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Functional and Physical Obsolescence in Property Tax

Strategies for Reducing Real and Business Personal Property Valuations

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Dorothy Radicevich Managing Director True Partners Consulting Chicago 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, S enior Manager, Real Estate and Related Assets Group, American Appraisal Associates,

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F ti l d Ph i l Ob l Functional and Physical Obsolescence in Property Tax Webinar

April 21, 2011 Todd Barron, Barron Corporate Tax S

• lutions

tbarron@ barrontax.com Dorothy Radicevich, True Partners Consulting dorothy.radicevich@ TPCtax.com Gregory Kort, Popp Gray & Hutcheson greg@ property-tax.com Kevin Reilly, American Appraisal kreilly@ american-appraisal.com

Today’s Program

Overview Of Valuation Approaches [Dorot hy Radicevich] S lide 7 – S lide 18 Physical Deterioration And Functional Obsolescence [Todd Barron] Calculating, Accounting For Physical Depreciation and S lide 19 – S lide 39 S lide 40 – S lide 51 Functional Obsolescence [Gregory Kort and Kevin Reilly] Case S tudies On Making An Obsolescence-Based Argument S lide 52 – S lide 83 [Gregory Kort , Dorot hy Radicevich, Todd Barron, Kevin Reilly]

OVERVIEW OF VALUATION

Dorothy Radicevich, True Partners Consulting

OVERVIEW OF VALUATION APPROACHES

Si ifi Of P T Significance Of Property Taxes

$215 billion $215 billion $215 billion $215 billion

8

Significance Of Property Taxes (Cont.)

35%

9

Significance Of Property Taxes (Cont.)

10

Wh I F i M k V l ? What Is Fair Market Value?

• S

tates may define value differently

• Michigan: True cash value

Texas: Appraised/ market value

• Indiana: True tax value

Florida: Just value

• S

tates generally follow appraisal industry’s definition of FMV:

• S

tates generally follow appraisal industry s definition of FMV:

• The most probable price, as of a specified

date, in cash, or in t erms of equivalent t o

cash, or in ot her precisely revealed t erms, for which t he specified propert y right s should sell aft er reasonable exposure in a compet it ive market under all condit ions requisit e t o a fair sale, wit h t he buyer and seller each act ing prudent ly, knowledgeably, and for self-int erest , and assuming t hat neither is under undue

duress.

• Appraisal Institute

11

F i M k V l C Fair Market Value Concept

• Assessor’s principal duty is to determine FMV of property.
• FMV: What a willing buyer would pay to a willing seller in an

k t

• pen market

Assessor can utilize three Approaches to value: Income Approach Market Approach Cost Approach

FMV

12

I A h T V l Income Approach To Value

• Value of an investment property

reflects the quality and quantity of income it is expected to generate income it is expected to generate

• ver its life.
• Means of converting future benefits

to present value

• Essential to the approach is the idea

that income to be received in the that income to be received in the future is less valuable than income received today.

13

Sales Comparison (Market Value) Approach

• The sales comparison approach is

a correlation of the subj ect property with comparable sales, property with comparable sales, adj usting those comparable sales to the characteristics of the bj t t L k f d t i subj ect property. Lack of data is maj or stumbling block in using this method. Many states do not y require statement of market value in purchase documents.

14

C A h Cost Approach

• The cost approach assumes value of an

asset cannot exceed cost to reconstruct or replace it with another of like utility.

• Replacement cost new (RCN) establishes

the highest amount a prudent investor would pay for an asset. To the extent assets are not new, the RCN is adj usted for losses in value due to physical deterioration and

• bsolescence.
• Obsolescence is a loss in value due to

factors internal and external to an asset.

15

C A h (C ) Cost Approach (Cont.)

• Mass appraisal cost approach: Assessor trends taxpayer’s

historical data by inflation factors in order to derive a value known as reproduction cost new.

• Inaccurate assumption is:

Reproduction cost new = Replacement cost new

• Not accounting for excess cost and obsolescence

g

• Assessor’s risk: The trends are not always current, so there is a

lag between the assessor’s trends and the current market value.

16

C A h (C ) Cost Approach (Cont.)

