Journal of Property Tax Assessment and Administration Volume 2, Issue 4 33
On Valuing Negative Cash Flows Related to
Contamination, Asset Removal, or Functional
Obsolescence
BY HAL B. HEATON, PHD
Hal B. Heaton, PhD is a professor of finance in the Marriott School of Management at
Brigham Young University in Provo, Utah, He teaches advanced corporate finance and
capital markets. He received a PhD in finance as well as a masters degree in economics from
Stanford University. Dr. Heaton also holds an MBA from Brigham Young University.
A ppraisers are frequently faced with
having to value future expected
negative cash flows. This article will
demonstrate that valuing negative cash
flows requires a different approach
from valuing positive cash flows. The
concepts of valuing remediation costs,
asset removal costs, and other types of
functional obsolescence will be used to
illustrate this concept.
In the cost approach to valuation, ap-praisers
often must adjust for all types
of depreciation, including physical and
functional depreciation and economic
obsolescence. Buyers are not willing
to pay as high of a price for a property
that exhibits physical deterioration or
functional obsolescence or that has en-vironmental
clean- up expenses as for a
new property without these problems. As
a result, the appraiser must subtract from
historical, replacement, or reproduction
cost new an amount that reflects these
deficiencies.
Often, the adjustments for func-tional
or environmental problems are
estimated by forecasting the additional
costs created by these problems and
discounting these costs back to present.
For example, one type of functional
obsolescence is represented by excess
operating costs, perhaps due to the
physical layout of an outdated facility.
The appraiser may forecast these excess
costs, discount them to present value,
and then subtract the net present cost
from the cost approach. In the case of en-vironmental
clean- up, remediation costs,
or asset- removal costs, the appraiser may
forecast the costs, discount them to pres-ent
value, and subtract the present value
from replacement cost new.
This article will show that the appro-priate
discount rate for valuing negative
cash flows is not the same as the rate used
to discount positive cash flows. It will be
demonstrated that the greater the un-certainty
in the negative cash flows, the
lower the appropriate discount rate that
an appraiser must use to value them. In
the case of high risk, a negative discount
rate could be warranted.
Although the examples given may
reflect a capitalization process, the
34 Journal of Property Tax Assessment and Administration • Volume 2, Issue 4
concepts explained are also applicable
to discounting a series of cash flows.
Financial Accounting Standards ( FAS)
Rule 143 recently issued by the Financial
Accounting Standards Board ( FASB)
makes this topic particularly current and
is also discussed.
Fundamental Problem in Valuing
Negative Cash Flows
In a real estate valuation, the cost ap-proach
requires an adjustment for
future reclamation or clean- up costs.
For example, if a property will require
substantial environmental clean- up costs
at the end of a finite life, a buyer will
reduce the price he or she is willing to
pay today below what the buyer would be
willing to pay if there were no clean- up
costs. To estimate the impact on value,
the future costs must be converted to a
present value impact on the price the
buyer is willing to pay today.
While standard discounting may be
appropriate for estimating the pres-ent
value of a future stream of positive
cash flows, it may not be appropriate
for estimating the present value of a
future stream of negative cash flows or
liabilities.
By “ value,” appraisers mean the price
between a willing buyer and willing seller
in an arm’s- length transaction. In the
case of positive cash flows, it is the price
a willing buyer is willing to pay today ( the
present value) to receive a stream of cash
flows in the future. However, in the case
of negative cash flows, it is the price a
seller of the negative cash flows is willing
to pay a buyer who agrees to assume the
future obligation of the cash outflows.
With positive cash flows, as the risk
or uncertainty of the future cash flows
increases, the appropriate discount rate
increases and, as a result, the present
value of those future cash flows decreas-es.
In contrast, as the risk increases with
negative cash flows, the buyer will re-quire
a higher price to assume the riskier
cash flows. Conceptually, as risk increases
with negative cash flows, the “ discount
rate” decreases and may even become
negative. A negative discount rate means
that the buyer requires a payment higher
than the expected future cash flow.
As a simple example to illustrate this
point, consider the following problem:
A company, in order to generate cash
today, sells its right to a future positive
cash flow twelve months hence of $ 1,000.
