Exhibit 99.7
SYNTHETIC LEASE PORTFOLIO
HANOVER EQUIPMENT TRUST 2001 A
NATURAL GAS COMPRESSORS
Appraisal Report
As of August 16, 2001
Prepared for
Hanover Compression Limited Partnership
Houston, Texas
ANY PARTIES THAT RECEIVE OR USE THIS
APPRAISAL REPORT AGREE TO BE BOUND BY ALL
THE PROVISIONS OF AMERICAN APPRAISAL'S
APPRAISAL REPORT, WHICH SHALL BE SUBJECT TO
SUCH LIMITATIONS AND QUALIFICATIONS SET
FORTH IN THE ENGAGEMENT LETTER, AND MAY
THEREBY RELY ON SUCH APPRAISAL REPORT. ANY
PARTIES THAT RECEIVE OR USE THIS APPRAISAL
REPORT AGREE TO BE BOUND BY ALL THE
PROVISIONS OF AMERICAN APPRAISAL'S APPRAISAL
REPORT, WHICH SHALL BE SUBJECT TO SUCH
LIMITATIONS AND QUALIFICATIONS SET FORTH IN
THE ENGAGEMENT LETTER, AND MAY THEREBY RELY
ON SUCH APPRAISAL REPORT.
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October 31, 2001
Hanover Compression Limited Partnership
Houston, Texas
In accordance with Hanover Compression Limited Partnership's ("Hanover")
authorization of October 19, 2001, we have made an investigation and appraisal
as of August 16, 2001 (the "Valuation Date"), of natural gas compressors,
including: (i) 688 natural gas compressors (the "Original Equipment") referenced
in our summarization letter (the "Original Summarization Letter") and final
appraisal report prepared in connection therewith (the "Original Report"), both
dated August 22, 2001; (ii) the original 688 natural gas compressors based upon
revised information supplied to us by Hanover (the "Revised Original
Equipment"); (iii) 618 natural gas compressors that are a subset of the Original
Equipment (the "Updated Equipment"); and (iv) 70 natural gas compressors that
were a part of the Original Equipment and that are not a part of the Updated
Equipment (the "Excess Equipment"; the Excess Equipment, the Original Equipment,
the Revised Original Equipment, and the Updated Equipment are from time to time
generically referred to herein as the "Equipment"). We submit our findings in
this report (the "Updated Report").
This report is intended to comply with the purpose and reporting requirements
set forth by the Uniform Standards of Professional Appraisal Practice ("USPAP")
for a summary appraisal report. As such, it presents only summary discussions of
the data, reasoning, and analyses that were used in the appraisal process to
develop the opinions of value of American Appraisal Associates, Inc. Supporting
documentation concerning these matters has been retained in our work papers. The
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depth of discussion contained in this report is specific to your needs as the
client and for the intended use stated. American Appraisal Associates, Inc., is
not responsible for the unauthorized use of this report.
It is our understanding that you have executed a synthetic lease (the "Lease")
with a term of approximately seven years (the "Lease Term"), and which will
terminate on September 1, 2008 (the "Lease Termination Date").
The Equipment was not inspected by American Appraisal Associates, Inc., for this
appraisal. In the course of our valuation analysis of this Equipment, we used
information supplied to us by Hanover. We have assumed the information supplied
to be a complete and accurate representation of the assets to be included in
this appraisal. The information received and relied upon is summarized in
Exhibit B of this report.
Our report consists of
This letter, setting forth the purpose of the appraisal, a
description of the property appraised and the industry in which it
is operated, an outline of the valuation procedures employed, the
conclusions of value, the assumptions and limiting conditions
affecting the values concluded, and a statement of general service
conditions
Exhibits, comprising
Exhibit A - Signed Amended and Restated Engagement Letter
B - Information Received and Relied Upon
C - Equipment Schedules
D - Certificates of Appraisers
E - Qualifications of Appraisers
F - Qualifications of American Appraisal Associates, Inc.
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Purpose of the Appraisal
This appraisal provides our opinions of the following:
1) Whether or not the Original Equipment, the Revised Original Equipment,
the Updated Equipment, and the Excess Equipment, in each case, is
reasonably projected to have an economic useful life in excess of 134%
of the Lease Term;
2) The fair market value in continued use of the Original Equipment, the
Revised Original Equipment, the Updated Equipment, and the Excess
Equipment, in each case, at the inception of the Lease Term;
3) The future fair market value in continued use (residual value) of the
Original Equipment, the Revised Original Equipment, the Updated
Equipment, and the Excess Equipment, in each case, at the end of the
Lease Term (and possibly other points as well), expressed in projected
then-current dollars, assuming such Equipment has been maintained and
returned according to the provisions of the Lease. The property would
be offered for sale in an "as-is, where-is" condition and location;
4) Whether or not the Original Equipment, the Revised Original Equipment,
the Updated Equipment, and the Excess Equipment, in each case, is
limited-use property, as that term is defined in the relevant Revenue
Procedures; and
5) A demonstration of the value of the security after the removal of the
Excess Equipment from the Original Equipment as compared to that set
forth in the Original Summarization Letter and the Original Report.
