property in the given industry, the average remaining useful life of the subject TPP is estimated. Using this as a proxy, the "percent good" for the TPP is estimated. This percent-good factor takes into account the normal physical depreciation of the TPP. From the observations regarding the condition of the subject, its maintenance schedule and so on, the costs and expenses that would be required to bring the existing TPP to state-of-the-art—or the costs required to operate the business with below state-of-the-art TPP—are estimated. This is the basis for the identification and estimation of curable functional obsolescence. The subject industry should be studied, including a check for any new government regulations being passed, and the demand of the product and supply of raw material—as well as competitive products. The input from these industry sources may lead to the identification and quantification of external—or economic—obsolescence. Of course, there may be other marketplace influences (not related to subject industry) that may cause economic obsolescence. Step 4: Data Analyses (for sales-comparison method). Adjustments to the transactional sale price should be made for any deviations from the specifications and information regarding the subject: 1. For comparable or guideline TPP, adjustments may be required for the year of manufacture. 2. Guideline TPP have to be adjusted for its name (i.e., manufacturer) and specifications. 3. An adjustment is required to consider the time of actual sale and the valuation date. 4. An adjustment is required to consider the location of actual sale and the location of the subject TPP. 5. An adjustment is required to compensate for the condition of the comparable/guideline equipment relative to that of the subject TPP. 6. An adjustment is required for any additions and/or deletions to the specifications of the comparable/ guideline properties and the specifications of the subject TPP. 7. Any special terms and conditions of the sale must be adjusted to reflect th
Journal Date: 
Saturday, September 1, 2001

Reprint Request