Cash Flow Valuation and Depreciation
(OVERVIEW)
The paper proposes a framework for depreciation measurement and asset valuation depending on
correlating the total asset value which is represented in the present value of future cash flows
promised by an asset, with the market value of the asset represented in its replacement cost and
its resale value. Through articulating several assumptions, the total change in the asset value is
concluded to be the summation of change in asset goodwill and asset depreciation, considering
the depreciation to be as a tangible component of the asset value that is represented in the change
of the market value of the asset, and goodwill to be the intangible component of the asset that
may or may not be susceptible to measurement and will be equal to the difference between total
asset value and depreciation.
Fractionating the Asset value into two major components is attributed to the interest of investors
to be aware of the asset goodwill because it is subjectable to competition threats and deemed to
be riskier than the resale value and replacement cost. Besides, Goodwill is generally much more
difficult to estimate than the market values since it requires forecasts of the future.
Moreover, the interest in displaying the total asset value in terms of market values is attributed to
the nature of the asset as if there is a probability of liquidating the asset, then its resale value
becomes a more relevant information, while if the asset demands replacement in the future, then
its replacement cost will attract the attention of investors.
However, utilizing this proposed framework depends on the availability of information where
each component of proposed correlation has its own measurement implications where the
application of present value theory to specific assets within the firm is difficult and sometimes
impossible because of joint products, joint costs, and sloping demand curves which makes it is
difficult to identify benefits earned by a firm in terms of a specific asset. Also, the use of present
values introduces a large degree of subjectivity into the measurement of specific assets due to
frequent requirement of highly subjective forecasts of the future. while, defining and measuring
replacement costs in a world of changing technology might involve real challenges.
Unfortunately, the conclusion is that the accounting depends on the information that is available
as well as the information needed. However, in case of inability to measure any of these items,
the historical asset cost will return to be the basis of assets recording.
METHODOLOGY:
The paper categorized the asset value into two main categories
a) The Asset value in use by a specific firm (V).
b) The market measures of asset value (S and R).
Defining the three alternative concepts of asset valuation as below:
R : Replacement cost (the cost of obtaining a factor of production that would offer the same
capacity for production or service adjusted for any differences in maintenance costs or life).
S : The resale value of the asset.
V: The present value of the future services offered by the asset to a specific firm.
The paper focused on the equilibrium case where V > R > S, in which the utilization of
replacement cost can logically be deemed to be as a basis of asset recording, where there is no
incentive to liquidate the asset neither when it is functioning nor when it wears out, also there is
no prioritization to continuously get it replaced.
Hence, by initially assuming that Replacement cost (R) is equivalent to the Resale Value (S) and
both represent the market value, which is the tangible component of Asset value (V), and then
defining (G) to be the “Goodwill”, which is the intangible component of the asset,
Hence: G = V - S, or V = S + G.
Taking into consideration the time periods of (V), (G) and (S) in the current and previous year’s
The Asset value in previous year will be: V(t-1) = S(t-1) + G(t-1)
The Asset value in previous year will be: V(t) = S(t) + G(t)
Then the Total Change in Asset Value (Dt) will be defined as below:
Dt = (Gt-1 - Gt) + (St-1 - St)
With reference to the depreciation(dt) definition proposed by the paper to be the change in the
market value, then dt = (St-1 - St)
Accordingly, the Total Change in Asset Value Dt = (Gt-1 - Gt) + dt
= ∆ 𝐺𝑜𝑜𝑑𝑤𝑒𝑙𝑙 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