We understand these opinions will be used to support your efforts to arrange
synthetic lease financing and an exchange offer with respect to notes issued in
connection therewith. This appraisal cannot be used for any other purpose.
Terminology
This appraisal and the methodology employed are based on the following
definitions:
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Economic useful life is defined as the estimated period of time over which it is
anticipated an asset may be profitably used for the purpose for which it was
intended. This time span may be limited by changing economic conditions, factors
of obsolescence, or physical life.
Fair market value is defined as the estimated amount at which the property might
be expected to exchange between a willing buyer and a willing seller, neither
being under compulsion, each having reasonable knowledge of all relevant facts.
When fair market value is established on the premise of continued use, it is
assumed the buyer and the seller would be contemplating retention of the
property at its present location for continuation as part of the current
operations. An estimate of fair market value arrived at on the premise of
continued use does not represent the amount that might be realized from
piecemeal disposition of the property in the open market or from an alternative
use of the property. The premise of continued use is generally appropriate when
The property is fulfilling an economic demand for the service it
provides or which it houses.
The property has a significant remaining economic useful life
expectancy.
Responsible ownership and competent management may be expected.
Diversion of the property to an alternative use would not be
economically feasible or legally permitted.
Continuation of the existing use by present or similar users
is practical.
Functional utility of the property for its present use is given due
consideration.
Economic utility of the property is given due consideration.
In our investigation, we appraised the designated property as part of an
operating entity. Balance sheets, financial statistics, and operating results
furnished to us
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were accepted without verification, were examined, and were assumed to properly
represent business operations and conditions. Given the trends indicated, it
was concluded that prospective profits were adequate to justify ownership and
arm's-length exchange of the designated property between a willing buyer and a
willing seller at the appraised fair market value. In the review, provisions
were made for the value of property not included in the appraisal and for
sufficient net working capital.
Residual value is defined as the estimated fair market value in continued use
as of a future date, with consideration given to the effects of inflation or
deflation as measured from the appraisal date; assuming the property is in good
condition and will continue to be maintained in good operating condition with
normal preventive maintenance; and assuming the market for used equipment of
this nature at the future date will not reflect unusual conditions of supply
and demand.
Original cost is defined as the actual or normal cost of new property in
accordance with market prices as of the date the property was first constructed
and originally installed.
Cost of replacement new is defined as the estimated amount required to replace
the entire property at one time with a modern new unit using the most current
technology and construction materials that will duplicate the production
capacity and utility of an existing unit at current market prices for materials,
labor, and manufactured equipment; contractors' overhead and profit; and fees;
but without provision for overtime, bonuses for labor, or premiums for material
or equipment.
Depreciation is defined as the loss in value from any cause in comparison with
a new item of property of like kind, resulting from physical deterioration,
functional obsolescence, and economic obsolescence.
Physical deterioration is defined as a form of depreciation that is
the loss in value resulting from wear and tear in operation and
exposure to the elements.
Functional obsolescence is defined as a form of depreciation
resulting in a loss in value caused by conditions within the
property such as changes in design, materials, or process and
resulting in inadequacy, overcapacity, excess construction, lack of
utility, or excess operating costs.
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External obsolescence is defined as a form of
depreciation, or an incurable loss in value, caused by
unfavorable conditions external to the property such as
the local economy, economics of the industry,
availability of financing, encroachment of objectionable
enterprises, loss of material and labor sources, lack of
efficient transportation, shifting of business centers,
passage of new legislation, and changes in ordinances.
Equipment Description
The Original Equipment consists of 688 natural gas compressors, with horsepower
("hp") ratings ranging from 200 hp to 2,590 hp, for a total of 706,938 hp, with
an average of 1,028 hp. The average hp age of the Original Equipment is
approximately 8.8 years. A detailed listing of the Original Equipment was
supplied by Hanover and is included as part of Exhibit C of this report.
The Revised Original Equipment consists of 688 natural gas compressors, with hp
ratings ranging from 200 hp to 2,590 hp, for a total of 706,938 hp, with an
average of 1,028 hp. The average hp age of the Revised Original Equipment is
approximately 8.8 years. A detailed listing of the Revised Original Equipment
was supplied by Hanover and is included as part of Exhibit C of this report.
The Updated Equipment consists of 618 natural gas compressors, with horsepower
("hp") ratings ranging from 200 hp to 2,590 hp, for a total of 619,468 hp, with
an average of 1,002 hp. The average hp age of the Updated Equipment is
approximately 8.8 years. A detailed listing of the Updated Equipment was
supplied by Hanover and is included as part of Exhibit C of this report.
