BASIC PRINCIPLES OF

ENGINEERING VALUATION

ADELEKE AA
 INTRODUCTION
• Valuation is the process of determining the current worth of an asset or company

• The Engineering Valuation program is important for the following reasons:

• The only course designed to prepare the Engineering students for Valuation of the industrial assets during
SIWES II
• Provide requisite skills to fill the yawning gap created by the conventional valuers with restricted expertise on
Land and building
• Prepare the Engineering students to convert to PG Valuation Engineering

• Regulatory bodies for Valuation include:

• The Royal Institution of Chartered Surveyors (RICS) –owns the Red Book that specifies the “Purposes and bases
of valuation ” of assets
• American Society of Appraisers (ASA)- provides guidelines for Machinery & Equipment appraisal
 CATEGORIZATIONS OF INDUSTRIES
• PRIMARY INDUSTRIES
• -extract material direct from land or sea and no further processing to finished products-
mining of solid minerals, crude oil and quarrying
• Secondary industries
• -bulk of manufacturing industries that process primary raw materials to finished goods such
food, chemical, metallurgical and mechanical plants and factories
• Tertiary industries
• -Provides retail oriented services and includes industries in construction, transport and
communication
• Quarternary industries
• -research establishments and those concerned with the provision of information
• 
 THE CONCEPT OF VALUE
 
• Value may mean: a measure of worth, a desirability of ownership or possession, or the
exchangeability of property and can be measured in terms of the price
• Three ways to view asset value: 
• Value to the owner-sentiments and attachment to the asset
• Market value- det by market forces of demand and supply
• Fair value -the value a competent Valuer has to derive
• Evidence of Value:
• Original cost of the asset
• The market value of the asset or a similar asset being exchanged in the market
• The income obtainable from the asset currently and by forecast into the future
• The replacement cost, that is, the cost to replace the asset with a new one of its type
THE CONCEPT OF VALUE II

• Approaches to derive a fair value 

• 1. Market approach
• 2. Earning approach (Income)
• 3. Cost approach
• The market approach involves:
• A direct comparison of the property being appraised to similar properties that have been sold in the same or in a
similar market. This approach is based on the principle of substitution which implies that a prudent person will not
pay more to buy a property than it will cost to buy a comparable substitute property.
• The income approach is based on the present value of cash flow that an asset can be expected to generate during its
remaining life. This approach is based on a forecast of the business income and expenses that the property will
generate over a given period of time
• The cost approach is based on the concept of replacement or reproduction cost as an indicator of value. A prudent
investor would not be expected to pay more for an item than the amount for which it could be purchased new.
Further, to the extent that a particular item provides less utility than a new one, its value will be less than the cost of
a new replacement or reproduction. To account for this difference, the replacement/reproduction cost new is
adjusted for losses in value due to physical depreciation, functional obsolescence, and economic obsolescence
 EQUIPMENT APPRAISAL-principles

• Machinery and equipment (M&E) appraisal work are expected to conform to the Uniform Standards of
Professional Appraisal Practice (USPAP). The steps in a typical machinery and equipment appraisal
assignment include:
• Identifying the assets to be appraised
• Classify the Equipment as- production machinery, Motor controls and Switch gear, support equipment,
process piping, general plant eq., rolling stock, tools, special tooling, patterns & templates, Lab & test eq.,
foundations & structural supports etc
• Rate the item’s condition-very good, good, fair, poor, scrap
• Defining the purpose of the appraisal
• Establishing the valuation date for the appraisal
• Determining the type of valuation study to be completed
• Selecting the type of appraisal report to be provided
• Checking the availability of data and information
• Apply the income, direct comparison or cost approach for the assignment based on data available
EQUIPMENT APPRAISAL-principles II

• Equipment Rating:
• Very Good- excellent condition, can be used to its full specified capacity, any abnormal maintenance not
required on inspection and for the foreseeable future.
• Good-an equipment subjected to modifications or repair, but presently in regular use, age OK
• Fair-equipment that has been used below their potential capacity due to age, need for repairs or
replacement in the immediate or foreseeable future to raise the level of utilization to or near the original
specifications.
• Poor- equipment requires extensive repairs or replacement of major components in the immediate future
• Scrap-item has reached the end of their useful life, requires large expenses to put them in working order
or those that are technologically or functionally obsolete.
•  Report Types
• Under USPAP, there are three types of reports for equipment appraisals: Self-Contained, Summary, and
Restricted Use based on the content, level of details and information provided. The Self Contained report
is the most detailed of the three.
EQUIPMENT APPRAISAL-principles III