Reproduction Cost New Replacement Cost New Excess Capital Cost

Physical det eriorat ion

Physical Depreciation F ti l Ob l

Physical det eriorat ion is a loss in value result ing from wear and t ear from use or t i

Functional Obsolescence Economic Obsolescence

exposure t o various element s.

Asset Costs

Fair Market Value

17

Ph i l D i i Physical Deterioration

• Expected on most equipment
• Not abnormal unless equipment is put to extensive use or

misused misused

• Curable: Cost to correct deficiency is less than resulting

economic benefit Incurable: Cost to correct deficiency is greater than resulting economic benefit

• Capitalized cost

Depreciation = Book value (accountant)

• Capitalized cost —Depreciation = Book value (accountant)

vs. Estimate of depreciation that directly relates to the Estimate of depreciation that directly relates to the actual loss in value the property has incurred (appraiser)

18

PHYSICAL DETERIORATION

Todd Barron, Barron Corporate Tax Solutions

PHYSICAL DETERIORATION AND FUNCTIONAL OBSOLESCENCE

Accrued Depreciation Accrued Depreciation

Loss in value from all of the causes of deterioration and obsolescence Loss in value from all of the causes of deterioration and obsolescence (physical, functional and external) Th diff b ’ d i f i k l = The difference between an asset’s cost new and its fair market value

20

Accrued Depreciation (Cont.) Accrued Depreciation (Cont.)

Why do we need to consider accrued depreciation in our analysis? Samuel Ichiye Hayakawa Samuel Ichiye Hayakawa Samuel Ichiye Hayakawa Samuel Ichiye Hayakawa

21

Accrued Depreciation (Cont.) Accrued Depreciation (Cont.)

Cow one … Cow one …

22

Accrued Depreciation (Cont.) Accrued Depreciation (Cont.)

Cow one … Cow one … is not is not Cow two. Cow two.

Language in Thought & Action

23

Blower Being Assessed Blower Being Assessed

24

New Blower New Blower

25

Why accrued d i i ? depreciation? The asset being i d i appraised is not new. not new.

26

Accrued Depreciation (Cont.) Accrued Depreciation (Cont.)

Question: What is “wrong” with the asset being assessed that would cause a buyer to pay less for it than for a new asset?

27

Physical Deterioration Physical Deterioration

Loss in value due to physical wear and tear during usage and/or from the forces of nature

28

Physical Deterioration (Cont.) Physical Deterioration (Cont.)

Causes and sources A f t

• Age of asset
• Usage over time
• Maintenance schedule
• Natural elements
• Other physical factors

29

Physical Deterioration (Cont.) Physical Deterioration (Cont.)

Causes and sources

• Age of asset
• Usage over time

M i t h d l

• Maintenance schedule
• Natural elements
• Other physical factors

Question: What is “wrong” with the asset being assessed that would cause a buyer to pay less for it than for a new asset?

30

Functional Obsolescence Functional Obsolescence

Loss in value due to the inability of the asset to perform adequately the function for which it is used; this can be considered a deficiency or a super- adequacy adequacy

31

Functional Obsolescence (Cont.) Functional Obsolescence (Cont.)

Causes and sources

• Technological innovation
• Production improvements
• Design changes
• Super-adequate design
• Inadequate design

q g

32

Functional Obsolescence (Cont.) Functional Obsolescence (Cont.)

Causes and sources (Cont.) ( )

• Technological innovation

P d ti i t

• Production improvements
• Design changes
• Super-adequate design
• Inadequate design

Question: What is “wrong” with the asset being assessed that would cause Q g g a buyer to pay less for it than for a new asset?

33

Functional Obsolescence (Cont.) Functional Obsolescence (Cont.)

34

Functional Obsolescence (Cont.) Functional Obsolescence (Cont.)

35

Functional Obsolescence (Cont.) Functional Obsolescence (Cont.)

36

Functional Obsolescence (Cont.) Functional Obsolescence (Cont.)

