Module No-2 Airline Valuations and Source of Finance

Valuation of Tangible and Intangible Assets

Tangible Assets
Assets with a physical existence that can be touched and felt are tangible assets.  They
are used primarily in the operation of the business to produce products or services.  Since
tangible assets are often purchased, they are much more easily valued than intangible assets.

Tangible assets can be accounted for as either long-term or current assets depending
on their estimated life.  These types of assets include buildings, automobiles, physical
inventory, furniture and machines.  They depreciate in value over time.

Classification

Fixed assets are long term assets that cannot easily be converted into cash for more
than one year. Example: Property, plant and equipment.

Current assets are liquid assets that can easily be converted into cash within a year.

Valuation of Tangible Assets 

 Appraisal method:  Fair market value of assets is estimated by considering the

current state of asset including depreciation and obsolescence.
 Liquidation method: Fair market value of assets is determined at liquidation, sale or
closure.
 Reproduction cost method:  The cost to reproduce an identical asset at current costs.
 Replacement cost method: The cost of creating the assets with similar characteristics
at current costs.

Tangible asset valuations are important for financial reporting, tax purposes, asset
monitoring, bankruptcy filing and insurance purpose.

Intangible Assets
Intangible assets do not have a physical character.  Yet, they are essential to the
continued operation of a business.  These types of assets can have either a definite or
indefinite life depending on the type of asset.  Examples of intangible assets include
goodwill, intellectual property (patents, copyrights and trademarks), brand names, customer
relationships, contracts and non-compete agreements.  Intangible assets have the ability to
appreciate in value.
 Patents have a definite life because they come with an expiration date.  Brand names
have an indefinite life because they can last for the entire life of the company.

Some economists feel that intangible assets are much more valuable than tangible
assets especially as we continue to transition from a “financially-based” to a “knowledge-
based” economy.

Classification

Definite life or Indefinite-life

Definite intangible assets have an expected economic life and may cease in some
time. These assets are amortized over their useful life, using a straight-line method. Patents
and copyrights are examples of limited-life intangible assets.

Indefinite-life intangibles have an unlimited useful life and have perpetual existence.
There are no legal, regulatory, contractual or economic limiting factors. Indefinite-life
intangibles are not amortized and tested for impairment annually. Examples include
trademarks and perpetual franchise agreements.

Purchased or internally created intangibles

Purchased intangibles are recorded at cost, which includes the acquisition costs as
well as expenses incurred to bring the asset in ready state.

Internally created intangibles are costs incurred internally to create intangibles are
generally expensed as incurred and only direct costs are capitalized and not recorded on the
balance sheet. Examples include research & development cost and legal costs.

Valuation of Intangible Assets

Income approach: Cash flows and earnings of intangible assets are discounted to the
present value by discounted cash flow or capitalization of cash flow method.

 Excess earnings method: Excess earnings are calculated by subtracting the earnings
of net tangible assets from total earnings. The capitalized excess earnings value is
obtained by dividing excess earnings by capitalization rate. The capitalized excess
earnings value is added to value of tangible assets to calculate total business value. It
is generally used to determine the value of business goodwill.
 Relief from royalty method: Value is based on saving the payment of licence fees to
third parties as employing an intangible asset.
 Market approach: Comparable market-based transactions of similar intangible assets are
not available easily. The transactions are related to sales or licenses of comparable intangible
assets. The problems of comparability and timing are there. The measures for comparison are
price multiples based on profit margins, growth rates and return on assets.

Cost approach: It is based on the principle of replacement and usually ignores the cash
flows associated with intangible assets. The cost of intangible asset is determined by
reproduction or replacement method and adjusted for depreciation & obsolescence. Cost
based approach are used for valuing workforce and internally developed software.

Intangible asset valuations are important for tax & financial reporting, dispute resolution,
licensing & franchising, corporate deals and investor relations.

