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

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

THURSDAY, APRIL 21, 2011

Today’s faculty features:

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

Dorothy Radicevich Managing Director True Partners Consulting ChicagoDorothy 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,

For this program, attendees must listen to the audio over the telephone.

Kevin Reilly, Senior Manager, Real Estate and Related Assets Group, American Appraisal Associates, Milwaukee, Wis.

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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 [email protected]

Dorothy Radicevich, True Partners [email protected]

Gregory Kort, Popp Gray & Hutcheson [email protected]

Kevin Reilly, American Appraisal [email protected]

Today’s Program

Overview Of Valuation Approaches[Dorothy Radicevich]

Slide 7 – Slide 18

Physical Deterioration And Functional Obsolescence[Todd Barron]

Calculating, Accounting For Physical Depreciation and

Slide 19 – Slide 39

Slide 40 – Slide 51Functional Obsolescence[Gregory Kort and Kevin Reilly]

Case Studies On Making An Obsolescence-Based Argument Slide 52 – Slide 83[Gregory Kort, Dorothy Radicevich, Todd Barron, Kevin Reilly]

OVERVIEW OF VALUATION Dorothy Radicevich, True Partners Consulting

OVERVIEW OF VALUATION APPROACHES

Si ifi Of P TSignificance 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?

States may define value differently Michigan: True cash value Texas: Appraised/market value Indiana: True tax value Florida: Just value

States generally follow appraisal industry’s definition of FMV:States generally follow appraisal industry s definition of FMV:

The most probable price, as of a specified date, in cash, or in terms of equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.

- Appraisal Institute

11

F i M k V l CFair 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 topen market

Assessor can utilize three Approaches to value:

Income Approach Market Approach Cost Approach

FMV

12

I A h T V lIncome 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 over 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 subject property with comparable sales, property with comparable sales, adjusting those comparable sales to the characteristics of the

bj t t L k f d t i subject property. Lack of data is major stumbling block in using this method. Many states do not yrequire statement of market value in purchase documents.

14

C A hCost 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 adjusted for losses in value due to physical deterioration and obsolescence.

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 obsolescenceg

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 NewExcess Capital Cost

Physical deterioration Physical Depreciation

F ti l Ob l

Physical deterioration is a loss in value resulting from wear and tear from use or

t i Functional Obsolescence

Economic Obsolescence

exposure to various elements.

Asset CostsFair Market Value

17

Ph i l D i iPhysical Deterioration

Expected on most equipment

Not abnormal unless equipment is put to extensive use or misusedmisused

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 DepreciationAccrued Depreciation

Loss in value from all of the causes of deterioration and obsolescenceLoss 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 HayakawaSamuel Ichiye HayakawaSamuel Ichiye HayakawaSamuel Ichiye Hayakawa

21


Cow one …Cow one …

22


Cow one …Cow one …is notis not

Cow two.Cow two.Language in Thought & Action

23

Blower Being AssessedBlower Being Assessed

24

New BlowerNew Blower

25

Why accrued d i i ?depreciation?

The asset being i d iappraised is

not new.not new.26


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 DeteriorationPhysical 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 ObsolescenceFunctional 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-adequacyadequacy

31

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

Causes and sources

Technological innovation Production improvements Design changes Super-adequate design Inadequate designq g

32


Causes and sources (Cont.)( )

Technological innovationP 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 ga buyer to pay less for it than for a new asset?

33


34


35


36


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. IncurableCurable Vs. Incurable

Curable deterioration or obsolescence is economically feasible to cureCurable 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 cureIncurable 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 & HutchesonKevin Reilly, American Appraisal

,FOR PHYSICAL DEPRECIATION AND DEPRECIATION AND FUNCTIONAL OBSOLESCENCE

Physical DepreciationPhysical 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 lwear and tear, deterioration, exposure to various elements, physical stress and similar factors.

Curable physical depreciation– Curable physical depreciation

– Incurable physical depreciation

41

Cost Approach SummaryCost 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 DepreciationMeasuring 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 DataSources Of Data

• American Society of Appraisers (MT&S)

• Fixed-asset listings with historical costs

• Maintenance records

• Future capital spending plans

• Plant managementg

44

Taxing Authorities’ ViewpointTaxing Authorities Viewpoint

• One-size-fits-all approach

• Mass appraisal methods may limit quantification of all forms ofMass 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 DepreciationExample: Physical DepreciationDescription Reproduction

Cost NewEffective 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 $800,000Less Physical Depreciation @ 53% $424,000

(PD)RCN Less Physical Depreciation $376,000 (RCNLD)

46

F ti l Ob lFunctional ObsolescenceFunctional 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 athe modern replacement, the analysis results in a net benefit (not a penalty) for the subject property.

47

C t A h SCost Approach Summary

Reproduction cost newLess FO from excess capital costspEquals cost of replacementLess depreciation

Ph i l d t i ti Physical deterioration FO from excess operating expenses Economic obsolescenceEquals the cost indicator of value

48

Causes Of Functional Obsolescence

Is the loss in value of a property caused by inefficiencies or

inadequacies of the property itself?• Excess operating expensesp 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 dataGood 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 lSimple Example Simple Example

Same Capacityand Utility

Functional ObsolescenceDue to excess operating expenses

Modern Replacement

Reduces Income Tax Liability “a Positive”

Remaining Life of the

Subject PlantAnnual Cost of Operations (Operating Expenses) $1,000,000 $500,000

Difference $500,000 Remaining Life of the Penalty

Low Risk WACCLess Penalty

Income Tax @ 40% $200,000After Tax Penalty $300,000

Present ValuePeriod in Years 20 Less Penalty

GrowthPeriod in Years 20Discount 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 & HutchesonDorothy Radicevich, True Partners ConsultingTodd Barron, Barron Corporate Tax Solutions

CASE STUDIES ON MAKING AN

Todd Barron, Barron Corporate Tax SolutionsKevin Reilly, American Appraisal

OBSOLESCENCE‐BASED ARGUMENTARGUMENT

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 tgeneral manufacturing equipment.