Properties affected P l t d f iliti ith b ttl k

• Process-related facilities with bottlenecks
• Facilities expanded over time
• Facilities with redundant production lines
• High-tech facilities with rapid tech changes
• Facilities with higher operating cost structures than modern

replacements

• Facilities with inactive machinery

37

Curable Vs. Incurable Curable Vs. Incurable

Curable deterioration or obsolescence is economically feasible to cure Curable deterioration or obsolescence is economically feasible to cure through replacement or repair, since the value added by the cure exceeds the cost of the cure.

38

Curable Vs. Incurable (Cont.) Curable Vs. Incurable (Cont.)

Incurable deterioration or obsolescence is not economically feasible to cure Incurable deterioration or obsolescence is not economically feasible to cure through replacement or repair, since the value added by the cure does not exceed the cost of the cure.

39

Gregory Kort, Popp Gray & Hutcheson

CALCULATING, ACCOUNTING

Gregory Kort, Popp Gray & Hutcheson Kevin Reilly, American Appraisal

, FOR PHYSICAL DEPRECIATION AND DEPRECIATION AND FUNCTIONAL OBSOLESCENCE

Physical Depreciation Physical Depreciation

• Physical depreciation is the loss in value or usefulness of a

property due to the using up or expiration of its useful life caused by d t d t i ti t i l t h i l wear and tear, deterioration, exposure to various elements, physical stress and similar factors. Curable physical depreciation – Curable physical depreciation – Incurable physical depreciation

41

Cost Approach Summary Cost Approach Summary

• Reproduction or replacement cost new
• Less physical depreciation
• Less functional obsolescence

L t l/ i b l

• Less external/economic obsolescence
• Plus value of land as if vacant
• Equals cost approach indicator of value

42

Measuring Physical Depreciation Measuring Physical Depreciation

• Observation method

– Iowa curves – Marshall & Swift tables

• Age-life method

– Ratio of effective age compared with total physical life

• Direct dollar measurement

– Cost to cure

• Indirect methods

– Market extraction for total depreciation

43

Sources Of Data Sources Of Data

• American Society of Appraisers (MT&S)
• Fixed-asset listings with historical costs
• Maintenance records
• Future capital spending plans
• Plant management

g

44

Taxing Authorities’ Viewpoint Taxing Authorities Viewpoint

• One-size-fits-all approach
• Mass appraisal methods may limit quantification of all forms of

Mass appraisal methods may limit quantification of all forms of depreciation and obsolescence.

• Obsolescence and depreciation hard to quantify
• Obsolescence and depreciation hard to quantify
• Temporary situation

45

Example: Physical Depreciation Example: Physical Depreciation

Description Reproduction Cost New Effective Age Physical Life Age/Life Product Line 1 $300,000 20 30 67% Product Line 2 $200,000 15 30 50% Utilities $150 000 18 40 45% Utilities $150,000 18 40 45% Buildings $50,000 20 50 40% Shipping & $100 000 18 50 36% Shipping & Storage $100,000 18 50 36% Total $800,000 53%

Reproduction Cost New $800,000 Less Physical Depreciation @ 53% $424,000 (PD) RCN Less Physical Depreciation $376,000 (RCNLD)

46

F ti l Ob l Functional Obsolescence

Functional obsolescence is the loss in value or usefulness of a property caused by inefficiencies or inadequacies of the property itself, when compared with a more efficient or less costly modern replacement property that new technology has developed.

• Functional obsolescence from excess capital costs
• Difference between reproduction cost and replacement cost
• Functional (operating) obsolescence from excess operating

expenses

• Caused by excess operating expenses of the subject when

compared with its modern replacement

• When operating expenses of the subject property are less than of

the modern replacement the analysis results in a net benefit (not a the modern replacement, the analysis results in a net benefit (not a penalty) for the subject property.

47

C t A h S Cost Approach Summary

Reproduction cost new Less FO from excess capital costs p Equals cost of replacement Less depreciation Ph i l d t i ti

• Physical deterioration
• FO from excess operating expenses
• Economic obsolescence

Equals the cost indicator of value

48

Causes Of Functional Obsolescence

Is the loss in value of a property caused by inefficiencies

• r

inadequacies of the property itself?

• Excess operating expenses

p g p

• Energy consumption
• Excess labor

Inefficient plant layout

• Inefficient plant layout
• Excess scrap
• Loss of yield (Profits)
• Excess equipment
• Every plant/facility is different.
• The key is understanding the causes of excess operating
• The key is understanding the causes of excess operating

expenses specific to the subject property.

