Functional and Physical Obsolescence in Property Tax Strategies for Reducing Real and Business Personal Property Valuations

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1 Presenting a live 110 minute teleconference with interactive Q&A Functional and Physical Obsolescence in Property Tax Strategies for Reducing Real and Business Personal Property Valuations THURSDAY, APRIL 21, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Dorothy Radicevich, Managing Director, True Partners Consulting, Chicago Todd Barron, President, Barron Corporate Tax Solutions, Wheaton, Ill. Gregory Kort, Director, Complex Property Appraisal, Popp Gray & Hutcheson, Austin, Texas Kevin Reilly, Senior Manager, Real Estate and Related Assets Group, American Appraisal Associates, Milwaukee, Wis. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

2 FUNCTIONAL OBSOLESCENCE: REAL LIFE STORIES Michael J. Remsha, P.E., ASA, CMI Kevin S. Reilly, ASA Functional obsolescence ( FO ) is an often misunderstood form of depreciation. Depending on the age, technology, and efficiency of the subject property, the impact of FO can vary widely. Because of its variance and the many different causes of FO, many assessors and appraisers find it hard to quantify and analyze correctly. The result of an inadequate analysis often leads to an incorrect cost indicator of value and is often overstated. However, if analyzed properly and explained clearly, it can prove critical to a solid and defendable cost approach indicator of value. The purpose of this article is to discuss the basic FO concepts and present four real life stories in which FO was identified and quantified. FO can result from many different causes and will affect the overall value of property, plant equipment. There are multiple ways a valuation expert can quantify the effect of FO on value, and there is no one correct way to quantify FO. FO is a very dynamic form of depreciation, and many variables can affect its existence. The point is, if technology has changed, and a new modern asset with the same capacity and utility can replace the subject property, that modern replacement asset is the basis (starting point) of the cost approach. That modern replacement asset could be more or less costly to acquire, and most importantly, will likely have different operating expenses. Any potential buyer of the subject property will know the cost of construction of the modern replacement and also its operating characteristics. Basic Concepts Functional obsolescence is defined as a form of depreciation resulting in a loss in value caused by conditions within the property such as changes in design, materials, or process and resulting in inadequacy, overcapacity, excess construction, lack of utility, or excess operating expenses. Functional obsolescence is caused by factors inherent in the facility, such as inadequacy, inability to perform designed functions, or deficiencies in technology. This loss in value is normally expressed as (1) excess capital costs and (2) operating obsolescence (the present worth of future excess operating expense penalties). Due to their definitions and forms, both can exist simultaneously for any particular property. Functional Obsolescence Due to Excess Capital Cost Excess capital cost reflects a loss in value from the reproduction cost new ( RCN ) as a result of technological advances and development of better construction materials or methods. This form of obsolescence, if any, is measured by comparing the RCN of the subject property with the cost of a new modern asset (cost of replacement or COR ) of equivalent capacity, utility, and desirability. Subtracting the COR from the RCN results in the quantification of functional obsolescence due to excess capital costs. This form of functional obsolescence is deducted from the RCN to result in the RCN less functional obsolescence due to excess capital costs. Functional Obsolescence Due to Excess Operating Expenses Functional obsolescence due to excess operating expenses, frequently termed operating obsolescence, is a penalty that the existing property endures if the subject property has higher operating expenses than would be necessary in the modern asset. It is measured by the present value of the excess operating expenses of the subject property compared to the new modern plant. The annual excess operating expense is discounted over either the remaining life of the subject property or the remaining period in which the operating deficiencies are anticipated to be incurred, whichever period is shorter. The discount rate selected is commensurate and comparable with the present industry return on similar-type low risk investments. It is possible that the operating expenses of the subject property are less than those of a new modern asset if the new modern asset is substantially less costly to acquire. In that case, the analysis results in a net benefit (not a penalty) for the subject property in the cost approach. This concept is explained later in this discussion. Remsha, Reilly - 1

