2. Residual Values for
Machinery and Equipment
ASA presents:
Presenter:
Sharon Desfor, ASA
Upon webinar completion, the participant will be better able to:
Define a residual value and assess when, why, and how is it used
Recognize common errors in residual values (how NOT to calculate
them)
Calculate equipment residual values
Determine other considerations (different depreciation rates, lease
return provisions, and using your own judgment)
7. The majority of banks do not account for any
further inflation in their calculations. This
conservatism can be used to mitigate their risk
factor. Some will then calculate their own present
values at various inflation rates just to see what
kind of margins they might enjoy at lease
termination, but then book the residual at the
uninflated number.
Comments on methodology
7
10. What is a Residual Value?
“Essentially, the term residual value
means the value remaining after some
of the asset’s normal useful life has
been consumed. It can also refer to the
value of the asset at a defined future
point in time. Though the future value is
often defined as the future fair market
value, that’s not always the case.
Again, it is important that the pertinent
sections of the lease document be
reviewed prior to performing any
valuation in connection with a lease.”
(Valuing Machinery and Equipment: The Fundamentals
of Appraising Machinery and Technical Assets, Third
Edition, American Society of Appraisers)
10
18. When are they used?
Lease inception
Annual FASB compliance
audit
Asset substitution in a
lease
18
19. Question
How often are you asked to perform a residual
value projection?
A. At least weekly
B. Every month or two
C.2 or 3 times a year
D.Once a year or less
E. I’ve never been asked for a residual value
projection before
19
21. Why & How Are They Used?
What are residual value projections used for,
anyway?
• Determining an assets’ end-of-lease value
21
22. Why & How Are They Used?
What are residual value projections used for,
anyway?
• Determining an assets’ end-of-lease value
• The ultimate purpose is developing the lease rate
22
23. Why & How Are They Used?
What are residual value projections used for,
anyway?
• Determining an assets’ end-of-lease value
• The ultimate purpose is developing the lease rate
• Fair rental calculations (remember ME204?)
23
24. Why & How Are They Used?
What are residual value projections used for,
anyway?
• Determining an assets’ end-of-lease value
• The ultimate purpose is developing the lease rate
• Fair rental (remember ME204?)
• Lease rate buildup
24
30. This is a blue book excerpt for the subject asset
2003 average Mid Time value is $1.52MM
2003 Factory List Price is $1.375MM
$1.52MM divided by $1.375MM is 110.5%
Therefore, in ten years the subject asset will be worth
110.5% of its new acquisition price
What is the error?
Common Errors (How NOT to calculate)
30
31. The example uses only current market data
Common Errors (How NOT to calculate)
31
32. The example uses only current market data
• There is no way of establishing from the given data
whether the current value of the asset is historically
relevant
Common Errors (How NOT to calculate)
32
33. The example uses only current market data
• There is no way of establishing from the given data
whether the current value of the asset is historically
relevant
The example uses an old historical price
Common Errors (How NOT to calculate)
33
34. The example uses only current market data
• There is no way of establishing from the given data
whether the current value of the asset is historically
relevant
The example uses an old historical price
• The correct price to use is the Replacement Cost New
Common Errors (How NOT to calculate)
34
35. • This is a compilation of past blue book data for the
subject asset
• What is the most common thing the asset manager
or appraiser will forget to do?
Common Errors (How NOT to calculate)
35
36. The inexperienced appraiser or the asset
manager often forgets to adjust the data for
inflation
Common Errors (How NOT to calculate)
36
37. Initial value at lease initiation
x
Does this look right? =
Common Errors (How NOT to calculate)
37
38. Failing to engage your brain to pick out
unrealistic projections
Common Errors (How NOT to calculate)
38
39. This particular asset ceased production in 1992
Once the resale values are adjusted for inflation, what
else needs adjustment?
Common Errors (How NOT to calculate)
39
40. Failure to adjust historical cost to a current
RCN is an incredibly common error for out-
of-production assets
Common Errors (How NOT to calculate)
40
41. We’re moving on next to calculating the
depreciation rate, or decline rate.
Any questions?
41
62. Other considerations
Different ages of parts of
line or asset:
2008 Sikorsky S92A,
Corporate/VIP
configured, factory
demonstrator
Purchased in 2011
Corporate configuration
removed, replaced
with offshore interior
Interior is 3 years
younger than the
airframe
62
65. Upcoming ASA Education
For a complete listing of ASA’s upcoming educational offerings, visit
www.appraisers.org.
Let’s Connect!
• Facebook.com/ASAappraisers
• @ASAappraisers
• Linkedin.com/company/american-society-of-appraisers
• Youtube.com/ASAappraisers
• Appraisersnewsroom.org
Thank you for joining us!
65
Notas do Editor
Businesses, nonprofits and government agencies finance more than $725 billion every year through loans, leases and lines of credit in order to acquire new plants, equipment and software. (Source: U.S. Equipment Finance Market Study 2012-2013 from the Equipment Leasing & Foundation). The majority of the leases will require one or more residual value projections in order to build up the lease rate.
