Opinion ID: 1188758
Heading Depth: 1
Heading Rank: 5

Heading: Theory of the Income Approach

Text: All of the expert witnesses were agreed that the Income approach was a valid, reliable approach to the determination of value in this case. The witnesses were in strong disagreement, however, as to which variation of the Income approach was appropriate to the valuation of a going concern of this size and nature. The Income approach to the valuation of property is a method of estimating the present worth of the benefits to be derived from the property in the future. The method involves a determination of the present and prospective income from the property, reduced to an indication of value by a mathematical process known as capitalization. A rate known as the capitalization rate is applied to the estimated net annual income produced by the property to determine its value. For example, if the net annual income from a parcel of undeveloped land were $10,000, and a fair return on the investment is eight percent per annum, the indicated value of the property would be $125,000. The formula is expressed as Value = Income Rate. The plaintiffs' appraisers calculated estimated net annual income after depreciation and taxes, applied the capitalization rate, and the result was their estimate of value under the Income approach. Their Income approach might be termed direct capitalization or straight capitalization or capitalization in perpetuity in the sense that these appraisers did not directly base their decision on the life expectancy of the plaintiffs' assets. The appraisal of the plaintiffs' expert John Green contains this analysis: The preceding pages reflects [sic] the net railway operating income for the year 1975 to be $53,766,000 for the year 1974 to be $71,258,000, for the year 1973 to be $44,649,000, for the year 1972 to be $44,630,000 and for the year 1971 to be $46,823,000. The unweighted average of the five year period was $52,225,000 with the weighted average being $54,926,000. The purpose of the Income Approach is to estimate the market value of a property based on the present capitalized value of future anticipated earnings. After a careful analysis of the past earnings, the present situation and future prospects of this railroad, I have concluded that an informed buyer would anticipate that he could expect a net railroad operating income of $54,926,000, which when adjusted for the effects of leased equipment results in an anticipated income stream of $71,213,000. It is my opinion that such an investor, after considering the capital structure, cost of existing debt and a return on equity consistent with the risks involved, would require an overall return of 10.50% on this investment. Capitalization of the anticipated income stream of $71,213,000 at a 10.50% rate results in a value conclusion by the Income Approach of $678,250,000. Mr. Woolery, the plaintiffs' other expert, pursued a similar course. He determined the probable future annual income from the railroad operating properties, selected a capitalization rate, and applied the formula set forth above. The defendant's appraiser, Richard Green, was critical of the approaches pursued by the plaintiffs' appraisers. He was critical of their treatment of depreciation, of deferred taxes, and of the treatment of federal income tax expense, all of which will be discussed below.