3 Oftentimes, an argument is made that by starting with a cost of replacement in the cost approach and then deducting operating obsolescence, the valuation expert is double dipping on depreciation penalties. In the text Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets (copyright 2005, the American Society of Appraisers, Washington, D.C.), the Machinery and Technical Specialties ( M&TS ) Committee of the American Society of Appraisers states the following: Some appraisers incorrectly assume that operating obsolescence double counts the functional penalties. The logic is that the appraiser has measured all functional obsolescence by starting with a replacement cost new instead of reproduction cost new. This is not correct. Starting from replacement cost new eliminates functional obsolescence caused by excess capital costs, but it does not take into account the future lost profits the buyer will incur after buying the subject with its excess operating costs. This operating penalty is independent of physical conditions existing in the property and reflects measurement of operating efficiency factors only. The operating expenses selected for comparison are only those that are controllable by process design and operating adequacy or those expenses that are incurred on-site as a result of production operations. After all, you are appraising the on-site assets and not a modern replacement, aren t you? Below is an example of where the various forms of functional obsolescence are investigated in the cost approach: Reproduction Cost New Less Functional Obsolescence due to Excess Capital Costs Equals Cost of Replacement Less Physical Deterioration Less Economic Obsolescence Less Functional Obsolescence due to Excess Operating Expenses Less Curable Depreciation Less Functional/Economic Obsolescence due to Necessary Capital Expenditures Equals Cost Indicator of Value of Improvements Plus Land Value Equals Cost Indicator of Value of Subject Property Note that economic obsolescence is deducted prior to the FO deduction. This is because all percentage deductions must be made prior to any dollar amount deductions. Mathematically, this is the correct order of deduction using the mathematical concept, orders of operations. Substitution is the underlying principle supporting the cost approach. According to this principle, a prudent purchaser would pay no more than the cost to acquire an equally desirable substitute. As a result of this principle, the cost or replacement typically is the starting point in the cost approach and, therefore, functional obsolescence due to excess operating expenses (operating obsolescence) will be the focus of this article. Typical Causes of Functional Obsolescence Due to Excess Operating Expense As previously mentioned, depending on the type of asset(s) being valued, functional obsolescence due to excess operating expenses may exist for several reasons including, but not limited to, the following: Excess energy consumption Excess labor Inefficient plant layout Excess scrap Yield loss Excess equipment Remsha, Reilly - 2

4 Understanding why FO exists helps determine how the valuation expert can analyze and quantify it. The remainder of this article provides four real life stories on how to quantify FO. Real Life Story #1 Power Generation One of the major reasons why FO exists in most almost all types of property is the difference in technology between older equipment and new modern equipment. In Real Life Story #1, the subject power generation facility was an old dog gasfired steam power plant built in the early 1970s. Comparing the subject to a new modern combined-cycle gas turbine plant provides indications of functional obsolescence; excess energy required to produce the same level of power and an excessive cost of labor to support plant operations and maintenance. To determine the amount of FO, an analysis was developed by analyzing distinct phases of the plant s operation to determine the present value of the excess operating expenses from continued operation. The analysis of operating expenses for the subject property was developed as follows: The excess operating costs were developed based on a comparison with a new modern combinedcycle gas turbine plant to arrive at the total annual excess expenses of continued operation of the appraised assets. An estimate was made of the remaining useful life of the properties, during which time the excess operating expenses would continue to exist. The present worth of the annual excess operating costs over the probable life expectancy was determined based on an after-tax rate of return. Because of the need for additional labor and maintenance to operate and maintain the subject plant, production costs become excessive when compared with the modern plant. A modern combined-cycle gas turbine plant would consume less energy than the subject due to advances in equipment technology and operations. The new modern plant is designed to have the same utility as the subject. Therefore, plant capacity and generation capacity are based on the actual level of performance as of the valuation date. Energy consumption for both the subject and the modern plant was calculated by multiplying the heat rate of the respective facility by the net generation. The price of fuel per million British thermal units ( MMBtu ) was developed by utilizing the current cost of natural gas in the subject s region. Total fuel cost for the subject and the modern plant was calculated by multiplying the energy consumption by the price of fuel. The difference of