• M&E consists of machinery, furniture, fixtures, office and

telecommunications equipment, computer and networking
equipment, vehicles, etc.
• Appraisals can be performed for individual pieces of equipment, a
production line, a complete operating facility, or multiple operating
facilities
• Purpose of Appraisal
An equipment appraisal can have many purposes include-Accounting,
Financing,Insurance,Leasing, Liquidation and bankruptcy,
Management Planning, Tax
EQUIPMENT APPRAISAL-principles IV

• M&E include the following categories:

• Machine tools such as lathe, shaping, drilling machines
• Hand tools such as wrenches, cutters, screw drivers, vises, clamps, saws, drills etc
• Vehicles, boats
• Chemical equipment and tanks
• Furniture and Supporting Equipment
• Communication Equipment and Computers
• Farm equipment
• Oilfield equipment
• Restaurant Equipment
• M&E valuation or appraisal assignment is different from real property assignments for the
following reasons:
• The aim of the appraisal may not be the determination of the market value
• M&E valuation or appraisal is often carried out as a component of the complete business
valuation that additionally includes real property valuation and financial analysis
 EQUIPMENT APPRAISAL-principles V

•Specific Valuing Concepts and Approaches

•Fair Market Value In Continued Use-reasonable estimated value ($/N), willing seller/buyer, earnings
known, equity, specific date
•Fair Market Value – Installed-estimated value, willing seller/buyer, earnings un-known, equity
•Fair Market Value – Removal-estimated value, willing seller/buyer, earnings un-known, removal cost
known, equity, specific date
•Orderly Liquidation Value In Place-failed facility, sell entire plant in place, a limited time duration,
specific date
•Orderly Liquidation Value- failed facility, to sell on an as is, where is basis, seller being compelled,
reasonable time
•Forced Liquidation or Auction Value- to sell on an as is, where is basis, seller being compelled,
advertised and conducted public auction, immediately
•Salvage Value- failed facility, whole/part, retired from service, to be taken away for use
•Scrap Value- failed facility, component, sell for its material content, not for a productive use,
•Insurance Replacement Cost and Insurance Value Depreciated-insurance policy based
EQUIPMENT APPRAISAL-principles VI

• Types of Valuation Studies

• Inventory appraisal of details on assets and site inspection-where there is no asset listing
• Site Inspection of assets with asset listing available
• Desktop appraisal- asset listing available, time short
• Types of Appraisal Reports
Under USPAP, there are three types of reports for equipment appraisals: Self-Contained, Summary, and
Restricted Use.
• The essential difference among the three reports is in the content, level of detail and information
provided.
• The Self Contained report is the most detailed of the three. The Restricted Use report is utilized when
the client will be the only party relying on that report.
• Availability of Data and Information
The data typically required -asset listings, purchase orders, invoices, maintenance logs and financial
statements
 METHODS TO ESTIMATE VALUE

• Direct Comparison method(DCM)

• DCM is used when sales data is available
• M&E items in active trading in markets and liquidation like vehicles-current prices
from markets (Going Concern) and auction prices for items in liquidation
• Determine the new price of item of the same functionality with the old item and
discount the price by differences such as condition, age, functionality, location,
installation costs, type and time of sale
• Use Retail market price for orderly liquidation or continued use in a going concern
and the wholesale price may be used in forced liquidation when no time for
adverts
•
 METHODS TO ESTIMATE VALUE