The Excess Equipment consists of 70 natural gas compressors, with horsepower
("hp") ratings ranging from 1,232 hp to 1,478 hp, for a total of 87,470 hp, with
an average of 1,250 hp. The average hp age of the Excess Equipment is
approximately 8.8 years. A detailed listing of the Excess Equipment was supplied
by Hanover and is included as part of Exhibit C of this report.
The Equipment is currently in service within Hanover's fleet; installed along
natural gas pipelines, as well as wellhead locations, located throughout various
states; or located at one of Hanover's facilities, ready to be installed.
On August 31, 2001, Hanover acquired Production Operators Corporation ("POC").
Prior to the acquisition, a significant portion of the Equipment was in
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service within POC's fleet; installed along natural gas pipelines, as well as
wellhead locations, located throughout various states; or located at one of
POC's facilities, ready to be installed. This type of equipment serves to
increase the pressure of the natural gas to move the product farther along the
pipeline to distribution points for customer use.
Our investigation dealt specifically with natural gas compressor equipment.
Excluded from the investigation were all other assets.
Industry Analysis
Introduction - Natural gas is a colorless, odorless fuel composed almost
entirely of methane and ethane. It burns cleaner than many other fossil fuels
and is one of the most popular forms of energy today. It is produced by drilling
into the earth's crust to release pockets of organic gas. The gas is brought to
the surface and is refined to remove impurities such as water, other gases, and
sand.
Compared to other energy resources, gas transportation is very efficient.
Natural gas delivery to an end user is more than 90% efficient. Because of this,
natural gas is becoming the fuel of choice in many economic segments, and demand
continues to rise steadily.
Clean-burning gas has grown in popularity with legislators as a way to cope with
environmental issues, as evidenced by the passage of the National Energy Policy
Act of 1992 and the Clean Air Act Amendments of 1990. Increasingly, natural gas
also is being used in combination with other fuels to improve their
environmental performance and to decrease pollution.
Natural gas is used in a variety of different ways in homes, businesses,
electric plants, industrial factories, and cars. According to industry
publications, the major U.S. markets in terms of volume for natural gas are
residential applications (23%); commercial applications (15%); industrial
applications (40%); and electricity generation (14%). Other uses, including
vehicle power, account for the remaining 8%.
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Deregulation - Deregulation has had, and will continue to have, a major effect
on the natural gas industry. The Natural Gas Act, passed in 1938, gave the
Federal Power Commission (now known as the Federal Energy Regulatory Commission,
or "FERC") jurisdiction over companies engaged in interstate sale or
transportation of natural gas. Prior to 1978, the industry's structure was
relatively simple. Gas producers searched for and produced natural gas. They
sold gas to pipeline companies, which transported the gas across the country and
sold it to gas utilities or local distribution companies ("LDCs"). These
companies then sold the gas to end users. The price for which the producers
could sell their gas to interstate pipelines was regulated by the federal
government, as was the price for which the interstate pipelines could sell their
gas to LDCs.
The first step toward making the industry more competitive was the deregulation
of natural gas production, or wellhead gas prices, by the passage of the Natural
Gas Policy Act of 1978. A competitive wellhead market began to develop in the
early 1980s, including a natural gas spot market. However, interstate pipeline
companies continued to act primarily as wholesalers, buying gas from producers
at the wellhead and selling it to LDCs. This policy soon came under pressure
because many LDCs, after arranging low-cost gas purchases directly from gas
producers in the spot market, subsequently found that interstate pipelines
denied them capacity for transporting their independently procured gas.
In 1986, the FERC addressed these problems through the issuance of Order 436,
which provided for an open-access gas transportation program. Despite open
access, the pipeline companies retained a competitive advantage over producers
through the late 1980s and early 1990s because they could combine
transportation, storage, and other services, and thus provide more reliable
overall service.
In April 1992, the FERC issued Order 636 to complete the transition to a
competitive natural gas environment. Order 636 mandated that pipeline companies
"unbundle" their services, so that gas sales, transportation, and storage must
be offered and priced separately to end users. FERC also split off pipelines'
merchant function. Pipelines could no longer directly sell natural gas to LDCs
and other consumers. Beginning with the 1993/1994 heating season, the LDCs
assumed responsibility for negotiating their own gas supply arrangements with
producers and marketers.
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In response to deregulation, the gas market changed dramatically from 1988
through 1999 as a result of both economic and federal initiatives. During this
period, gas production increased by 10%, whereas real wellhead prices fell by
11%. Prices to consumers also dropped, as customers benefitted from declining
wellhead prices and lower transmission costs.
The deregulation of the industry has led to the development and rapid growth of
a type of business that did not exist a few years ago - the independent natural
gas marketer. Gas marketers serve as intermediaries between gas buyers and all
other segments of the industry. They gather and aggregate gas supply, power
generation, and market pipeline capacity, and provide energy services to
distributors and retail customers.