the two total energy costs is the annual excess operating expense differential. The net generation as of the valuation date was 580,260,000 kwh. The subject s heat rate was 11,000 Btu/kWh and the modern replacement s heat rate was 6,752 Btu/kWh. The heat rate of a generating plant is an indication of the amount of fuel energy (Btus) required to produce a product (kwhs). The price of fuel at the time of the valuation was $6.25 per MMBtu. The results of the annual excess energy penalty are shown as follows: Net Generation (kwh) Heat Rate (Btu/kWh) Total Energy Consumption (MMBtu) Price of Fuel ($/MMBtu) Annual Energy Subject Plant 580,260,000 11,000 6,382, ,893,000 Modern Replacement Plant 580,260,000 6,752 3,917, ,487,000 Annual Excess Energy Penalty 15,406,000 The total fuel costs for the subject was $39,893,000, while the total fuel costs for the modern plant was $24,487,000. Thus, the annual excess fuel cost differential for the subject is $15,406,000. This is a penalty of over $15 million per year that the subject property must endure when compared to a new modern competitor. The effect of excess labor was also considered. The subject plant currently has approximately 44 full-time employees. A modern replacement plant typically would require only 20 employees. This results in an excess of 24 employees at the subject as compared with a modern replacement plant. The subject s average annual labor cost, including benefits, per Remsha, Reilly - 3

5 employee is $140,000. Total labor cost for the subject and the modern plant was calculated by multiplying the total number of employees by the average labor cost. The difference of the two total labor costs is the annual excess operating cost differential. Labor Analysis Number of Employees Annual Labor Rate per Employee ($) Annual Labor Subject Plant ,000 6,160,000 Modern Replacement Plant ,000 2,800,000 Annual Excess Labor Penalty 3,360,000 Thus, the annual excess labor cost differential is $3,360,000. Adding the excess fuel and labor cost differentials results in a total excess operating cost penalty of $18,766,000 per year. After adjusting for the income tax benefit (40.5% composite state and federal tax rate), the annual excess operating cost differential is $11,165,770. The income tax benefit reflects the decrease in tax liability of the owner because of the reduced taxable income at the subject plant. To convert the annual operating cost differential into an indication of obsolescence, the differential was discounted over the remaining useful life during which this cost will continue to be incurred. A weighted average cost of capital ( WACC ), or discount rate, of 8.5% (less additional risk factors) for the subject was concluded based on the analysis of the merchant power industry. However, because the operating cost differential is discounted on a constant-dollar basis, the effect of anticipated growth, which was concluded to be approximately 2.5%, must be removed. Therefore, the discount rate to be applied for the operating cost differential on a constant-dollar basis is 6.0% (8.5% - 2.5%). This differential is calculated using the remaining useful life of five years for the subject. A chart showing a summary of the results is presented as follows: REAL LIFE STORY #1 - POWER GENERATION FUNCTIONAL OBSOLESCENCE DUE TO EXCESS OPERATING EXPENSE Energy $15,406,000 Labor 3,360,000 Total Annual Excess Operating Penalty $18,766,000 Less Income Tax Benefit at 40.5% 7,600,230 Annual Excess Operating Expense After-Tax $11,165,770 Present Value Remaining Useful Life (Years) 5 Discount Rate 8.5% Growth 2.5% Adjusted Discount Rate 6.0% Present Value Factor Functional Obsolescence Due to Excess Operating Expense $47,030,223 Based on the analysis, functional obsolescence due to excess operating expenses or operating obsolescence is indicated to be $47,030,223. The above analysis was developed on an after-tax basis where the annual penalty was adjusted downward for the income tax benefit. The after-tax penalty was then developed into a functional obsolescence deduction using an after-tax discount rate. The same analysis can be developed on a before tax basis, where the income tax benefit would not be deducted, resulting in a larger penalty to discount. The larger penalty would be discounted using a before tax discount rate, which would be a higher discount rate. The result of the before tax functional obsolescence deduction may not be the exact number as the after-tax number, but if done correctly, should be close to the above deduction. Real Life Story #2 Oil Refinery Significant technological advances have been made in oil refinery technology, energy conservation and process configuration over the years which a prudent investor would consider if constructing a refinery today. The use of new Remsha, Reilly - 4