49

Determining Modern Replacement Data

• Good sources of data

Good sources of data

• Government data (Energy Information Administration “EIA”)
• Benchmarking reports
• Solomon reports (refining power)
• Solomon reports (refining, power)
• Townsend reports (chemicals)
• Harbour reports (automotive)

Market information from recently built facilities

• Market information from recently built facilities
• Engineering firms
• The owner of the facility
• Be independent; use market data
• Have supportable data
• Know your audience: Make it easy to explain

50

Si l E l Simple Example

Simple Example Same Capacity and Utility Functional Obsolescence Due to excess operating expenses

Modern Replacement

Reduces Income Tax Liability “a Positive” Remaining Life of the

Subject Plant Annual Cost of Operations (Operating Expenses) $1,000,000 $500,000 Difference $500,000

Remaining Life of the Penalty Low Risk WACC Less Penalty

Income Tax @ 40% $200,000 After Tax Penalty $300,000 Present Value Period in Years 20

Less Penalty Growth

Period in Years 20 Discount Rate 8.0% Present Value Factor 9.818 Functional Obsolescence Due To Excess Operating Expenses 2 945 400 51 Expenses 2,945,400

Gregory Kort, Popp Grey & Hutcheson Dorothy Radicevich, True Partners Consulting Todd Barron, Barron Corporate Tax Solutions

CASE STUDIES ON MAKING AN

Todd Barron, Barron Corporate Tax Solutions Kevin Reilly, American Appraisal

OBSOLESCENCE‐BASED ARGUMENT ARGUMENT

Kort Case Study No. 1: Depreciation Schedules

• Subject property is an auto assembly plant.
• Assessor cost approach fails to account for all forms of depreciation

and obsolescence.

• Physical depreciation is understated through use of a 10-year life for

l f t i i t general manufacturing equipment.

• Revise physical depreciation schedules using an 8-year life

53

Depreciation Schedule Impact Depreciation Schedule Impact

Summary of Machinery & Equipment Depreciation Schedules - % Good Factors

Effective Assessor 8 Year Assessor 10 Year Year Effective Age Assessor - 8 Year Depreciation Guidelines Assessor - 10 Year Depreciation Guidelines Michigan QAM 2010 1 88% 90% 73% 2009 2 77% 81% 60% 2008 3 67% 73% 51% 2007 4 59% 66% 44% 2006 5 51% 59% 38% 2005 6 45% 53% 28% 2004 7 39% 48% 27% 2004 7 39% 48% 27% 2003 8 34% 43% 26% 2002 9 26% 39% 25% 2001 10 19% 35% 24% 2000 11 14% 28% 23% 1999 12 11% 22% 22% 1998 13 11% 18% 21% 1997 14 11% 14% 21% 1996 15 11% 11% 20%

Floor value reached in year 12

54

Depreciation Schedule Comparison Depreciation Schedule Comparison

Machinery & Equipment Depreciation Schedules Comparison

100% 80% 90% 50% 60% 70%

• d Factors

Tax savings for current and future years

30% 40% % Goo 0% 10% 20% 0% 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 8 Year 10 Year Michigan QAM

55

Typical Assessor Cost Approach Typical Assessor Cost Approach

• RCN = Historical cost x trend factor
• Physical depreciation derived from table or curve: % good factor

(%GF)

• Functional and economic obsolescence accounted for with a

i f t (SF) service factor (SF)

• Cost indicator of value = RCN x %GF x SF

56

Service Factors: Common Errors Service Factors: Common Errors

• Common errors in this approach are:

– The assumption that “economic inutility” includes all forms

• f functional and economic obsolescence

– Excluding curable functional obsolescence items – Excluding curable economic obsolescence items

57

Kort Case Study No. 2: Service Factors Kort Case Study No. 2: Service Factors

Manufacturing Plant

Reproduction Cost New $800,000 (Indexed Historical Cost) Physical Depreciation 53% (47% GF) Current Production 2,500 units/day Cost to Cure Process Bottleneck $100,000

