The market extraction method serves as a way to estimate depreciation for an investor who does not know specific details about individual items inside an office building, a retail store or another business. The investor uses the market extraction method as part of the cost approach method to help him decide how much to offer for a business he wants to buy, using the proceeds of another sale as a comparison.
To use the market extraction method, the investor first separates out the value of the land in the sale. If a restaurant owner sells her restaurant for $800,000, and the plot that the restaurant is on is worth $500,000, the investor subtracts the value of the plot from the restaurant proceeds, leaving him $300,000 to assign to the other items inside the restaurant.
The investor then uses the restaurant's cost to purchase new tools to determine how much depreciation to record for each item that the restaurant owns. If the investor estimates that purchasing new tables, chairs, ovens and silverware costs $500,000, he can compare this to the $300,000 in proceeds that the restaurant owner receives after deducting land, so the price includes 40 percent depreciation.
The disadvantage of market extraction is that this method does not separate assets into individual classes. The restaurant building itself may remain standing for 50 years, but the owner may normally replace an individual chair after four years. Under the market extraction method, the investor estimates 40 percent depreciation on both the chair and the building, so one of these values is probably not very accurate.
After subtracting land value, the investor uses the age of the business's assets to estimate the speed of depreciation in the industry. If the investor determines that a restaurant that has fixtures that are 20 years old has lost 40 percent of its value, this is a rate of 2 percent per year, assuming that the value of the equipment in the restaurant decreases at a steady rate.
The investor then applies the market extraction method when he bids on another restaurant. If a nearby restaurant is on land that is worth $600,000, and its equipment is 15 years old and would cost $400,000 to replace, the investor can apply 30 percent depreciation to the equipment, so he adds $280,000 for equipment and $600,000 for the plot to reach a bid price of $880,000.
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