Suppose the single cash flow or payment
will be $ 1,000 with certainty; that is, there
is no risk about what the amount will be.
To determine the price to pay today, a
buyer will discount the $ 1,000 at a safe
or “ risk- free” rate of, say, 5 percent to
arrive at the following price:
$ 1,000/ 1.05 = $ 952
Now suppose there is risk or uncer-tainty
surrounding the $ 1,000; that
is, the single cash flow is expected to be
$ 1,000, but it may be more or less than
$ 1,000. Expected cash flow refers to the
average amount a buyer would receive
if the investment were repeated many
times. A buyer will discount at a higher
rate to adjust for this risk. If the buyer
determined that 10 percent was the
higher rate that adjusted for the risk,
then the buyer would be willing to pay
the following:
$ 1,000/ 1.10 = $ 909
Note that the present value of the
positive single cash flow falls as the risk
increases. If the risk or uncertainty was
even greater, then the buyer might use
an even higher discount rate, say 20 per-cent,
to arrive at a value today of $ 833.
$ 1,000/ 1.20 = $ 833
Therefore, the present value of the
future $ 1,000 falls even more. A basic
principle in finance is that the greater
the risk of a cash flow, the less a buyer
would be willing to pay today to receive
it. In other words, the greater the risk,
the more a buyer will discount the future
Journal of Property Tax Assessment and Administration • Volume 2, Issue 4 35
cash flow to arrive at a price.
This approach to dealing with risk
or uncertainty does not work when the
future cash flows are negative. In fact,
the relationship will run in the opposite
direction: As the risk increases, then the
price a buyer will require to assume the
liability will go up, not down.
Because the term buyer is awkward
when referring to future liabilities, I will
refer to the entity assuming the future
liability as the “ insurer” and the current
payment required by the insurer as the
premium.
If the single negative cash flow were
known with certainty ( i. e., had no risk),
then an insurer could value the $ 1,000
at the 5 percent risk- free rate shown
above:
$ 1,000/ 1.05 = $ 952
The insurer could simply deposit the
$ 952 into a safe account and use the
$ 1,000 proceeds in one year to meet the
obligation. However, if there is risk sur-rounding
the $ 1,000, then the insurer
would not use a higher rate to discount
the cash flow to determine the present
value. For example, suppose a higher
rate were used, say 10 percent, to obtain
a price of $ 909.
$ 1,000/ 1.10 = $ 909
It would be nonsense to believe that
an insurer would accept a lower price
to assume a riskier obligation. It would
be even more nonsensical for an insurer
to use an even higher discount rate and
be willing to receive only $ 833 ( using 20
percent) to assume an even riskier cash
flow obligation.
$ 1,000/ 1.20 = $ 833
This approach would imply that if the
risk was great enough, the discount rate
would be huge and the insurer would be
willing to take it on for almost no com-pensation.
This is clearly absurd.
Insurance companies accept payment
today in exchange for uncertain payoffs
in the future. Thus, effectively valuing
potential liabilities is their greatest chal-lenge.
The present value of a future
liability may actually exceed the expected
cash outlay; insurance premiums can
and often do exceed the future expected
or probability- weighted costs of an ac-cident.
The greater the risk, the greater
the present value or insurance premium
that must be paid; in other words, the
discount rate goes even lower for greater
risk liabilities.
As early as 1733, mathematician Dan-iel
Bernoulli noticed that people do
not value potential uncertain positive
and negative cash flows in the same
way ( Bernstein 1996). People will pay
a higher price to avoid a negative cash
flow than they would pay to receive the
same uncertain positive cash flow. This
economic analysis ultimately stems from
the way in which a person’s sense of well-being
changes at different income levels.
A loss of $ 100,000 for most individuals
creates greater pain than the gain of
$ 100,000 adds in greater utility; that is,
people are willing to pay a greater price
to avoid a risky liability that averages
$ 100,000 than they would be willing to
pay to receive a potential payoff that
averages $ 100,000.