Prices and Demand - A major indicator for the natural gas industry is the price
level. Price level provides valuable information about current and future level
activity in the industry. Specifically, economic growth, weather conditions and
temperature, and competition from other fuels are factors contributing to the
natural gas price level.
In recent years, natural gas prices have been volatile. In 1999, the latest year
for which confirmed data was available, the average natural gas wellhead price
was approximately $2.17 per thousand cubic feet, 11% higher than in 1998, but 7%
lower than 1997. The 1999 monthly wellhead price ranged from a low of $1.68 per
thousand cubic feet in March to a high of $2.67 in November. This rise in prices
in late 1999 can be attributed to the varying amounts of working gas. In January
and February 1999, working gas was estimated to be 22% to 26% higher than in
1998, by July this amount was only 2% greater than in July 1998, and by
December, it was 8% less than in December 1998. With less working gas to supply
the demand, the prices increased.
In the future, several foreseeable factors of demand will have a direct effect
on price levels. First, a new contracting structure has evolved for the purchase
of natural gas and ancillary services. Historically, natural gas was purchased
under contracts of 20 years or more, but under deregulation, "long-term"
contracts may have a term of one year. Another trend that will affect natural
gas consumption is that New England will have significantly greater access to
natural gas. The Sable Island project in the northern Atlantic, which was
completed in late 1999, has expanded
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the potential for growth in the northeastern U.S. market. The largest
contributing factor is environmental concerns that have led to proposals that
may make the consumption of natural gas more attractive.
Addressing these environmental concerns, the leading industrialized nations have
proposed to limit carbon emissions worldwide. An organized consortium called the
Kyoto Protocol directly addresses the carbon emission issue. Natural gas has
been deemed the potential fuel to meet these environmental goals. An estimated
19.5 trillion cubic feet of gas was consumed in 1999, a 2% increase over 1998.
It is expected that natural gas consumption will reach somewhere between 28.58
trillion cubic feet and 36.09 trillion cubic feet by 2020, depending on which
forecast source is referenced; the lower figure from Standard & Poor's DRI, and
the higher from Annual Energy Outlook 2001.
Also related to environmental concerns in the United States is future generation
of electricity. The generation of electricity by coal and fuel oil has come
under pressure lately due to excessive carbon emissions. The use of gas turbines
that consume natural gas is considered the electricity generation of choice in
the future due to lower capital costs, shorter construction lead times, higher
efficiencies in the combined cycle configuration, and the ability to easily
place these turbines in strategic locations. Therefore, the predicted growth in
natural gas demand is directly attributable to its expected use for electricity
generation.
Domestic Production - In the United States, natural gas production occurs
chiefly onshore, but offshore production has been increasing gradually.
The two areas that produce the majority of domestic natural gas are Texas and
the Gulf of Mexico. Although deepwater drilling has greatly increased in the
Gulf, Texas has more reserves by means of extensions at already discovered
reservoirs.
Increases in U.S. natural gas production have not kept pace with increases in
demand in recent years, leading to increases of imports, chiefly from Canada.
While U.S. production experienced only moderate growth between 1986 and 1999,
Canada more than doubled its production of natural gas. The anticipated
continued growth in Canadian production, when coupled with the
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extensive and growing Canadian gas pipeline system, indicates that the
United States expects to be increasing imports as demand increases. The
trans-Canada pipeline was expanded in late 1999, and the new Alliance pipeline
to the U.S. Midwest, completed in 2000, is expected to facilitate this increase
of Canadian imports.
Forecast - Demand for, production of, and prices for natural gas are all
forecasted to increase through 2020. Demand has increased at an average of just
under 2% per year for the past decade, and this growth rate is expected to
continue until 2020. Prices have reflected a similar percentage of growth over
the same period, and this growth is forecasted to continue until 2020.
Domestic offshore production of natural gas is expected to increase from 35.4%
of total U.S. production in 1998 to approximately 40.7% by 2020. The innovative
use of cost-saving technology and the expected midterm continuation of recent
huge finds, particularly in the deep waters of the Gulf of Mexico, help to
support this projection. Although Alaskan production levels are expected to
contribute to this increase, Alaskan natural gas likely will not be transported
to the lower 48 states because the forecasted prices do not support the required
transport system.
A significant factor in the growth of the natural gas compression equipment
industry is the increased consumption of natural gas. In the United States,
natural gas is the second leading fuel in terms of total consumption and is the
fuel of choice for power generation and industrial use. As of December 31, 2000,
domestic natural gas field compression equipment totaled approximately 16.3
million hp. The compression rental industry has experienced rapid growth,
increasing an estimated 16% annually, in terms of hp, and this industry is
expected to grow due to several factors, including increased natural gas
consumption, aging natural gas fields which will require additional compression
to continue static production levels, and increases in outsourcing by companies
with compression needs in order to reduce operating costs and to improve
production and efficiency.
