VALUATION BY COST APPROACH

DR. RAJWINDER SINGH BANSAL

Three Main Approaches

■ 1. Market Approach
■ 2. Income Approach
■ 3. Cost Approach

These are based on the economic principles of

a. Price equilibrium
b. Anticipation of benefits
c. Substitution
Methods of Valuation

Approach to valuation Methods

Market Approach Ad-hoc method
Adjusted grid method
Weighted score method
Hedonic pricing method

Income Approach Capitalisation method

DCF Analysis

Cost Approach Depreciated replacement cost

Depreciated reproduction cost
Summation method
COST APPROACH

■ ‘The cost approach provides an indication of value using the

economic principle that a buyer will not pay more for an asset than
the cost to obtain an asset of equal utility, whether by purchase or
by construction, unless undue time, inconvenience, risk or other
factors are involved.

■ The approach provides an indication of value by calculating the

current replacement or reproduction cost of an asset and making
deductions for physical deterioration and all other relevant forms of
obsolescence.’
When Cost Approach is used ?
■An asset with same utility can be recreated without regulatory or
legal restrictions, and this can be done quickly.

■(i) there is either no evidence of transaction prices for similar property

(ii) there is no evidence of actual or notional income stream that

could accrue to the owner.

■the unique nature of the asset makes use of income approach or market
approach unfeasible

■the basis of value is replacement cost, such as replacement value

■If market transaction prices or income stream is available, the cost approach
may be used as a corroborating approach.
The three Cost Approach Methods

■ (a) replacement cost method: in this method the value is estimated by

calculating the cost of a similar asset offering equivalent utility,

■ (b) reproduction cost method: in this method the value is estimated by

calculating the cost that will be incurred for recreating a replica of an asset,

■ (c) summation method: in this method the value of an asset is estimated by

addition of the separate values of its component parts.
Costs to be considered
■(a) direct costs:
i. cost of materials
ii. labour costs

■(b) indirect costs:

i. transport costs,
ii. installation costs,
iii. professional fees (design, architectural, structural, legal, interior
designer, landscaping, supervision, construction management, etc),
iv. other fees (permits/licenses, commissions, insurance, etc),
v. overheads,
vi. taxes (infrastructure tax, municipality tax, etc),
vii. finance costs (interest on borrowings), and
viii. profit margin/entrepreneurial profit to the creator of the asset
(e.g. contractor’s profit, return to investors).
 Depreciation estimation

■ Adjustments for three types of obsolescence

■ (a) Physical obsolescence : Any loss of utility due to the physical deterioration of
the asset or its components resulting from its age and usage.

■ (b) Functional obsolescence : Any loss of utility resulting from inefficiencies in

the subject asset compared to its modern replacement such as outdated design,
specification or technology.

■ (c) External or economic obsolescence : Any loss of utility caused by economic

or locational factors which are external to the asset. This type of obsolescence
can be temporary or permanent.
The process of valuation by cost approach

 1. Calculation of replacement cost

 This is normally the cost of replacing the property with a modern equivalent at
the relevant valuation date. An exception is where an equivalent property
would need to be a replica of the subject property, in which case the
replacement cost would be that of reproducing or replicating the subject
building rather than replacing it with a modern equivalent.

 The replacement cost must reflect all incidental costs, as appropriate, such as
the value of the land, infrastructure, design fees, finance costs and developer
profit that would be incurred by a participant in creating an equivalent asset.
 2. The cost of the modern equivalent must then be subject to adjustment for
physical, functional, technological and economic obsolescence.

 The objective of a mark down for obsolescence is to estimate how less valuable
the subject property will be to a potential buyer when compared its modern
equivalent.

 Obsolescence takes into account the physical condition, functionality and

economic utility of the subject property compared to the modern equivalent.
Suggested application of depreciation curves
in absence of market based empirical
observations (S curve)
 Findings of empirical studies for depreciation -
S Curves
Buildings Plant and equipment
Value

Value
Age Age
RICS Guidance Note
“Depreciated replacement cost method of valuation for financial
reporting” 1st Edition - November, 2018

 Throws light on different methods of depreciation commonly in use

1. Straight Line method
2. Constant Percentage or Reducing Balance method
3. S curve

Findings of the guidance note :

S curves (constructed based on empirical data) tend to correctly bring out the path of depreciation
traced by a structure / plant & equipment.
Depreciation graph from the RICS guidance note
Anomalies in RICS Guidance Note

 i) Straight Line method of depreciation -

 9.29 The weakness of this method is the very simplistic assumption of the
uniform erosion of the asset’s value over its total life, compared with the
equivalent replacement asset. The assumption is clearly correct at two
points in the life – the beginning and the end – but it would be entirely
fortuitous if it were correct at any intermediate point, which is when a
valuation is most likely to take place.
 Observation – on para 9.29 of the Guidance Note

 Depreciation of a building generally follows S curve wherein there is slow depreciation in the
beginning, rapid depreciation in middle years and again slow depreciation towards the final
stages.
 Therefore, the S curve in the initial stages will be above the Straight Line depreciation (which
represents depreciation at constant amount each year) and in the final stages will be below
the Straight Line depreciation.
 This implies that in the middle years when the building depreciates at a rapid pace, the S
curve is bound to intersect the straight line when it traverses from above the straight line to
below.
 Thus, the Straight Line depreciation will not only give correct depreciation value at the
beginning and at the end of the asset life, but also at some point in the middle of the asset
life.
 It is quite possible that straight line depreciation can give depreciated values very close to
the values of S curve for some period over the middle life of the asset.
 ii) Reducing balance / constant percentage method of depreciation -
9.30 The reducing balance method of depreciation assumes a constant percentage rate of
depreciation from the reducing base. This may match reasonable expectations of declining value
over time better than the straight-line method.