While some equipment financiers calculate their own residual values in-house, many use the services of a professional appraiser. An experienced appraiser with an extensive value database can provide credible, reliable residual value projections; even less experienced appraisers can use commercially-provided databases when they’re available.
At HeliValue$, we do residual value projections pretty much every day, but it’s only fair to warn you that our approach was developed for helicopters.
We’ve looked carefully at what we do and how we do it, and the methodology looks valid to us for other forms of machinery and equipment.
But we don’t do other M&E, so please bring your knowledge, your judgment, your historical data and your critical thinking to the table today.
And please, if you have comments or arguments about our methodology, we’d be happy to hear it. Sharing methodology and critiquing it is how we as appraisers develop new methods and flesh out the old ones.
HeliValue$ calculations are almost always given in constant dollars. To reach these projections, we trend all historical values to today’s dollars, then give our projections still in current dollars. This means the historical inflation over the past decade is taken into account; future inflation is not.
As appraisers who work for lessees as well as for lessors, we should worry about lessors who want to see 10-year projections with 3% annual inflation. That’s incredibly aggressive pricing, and should be reserved as an incentive for a new client that they really want, like a HNWI (High Net Worth Individual).
If a lessor can’t get a deal without booking residuals that aggressive, they may be a high-risk source of capital.
That which is left.
At HeliValue$, we believe the answer is a resounding “Yes!” With a decade’s worth or two of historical pricing data, you can create a credible “depreciation rate” (as we call it in ME204) or “decline rate” as Peter Daley used in his January 2013 residual value webinar. (Which is available on the ASA website Marketplace)
With just ten years’ data, you have a reasonable look at a period of time that reflects market cycles, economic cycles, socio-political cycles, and technological cycles. With that information and your understanding of market behaviors, you can both assemble and assess reasonable estimate of future value, based on past history but reflecting today’s market, and considering both aggressive and conservative risk positions or choosing a median risk position.
Any other ideas? Those of you joining us virtually can feel free to use the Chat box to participate any time
Please enter your answer into the Chat box
A lease rate is built of both controllable and non-controllable elements. The lessor can adjust its internal structure, operating expenses, assessment of risk on the deal, and the ”haircut” it gives the appraiser’s residual value at lease termination. They have no ability to affect the deal price if it’s not a sale/leaseback. The tax benefits are mandated by federal and state taxing bodies. And the cost of funds is set on a bank-wide level.
If we want to look at an example of a loan in comparison to a lease, a bank’s cost of funds is 2.5%. It’s fixed and non-controllable. Add the bank’s risk provision of 0.75%, which is controllable to a certain extent – within bank parameters anyway – to get 3.25%. Then add the bank’s operating expense of 1.5% which is also controllable to reach 4.75%. Add again for the bank’s profit of 1.5%, which is controllable depending on how influential the dealmaker may be on either side of the table (and never forget that sometimes it’s the guy on the other side of the table with the power. Even gazillionaires get loans) and you get 6.25%. Deduct the bank fees of 0.25% (controllable) and you end up with a loan rate to the client of 6% even.
A lease rate, on the other hand, might look like this:
The lessor starts with the client’s loan rate.
He deducts the upside benefits to the residual value, less any haircuts mandated by internal policy.
Then he deducts some of the tax benefits which accrue to the bank (he has to keep some to make a profit, you know).
Finally he deducts any Like Kind Exchange benefits that come with the deal, for instance in a trade-up.
The result is a lease rate which is almost invariably lower than the rate the same client would pay for a loan.
It’s in that second circle there, that we appraisers have a chance to get a job. In order to calculate their upside benefits or downside risks, the lessor needs to discover the residual value at the end of the lease term before he can perform his magic. And the appraiser is the guy who can tell him with any degree of reasonable credibility just what the residual value will be when his lease ends.
Here at HeliValue$, we find the greatest challenge is consistency. When you do residual values for multiple banks for a single project, or do multiple projects for a single bank, making sure the future values align with each other and make sense in context with each other is , to us, the hard part.
Bankers rely on our residual values to book a deal,, to talk to credit, to create risk profiles for different models of equipment. Once your residual spreadsheet is set up, there shouldn’t be huge variances in the lease-termination values from year to year when you do the annual FASB updates (which, by the way, the bank won’t want to pay for. Just saying)
Why it works this way I can’t begin to guess. You’d think that comparing each year ‘s value to its historical cost – trended for inflation – would make sense. But try it anytime. It returns nonsense values that will never work in the real world.
Never compare 2002 dollars to 2008 dollars to 2015 dollars. Always bring your pricing data to a common date before proceeding
We want you thinking generically here, which is why there’s no spreadsheet.