Assessor Cost Approach Reproduction Cost New x %GF x SF = Cost Indicator of Value $800,000 x .47 x .734 = $276,000

58

R di i h Ob l S d Radicevich Obsolescence Study

ABC Co ABC Co. Semi-Truck Trailer Plant North Plant Tax Year 20xx Assessment Quantification of Abnormal Obsolescence Abnormal Obsolescence Pursuant To 50 IAC 4.2-4-8: ABC Co. designs, manufactures and markets st andard and customized truck trailers and related transportation equipment at its plants. The current economic conditions are negatively affecting ABC Co., which is reflected in reduced production figures. Fuel, steel, d l i t t d hi h d i hi h R t i l d t t and aluminum costs are at record highs and going higher. Raw material and component costs are rising at unprecedented rates and to levels never before seen. As of the assessment date

• f March 1, 20xx, the north plant’s rated production capacity is 49,149. However, due to the

current economy, lack of demand, the current price of fuel and other adverse conditions, the north plant is expected to produce an estimated 23,007 or fewer trailers annually for the p p p , y foreseeable future. ABC Co. claims an abnormal obsolescence adj ustment in the computation of true tax value pursuant to 50 IAC 4.2-4-8. The loss of value of personal property at both plants occurred as a result of adverse market conditions in the trailer industry and more generally in the economy, which was unanticipated and unexpected and could not have been reasonably foreseen by a which was unanticipated and unexpected and could not have been reasonably foreseen by a prudent business person. ABC Co. is unable to economically adapt the property to a different use.

59

Radicevich Obsolescence Study (Cont.)

• The current trailer industry is again suffering one of its worst years in

recent history. Lack of demand for trailers, the extremely high price of fuel and competition have conspired to create an unforeseen i t f ABC C Th th l t d d 47%f t il environment for ABC Co. The north plant produced 47%fewer trailers than the previous year, and ABC Co. does not anticipate that trend reversing in the near future. The graph below illustrates trailer production (actual or proj ected) at the north plant from 200x 20xx: production (actual or proj ected) at the north plant from 200x-20xx:

50000 10000 20000 30000 40000 Rated Capacity Trailer Production 200x 200x 200x 200x 200x 200x

60

Radicevich Obsolescence Study (Cont.)

• Based upon the analysis the inutility percent as it relates to the
• Based upon the analysis, the inutility percent as it relates to the

computation of abnormal obsolescence is 41% for tax year 20xx (see calculation below).

l l Inutility Formula: Actual Production = Trailers Assembled Rated Capacity = Plant Trailers Capacity n = S cale Factor of 0.7 based on average population of industry range. Key Company Statistics: Trailer Production As Of 02/ 28/ 200x: 23,007 Total Capacity: 49,149 Inutility Percent Calculation:

Inutility Percent = 100 49,149 23,007 1

                 

Inutility Percent: 41

61

Radicevich Obsolescence Study (Cont.)

• Pursuant to Rule 50 IAC 4.3-9-6, taxpayer claims an adj ustment

for abnormal obsolescence on all tangible personal property at the north plant as outlined below the north plant, as outlined below.

Original Cost As Of March 1, 2009 $107,013,785 g , $ , , True Tax Value of Assets Prior To Adj ustment For Abnormal Obsolescence $31,491,299 Less: Allowable Adj ustment for 41% Extraordinary Abnormal Obsolescence ($12,911,433) Total True Tax Value After Adj ustment $18 579 866 Total True Tax Value After Adj ustment $18,579,866

62

Radicevich Obsolescence Success Story

• Facts
• Manufacturer operated facility in IN in one of its original

buildings.

• County assessor valued real estate using the cost approach.
• Issues
• Facility’s design compared with a state-of-the-art facility

lacked continuity, new building materials, and efficient flow

• f goods and materials. Additionally, the facility was limited

in its ability to expand.

• Conclusion

B d b l tifi ti t d d ki

• Based on an obsolescence quantification study and working

with the local assessor, company’s real property liability was reduced by 25% , and company received a tax refund of $140 000 $140,000.

63

Radicevich Obsolescence Success Story (Cont.)