• The direct comparison approach is easier when there are valuation

benchmarks to use. For example, in the hotel and motel industry, the
furniture, fixtures and equipment (FF&E), command values that depend
on the quality of the hotel (motel, five star etc) and the age of the
equipment. For a motel, 80% of value may be assigned to a one year old
FF&E item with known price and estimated economic life.
• The value of machinery, fixtures and equipment are established by
comparison with the sales or asking price of similar M&E in a similar
market on or about the valuation date.
• The comparability of the M&E item determines the level of confidence
that can be placed on the values concluded.
THE INCOME APPROACH
• The Income Approach
• The earning or income approach uses the present worth method for discounting the expected future
monetary returns to arrive at an estimate of value of the property.
• The basic approach is to determine the net income obtainable from an M&E item being valued and then
capitalize this over the expected remaining economic life of the M&E item. The net income is determined
by:
• -determine the difference in the income generated in the business with or without the M&E item
• -determine the lease rate applicable to the M&E item
• After determining the net income obtainable from an M&E item, the value of such an item can be
deduced as follows:
• Gross Income Multiplier-The sale price of comparable M&E item sold is divided by its gross income to
obtain a multiplier for the income determined for the subject item. The resulting value is then adjusted
for age and other forms of depreciation
 
EXAMPLE ON INCOME/EARNING
APPROACH
•• The
  Discounted Cash Flow (DCF) is a mehod used to estimate the value of an
investment based on its expected future cash flows.
• DCF attempts to determine the value of an investment today based on projections of
how much money it will generate in the future
• This formula assumes that all cash flows received are spread over equal time periods,
whether years, quarters, months, or otherwise. The discount rate has to correspond to
the cash flow periods, so an annual discount rate of r% would apply to annual cash
flows.

• Where:
• DCF =Discounted Cash Flow, CF1= Cash Flow Period 1, r =borrowed fund interest rate
EXAMPLE ON INCOME/EARNING
APPROACH
• Suppose that an investor estimates that a certain unit of depreciable property would be able to earn, after taxes and
• operating expenses, a uniform $1000 per year for the next 10 years at which time he estimates that he can get $50 for
net salvage. The annual $1000 would pay interest on the part of capital borrowed to acquire the property; plus an
allowance for yearly consumption of usefulness or for depreciation of
• the property; plus net income on his own money invested. Now he computes what the property is worth by discounting
these 10 annual returns and the net salvage with a discount rate for his specific mix of debt and equity capital
commensurate with comparable opportunities, say 10%. He comes out with $5778.30 as what the property is worth at
age zero. If he acquires the property for that amount and the property earns the yearly $1000 forecast, then the value of
the machine at any other age would be the present worth of the remaining returns plus the present worth of net
salvage. For example, at age 6, the value of the property would be estimated at $1987.51 by discounting, at 10%, the
four remaining $1000 returns and the $50 net salvage. On the other hand if at age 6, he estimates different returns for
the remaining years or different net salvage or different discount rate or that he intends to keep the property longer or
to sell it earlier than the original 10 years life, he would apply the new estimations to arrive at an estimate of value at
age 6. The same procedure would apply at any other age.
• The Net Salvage is value of an asset at the end of its useful or fully depreciated life. It is determined by estimating the
after-tax sale price minus the costs of disposal.
• 
EXAMPLE ON INCOME/EARNING
APPROACH II

• Table 1: Calculation of present value of equipment

YEAR CASH FLOWS DCFs

• by earning method 1
2
1000
1000
909.0909091
826.446281
3 1000 751.3148009
4 1000 683.0134554
5 1000 620.9213231
*6 1000 564.4739301
7 1000 513.1581182
8 1000 466.5073802
9 1000 424.0976184
10 50 19.27716447
AFTER 10
YEARS NPV 5778.300981
AFTER 6 YEARS NPV 1987.514211
 THE COST APPROACH
• The steps in a cost approach are:
• a. Establish the cost new-replacement or reproduction. The depreciation analysis for
both cases will consider the difference in functionality between the original and
replacement M&E.
• b. Determine the age and rate the condition of the M&E
• c. Estimate the remaining economic life of the M&E
• d. Apply the age-related depreciation
• e. Consider adjustments for functional and economic obsolescence
• f. Make adjustments for the nature of value being established (that is, disposal or
value – in - use)
• g. Conclude value
 METHODS TO DETERMINE COST NEW