6 technology results in higher production yields, increased control, reduced labor requirements and utility costs, reduced chemical and catalyst expense, and greater operating flexibility for a given throughput. The primary factors to be considered when investigating functional obsolescence in an oil refinery are labor, energy, margin (yield), and the cost of chemicals and catalysts. At the date of the analysis, the subject oil refinery in Real Life Story #2 had 850 full-time employees. For this analysis, it was determined that a modern replacement refinery (of the same capacity) would require 558 employees. The subject s average annual labor cost, including benefits, per employee is $75,000. The following table summarizes the results of the labor analysis: Number of Employees Annual Labor Rate per Employee ($) Annual Labor Subject Plant ,898 43,263,000 Modern Replacement Plant ,898 28,401,084 Annual Excess Labor Penalty 14,862,216 Hence, the excess labor cost differential for the subject is $14,862,216 per year. When comparing a modern replacement refinery with the subject refinery, excessive energy consumption becomes apparent due to the annual requirements for electricity and natural gas. The subject refinery is a large facility that has long pipe runs and some older equipment that requires excess energy. A modern refinery would have shorter pipe runs, more energy-efficient rotating equipment, and modern furnaces that would allow for more efficient energy usage. In addition, older oil refineries must purchase natural gas as a fuel source to supplement refinery gas produced on site. New modern refineries can supply 100% of their fuel needs with refinery gas produced on site. When oil refineries were built, energy was cheap, and energy conservation was not an issue. Today, the cost of fuel is expensive and is an issue. An analysis of the energy requirements of the modern replacement plant, based on total energy consumption, in comparison with the subject refinery s actual operating results, indicated that the modern replacement would be significantly more energy efficient. Until the 1970s, energy was very inexpensive in comparison with the capital required to conserve energy. The refinery has many process units and off-sites that are very old. Hence, many process units were designed and constructed with energy inefficiencies. Construction features to reduce energy consumption would include compact layout of the process units, high-efficiency furnaces and boilers, and the use of waste heat streams for reheating other process streams. The analysis of the annual excess operating cost penalty resulting from the projected annual energy requirements is presented as follows: Electricity ($) Purchased Fuel ($) Total Energy Subject Plant 20,530,688 10,761,197 31,291,885 Modern Replacement Plant 24,329,280-24,329,280 Annual Excess Energy Penalty 6,962,605 Based on the above chart, the annual excess operating cost penalty for energy consumption the subject refinery will sustain over its remaining life is $6,962,605. A new modern oil refinery, utilizing processing units with current technology, also would be able to utilize catalysts and chemicals more efficiently using lower quantities and, hence, reduce the annual operating expense. The analysis follows: Catalyst and Chemical Cost Energy Analysis Fluid Bed Catalyst ($) Additives ($) Acids, Caustic and Other ($) Fixed Bed Catalyst ($) Annual Catalyst and Chemical Subject Plant 2,917, ,802 14,418,998 2,514,758 20,834,110 Modern Replacement Plant ,093,280 Annual Excess Catalyst and Chemical Penalty 9,740,830 Based on the above, the annual excess operating cost penalty is $9,740,830. Remsha, Reilly - 5

7 A modern oil refinery, processing the same crude oil as the subject, would be able to develop a slate of products of more value than the subject. Because of a more efficient control system and more balanced process units, the gross margin of the modern replacement refinery would realize a higher gross margin and hence, an increased yield. The analysis follows: Subject Plant $260,735,515 Modern Replacement Plant 287,551,647 Annual Gross Margin Penalty $ 26,816,132 Based on the above, the annual gross margin or yield penalty is $26,816,132. Based on the above, the annual excess operating cost penalty the subject refinery must endure over its remaining life is summarized as follows: Labor Energy Catalyst and Chemicals Yield Loss $14,263,300 6,962,605 9,740,830 26,816,132 Total $58,381,783 Functional obsolescence, or operating obsolescence, for the oil refinery is calculated as follows: REAL LIFE STORY #2 - OIL REFINERY FUNCTIONAL OBSOLESCENCE DUE TO EXCESS OPERATING EXPENSE Total Annual Excess Operating Expense Penalty $58,381,783 Less Income Tax 40.1% 23,411,095 Total Annual Excess Operating Expense After Tax $34,970,688 Present Value Remaining Life (Years) 10 Discount Rate 13.0% Growth 3.5% Adjusted Discount Rate 9.5% Present Value Factor Functional Obsolescence Due to Excess Operating Expense $219,581,000 Hence, an operating obsolescence penalty in the amount of $219,581,000 must be deducted in the calculation of the cost approach indicator of value. Applying this level of operating obsolescence in the cost approach in addition to other forms of depreciation drove the cost indicator of value to a negative value for the subject refinery, as seen below: Reproduction Cost $1,572,000,000 Functional Obsolescence ( FO ) Due to Excess Capital Costs 25,000,000 Replacement Cost Physical Deterioration ( PD 39% 1,547,000, ,000,000 Cost Less PD 944,000,000 Economic Obsolescence ( EO ) 220,000,000 Functional Obsolescence Due to Excess Operating Expense 219,581,000 Environmental FO/EO CAPEX 558,119,000 Cost Indicator of Value ($53,700,000) This causes the question, Why is this oil refinery even operating? Considering the high levels of depreciation quantified in the investigation and the high magnitude of environmental capital investments required to allow the oil refinery to continue to operate, any prudent investor would ask the same question. The refinery did shut down within a few years after the appraisal date. The environmental expenditures were never made. Remsha, Reilly - 6