Summary - Based on the growth rates of demand over the past decade, and the
forecasted continued growth in demand, production levels must be increased to
lessen reliance on imported natural gas. As demand and production grow, prices
are also anticipated to grow in proportion.
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With increases in production forecasted, the need for natural gas compressors
also will increase, thereby indicating a strong market in the mid- to long-range
forecast.
Company Profile
The Hanover Company is an international leader in three complimentary business
enterprises: natural gas compression services, compression fabrication and
processing, and oil & gas production equipment. Hanover Compressor Company,
founded in 1990 and publicly traded since 1997, is the market leader in full
service natural gas compression, and a leading provider of service, financing,
fabrication and equipment for contract natural gas handling applications.
The Hanover Company maintains a rental compression fleet with in excess of 2.5
million hp, the largest in the industry. Operations are primarily in the
Western Hemisphere, including the United States and Canada, Argentina,
Venezuela, and Mexico; and operations continue to expand into Europe, Asia,
and Australia.
Following the acquisition of POC, Hanover remains the largest supplier of
natural gas compressor packages, increasing its worldwide rental fleet
compression by approximately 900,000 hp.
Primarily, Hanover combines complete compressor units from manufacturers such
as Ariel and Gemini, amongst others, on a steel skid with natural gas-fired
drivers (engines) from manufacturers such as Caterpillar and Waukesha, amongst
others, and then adds aftercoolers, which are required to maintain a working
temperature for the compressed gas. Hanover also has a large number of Ajax
integral design compressor systems. With an Ajax system, the compressor and
engine share a common frame and crankshaft and the engine is two-cycle with
fuel injection; this design is unique among field gas compressors and has been
around for over50 years.
All units are tested prior to placement in the field. Hanover maintains a high
degree of quality control through an in-house assembly, maintenance, and
testing process. When compressor systems are added to the Hanover fleet through
acquisition of other companies' fleets, these acquired systems are subjected to
Hanover's rigorous maintenance process.
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Economic Useful Life (Opinion 1)
The standard method for estimating the economic useful life of a property is to
determine the total expected life (new) of the property on a
component-by-component basis and then adjust the estimate for anticipated or
actual physical, functional, and external depreciation. For new property,
depreciation is not taken into consideration since the components are new,
employ state-of-the-art technology, and have not been used in production.
Consideration must also be given to the maintenance and repair policies of a
potential user. Factoring these considerations into the analysis helped to
determine the physical useful life of the Equipment.
In establishing the economic useful life of the Equipment, we identified the
Equipment by its asset class. Because different types of equipment experience
different amounts of physical, functional, and external depreciation, the
Equipment must be categorized by asset life and type. Then, each component can
be analyzed by the way it is utilized and the environment in which it functions.
The first part of the investigation and valuation analysis was accomplished
through discussions with Hanover representatives regarding preventive
maintenance, anticipated utilization rates, and general quality of the
manufacturer of the Equipment.
The second step in the economic useful life analysis was to determine expected
lives for the components. This was possible after analyzing the information
gathered through conversations with Hanover representatives. As part of our
analysis, we researched the market for assets of this type, reviewed past
analyses, and held discussions with dealers of this type of equipment.
By correlating all of this information and data, we were able to estimate the
economic useful lives for the various components. We confirmed these estimates
through conversations with the original manufacturer or manufacturers of similar
equipment.
Therefore, based on the above information and analyses, it is our opinion that
the economic useful life of each item of Equipment, under normal operating
conditions, is at least 20 to 25 years. The extensive predictive/preventive
maintenance policies employed by Hanover and POC greatly increase the economic
useful life, such that a properly maintained unit is expected to have a useful
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life of 40 years or more. The average hp age of the Equipment is approximately
8.8 years. Using an average life of 22.5 years, without taking into account
Hanover's and POC's extensive predictive/preventive maintenance policies, the
average remaining economic useful life of the Equipment is 13.7 years, which is
greater than 134% of the Lease Term, or 9.38 years. Taking into account the
predictive/preventive maintenance policies, the remaining economic useful life
would be in excess of 20 years, which is sufficiently greater than 134% of the
Lease Term.
Valuation Procedures
In any appraisal, consideration must be given to the three approaches to value.
These are the income approach, the market approach, and the cost approach. These
approaches are outlined as follows:
The Income Approach
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The income approach establishes the value of the property on the
basis of capitalization of the net earnings or cash flow. The income
approach is typically used in the valuation of assets which produce,
or are capable of producing, an identifiable stream of income or
cost savings that can be uniquely quantified.
The Market Approach
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The market approach establishes value through analysis of recent
sales of comparable property. An analysis is made of the differences
between the properties and the subject, and the sale prices are
correspondingly adjusted to arrive at indications of the subject's
value. The market approach is commonly employed in the appraisal of
machinery and equipment and other replaceable property for which
there is a known and active used market.
