Chapter Two Fair value measurement and Impairment

Direct unit pricing method. Often referred to as the detail method, the summation method, and the engineering method, estimates the current cost new for each component necessary to replace or re-create the subject asset. The property is itemized, or detailed, such that the sum of the cost of each component yields the current cost new. The cost components are generally classified into five categories: material, labor, overhead, developers’ profit, and entrepreneurial incentive.

Example: The following data is for floating hatchery built in South Korea for a fish-farming business in Singapore.

	DCN ($’000)	RCN ($’000)
Material	1,622	1,402
Labor	958	860
Supervision overhead	751	659
Shipping and storage	655	590
Engineering service	278	245
Administration	319	281
Insurance and interest	598	527
Licenses and fees	119	106
Developers’ profit^3 (10%)
Entrepreneurial incentives^4 (5%)

Required: Calculate the DCN and RCN

Component analysis	DCN ($’000)	RCN ($’000)
Material	1,622	1,402
Labor	958	860
Overhead	2,720	2,408
Developers’ profit	530	467
Entrepreneurial incentives	265	233
Creation Cost	6,095	5,370

2. 
   Trended historic costs method: Another common method of estimating the DCN is by trending the original installed costs (historic costs) of each property from its commencement to the valuation date. This is accomplished by using indices that reflect changes in installed costs over time. This method assumes RCN is similar with DCN. For example, if the installed cost has increased 10.8% in the last year, then the DCN of an asset installed 12 months ago for $100 would be $100 × (1 + 0.108) today.
   

Example: The following data is for floating hatchery built in South Korea for a fish-farming business in Singapore.

	Trended DCN	Historic index	Trended historic costs method DCN	Component analysis
Material	1,327	1.2165	1,615	Material	1,615
Labor	737	1.2462	918	Labor	918
Supervision overhead	598	1.2462	745	Overhead	2,697
Shipping & storage	575	1.1497	661
Engineering service	227	1.2532	284
Administration	239	1.2462	298
Insurance & interest	456	1.296	591
Licenses and fees	88	1.3409	118
Developers’ profit (10%)	428			Developers’ profit	523
Entrepreneurial incentives (5%)	----			Entrepreneurial incentives	262

3. 
   Unit of production method: The construction of certain types of assets has been uniform enough that valuators have developed rules of thumb. For assets, a unit of production method can be used for current cost measurements. For example, building construction may be calculated as dollars per square foot, fast food outlets as dollars per seat, highways as dollars per mile, and so on. For producing certain types of machinery and equipment, component costs as a percentage of total unit cost are often fairly uniform. Once a total unit cost is known, then each component, either a direct or an indirect cost, can be calculated as a fixed percentage.
   

For example, the various percentages for direct and indirect costs for each component of a mineral processing plant are estimated as shown in the next table.

Assumptions		$’000
Cost per ‘000 tonnes per day		1,230
Planned Output (tonnes-per-day)	2,500
RCN		???

RCN=3,075

Direct cost	Percentage	Solution by using unit of production method
Piping	25%	769
Instrumentation & control	15%	461
Electrical	13%	400
Installation + Materials	12%	370
Indirect costs
Design, Engineering and Supervision	10%	308
Construction Expense + Materials	10%	308
Contractors Fee +Materials	5%	153
Contingency	10%	308
RCN		3,075

2.1.4.3. Income Approach: Capitalization Method
Capitalization of sustainable earnings is one of the most frequently adopted methods under the Income Approaches to value an asset or business. The underlying concept is the amount a potential buyer is willing to pay for a business is directly linked to the expected rate of return, taking into consideration the associated risks. It uses some average of annual historic results as a proxy for the future performance.
Under this method, the value of an asset or business is determined by dividing its expected economic benefits by a capitalization rate that represents the risks involved. Before using the capitalization of earnings method, a valuator has to determine two critical variables: the total economic benefits being generated and as accurate an estimate as possible of the risks associated with the economic benefits.
The capitalization of earnings method can be summarized as:
Value = Benefits in coming year/ (d–g)
Where: d = Discount rate; and g = Growth rate
It is important to note that this formula is forward looking, as the coming year’s benefits are divided by a capitalization rate which includes a growth factor. As a result, if it is to be applied to the current/latest year’s figure, the capitalization rate has to be adjusted to take out the growth rate component (g); otherwise, the results will be distorted. The adjustment retroactive to the current year is to multiply the capitalization rate by the:

Calculation of discount rate: While the growth rate is normally established from historic financial performance, the discount rate is calculated by using build-up model. The build-up model defines the discount rate in terms of a composite of multiple risk elements, including the risk-free rate of return (normally the yield on government bonds with an appropriate term) plus the extra return expected by investors for investing in equity securities (equity risk premium), as well as expected additional returns to compensate for specific risks related to the industry and firm.
Example: The following data represent the business valuation of Roomer Nut Limited. Based on the given data calculate the adjusted capitalization rate and the calculated fair value of the business for the year 2008.

Roomer Nut Limited Valuation of Business
Normalized EBIT:	($’000)	Growth
2006	5,351	11.6%
2007	5,971	9.8%
2008	6,556	10.7%
	17,878
Reported net earnings 2008	2,735
Expected Annual Income Growth Rate	10%
Current year’s interest	1,352
Income tax	30%
Risk-Free Rate	6%
Equity Risk Premium	7.5%
Industry Premium	3%
Entity-Specific Premium	5%

Solution:

3-year Average Normalized EBIT	5,959
Current Year’s Interest	(1,352)
Sustainable Earnings Before Taxes	4,607
Income Tax 30%	(1,382)
Sustainable Net Earnings	3,225
Calculation of Adjusted Capitalization Rate:
Discount Rate (“d”) (6+7.5+3+5) %	21.50%
Expected Annual Income Growth Rate (“G”)	10.00%
Implied Capitalization Rate	11.50%
Growth Adjustment (1/1+g)	0.91
Adjusted Capitalization Rate	10.45%
Calculation of Fair Value:	$’000
Sustainable Net Earnings	3,225
Adjusted Capitalization Rate	10.45%
Calculated Fair Value	30,848

2.1.5. Fair value hierarchy
The fair value hierarchy is intended to increase consistency and comparability in fair value measurements and the related disclosures. Application of the hierarchy requires an entity to prioritize observable inputs over those that are unobservable when measuring fair value. In addition, for disclosures, it provides a framework for users to consider the relative subjectivity of the fair value measurements made by the reporting entity.
Level 1 inputs: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Quoted prices in active markets should not be adjusted when determining the fair value of identical assets and liabilities