8 Real Life Story #3 Tire Manufacturing In Real Life Story #3, the subject facility was an old outdated tire manufacturing facility. Discussions were held with plant management and engineers to understand the operational differences between the subject facility and a new modern facility. The subject plant was built in the 1970s. Over the years, manufacturing changes had been made and equipment added, and the result was an inefficient manufacturing layout that required excessive labor and energy and produced excessive scrap during the manufacturing process. A new modern facility would have an efficient plant layout and automated equipment that would result in a reduced labor force, less energy consumption, and a reduction in scrap. You will notice that two of the causes of functional obsolescence are the same as the power plant Real Life Story #1 (excess labor and energy). However, you will also notice that excess scrap in this real life story contributed to additional functional obsolescence and, overall, a reduction in value of the plant. The subject plant currently had 2,100 full-time employees. A modern replacement plant would require 1,200 employees. This results in an excess of 900 employees. The subject s average annual labor cost, including benefits, per employee is $75,000. The difference of the two total labor costs is the annual excess labor cost differential, as shown as follows: Number of Employees Remsha, Reilly - 7 Annual Labor Rate per Employee ($) Annual Labor Subject Plant 2,100 75, ,500,000 Modern Replacement Plant 1,200 75,000 90,000,000 Annual Excess Labor Penalty 67,500,000 Hence, the excess labor cost differential that the subject is anticipated to incur over its remaining useful life is $67,500,000 per year. The effect of excess energy was also considered. A modern tire manufacturing plant would consume less energy than the subject due to advances in equipment technology. As in the previous examples, the modern plant is designed to have the same utility as the subject. Therefore, plant annual tire production is based on the actual level of performance as of the valuation date and is the same for both the subject plant and the modern replacement plant. In this case, the energy consumption for both the subject and the modern plant was provided by the company s engineering group. The price of fuel was developed by utilizing the current cost of natural gas in the subject s region. Total fuel cost for the subject and the modern plant was calculated by multiplying the total energy consumed by the price of fuel. The difference of the two total energy costs is the annual excess operating cost differential. The results of the annual excess energy penalty are shown as follows: Total Energy Consumed (MMBtu) Cost of Energy per MMBtu ($) Current Production (lbs) Energy Consumption (MMBtus/1,000 lbs) Annual Energy Subject Plant 285,000, ,707, ,538,000 Modern Replacement Plant 285,000, ,140, ,700,000 Annual Excess Energy Penalty 7,838,000 Thus, the annual excess fuel cost differential of the subject is $7,838,000. Scrap becomes excessive when compared with the modern plant because of the inefficiency, lack of machine tolerances, and the old nonautomated manufacturing equipment. Replacing the old equipment with new modern equipment would greatly reduce the amount of scrap produced primarily because of less material handling issues. During discussions with the plant engineers, the percentage of total scrap per tire was provided for both the subject and modern replacement plant. The current level of production was 12,500,000 tires per year. Multiplying the annual tire production by the percent of scrap per tire resulted in the amount of tires per year scrapped. The cost to the manufacturer for each tire was $ Multiplying the manufacturing cost per tire by the number of scrapped tires results in the total

9 yield or value lost per year caused by excessive scrap. The results of the annual excess scrap penalty are shown as follows: Percentage of Total Scrap per Tire Cost of Scrapped Tire Production ($) Annual Scrap Current Tire Production Tire Production Scrapped per Year Subject Plant ,500, , ,453,000 Modern Replacement Plant ,500, , ,156,000 Annual Excess Scrap Penalty 4,297,000 The total annual scrap cost for the subject was $9,453,000, while the total annual scrap cost for the modern plant was $5,156,000. Thus, the annual excess scrap cost differential is $4,297,000. Adding the annual excess fuel cost, labor cost, and scrap cost differential that the subject is anticipated to endure over its remaining useful life results in a total excess operating cost of $79,635,000. This differential is calculated using the remaining useful life of the subject plant and is shown as follows: REAL LIFE STORY #3 - TIRE MANUFACTURING FUNCTIONAL OBSOLESCENCE DUE TO EXCESS OPERATING EXPENSE Labor Energy Scrap Total Annual Excess Penalty