• Facts
• Facts
• A manufacturer built a state-of-the-art facility in MO

based on the demand for a particular snack product.

• County assessor placed M&E on a 15-year life table and

County assessor placed M&E on a 15 year life table, and company paid $300,000 annually in personal property taxes.

• Issues

Issues

• Five years after the facility was built, demand for product

drastically declined. Did economic obsolescence exist?

• Conclusion
• Conclusion
• Based on obsolescence quantification study and

representation at the local board, company’s personal property liability was reduced to $150 000 Tax savings: property liability was reduced to $150,000. Tax savings: $150,000.

64

Functional: Cost To Cure Functional: Cost To Cure

In the Lucy chocolate candy factory sketch, the capacity of the packaging line (i.e. Lucy & Ethel) did not match the capacity of the candy line (i.e. Lucy & Ethel) did not match the capacity of the candy manufacturing process. Therefore, the process is affected by functional

• bsolescence.

Cost to cure: Is the obsolescence curable, and what is the cost of additional capacity?

65

Functional: Cost To Cure (Cont.) Functional: Cost To Cure (Cont.)

Additional packaging capacity Additional packaging capacity

Equipment cost (including freight, tax and installation) = $170 000 initial investment = $170,000 initial investment

66

Functional: Cost To Cure (Cont.) Functional: Cost To Cure (Cont.)

Cost approach valuation: Manufacturing

Reproduction cost new $900,000 Effective age 15 yrs. g y Total economic live 30 yrs.

67

Functional: Cost To Cure (Cont.) Functional: Cost To Cure (Cont.)

Cost approach valuation - Manufacturing

Reproduction cost new $900,000 Less: Physical deterioration y ($900,000 x (15yrs./30 yrs.)) (450,000) Reproduction cost less physical $450,000

68

Functional: Cost To Cure (Cont.) Functional: Cost To Cure (Cont.)

Cost approach valuation - Manufacturing

Reproduction cost less physical $450,000 Less: Functional obsolescence (cost of automated equipment) (170,000) Fair market value $280,000

69

Functional: Utilization Functional: Utilization

Cost-to-capacity analysis

Obsolescence (%) = A/

• [ 1 – (Capacity A/Capacity B)n] x 100
• Capacity A = Actual production

Capacity A Actual production Capacity B = Rated or design capacity

• n = Scale factor

70

Functional: Utilization (Cont. Functional: Utilization (Cont.

Cost-to-capacity analysis

Designed capacity 750 000 Designed capacity 750,000 Actual capacity 350,000 Industry service factor 60 Industry service factor .60

71

Functional: Utilization (Cont.) Functional: Utilization (Cont.)

Cost-to-capacity analysis

Actual/designed = 350,000/750,000 = .4667 Result ^ service factor = (.4667) ^.60 = .6330 1-result =1 - .6330 = .3670 Result x 100 = .3670 x 100 = 36.70% (1-((350,000 / 750,000) ^ .60) x 100 = 36.70%

72

Functional: Utilization (Cont.) Functional: Utilization (Cont.)

Cost approach valuation - Manufacturing

Reproduction cost new $900,000 Less: Physical deterioration y ($900,000 x (15yrs./30 yrs.)) (450,000) Reproduction cost less physical $450,000

73

Functional: Utilization (Cont.) Functional: Utilization (Cont.)

Cost approach valuation - Manufacturing

Reproduction cost less physical $450,000 Less: Functional obsolescence (obsolescence @ 36.70%) (165,150) Fair market value $284,850

74

Reilly Case Study No. 1: Power Generation

The facts

• Subject plant is an old, outdated gas-fired steam plant.
• Requires a large labor force – 40-plus employees – high labor expense
• High heat rate and is thermally inefficient
• Replacement plant is a new, modern combined cycle gas turbine

(CCGT).

• Requires a smaller labor force – 20 employees or fewer – low labor expense
• Heat rate is low

Efficient!

• Heat rate is low – Efficient!