A variant of the direct market comparable approach is the use of
market relationships. Recent market prices for property in an asset
classification are determined with respect to age and are compared
with a benchmark price, such as the cost of reproduction new (a
"market:cents-on-the-dollar" relationship). The ratio is applied to
similar assets in the classification when the secondary market for
the subject equipment is too sparse to exhibit appropriate
comparables.
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The Cost Approach
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The foundation of the cost approach is the proposition that an
informed purchaser would pay no more for a property than the cost of
producing a substitute property with the same utility. When the
approach is applied, property facts are assembled in an appraisal
inventory, and data regarding costs and price-governing factors are
gathered. The accumulated data are then employed to develop the cost
of reproduction new or the cost of replacement of the subject
property.
From the cost to reproduce the property as if new, an amount is
deducted for accrued depreciation or physical deterioration, plus
any functional and economic obsolescence that might exist. If the
cost of replacement has been determined, no penalty for functional
obsolescence is applied, since this cost represents that of a
state-of-the-art property. The cost approach ordinarily supplies the
most reliable indication of the fair market value of special
structures, systems, and special machinery and equipment.
The nature of the assets to be appraised, as well as the premise of value and
purpose for which the value conclusions are developed, bears heavily on which
approaches to value are appropriate.
All three approaches to value were considered. Since this appraisal is under the
premise of continued use, we used the cost and income approaches to value. While
individual assets of similar type are indeed marketed, the available data are
not sufficient to support a market approach to value.
Fair Market Value in Continued Use (Opinion 2)
Cost Approach - The cost approach generally provides a meaningful indication of
the value of special systems and special machinery and equipment. In this
instance, the original cost of the Equipment was not available, so in order to
determine the fair market value in continued use of the Equipment as of the
Valuation Date, we first determined the current cost of replacement new of each
item of the Equipment, with the assistance of representatives from Hanover. This
current cost of replacement new represents what a similar compressor system
would cost if sold to a customer and installed in the field. Once this current
cost of replacement new was determined, we reduced the cost of replacement new
by applying a factor representative of physical depreciation. Since all causes
of obsolescence were accounted for in determination of the economic useful life
of the
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Equipment, the depreciation factor is based on an effective age-life calculation
method over the expected remaining economic useful life of the individual pieces
of the Equipment.
We discussed Hanover's and POC's predictive/preventive maintenance policies with
representatives from Hanover and have determined that, to remain competitive in
the industry, the Equipment must be maintained in new to like-new condition.
Since these compressors are designed to run 24 hours per day, seven days per
week, the units must be continuously maintained. This predictive/preventive
maintenance keeps the units in top working condition. Based on the frequency and
type of maintenance performed, the effective age of even the oldest units in the
fleet has been determined to be between five and six years. If a compressor has
been in operation for this amount of time, it would be scheduled for a complete
overhaul, which would effectively reduce the age of the unit to near zero,
reflecting like-new condition.
Based on our analyses and the discussion above, it is our opinion that the fair
market values in continued use of the Original Equipment, the Revised Original
Equipment, the Updated Equipment, and the Excess Equipment, in each case at the
inception of the Lease Term, as determined through the cost approach, are
reasonably presented in the following table:
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Fair Market Value in Continued Use - Cost Approach (U.S.$)
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Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
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298,467,100 345,630,759 298,471,900 47,158,859
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Income Approach - The income approach to value recognizes the economic benefits
inherent in the ownership rights of the subject asset, when used in the
production of income. While this approach may result in somewhat different
conclusions than other approaches to value, it can be a very reliable indicator,
as most business decisions are based on economic influences. This section of our
report describes the methodology, inputs, and assumptions used in that analysis.
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Discounted Cash Flow Methodology - We utilized a common financial technique
known as the discounted cash flow method to determine the income approach
indication of value. This technique relies on projections of income, expenses,
and other receipts and expenditures reasonably anticipated over the life of the
subject assets. These figures become the basis for projected net cash flow, the
amount of cash that the providers of capital might receive or disburse, after
tax, through the highest and best business use of the assets. Projections are
made on a debt-free basis, that is, without consideration of interest costs that
may be incurred. The reason for this perspective is that the resulting invested
capital net cash flow is the return available to all equity sources, including
creditors and owners.
Finally, the projected invested capital net cash flow is converted from future
amounts into present amounts, through a process known as discounting.
Discounting reflects the time value of money in any investment situation.
Generally, investors prefer to have cash now versus some time in the future.
Since the nature of most investments includes waiting for future receipts of
cash, investors expect to earn a return on their investment, much like interest
paid by a bank to savings account holders. Discounting incorporates a fair
return for all equity holders of the subject assets, and reduces the value of
anticipated future cash flows which typical investors would expect.