Differences Between Tangible and Intangible Assets

Tangible Assets Intangible Assets

Physical form Abstract form

Depreciated Amortized

Easily liquidated Not easily liquidated

Cost can be easily determined Harder to evaluate

Salvage value exists No salvage value

Used as collateral to obtain loans Not used as collateral to obtain loans

Reported on balance sheet Not reported on balance sheet

Managed by control Managed by alignment

Easily duplicated Difficult to duplicate

Limited application Multiple applications

Source of Finance
A source or sources of finance, refer to where a business gets money from to fund
their business activities. A business can gain finance from
either internal or external sources.

Internal sources of finance

 Internal sources of finance refer to money that comes from within a business. There
are several internal methods a business can use, including owners’ capital, retained profit and
selling assets.

Owners’ capital refers to money invested by the owner of a business. This often comes from
their personal savings. Personal savings is money that has been saved up by an entrepreneur.
This source of finance does not cost the business, as there are no interest charges applied.

Retained profit is when a business makes a profit, it can leave some or all of this money in
the business and reinvest it in order to expand. This source of finance does not incur interest
charges or require the payment of dividends, which can make it a desirable source of finance.

Selling assets involves selling products owned by the business. This may be used when either
a business no longer has a use for the product or they need to raise money quickly. Business
assets that can be sold include for example, machinery, equipment, and excess stock.

External sources of finance

External sources of finance refer to money that comes from outside a business. There are
several external methods a business can use, including family and friends, bank loans and
overdrafts, venture capitalists and business angels, new partners, share issue, trade credit,
leasing, hire purchase, and government grants.

Family and friends - businesses can obtain a loan or be given money from family or friends
that may not need to be paid back or are paid back with little or no interest charges.

A bank loan is money borrowed from a bank by an individual or business. A bank loan is
paid off with interest over an agreed period of time, often over several years.

Overdrafts - are where a business or person uses more money than they have in a bank
account. This means the balance is in minus figures, so the bank is owed money. Overdrafts
should be used carefully and only in emergencies as they can become expensive due to the
high interest rates charged by banks.

Venture capital and business angels - refers to an individual or group that is willing to

invest money into a new or growing business in exchange for an agreed share of the profits.
The venture capitalist will want a return on their investment as well as input into how the
business is run.

New partners - is when an additional person or people are brought into the business as a new
business partner. This means they would provide money to then own part of the business.

Share issue - a business may sell more of their ordinary shares to raise money. Buying shares
gives the buyer part ownership of the business and therefore certain rights, such as the right
to vote on changes to the business.

A trade credit must be agreed with a supplier and forms a credit agreement with them. This
source of finance allows a business to obtain raw materials and stock but pay for them at a
later date. The payment is usually made once the business has had an opportunity to convert
the raw materials and stock into products, sell them to its own customers, and receive
payment.
Leasing - is a way of renting an asset that the business requires, such as a coffee machine.
Monthly payments are made and the leasing company is responsible for the provision and
upkeep of the leased item.

Hire purchase - is used to purchase an asset, such as a delivery van or piece of equipment. A
deposit is paid and the remaining amount for the asset is paid in monthly instalments over a
set period of time. The business does not own the item until all payments are made.

Government grants - are a fixed amount of money awarded by the government. Grants are
given to a business on the condition that they meet certain criteria such as providing jobs in
areas of high unemployment. These do not usually need to be paid back.

Term of loan payments

Money borrowed for long-term capital investments usually is repaid in a series of

annual, semi-annual or monthly payments.
There are several ways to calculate the amount of these payments:

1. equal total payments per time period (amortization);

2. equal principal payments per time period; or
3. equal payments over a specified time period with a balloon payment due at the
end to repay the balance.
When the equal total payment method is used, each payment includes the accrued
interest on the unpaid balance, plus some principal. The amount applied toward the principal
increases with each payment (Table 1).

The equal principal payment plan also provides for payment of accrued interest on the
unpaid balance, plus an equal amount of the principal. The total payment declines over time.
As the remaining principal balance declines, the amount of interest accrued also declines.

These two plans are the most common methods used to compute loan payments on
long-term investments. Lenders also may use a balloon system. The balloon method often is
used to reduce the size of periodic payments and to shorten the total time over which the loan
is repaid. To do this, a portion of the principal will not be amortized (paid off in a series of
payments) but will be due in a lump sum at the end of the loan period. For many borrowers,
this means the amount to be repaid in the lump sum must be refinanced, which may be
difficult.