The technical economic literature
refers to this phenomenon as a concave
utility function. A utility function ex-presses
a person’s sense of well- being
( i. e., utility) as it depends on wealth. As
a person’s wealth increases, his or her
sense of well- being increases, but at a
declining rate. Thus, when graphed,
total utility “ curves off.” This curvature
is referred to as a concave function.
( See Bodie, Kane, and Marcus [ 2005,
Chapter 5, Appendix B] for a more de-tailed
explanation.) Expected cash flow
is defined mathematically as the mean
of the probability distribution; expected
cash flow is the cash flow, on average, that
would occur if the situation occurred
many, many times. For example, the ex-
36 Journal of Property Tax Assessment and Administration • Volume 2, Issue 4
pected cash flow of a $ 10 accident that
occurs with 10 percent probability is $ 1.
.10 x $ 10 = $ 1
Similarly, the expected cash flow of
a $ 100,000 accident that occurs with a
probability of .001 percent is $ 1.
.00001 x $ 100,000 = $ 1
Even though the expected or average
negative cash flow is the same $ 1 for
both accidents, people would be willing
to pay a higher premium for the insur-ance
company to assume the liability of
the second accident than the first ( Pratt
1964). One might pay an insurer $ 2 to as-sume
the potential $ 100,000 liability but
only $ 1.10 to assume the potential $ 10
liability even though the expected cost
is $ 1 for both. This result is equivalent
to saying that the expected discount rate
for the second, riskier cash flow is lower
( i. e., more negative) because it results
in a higher present value. If the insur-ance
premium exceeds the expected
cash flow of $ 1, then the discount rate
is negative.
In short, an appraiser must not value
negative cash flows with the same dis-counting
techniques that are used to
value positive cash flows.
Techniques for Appropriately
Valuing Negative Cash Flows
What determines the price, or value,
that the insurer will demand to assume
future liabilities?
Insurance companies are in the busi-ness
of receiving payment today to
assume a future, uncertain liability. To
estimate the present value of, say, an
environmental cleanup, an appraiser
must ask, “ How much would I have to
pay someone to get them to agree to
accept the burden of paying for the
environmental cleanup?” That someone
who is accepting this liability will value
the future liability in the same way that
an insurance company values negative
cash flows.
To understand the insurance ap-proach,
consider the following example:
Suppose the expected environmental
clean- up cost is $ 1 million, but some-times
it is only $ 500,000 and sometimes
it is $ 10 million. This uncertainty could
be reflected in a frequency table similar
to figure 1.
Suppose an insurance company was
created for the sole purpose of insur-ing
this single project; we’ll deal with
multiple projects later. If a discounting
approach was used and the discount
rate was 6 percent, then the insurance
Figure 1. Environmental Clean- up Cost Example
Journal of Property Tax Assessment and Administration • Volume 2, Issue 4 37
company would collect $ 943,000 today to
assume the environmental liability.
Present Value =
$ 1,000,000/( 1.06) = $ 943,000
The insurance company would then
place the $ 943,000 in an investment that
earns 6 percent, which would produce $ 1
million in one year.
$ 943,000 x ( 1.06) = $ 1,000,000
On average, this would be enough to
perform the environmental clean- up.
However, if the average is $ 1 million,
then a large percentage of the time the
cleanup will cost more than $ 1 million.
What if this cleanup were to cost $ 2
million? The insurance company would
have only $ 1 million and be forced
into bankruptcy. Bankruptcy would
occur whenever the liability exceeded
$ 1 million, which would occur almost
50 percent of the time. No person
or company would accept a deal that
would cause it to be bankrupt with high
probability nor would anyone pay the
insurance company to accept the liability
if the insurer were likely to be bankrupt
with high probability.
The issue of valuing an environmen-tal
clean- up cost is even worse than
this simple example suggests due to
the uncertainty about the probability
distribution for cleanup if there are not
enough historical statistics to measure
the probabilities. In addition, environ-mental
regulations keep changing, so,
even if there were historical examples,
they may underestimate future costs
under regulations that may become even
more stringent.
To set the premium for assuming
an environmental clean- up risk, an
insurance company would estimate the
frequency or probability distribution
as best it can. It would then establish a
risk threshold that it would be willing
to accept.