Always remember to look at your results. After a while the formulae start to look alike. If you’re not paying attention, the result may not make sense
Use your common sense; read what you wrote before you send it to your client
I repeat: never compare 2002 dollars to 2008 dollars to 2015 dollars. Bring ALL your pricing data to a common date before proceeding
*share other answers*
Okay, now that you’re forewarned about possible mistakes, let’s learn how to calculate your depreciation rate, or decline rate.
We’ll start with calculations for the current values – it’s not enough to find residual values, but you’ll need part of it.
First you have to build a matrix that makes sense, of theoretical otherwise identical equipment that differ by year of manufacture only.
You’ll need a column for year of manufacture, otherwise you’re going to get lost in the middle of the spreadsheet and have to start over.
We’ll use the CPI here to calculate our trend factor. You can develop your own index as appropriate to your equipment type and industry.
The trend factor is the current CPI divided by each annual CPI and converted to percentages.
This column is for that matrix you built, of theoretical otherwise identical equipment that differ by year of manufacture only.
Let’s say you have real sales data for earlier years of manufacture, but nothing of younger models because the buyers are still holding the newer machines . You can extrapolate values for those years with a straight-line depreciation from the known new price to the youngest known resale value.
We’ll use the CPI here to calculate our trend factor. You can develop your own index as appropriate to your equipment type and industry.
The trend factor is the current CPI / each annual CPI and converted to percentages. Multiply each year’s trend factor by the historic cost to find the trended historic cost.
You’ll divide the current value for each year of manufacture by the trended historic cost, or the replacement cost new if it’s a current production model.
This will give you a column with the percentage of RCN to apply to the subject asset’s acquisition price or fair market value.
Now you start another set of calculations to accommodate the resale history of the machine.
Here you’ll have to create another pricing matrix of past sales for each of the past ten or so years. How detailed you want to be will depend on the market nature of the asset you’re looking at. Some machines need you to create a matrix of values for the exact same age as the subject asset. Other machines can use an average age.
Just like with the current values, you can fill in some of the missing years using various tools,.
In this case we’ll use straight-line depreciation to keep the approaches similar.
Don’t forget that the past values need to be trended up to current dollars. Don’t try to compare apples and municipal bonds.
You can trend the historical costs to current dollars, or you can make these separate columns in the original spreadsheet.
Divide the trended past values by the trended historical cost, or by the RCN if it’s a current production model.
While it’s possible to end up with similar values for the current value matrix and the past value matrix, it’s equally possible to end up with wildly varying value. It depends on the current market for the model compared to past history, and market volatility for that model.
Start by tucking the trended historical cost, or the RCN for a current production model, into a corner of your spreadsheet where you can reach it easily.
You’ll take the percentages of RCN that you derived from both the current value calculations and the past value calculations, and multiply those by the trended historic cost or RCN, in order to find the projected values based on both the current market and the past markets.
When you’re working with a new asset as the subject, start with the current values. This will give you the depreciation over the first few years as the asset burns off its warranty, its factory profit margin, and its newness, whether that’s mileage or usage hours or whatever measure of usage is common to that asset class. It also accommodates the incentive needed for an asset to sell from an end-user as opposed to the dealer or factory.
Next, you’ll go to the last year for which you’re projecting. You’ll want to pick an appropriate percentage. You can choose the most conservative value of the decade, or the median value, or the value that best matches the contract and what you know of your client’s situation and needs.
Lastly, you’ll fill in the missing years with a depreciation picture that looks right to you for the job. Straight-line depreciation is pretty safe, or some other method that emulates the market perception of age for your asset class.
Divide all those reconciled values , which we’ve named “Most probable” here, by the trended historic cost that you tucked into the corner. This will give you the depreciation schedule, or decline rate, that you are going to apply to your subject asset.
Before you go any further, take a look. Do you believe the bottom line? Does it match what you know of the market history for this model? In ten years, is it reasonable to think that someone will pay that much for this asset in used condition?
If not, you’ll need to go back to look for errors in math, in assumptions, or in depreciation schedules.
If so, you’re ready to apply the percentages to your subject asset.
There are often other things you need to consider in a residual value projection. Options and accessories that have a different useful life, or different depreciation rate. Different ages for different components of the machine. Different return provisions written into the lease. Prepaid service agreements. Maintenance reserve payments.
In this example, we’re looking at optional equipment that matures at a different rate and different market level than the base machine. You can create calculations for these items similar to the other calculation lines, or you can do a straight-line depreciation from the new cost of the option to the amount it will add to the value of the base machine in some number of years.
This is an example of a helicopter that had a complete configuration change at 3 years old. In the actual transaction the work was completed prior to closing and was calculated into the FMV, BUT had the work been planned for part-way through the lease contract, we could have calculated for it using a variation of the methodology on the previous slide.
Always read as much of the lease contract as you can get your hands on. Excerpts of the maintenance and return provisions are a minimum requirement.
Different leases with different return provisions (such as 50% used, 20% used, requirement for a prepaid maintenance program or maintenance reserve account to a certain age or to lease termination) will impact the bottom line, and therefore your depreciation schedule, or decline rate.
Read the darn contract already.