Generally, the rate of return utilized in the discounting process accounts for
various risks inherent in the subject assets, as well as foregone returns
available from less risky investment alternatives, such as U.S. Treasury Bonds.
A more complete discussion of the discount rate used for this analysis is
provided on the weighted average cost of capital section.
Once discounted to present value, the projected invested capital net cash flows
are summed to determine the aggregate cash return expected for the subject
asset, in terms of present value. This sum of present values of projected
invested capital net cash flows represents the economic benefit, or return, from
the asset, in current terms. This amount is also the maximum amount that a
prudent investor would be willing to pay for the asset. Hence, this sum
represents an indication of fair market value.
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Assumptions - In our application of the discounted cash flow methodology, we
made certain assumptions that result in the projected cash flows. The specific
assumptions used, and how they affect the analysis, are discussed in the
following sections.
Revenue - The subject natural gas compressors include a wide variety of hp
ratings, which have been classified into categories established by Hanover.
Revenue data provided by Hanover that were specifically related to the type of
units included were utilized.
The number of units and average rent per month were utilized as the basis for
projecting revenues that could be derived from the Equipment. Number of units
times rent per month times 12 months equals the maximum annual rent available
for each group of units. Since units are not necessarily utilized every day,
rents may not be due for every day of the year. According to information
provided by Hanover, average overall utilization for their most recent five
years was 92.50%; for their most recent fiscal year, 2000, was 93.22%; and at
the Valuation Date was approximately 92.60%. Considering these various
indications, we projected long-term overall utilization at 90%. We assumed that,
as each group of units ages to the end of its physical life, utilization would
decline to 75% over the last five years of physical life due to increased
maintenance and repair, as well as some retirements from the group. Finally, at
the end of the physical life (reflecting the average age of the group), the
utilization is adjusted to zero, as the remaining units in the group are
presumed to be retired or replaced.
We also made an assumption regarding the rents per month that may be charged in
the future. According to published Producer Price Index information, average
historical inflation in the transportation industry has been approximately 2.0%.
The recent experience of Hanover reflects both increases and declines, due at
least in part to the acquisition of assets leased at below-market rents and
Hanover's efforts to put idle units into service. Based on this information, we
projected growth in the rate per diem at 2.0% throughout. We believe this
accounts for recent historical patterns of growth in per diem rents, as well as
typical core inflation.
The projections of revenue included in our analysis reflect the average
annualized utilization percentages, rounded, then multiplied by the rent per
month available for each group of units.
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Expenses - Based on our analysis of historical information provided by Hanover,
we determined the expense characteristics of the entire portfolio of compressors
owned by HET 2001 A and leased to Hanover. We applied the general expense
characteristics of Hanover's overall experience to determine the anticipated
expenses of the Equipment. Hanover has improved margins steadily and anticipates
further improvements. For this reason, operating expenses were projected at the
most recent indicated results, rounded. We believe that the recent observations
provide a reasonable basis for the projections because the historical data show
substantial improvements in recent years.
Operating expenses were estimated at 35.0% of revenue. We also incorporated a
small amount for administrative costs, based on Hanover's experience. The
administrative costs were projected at 9.0% of revenue.
While depreciation is not a cash expenditure, the deduction of depreciation in
calculating taxable income results in a tax savings. Therefore, we deducted
depreciation of the Equipment value as well as any capital expenditures before
considering the income tax which must be paid, then added the amount back, since
no cash was expended. Depreciation of the chassis was determined under the
statutory provisions of the Internal Revenue Code. We utilized the standardized
percentages of the Modified Accelerated Cost Recovery System for an asset with
a seven-year recapture period. We selected this depreciation category from
descriptions of asset classes provided by the Internal Revenue Service.
Income tax was then deducted from the income in determining cash flows. We
considered the marginal rate of tax to be appropriate since a hypothetical
investor would incur this level of tax due to the incremental income, regardless
of the investor's actual tax situation. In the event that an investor pays less
tax than this rate, the tax savings of other items would clearly be offset by
the tax due on the income of the portfolio. Therefore, our analysis assumes
income tax payments at the rate of 40% of taxable income. This rate reflects the
marginal tax rate for federal income tax and an allowance to provide for the
average rate of state income taxes.
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Working Capital - Most businesses require a small amount of liquid assets
(primarily cash and equivalents) in order to meet day-to-day obligations of
operating the business. To reflect the need to sustain this necessary resource,
we have assumed that a hypothetical buyer of the Equipment would retain three
months' operating costs, basically allowing a 90-day lapse between payment of
expenses and receipt of customer payments.
Capital Expenditures - Capital expenditures are also a deduction from cash flow.
These costs represent nondepreciable cash expenditures required to maintain and
improve the subject property. While depreciation of these costs is calculated in
prospective periods, resulting in a tax savings, the initial cash outlay is
nondeductible for tax purposes. However, the cash outlay is a reduction in the
cash available to provide investor returns. The information available from
Hanover with respect to capital expenditures is rather limited. Based upon our
experience, we project initial capital expenditures at $12 million per year. We
have further assumed that the amount of capital expenditures would increase at
the rate of 2.50% per year.