For example, suppose, using the prob-ability
distribution shown in figure 1,
the insurance company sets 5 percent as
the probability of ruin or risk threshold
it is willing to accept. It will determine
the cost at which a higher cost will only
occur 5 percent of the time. Suppose
that this dollar amount is $ 2 million. To
determine the premium it will charge,
the insurance company will next de-termine
what rate of return it can earn
on a safe investment; suppose that is 6
percent. The company will then discount
the $ 2 million by 6 percent and charge
$ 1,887,000 to assume the liability.
$ 2,000,000/ 1.06 = $ 1,887,000
Note that, although the process did
involve discounting, the insurance com-pany
did not discount the “ expected” $ 1
million cost. Rather, it first determined
the amount that would ensure its surviv-ability
with 95 percent probability and
then discounted that amount.
Of course, insurance companies try
to insure many similar risks so that
projects that go over cost are offset by
projects that are under cost. But, even if
there were a number of clients wanting
environmental cleanup so the insurance
company could diversify the risk across
many clients, the law of large numbers
would only reduce the risk: It would
not remove this risk. When there are
several projects that are insured, the law
of large numbers means that the insur-ance
company can offer a more favorable
rate. When there are many projects, the
insurance company first calculates the
standard deviation of the average cost
as follows:
Standard deviation of average =
( Standard deviation of individual cleanup)/ n
where n is the number of projects in-sured.
This equation stems from the Central
Limit Theorem. The smaller standard
deviation when estimating the average
cost rather than the cost of an individual
38 Journal of Property Tax Assessment and Administration • Volume 2, Issue 4
project means that the probability distri-bution
is much “ tighter” around the $ 1
million average than it is for any individ-ual
project. Suppose that the frequency
distribution of the average cost was such
that, with 95 percent probability, the
average cost would be less than, say, $ 1.2
million rather than the $ 2 million for
an individual occurrence. Then the
insurance company would set the cost
or premium for the group of insured at
$ 1,132,000 per project insured.
$ 1,200,000/ 1.06 = $ 1,132,000
This would be a substantial savings over
the $ 1,887,000 premium when there was
a single project, but it is still more than
the expected cost of $ 1 million.
Note that charging $ 1,132,000 for
an expected liability of $ 1 million is
equivalent to discounting the expected
cash flow of $ 1 million at a negative 13.2
percent.
It should be clear from this example
that the introduction of enough risk into
the problem will cause the appropriate
discount rate to become negative. The
cash flow to be discounted should be
adjusted upward to reflect the risk; the
greater the risk, the greater should be
the upward dollar adjustment.
Even if there are a large number of
projects to be covered, insurers also
must recognize the additional need to
adjust for whether the individual insured
projects have correlated or uncorrelated
risk. The willingness of people to sup-ply
insurance depends on the ability to
diversify the risk. The more correlated
the risks, the less diversification helps.
For automobile insurance, whether or
not one insured person has an accident
has little to do with whether another
insured person has an accident; the risks
are independent and diversifiable. But,
for example, with hurricane insurance,
the risks are not independent. If one
person has a home destroyed by the
hurricane then usually several people
do. In the cases of correlated risks such
as hurricanes, earthquakes, or floods,
the insurance company must charge
even more than the expected or average
cost to make sure that there is enough
available to cover all the costs, which will
tend to arrive for several of the insured
at the same time.
The cost to cure environmentally
damaged property usually demonstrates
much more predictability than hurri-canes
or earthquakes, but the economic
principles are the same. The present
value of the cash flows is the price the
owner of the property must pay someone
to assume the responsibility of the clean-up
costs in the future. If the costs were
known with certainty, then someone
would charge based on the return they
could earn on a reserve account. How-ever,
environmental clean- up costs are
much more unpredictable. Even worse,
the future costs tend to be correlated
because when the federal government
or one state adopts a change in regula-tions,
most other states adopt similar
rules. This is due to the fact that rule
changes tend to be the result of a study
or new findings about the hazards. An
insurer’s reduced ability to diversify will
increase the present value, which is the
price that an insurer would charge to
accept the liability.