Old Steam Plant Modern Combined Cycle Gas Turbine Plant

75

Power Generation: Energy A l i Analysis

Heat Net Generation (kWh) Rate (Btu/kWh ) Total Energy Consumptio n (MMBtu) Price of Fuel ($/MMBtu) Annual Energy Cost S bj t Pl t 580 260 000 11 000 6 382 860 $6 25 $39 893 000 Subject Plant 580,260,000 11,000 6,382,860 $6.25 $39,893,000 Modern Replacement Plant 580,260,000 6,752 3,917,916 $6.25 $24,487,000 Annual Excess Energy Penalty $15,406,000

Lower heat rate means less fuel required to produce electricity

76

y

Power Generation: Labor Analysis

Labor Analysis Number of Employee s Annual Labor Rate Per Employee Annual Labor Cost Subject Plant 44 140,000 $6,160,000 Subject Plant 44 140,000 $6,160,000 Modern Replacement Plant 20 140,000 $2,800,000 Annual Excess Labor Penalty $3,360,000 y $ , , 77

Power Generation: Functional Obsolescence Calculation

Real life story No. 1: Power Generation Functional obsolescence Functional obsolescence due to excess operating expense

Energy 15,406,000 Labor 3,360,000

Projects Growth Of the Penalty

, , Total Annual Excess Penalty $18,766,000 Less Income Tax Benefit at 40.5% 7,600,230

Of the Penalty At 2.5% Per Year

Annual Excess Operating Cost After-Tax $11,165,770 Present Value Remaining Useful Life 5 Discount Rate 8 5% Discount Rate 8.5% Growth 2.5% Adjusted Discount Rate 6.0% Present Value Factor 4.212 78 Functional Obsolescence Due To Excess Operating Expense $47,030,223

Note: The above analysis can also be developed on a before-tax basis.

Reilly Case Study No. 2: Tire Manufacturing

The facts

• Subject tire plant is an old and outdated facility.
• Subject plant was built in the 1970s.
• Inefficient manufacturing layout requires a large labor

Inefficient manufacturing layout requires a large labor force (lots of people and forklifts).

• Old production equipment requires large amounts of

energy. O

• Outdated equipment produces excessive scrap.
• Replacement plant is a “newer” tire plant.
• Replacement plant was built in the 1990s

Replacement plant was built in the 1990s.

• Smaller labor force required (lots of automation &

conveyors)

• Newer production equipment requires less energy.
• Newer equipment and streamlined process reduce

scrap.

79

Tire Manufacturing: Excess Labor Analysis

Number Annual

• f

Employee s Labor Rate Per Employee Annual Labor Cost Subject Plant 2,100 $75,000 $157,500,000 Modern Replacement Plant 1,200 $75,000 $90,000,000 Annual Excess Labor P lt $67 500 000 Penalty $67,500,000 80

Tire Manufacturing: Energy A l i Analysis

Current P d ti Energy Consumptio n MMBtu's 1 000 Total Energy C d Cost of E A l Production in Pounds per 1,000 Pounds Consumed in MMBtu Energy per MMBtu Annual Energy Cost Subject Plant 285,000,000 9.5 2,707,500 $5.00 $13,538,000 Modern Replacement Plant 285,000,000 4.0 1,140,000 $5.00 $5,700,000 Annual Excess Energy Penalty $7,838,000 81

Ti M f t i S A l i Tire Manufacturing: Scrap Analysis

Scrap Percentage Tire Production Tire Production Scrapped Per Year Cost of Scrapped Tire Annual Scrap Cost Subject Plant 2.75% 12,500,000 343,750 $27.50 $9,453,000 Modern Replacement Plant 1.50% 12,500,000 187,500 $27.50 $5,156,000 Annual Excess Scrap Penalty $4,297,000 82

Tire Manufacturing: Functional Obsolescence Calculation

Real-life story No. 3: Tire manufacturing Functional obsolescence Functional obsolescence due to excess operating expense

Labor 67,500,000 Energy 7,838,000 Scrap 4,297,000 Total Annual Excess Penalty 79,635,000 Less Income Tax Benefit at 39.5% 31,455,825 Annual Excess Operating Cost After-Tax 48,179,175 Present Value Period in Years 10 Discount Rate 9.0% Growth 2.5% Adjusted Discount Rate 6.5% Present Value Factor 7.189 83

Functional Obsolescence Due To Excess Operating Expense 346,360,089