Equipment appraisals and the basis of value

Paul Fields

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.

There is a great deal of truth in the old adage that says “What something is worth depends on who you ask.” It is pointless to ponder over whose opinion is correct until first examining the purpose of the valuation. When it comes to machinery and equipment, many different values may be placed on the same asset, all of which are correct, depending on the circumstances surrounding the appraisal. The more relevant question would be, “Is the value consistent with the underlying assumptions that motivated the appraisal?”

There are a variety of reasons for a dealer to obtain an equipment appraisal. Usually, the purpose of the appraisal will determine the appropriate methodology and the relevant basis of value. When an appraisal is requested by an outsider or an advisor, it is important that the dealer query the source to determine the precise scope of the assignment and to clarify any esoteric meaning that may be attached to the word “value.” For example, when a lender uses the word, he usually means something entirely different from that of an insurance broker.

There are four values most commonly used in the business today. They are as follows:

(1) New Replacement Cost

New Replacement Cost is the dollar amount necessary to replace the assets under present market conditions with a modern, new unit of equivalent capacity. Appraisals based on New Replacement Cost are almost always conducted for insurance purposes. Here the appraiser views the equipment and its related installation as new, without regard for age, condition, or obsolescence.

(2) Liquidation Value

Liquidation Value is defined as the amount that may be realized through a forced sale when a reasonable time to find a buyer is not allowed. Implicit in the definition of Liquidation Value is the assumption that the assets may be broken up and sold as scrap or to dealers in the used market. Liquidation Value is rarely used except in bankruptcy situations or by lending institutions when the equipment is to be used to collateralize a loan.

(3) Fair Market Value

Fair Market Value is the most probable amount, in terms of money, for which the property would exchange between a willing buyer and a willing seller, neither being under abnormal pressure to trade, with each having full knowledge of the relevant facts, and with equity to both.

Unless otherwise stated, Fair Market Value appraisals analyze the equipment independent of the operation. Typically, they are conducted when the equipment is to be relocated.

These appraisals do not take into account the value associated with the installation of equipment and other costs required to assemble the assets into a productive process. Furthermore, these appraisals sometimes intentionally omit certain assets which, although physically possible to move, would be economically unfeasible to relocate. It is unlikely, for example, that anyone would relocate an in-ground hoist or obsolete telephone system.

(4) Fair Market Value, Installed For Continuous Use

Fair Market Value, Installed for Continuous Use is the most common basis of value used in buy-sell agreements. Here the appraiser does give weight to the fact that the equipment is installed. Installation, of course, encompasses freight, delivery, engineering, and all other costs necessary to establish a turnkey operation. As illustrated in our example, a dealer would probably not relocate an in-ground hoist or obsolete telephone system. He would, however, continue to use such an asset if it were on-site, at least on an interim basis. Without the asset, he might as well close his doors.

It is a sad fact of life, as many dealers who have opened new facilities can attest, that some equipment costs more to install than it does to procure. Older facilities may not enjoy the advantage of employing state-of-the-art equipment. Nevertheless, when installed, older equipment does give the dealer the ability to postpone major purchases and provides the necessary time to make an orderly transition. This advantage has value and should be taken into account when relevant.

Today, most machinery and equipment appraisals are designed to facilitate buy-sell agreements. The appraised values may play only an auxiliary role, or they may be incorporated in the body of the buy-sell agreement. In the latter case, it is not uncommon to encounter buy-sell agreements that contain the standard verbiage relating to Fair Market Value. Unfortunately, the language in these agreements frequently omits any reference to the installation or the continuous use of the equipment. This creates an unnecessary ambiguity and poses a real problem for the appraiser. Should he blindly follow the terms of the agreement, or should he base the values on what was clearly implied in the agreement? The problem is avoided if the issue is addressed one way or another in the agreement. This not only makes life easier for the appraiser; it also assures that the buyer and seller concur on the scope of the appraisal.

It may be appropriate in certain situations to appraise part of the assets on one basis of value and part on another basis, or to exclude a particular class of assets entirely from the scope of the appraisal. Some items (i.e., signage, specialty tools, factory merchandising displays, etc.) have value only in the context of a particular franchise. In fact, sometimes the only benefit to the buyer of purchasing these items from the seller is that he does not have to turn around and buy them at new replacement cost from the factory.

Now consider the case in which a facility is being sold with the intention of changing the franchise. What is the logical basis for valuing these assets? How the negotiating parties resolve this issue should be included in the instructions to the appraiser.

When the appraised values are not incorporated in the buy-sell agreement, the appraisal plays an auxiliary role only. Once the dealer has decided to sell, there is good reason to obtain an appraisal before he finds a buyer. The appraisal may serve as a negotiated tool similar to the way the “Blue Book” assists when buying or selling a used car. Although not an infallible source, it does provide an independent, impartial opinion of value from someone who analyzes market data on a full-time basis. As such, it defines a reasonable starting point for negotiations and may eliminate, from the outset, any unreasonable expectations held by the buyer or seller. (Ironically, many sellers underrate their own equipment. I believe this is due to dealers allowing book values to influence their opinion.)

Of course, two parties may agree on a price different from the appraised value; in which case, who cares about a third opinion. After all, when one buys or sells a dealership, he is dealing with more than a collection of machinery and equipment. There are overriding considerations that may impel him to agree on a price at variance with the prevailing market. Likewise, it is not uncommon for the parties to negotiate a price at or near the appraised value, only to later allow different purchase price for tax accounting purposes. Even in these cases, however, the appraisal supplies an accurate, detailed inventory of the assets subject to the buy-sell agreement. By documenting the property to be transferred, it promotes an orderly exchange and performs an important function

On occasion, a dealer or his advisor may order an appraisal based on values that seem inconsistent with the circumstances surrounding the property. More often than not, these appraisals are motivated by tax considerations rather than buy-sell agreements. We have conducted liquidation appraisals on equipment owned by profitable companies that remained as going concerns. We have also appraised equipment as installed for continuous use, even though it was designated for relocation. There is nothing wrong with this provided it is done deliberately, and everyone is aware of the purpose and the inconsistency. What appears illogical from an appraisal point of view might make perfect sense when viewed from a business or tax perspective.

In summary, the values assigned to equipment will largely depend on the perceived future service rendered by the equipment. Before examining market data, one must first determine the objective of the appraisal, the current use of the property, and its future disposition. For this reason it is a prudent practice to consult the appraiser prior to committing to any course of action involving appraised values or appraisal methodology.

This article was written in 1996.

Paul Fields is president of Paul Fields & Associates, a Mission Viejo-based appraisal company specializing in automobile dealerships and related businesses. He can be reached at (714) 537-7144.