Functional Obsolescence
Discounting Process
Technologies and production processes
change over time and as a result, a
facility’s existing design may cause the
owner to incur additional labor, trans-portation,
administrative, or other costs
above what a facility with a new design
would require. These excess operating
costs reduce the value of the existing
facility.
However, these excess operating costs
not only reduce the margin, but they also
increase the volatility or risk of earnings.
As a result, the cash flows of the com-pany
with excess operating costs must
be discounted at a higher rate to reflect
this risk. Increasing the discount rate on
Journal of Property Tax Assessment and Administration • Volume 2, Issue 4 39
positive cash flows reduces the present
value of these cash flows. To reflect both
the reduced margin and the increased
risk, these excess operating costs must be
discounted at a much lower rate than the
rate used for positive cash flows. Decreas-ing
the discount rate on costs ( negative
cash flows) also reduces the present
value of these cash flows. Increasing
discount rates for benefits ( positive cash
flows) and decreasing discount rates for
costs ( negative cash flows) both reduce
the value of the property which is the
expected outcome.
To illustrate this, consider the follow-ing
example in which excess operating
costs are fixed each period and do not
fluctuate. Suppose the operation with
excess operating costs must pay $ 1,200
in costs regardless of what happens to
revenues, but the efficient operation
only incurs fixed costs of $ 1,000. The
additional $ 200 in costs reflects the
functional obsolescence of the inef-ficient
property. Suppose the efficient
operation cost $ 4,000 to build. As table 1
illustrates, the income approach for the
efficient operation produces a value just
equal to the cost of $ 4,000.
The fact that the inefficient operation
has a 300 percent fluctuation around its
average while the efficient operation has
only a 150 percent fluctuation around
its average means that the cash flows of
the inefficient operation ( the one with
functional obsolescence as evidenced by
the additional $ 200 of costs) are riskier.
Riskier cash flows must be discounted at
a higher rate. If that rate is 20 percent,
then the inefficient operation is worth
Table 1. Comparison of Income Approach Valuations for Lower- risk and Higher- risk Compa-nies
Efficient Operation Company Excess Operating Costs Company
Good Market Bad Market Good Market Bad Market
Quantity 1,000 800 1,000 800
Price $ 3.00 $ 2.00 $ 3.00 $ 2.00
Variable Cost/ Unit $ 1.00 $ 1.00 $ 1.00 $ 1.00
Fixed Cost $ 1,000 $ 1,000 $ 1,000 $ 1,000
Excess Cost due
to Functional
Obsolescence
$ 200 $ 200
Revenues $ 3,000 $ 1,600 $ 3,000 $ 1,600
Costs $ 2,000 $ 1,800 $ 2,200 $ 2,000
Profits $ 1,000 ($ 200) $ 800 ($ 400)
Average Profits $ 400 $ 200
Deviation from
Average + 150% - 150% + 300% - 300%
Capitalization Rate 10% 20%
Present Value $ 400/. 10 = $ 4,000 $ 200/. 20 = $ 1,000
40 Journal of Property Tax Assessment and Administration • Volume 2, Issue 4
only $ 1,000 compared to the $ 4,000
value of the efficient operation. This in-dicates
that there is $ 3,000 of functional
obsolescence.
To use the cost approach for the inef-ficient
facility, an appraiser must first
value the efficient operation at a cost of
$ 4,000 and then subtract an adjustment
for the functional obsolescence reflected
by the excess operating costs. To value
functional obsolescence, the excess op-erating
cash flows must be discounted
at a lower rate than the rate used on the
efficient operation’s positive cash flows.
In this case, the appropriate rate is 6.67
percent, which produces the more ap-propriate
value of the operation with
excess operating costs.
$ 4,000 - ($ 200/. 0667) =
$ 4,000 - $ 3,000 = $ 1,000
If, however, an appraiser were to make
the error of using 10 percent to value the
excess operating cash flows, the same
rate as that used on the positive cash
flows of the efficient operation, then a
significant overvaluation of the property
would result:
$ 4,000 - ($ 200/. 10) =
$ 4,000 - $ 2,000 = $ 2,000
The $ 2,000 estimated value produced
by this erroneous approach is twice the
appropriate value of the property. The
mistake of using the same rate to dis-count
excess operating cash flows can
lead to significant overvaluations.