Less Income Tax Benefit at 39.5% $ 67,500,000 7,838,000 4,297,000 $ 79,635,000 31,455,825 Annual Excess Operating Expense After-Tax $ 48,179,175 Present Value Period (Years) 10 Discount Rate 9.0% Growth 2.5% Adjusted Discount Rate 6.5% Present Value Factor Functional Obsolescence Due to Excess Operating Expense $346,360,089 Based on the analysis, functional obsolescence due to excess operating expenses is $346,360,089 for the subject tire manufacturing plant equipment. Real Life Story #4 Nuclear Power Plant In Real Life Story #4, the subject facility was a nuclear power plant. The analysis was performed in the late 1990s; at that time, building a nuclear power plant was not an option. It wasn t politically possible! The question then becomes what type of technology would one utilize in a cost approach to replace a nuclear power plant. At the time of the appraisal, we were in the midst of the new deregulation phenomena sweeping the nation, and everyone wanted to own, operate, and build natural gas-fired power plants. Therefore, for the replacement plant, a series of combined-cycle gas turbines ( CCGT ) were used. The cost of construction of a CCGT is very inexpensive when compared to a nuclear plant. Discussions were held with plant management and engineers to understand the operational differences between the subject facility, a nuclear plant, and a new modern CCGT. The difference in technologies between the subject and the replacement plant creates some interesting and critical differences when analyzing the level of functional obsolescence. A nuclear power plant requires a large labor force, has numerous complex control systems, and requires large amounts of operating expenses. A CCGT plant requires a small labor force and requires lower operating expenses when compared to a nuclear plant. Overall, the fixed and variable operating expenses at the subject are much larger than at the replacement plant. The difference in fixed and variable operating expenses is calculated as follows: Remsha, Reilly - 8

10 Subject Plant $318,689,826 Modern Replacement Plant 54,599,824 Annual Excess Operating Penalty $264,090,002 As in the first real life story (power generation), excess energy consumption must also be considered as a form of functional obsolescence. For both the subject and the modern replacement plant, excess energy consumption was calculated by multiplying the heat rate by the net generation. The price of fuel per MMBtu for the CCGT plant was developed by utilizing the current cost of natural gas in the subject s region. The price of fuel per MMBtu for the subject plant was developed by utilizing the current cost of uranium in the subject s region. Total fuel cost for the subject and the modern plant was calculated by multiplying the energy consumption by the price of fuel. The difference of the two total energy costs is the annual excess operating cost differential. The net generation as of the valuation date was 15,602,611,000 kwh. The subject s heat rate was 10,397 Btu/kWh and the modern replacement s heat rate was 6,852 Btu/kWh. Because the subject plant utilized uranium and the replacement plant utilizes natural gas, there is a large difference in price of fuel between the two. The price of uranium at the time of the valuation was $0.50 per MMBtu, while natural gas was $3.60 per MMBtu. The following chart shows the results of the annual excess energy penalty. The difference in fuel prices between uranium and natural gas is very significant. Net Generation (kwh) Heat Rate Remsha, Reilly - 9 Total Energy Consumption (MMBtu) Price of Fuel ($/MMBtu) Annual Energy (Btu/kWh) Subject Plant 15,602,611,000 10, ,220, ,110,000 Modern Replacement Plant 15,602,611,000 6, ,909, ,873,000 Annual Excess Energy Penalty 303,763,000 It is interesting to note that the annual energy cost for the subject is significantly less than the replacement plant. Adding the annual excess energy cost, and the fixed and variable operating expense differential that the subject is anticipated to incur over its remaining useful life, results in a total excess operating cost of negative $39,672,998. A summary of the functional obsolescence analysis results is presented as follows: REAL LIFE STORY #4 - NUCLEAR POWER PLANT FUNCTIONAL OBSOLESCENCE DUE TO EXCESS OPERATING EXPENSE Energy ($303,763,000) Fixed Variable Operating Expense 264,090,002 Total Annual Excess Penalty ($39,673,998) Less Income Tax Benefit at 40.0% (15,869,199) Annual Excess Operating Expense After-Tax ($23,803,799) Present Value Period (Years) 30 Discount Rate 9.1% Growth 2.5% Adjusted Discount Rate 6.6% Present Value Factor 12,924 Functional Obsolescence Due to Excess Operating Expense ($307,640,298) Based on the analysis, functional obsolescence due to excess operating expenses (operating obsolescence) is indicated to be negative $307,640,298. Can functional obsolescence be negative and does it make sense? The answer to both of those questions is... yes! While the functional obsolescence penalty is negative, the cost to replace a nuclear plant with CCGTs (the starting point of the cost approach) is significantly less. While the fixed and variable operating expenses are significantly higher for a nuclear plant compared to a CCGT, the cost of uranium is significantly lower than natural gas.