• Revise physical depreciation schedules using an 8-year life

53

Depreciation Schedule ImpactDepreciation Schedule ImpactSummary of Machinery & Equipment Depreciation Schedules - % Good Factors

Effective Assessor 8 Year Assessor 10 YearYear

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 ComparisonDepreciation Schedule ComparisonMachinery & Equipment Depreciation Schedules Comparison

100%

80%

90%

50%

60%

70%

od F

acto

rs Tax savings for current and future years

30%

40%% G

oo

0%

10%

20%

0%2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996

8 Year 10 Year Michigan QAM55

Typical Assessor Cost ApproachTypical 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 ErrorsService Factors: Common Errors

• Common errors in this approach are:

– The assumption that “economic inutility” includes all forms of functional and economic obsolescence

– Excluding curable functional obsolescence items

– Excluding curable economic obsolescence items

57

Kort Case Study No. 2: Service FactorsKort 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/dayCost to Cure Process Bottleneck $100,000

Assessor Cost ApproachReproduction 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 dRadicevich Obsolescence Study

ABC CoABC Co.Semi-Truck Trailer Plant

North PlantTax Year 20xx Assessment

Quantification of Abnormal ObsolescenceAbnormal Obsolescence Pursuant To 50 IAC 4.2-4-8:ABC Co. designs, manufactures and markets standard 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 of 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 , yforeseeable future.ABC Co. claims an abnormal obsolescence adjustment 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 projected) at the north plant from 200x 20xx:production (actual or projected) at the north plant from 200x-20xx:

50000

10000

20000

30000

40000

Rated CapacityTrailer Production

0200x 200x 200x 200x 200x 200x

60


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 = Scale 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 = 10049,14923,0071

7.0

Inutility Percent: 41

61


Pursuant to Rule 50 IAC 4.3-9-6, taxpayer claims an adjustment for abnormal obsolescence on all tangible personal property at the north plant as outlined belowthe north plant, as outlined below.

Original Cost As Of March 1, 2009 $107,013,785 g , $ , , True Tax Value of Assets Prior To Adjustment For Abnormal Obsolescence $31,491,299 Less: Allowable Adjustment for 41% Extraordinary Abnormal Obsolescence ($12,911,433) Total True Tax Value After Adjustment $18 579 866 Total True Tax Value After Adjustment $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 of goods and materials. Additionally, the facility was limited in its ability to expand.

ConclusionB 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.)

FactsFacts 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.

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

drastically declined. Did economic obsolescence exist?ConclusionConclusion

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 CureFunctional: 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 candyline (i.e. Lucy & Ethel) did not match the capacity of the candy manufacturing process. Therefore, the process is affected by functional obsolescence.

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 capacityAdditional packaging capacity

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

66


Cost approach valuation: Manufacturing

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

67


Cost approach valuation - Manufacturing

Reproduction cost new $900,000Less: Physical deteriorationy

($900,000 x (15yrs./30 yrs.)) (450,000)

Reproduction cost less physical $450,000

68



Reproduction cost less physical $450,000Less: Functional obsolescence

(cost of automated equipment) (170,000)

Fair market value $280,000

69

Functional: UtilizationFunctional: Utilization

Cost-to-capacity analysis

Obsolescence (%) =

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

• Capacity A = Actual productionCapacity A Actual production Capacity B = Rated or design capacity

• n = Scale factor

70

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


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

71

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


Actual/designed = 350,000/750,000 = .4667Result ^ service factor = (.4667) ^.60 = .63301-result =1 - .6330 = .3670Result x 100 = .3670 x 100 = 36.70%

(1-((350,000 / 750,000) ^ .60) x 100 = 36.70%

72



Reproduction cost new $900,000Less: Physical deteriorationy

($900,000 x (15yrs./30 yrs.)) (450,000)

Reproduction cost less physical $450,000

73



Reproduction cost less physical $450,000Less: 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 PlantModern Combined Cycle Gas Turbine Plant

75

Power Generation: Energy A l iAnalysis

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 000Subject 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

EmployeeAnnual Labor

Cost

Subject Plant 44 140,000 $6,160,000Subject 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 GenerationFunctional obsolescenceFunctional obsolescencedue to excess operating expense

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

Projects GrowthOf the Penalty

, ,Total Annual Excess Penalty $18,766,000

Less Income Tax Benefit at 40.5% 7,600,230

Of the PenaltyAt 2.5% Per Year

Annual Excess Operating Cost After-Tax $11,165,770

Present ValueRemaining Useful Life 5Discount Rate 8 5%Discount Rate 8.5%Growth 2.5%Adjusted Discount Rate 6.0%


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 laborInefficient 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 1990sReplacement 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 of

Employees

Labor Rate Per

EmployeeAnnual 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 000Penalty $67,500,000

80

Tire Manufacturing: Energy A l iAnalysis

Current P d ti

Energy Consumptio

n MMBtu's 1 000

Total Energy C d

Cost of E A lProduction

in Poundsper 1,000

PoundsConsumed

in MMBtuEnergy per

MMBtuAnnual

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 iTire Manufacturing: Scrap Analysis

ScrapPercentage

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 manufacturingFunctional obsolescenceFunctional obsolescencedue to excess operating expense

Labor 67,500,000Energy 7,838,000Scrap 4,297,000Total 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 ValuePeriod in Years 10Discount Rate 9.0%Growth 2.5%Adjusted Discount Rate 6.5%


83Functional Obsolescence Due To Excess Operating Expense 346,360,089

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