FAS Rule 143
A recent accounting ruling has made the
issue of valuing the negative cash flows
associated with environmental cleanup
or asset removal particularly current and
critical. The recently passed FAS 143:
Accounting for Asset Retirement Obligations
( FASB 2001) requires that, for some
assets, an adjustment for the future
retirement cost of the asset be included
in the financial statements. Appraisers
may be asked to determine the current
value of future retirement costs for ac-counting
purposes. A cursory reading of
the pronouncement seems to indicate a
discounting process. However, the word-ing
in the document indicates that the
accounting profession is aware of the
above difficulties and the “ discounting”
discussed in the document may refer to
the previously described technique that
insurance companies use.
Paragraph 8 of the rule explicitly in-dicates
that
In addition, an asset retirement obliga-tion
will usually have uncertainties
in both timing and amount. In that
circumstance, employing a traditional
present value technique, where uncer-tainty
is incorporated into the rate, will
be difficult, if not impossible. ( FASB
2001)
Although the effective meaning and
impact of the standard will not be known
for several years, this statement probably
reflects the issue discussed earlier that
increasing risk implies a lower ( and
perhaps negative) discount rate, not a
higher one.
In addition, the discounting process
discussed in the rule may be the one
described in the earlier discussion of the
insurance approach. In this approach,
the risk- adjusted cash flow is discounted,
not the expected cash flow. Indeed, the
wording of paragraph 8 of the rule may
indicate exactly this:
Concepts Statement 7 discusses two
present value techniques: a traditional
approach, in which a single set of esti-mated
cash flows and a single interest
rate ( a rate commensurate with the risk)
are used to estimate fair value, and an
expected cash flow approach, in which
multiple cash flow scenarios that reflect
the range of possible outcomes and a
credit- adjusted risk- free rate are used to
estimate fair value. ( FASB 2001)
It is much too early to know for sure
the effect FAS Rule 143 will have, but the
“ credit- adjusted risk- free rate” may be
Journal of Property Tax Assessment and Administration Volume 2, Issue 4 41
the conceptual equivalent of the negative
13.2 percent in the example in which
insurance companies discounted the
cash flow, which ensured survival with
95 percent probability. The insurance
approach described above does involve
a discounting process, which Rule 143
refers to, but it is much more complex
than a simple present value technique.
Of course, there is no implication in
any of this discussion that the accounting
treatment imposed by Rule 143 equals
the impact on market value. Accounting
rules can have an impact, but the value
of impact should always be measured by
direct market observation.
Summary
In the cost approach to valuation, ap-praisers
must adjust the cost approach
for functional obsolescence, environ-mental
cleanup, or other asset removal
costs. Usually, this involves valuing a set
of future negative cash flows. As the risk
or uncertainty of these negative cash
flows increases, the appropriate discount
rate should decrease, not increase. There
is a significant probability that the cor-rect
discount rate should be negative if
the uncertainty, or risk, is great enough.
This fact may explain the high discounts
associated with contaminated property
( Mundy 1992).
Of course, the basic concept that a
different discount rate is required on
negative cash flows than positive cash
flows may be applicable to more than
just the cost approach. There are, of
course, other situations in which an ap-praiser
must value negative cash flows in
which the concepts of this article may be
applicable.
References
Bernstein, P. L. 1996. Against the gods: The
remarkable story of risk. New York: John
Wiley & Sons.
Bodie, Z., A. Kane, and A. Marcus. 2005.
Investments, 6th ed. New York: McGraw-
Hill/ Irwin.
FASB. 2001. Statement of financial account-ing
standards no. 143: Accounting for asset
retirement obligations. Norwalk, CT: Finan-cial
Accounting Standards Board.
Mundy, B. 1992. Stigma and value. The
Appraisal Journal 60 ( January): 7- 13.
Pratt, J. W. 1964. Risk aversion in the
small and the large. Econometrica 32 ( 1-
2): 132– 36.
42 Journal of Property Tax Assessment and Administration Volume 2, Issue 4