 Observation – A reading of the above para 9.30 and a close look at Figure 1 reveals that there is nothing in
Figure 1 to indicate that reducing balance method gives better estimation of depreciated value than the
straight line method of depreciation.

 iii) The S curve as discussed in the guidance note partially traces concave, convex and in the middle portion
an almost straight line path.
 However, other than the S curve, the discussion in RICS guidance note deals with only straight line method
(which obviously gives a straight line graph) and constant percentage method (which gives a sagging /
convex curve graph).
 There is no discussion whatsoever regarding any curve which is concave in nature, despite the fact that a
part of the S curve is concave.
 The sinking fund curve based on sinking fund method results in a concave curve of depreciation and can
have an important application in depreciation estimation.
 This is a great shortcoming of the RICS Guidance Note.
 Advocacy of Sinking Fund method as a tool for depreciation estimation

 It is felt that sinking fund curve can be a handy tool for depreciation estimation and
requires proper consideration and application by practicing valuers.

 It is seen from the graph (Figure 1) that reducing balance curve is in the form of a
convex curve below the line arrived at by straight line method. However, if a sinking
fund curve is plotted it is in the form of a concave curve above the line arrived at
straight line method.

 In the absence of any empirical market-based observations (S-curve), the two curves
(constant percentage and sinking fund method) and the straight line are likely to have
application in different circumstances.
 Suggested application of depreciation curves in absence of market
based empirical observations (S-curve)

Example

 It is assumed that replacement cost of the building is Rs. 1,00,00,000/- and its useful
life is 60 years. The value is expected to be zero at the end of the useful life of the
building.

 The depreciated values by straight line method, constant percentage (reducing

balance) method and sinking fund method at 0 year,10 years, 20 years, 30 years, 40
years, 50 years, and 60 years are shown in Table 1
Table 1
S-curve is traced by assuming slow depreciation in the initial years (0 year to 20
years), rapid depreciation in the mid-life of the asset (20 years to 40 years) and
again slow depreciation towards the end of the asset life (40 years to 60 years).
Based on the Table 1 & 2, a graph is prepared (Figure 3) depicting depreciated values of the asset
(building) over its life time by the four methods (the values by S-Curve being probable values).

GRAPH
12000000

10000000

8000000

6000000

4000000

2000000

0
0 10 20 30 40 50 60 70

Straight Line Constant Percentage Sinking Fund S Curve

 Conclusion

 For the asset class buildings, in absence of any credible empirical data of actual
depreciation path traced, it is very likely that for depreciated value estimation

1. In the initial phase (first 1/3rd) of the asset life, sinking fund method may give most
credible results,

2. In the middle phase (middle 1/3rd) of the asset life, straight line method may give
most credible results, and

3. In the final phase (final 1/3rd) of the asset life, constant percentage method may give
most credible results.

 For judging the veracity of this proposed hypothesis, it needs to be tested in markets
where proper empirical data is available for plotting S curve.
Methods of Depreciation

Straight-line depreciation
 Most commonly adopted method for calculating depreciation of buildings

 Simple and easy to apply.

 Assumes the same amount is allocated for depreciation for each year of the
estimated life.

 Depreciated Cost of Building

= Replacement cost – Depreciation

= Replacement cost –
{ Replacement cost x (Age of the building / Estimated total life)
x % of asset value net of salvage value }
 Reducing balance or constant percentage depreciation

A constant percentage rate of depreciation is applied to the reducing base.

Results in a sagging depreciating value curve over the life of the asset

Meets expectations of decline in value of an asset over its life time better than the

straight-line method.

 Depreciated cost of the building = Replacement cost X (1 – p) n

Where,
p = depreciation percentage expressed in decimal
n = age of the building
 Sinking fund depreciation
 1. In this method, in the first step sinking fund (S) is calculated to recoup the required amount
over the life time of the asset.
r
S = ---------------- , where r = sinking fund percentage in decimal
(1 + r) n - 1 n = life span of the asset

 2. In the second step amount that has accrued by starting the sinking fund (A) is calculated.
This depends on the age of the asset on the valuation date.
(1 + r) m – 1
A = ------------------- , where r = accumulative percentage in decimal.
r This is same as ‘r’ is step 1
m = age of the building
 3. In the third step the depreciation percentage applicable is obtained by the following formula
Depreciation percentage = S x A x 100

 4. In the fourth step the depreciated cost of the asset is obtained by

Depreciated cost = Replacement cost – depreciation amount
THANK YOU