• Methods to Determine Cost New in the last slide when it is not readily
available online or in literature
• The current new cost of equipment can be determined by methods such
as detail method, trending, cost-to-capacity and indexing.
• In indexing, the historic cost of the M&E item is updated to current by
indexing. The appraiser can obtain the indices from commercial data
providers like RS Means and Marshall & Swift as well as by independent
research.
• If the source material includes the installation costs, this has to be
deducted if an off-site disposal is required to factor in re-installation cost
 THE CONCEPT OF DEPRECIATION
• An M&E can experience functional, external or economic obsolescence with use
• Remaining Economic Useful Life-can be taken from Company’s book
• Depreciation is caused by the interactions of internal external forces. Like buildings, M&E deteriorates with age and
usage and prone to technological changes and innovation that may quickly render any obsolete in function or process
• The three classes of depreciation for M&E are physical, functional and external. Depreciation may also be curable or
incurable.
• Physical depreciation is generally measured by physical observation or by checking owner’s record, serial number,
model number, date stamping. Improving technology may also render an equipment obsolete in function
• When the M&E valuation is for insurance, taxation or business as on-going concern, age-related depreciation is used.
The types applicable are:
• Straight-line Depreciation
• Double-declining balance
• Percentage of useful life
• Schedules from Cost Manuals
• Cost manuals like that of Marshall & Swift Valuation Services Manual have depreciation tables applicable to certain
M&E items
EXAMPLES-DEPRECIATION
CALCULATIONS
•  Straight Line Method
• For example, an item with a 5 year economic life and a terminal value
of 20%, is expected to decline in value by:
• Double Declining method
Year Rate (%) Calculation Depreciation Remaining
($) Book Value ($)
0 0 0 0 10000
1 40 40% of 10000 -4000 6000
2 40 40% of 6000 -2400 3600

• Percentage of Useful Life

EXAMPLES-DEPRECIATION
CALCULATIONS
• Percentage of Useful Life
Year Hours Depreciation (%) Remaining Remaining Book Value ($)
Used Hours

1 1638 1638/20000=8.19 18362 ((18362/20000)*25000))+1000=23952.5

2 2822 2822/20000=14.11 15540 20425

 FUNCTIONAL AND EXTERNAL
OBSOLESCENCE
• Functional Obsolescence is the inability of the M&E item to adequately perform the function for
which it was designed or acquired. This situation arises due to the emergence of newer, better, more
productive and/or less costly M&E item alternative to the existing M&E item. The new M&E item may
also be less costly to operate and may occupy less space but may not fit into the existing process line.
• External obsolescence may also affect the cost of the M&E item. It may arise from economic and/or
locational obsolescence. Economic obsolescence indicates that the machine is not appropriate for
current needs, while locational obsolescence means that the machine is in the wrong place where
some services are no longer needed or required only in small quantity. The situation may thus leads to
capacity under-utilization. Other factors such as non-availability and high cost of a raw material,
decreasing demand for product, high labour cost, lack of skilled labour to operate the equipment etc.
The M&E item is also only as valuable as the industry to which it belongs.
• 
• 
• 
GUIDELINES FOR THE VALUATION
REPORT
• CHAPTER ONE: INTRODUCTION
• This should include pints such as:
• Introduction to the Company
• The nature of the Company’s business
• The engineering equipment asset management approach in the company
• Outline of the specific objectives of your study
• CHAPTER TWO: LITERATURE REVIEW
• This should include points such as:
• General introduction to Engineering Valuation, depreciation
• Methods of Engineering Valuation
• Method of Valuation specific to the engineering equipment assets of the company under study
• The present method in practice in the company
• The current market supply and demand of the equipment under study from Internet sources
• Relevant references should be indicated as appropriate
GUIDELINES FOR THE VALUATION
REPORT II
• CHAPTER THREE: METHOD OF VALUATION
• This should include:
• List of engineering equipment asset in the company to be evaluated
• The procurement history and costs
• Valuation Analysis based on a, b
• CHAPTER FOUR: RESULTS AND DISCUSSION
• Results: Tables and graphs of Results obtained
• Discussion: Discussion of Results
• CHAPTER FIVE: CONCLUSIONS AND RECOMMENDATIONS
• Conclusions: Your basic deductions on the equipment valuation
• Recommendations: Your recommendations to the company
• REFERENCES
• List your references, at least 5
•