11 Hence, it is more expensive to operate a CCGT, resulting in negative FO. Applying negative FO to the cost approach creates an addition (two negatives make a positive) for FO obsolescence. If one hypothetically replaces the nuclear plant with a nuclear plant, the cost to replace would be higher, but one also would have a smaller amount of functional obsolescence to deduct, not a large amount to add back in the case of replacing with the CCGT. In theory, the results of the cost approach whether one replaces the subject with a nuclear plant or a CCGT should theoretically be the same. The following table shows a side-by-side comparison of the cost approach summary with both a nuclear plant and a CCGT as a modern replacement. Subject Nuclear Plant ($) Modern CCGT Plant ($) Reproduction Cost 2,000,000,000 Replacement Cost 1,000,000,000 Physical Deterioration ( PD 50% 1,000,000, ,000,000 Cost Less PD 1,000,000, ,000,000 Operating Obsolescence 200,000,000 (307,600,000) Economic Obsolescence 0 0 Cost Indicator of Value 800,000, ,600,000 When developing the cost indicator of value, the analyst must investigate the market to determine what technology would represent a new modern replacement for the subject property. In the case of a nuclear plant, would an investor spend an additional billion dollars in construction costs and realize inexpensive fuel costs over the next 50 years, or spend less to build the plant and experience higher fuel costs? The answer in 1999 might be different than in 2010! Conclusion The above real life analyses show that functional obsolescence can be identified and quantified. It requires the valuation expert to be knowledgeable of the technology changes in the industry the subject property is property in and, also, where to obtain the necessary data needed to quantify functional obsolescence. The cost approach is especially useful for unique property where sales do not exist and an income approach is not possible. In the cost approach, the current cost of the property being valued, less all forms of depreciation and obsolescence, plus land value (if required), is developed. One problem, however, is that the valuation expert must be knowledgeable of the industry s economics and technology. Preparing a complete and detailed cost indicator of value is very time consuming, but if done right, the cost approach can produce the most subject-specific detail of any of the three indicators of value. In some industries, published data discussing new construction and operating characteristics are available. It is not uncommon to work with an engineering firm to design a new modern replacement plant using technology available as of the appraisal date. The engineering firm will also provide fixed and variable operating expenses for the replacement plant to be compared against the subject property to quantify operating obsolescence. This is especially useful if a new modern plant has not been built in many years. Often, the owner of the subject property will have actual plants that represent a new modern plant that can be utilized in the analysis. All three indicators of value, cost, income and sales comparison, reflect the market. The market is defined by the actions of buyers and sellers, projections of product and raw material prices, operating expenses, future capital investments, environmental requirements and their costs, the required returns of equity investors, the cost of debt, an industry capital structure, the cost of new modern construction, all forms of depreciation and obsolescence, and industry economics. Remsha, Reilly - 10

12 Michael J. Remsha, P.E., ASA, CMI, is a managing director and vice president with American Appraisal Associates, Inc., in Milwaukee, Wisconsin. In this capacity, he provides direction and technical support on the valuation of specialpurpose and personal property, specializing in utilities and the petrochemical industries. Mr. Remsha has valued properties throughout the world and has been a full-time appraiser since Kevin S. Reilly, ASA, is a senior manager with American Appraisal Associates, Inc., in Milwaukee, Wisconsin. In his role, he is responsible for the valuation and oversight of complex property valuations. Mr. Reilly is experienced in valuations in the electrical generation, petrochemical, telecom, airline, and general manufacturing industries. He has been a full-time appraiser since References: Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets, Copyright 2005, American Society of Appraisers, Washington, D.C. Remsha, Reilly - 11