PPA part 2 - Fixed asset valuation

Overview

The second part addresses the valuation of fixed assets (FA) as part of a Purchase Price Allocation (PPA). Fixed assets, also known as property, plant, and equipment, encompass a variety of assets depending on the industry. These primarily include buildings, infrastructure, machinery, vehicles, land, and other similar assets.

Types of FA by Liquidity

Fixed assets, categorized by liquidity (how easily they can be converted to cash without significantly affecting their market price), are divided into specialized and non-specialized assets:

- Specialized Assets: These assets are specific to particular industries and are rarely traded in the market. For example, mills used exclusively in the mining industry.

- Non-specialized Assets: These assets have universal applications and are frequently traded in the market, such as vehicles and real estate (including land, offices, and apartments). In certain cases, they can also be classified as specialized assets. For instance, land restricted to industrial use due to government regulations and located in a rural area with low demand can be considered specialized.

Valuation Methodology

Three primary methodologies are used in the valuation of fixed assets: the Cost Approach, the Market Approach, and the Income Approach:

- Cost Approach: This approach assumes that an investor will not pay more for an asset than the cost to reproduce or replace it with a similar asset or one that provides the same utility.

- Market Approach: This approach determines the value based on the prices of similar assets in the market, considering market trends, supply, and demand.

- Income Approach: This method values the asset based on the future benefits it is expected to generate.

The choice of methodology can vary depending on whether the asset is specialized or non-specialized:

- Specialized Assets: The cost approach is primarily used for valuing these assets. Since they are not actively traded in the market, the market approach may not provide a fair valuation. Additionally, forecasting future cash flows for a specific asset apart from others can be unreliable, making the income approach less applicable.

- Non-specialized Assets: The market approach and income approach are commonly used for these assets. Due to their active market trading, appropriate analogues can be found. If the cash flows from such assets can be separately projected, the income approach is also applicable. For example, a wagon rented to a third party.

Cost Approach

As mentioned, the cost approach is used for valuing specialized fixed assets.

DRC = RCN * (1 - Ph.d) * (1 - Func.d)

- RCN: Replacement/Reproduction Cost New. This is the cost to replace or reproduce the asset with a new identical asset or a new item with comparable utility. For example, if we need to value a crane with a 50-ton capacity, we would find the cost of a new crane with the same capacity. This cost is the RCN.

- DRC: Depreciated Replacement Cost. This is the RCN adjusted for physical and functional depreciation.

- Ph.d: Physical Depreciation. This represents the decrease in value due to physical wear and stress over the asset's useful life. For instance, if an asset has been used for 4 years of a 10-year useful life, the physical depreciation is 40% (Age/Normal Useful Life = 4/10 × 100%).

- Func.d: Functional Depreciation. This is the reduction in value due to the asset's inadequacy or inefficiency compared to modern items or best practices. For example, a production building with a height of 25 meters, while the standard is 15 meters, would require a deduction for the excess 10 meters.

Economic Obsolescence or Impairment

After calculating DRC, the final step is to test for economic obsolescence to determine fair value. This type of depreciation reflects a decrease in value due to external and internal factors.

- External Factors:

- Negative changes in technology, markets, economy, or laws

- Internal Factors:

- Inefficiency or weaknesses in management and operations

The first step in impairment testing is determining the recoverable amount, which is the higher of fair value less costs to sell or value in use. The asset is evaluated based on whether it can be sold or used to generate benefits. Typically, finding identical assets in the market is challenging for specialized fixed assets, so the Value in use approach is often used. Value in use is the present value of future cash flows related to cash-generating units (CGUs), the smallest identifiable groups of assets that generate cash flows from ongoing use.

Steps to determine value in use:

1. Determine enterprise value (EV) using the income approach or discounted cash flow (DCF) method. This involves valuing the overall business, including net debt and equity. For complex businesses with multiple CGUs, cash flows should be calculated separately for each CGU. Generally, free cash flow to the firm (FCFF), discounted to present value using the weighted average cost of capital (WACC), is used for EV determination. More detailed information about DCF valuation and its components is available from sources such as Investopedia, the Corporate Finance Institute, and similar resources.

2. Deduct net working capital (NWC), including trade receivables, inventory, trade payables, and other working capital elements.

3. Deduct the fair value of intangible assets.

4. Deduct the fair value of non-specialized assets.

These deductions are made to focus solely on the value in use of specialized assets.

Finally, compare the recoverable amount with the DRC of specialized assets. If the recoverable amount is higher than the DRC, the fair value of the specialized FA equals the DRC. If the recoverable amount is lower than the DRC, it indicates that the business cannot recover the stated DRC amount, and the fair value is lower. For instance, if DRC is USD 50 million but value in use is only USD 35 million, the fair value would be USD 35 million, and economic obsolescence would be USD 15 million or 30% (USD 15 million/USD 50 million). Another reason for this is that a typical investor would not be willing to pay USD 50 million for an asset that is only expected to generate USD 35 million in present value terms.

Market Approach

Valuation of fixed assets under this approach involves finding suitable analogues (3-5 analogues are preferable) or conducting regression analysis of analogues.

Income Approach

This method involves discounting the cash flows generated by the asset using an appropriate discount rate.

Conclusion

In conclusion, it is important to note that some explanations in PPA Part 2 have been simplified for illustrative purposes and to enhance understanding. Each valuation method can involve complex calculations and assumptions.