Repayment Principles

To calculate the payment amount, all terms of the loan must be known: interest rate,
timing of payments (e.g., monthly, quarterly, annually), length of loan and amount of loan.
Borrowers should understand how loans are amortized, how to calculate payments and
remaining balances as of a particular date, and how to calculate the principal and interest
portions of the next payment. This information is valuable for planning purposes before an
investment is made, for tax management and planning purposes before the loan statement is
received, and for preparation of financial statements.
 With calculators or computers, the calculations can be done easily and quickly. The
use of printed tables is still common, but they are less flexible because of the limited number
of interest rates and time periods for which the tables have been calculated.

Regardless of whether the tables or a calculator is used, work through an example to help
apply the concepts and formulas to a specific case.

Lenders Use Different Methods

Different lenders use different methods to calculate loan repayment schedules

depending on their needs, borrowers’ needs, the institution’s interest rate policy (fixed or
variable), the length of the loan, and the purpose of the borrowed money. Typically, home
mortgage loans, automobile and truck loans, and Consumer instalment loans are amortized
using the equal total payment method.

The Farm Service Agency enquires equal total payments for intermediate and long-
term loans.

The Federal Credit Services (FCS) uses the equal total payment method for many
loans. Under certain conditions the FCS may require that more principal be repaid earlier in
the life of the loan, so they will use the equal principal payment method. For example, in
marginal farming areas or for ranches with a high percentage of grazing land in non-deeded
permits, FCS may require equal principal payments.

Production Credit Associations (PCA) usually schedule equal principal payment loans
for intermediate term purposes. Operating notes are calculated slightly differently. Other
commercial lenders use both methods.

Lenders often try to accommodate the needs of their borrowers and let the borrower
choose which loan payment method to use. A comparison of Tables 1 and 2 indicates
advantages and disadvantages of each plan. The equal principal payment plan incurs less total
interest over the life of the loan because the principal is repaid more rapidly. However, it
requires higher annual payments in the earlier years when money to repay the loan is
typically scarce. Furthermore, because the principal is repaid more rapidly, interest
deductions for tax purposes are slightly lower. Principal payments are not tax deductible, and
the choice of repayment plans has no effect on depreciation.

The reason for the difference in amounts of interest due in any time period is simple:
Interest is calculated and paid on the amount of money that has been loaned but not repaid. In
other words, interest is almost always calculated as a percentage of the unpaid or remaining
balance: I = i x R

Where:

I = interest payment

i = interest rate

R = unpaid balance.
Using the Formulas

Because of the infinite number of interest rate and time period combinations, it is
easier to calculate payments with a calculator or computer than a table. This is especially true
when fractional interest rates are charged and when the length of the loan is not standard.
Variable interest rates and rates carried to two or three decimal places also make the use of
printed tables difficult.

Equal Total Payments

For equal total payment loans, calculate the total amount of the periodic payment using the
following formula:
B = (i x A) / [1 – (1 + i)-N]
where:A = amount of loan,

B = periodic total payment, and

N = total number of periods in the loan.

The principal portion due in period n is: Cn = B x (1 + i) -(1 + N – n)

where:

C = principal portion due and

n = period under consideration.

The interest due in period n is: In = B – Cn.

The remaining principal balance due after period n is: Rn = (In / i) – Cn.

Equal Principal Payments

For equal principal payment loans, the principal portion of the total payment is
calculated as: C = A / N.

The interest due in period n is: In = [A – C(n-1)] x i.

The remaining principal balance due after period n is: Rn = (In / i) – C.

Calculating Payments with Variable Interest Rates

Many lenders (especially the Farm Credit System) now use variable interest rates,
which greatly complicates calculating the payment. The most common way to amortize a
loan under a variable interest rate is to calculate the amount of principal due, based on the
interest rate in effect on the payment due date. The interest payment is then calculated in the
normal fashion.

This method computes the amount of principal and total payments and is used only
for equal total payment loans. If the loan schedule was originally specified as the equal
principal payment plan, the calculations are much easier because C (principal payments)
remains the same for each period.