Salvage Value - We have assumed that the salvage value of the compressor units
at retirement (after deinstallation costs) is negligible and, accordingly, have
assigned zero salvage value in our projections.
Debt-Free Net Cash Flow - Using the above assumptions, we projected the expected
debt-free net cash flow of the subject Equipment. Debt-free net cash flow was
defined as revenue, less expenses, taxes, capital expenditures, and working
capital requirements, plus depreciation add-back. The next step in the
discounted cash flow method is to determine a discount rate for application to
the projected net cash flows.
Weighted Average Cost of Capital - The discount rate applied to the debt-free
net cash flow mathematically expresses perceived risk. Perceived risk represents
the uncertainty related to achievement of the forecasted earnings levels.
In examining an investment situation, an investor would weigh the perceived
levels of business and financial risk against the return expected from the
investment. The discount rate utilized in this
American Appraisal Associates Page 21
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analysis is the weighted average cost of capital ("WACC") for companies
in Standard Industrial Classification ("SIC") Code 138, Oil and Gas Field
Services. It is the rate of return required to compensate an investor for
undertaking an investment in the Equipment.
The equation for the WACC is as follows:
WACC = [Kd x %D x (1-T)] + (Ke x %E)
where
Kd = Cost of debt capital
%D = Proportion of debt capital to total capital
T = Marginal tax rate
Ke = Cost of equity capital
%E = Proportion of equity capital to total capital
The rate of return on debt capital (Kd) is the current rate that an investor
would pay for long-term debt capital to finance the business. We considered
several indicators of the cost of debt. First, we considered published rates for
typical debt in the market. As of July 27, 2001, the following rates were
reported by the Federal Reserve Board: prime rate, 6.75%; Moody's AAA, 7.12%;
and Moody's BAA, 7.95%. Since these rates represent current market rates on
publicly issued debt, they provide useful indicators of the rate that might be
required for any public issuances. A rate equivalent to the average of these
rates at or near the Valuation Date (7.5%) was considered appropriate for the
Equipment.
The proportion of debt capital to total capital (%D) is the target degree of
leverage for the firm. It represents the optimal long-term capital structure of
the industry and was determined to be 60% debt and 40% equity based on an
analysis of the capital structures for 28 public companies in SIC Code 138, as
published in Ibbotson Associates' Cost of Capital Quarterly (September 2000), as
well as the actual capital structure of the subject transaction.
The marginal tax rate (T) reflects the interest tax shield on debt and was
estimated at a blended rate of 40.0%.
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The rate of return on equity capital (Ke) is a function of the systematic and
unsystematic risks of a particular security or business asset. Systematic risk
is risk associated with stocks in general and cannot be eliminated in a
diversified portfolio. It is considered to reflect the risks of the economy as
a whole. The components of systematic risk include a risk-free rate of return
plus a risk premium for holding common stock versus risk-free government bonds.
Unsystematic risk, or specific risk, is associated with a particular security
or business asset and can be eliminated in a diversified portfolio. It is
considered to reflect risk unique to the business or asset.
The cost of equity is estimated using the capital asset pricing model ("CAPM"),
modified to account for specific risk. The CAPM is a well-known financial model
that evaluates the risk of a particular security relative to the systematic risk
of a market portfolio of stocks. A basic assumption underlying the CAPM is that
investors are not compensated for undertaking unsystematic risk, which is
diversifiable, but are only compensated for undertaking systematic risk.
While diversification is readily possible for stock investors, it is generally
not feasible for corporations and investors in private businesses. As a result,
unsystematic risk constitutes an important part of buyers' perception of risk
and their required rate of return. To account for unsystematic risk, an
additional risk premium is added to the CAPM-derived cost of equity.
The CAPM equation, modified to account for unsystematic risks, is as follows:
Ke = Rf + ((beta) x Rp) + Ru
where
Ke = Cost of equity capital
Rf = Risk-free rate of return
(beta) = Beta
Rp = Common stock risk premium
Ru = Unsystematic or additional risk premium
In the CAPM, the risk-free rate of return (Rf) is considered to be the yield to
maturity of long-term (20-year) government bonds, which currently are yielding
5.71%, according to the Federal Reserve Bank, as of July 27, 2001.
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Beta ((beta)) is a statistical measure that evaluates the risk of a particular
security relative to the systematic risk of a market portfolio of stocks. The
beta of a stock is computed by regressing the returns from that stock in excess
of the risk-free rate with the returns for a market portfolio of stocks in
excess of the risk-free rate. An appropriate beta for a business can be derived
from analysis of publicly traded companies engaged in similar lines of business.
Ibbotson Associates' Cost of Capital Quarterly reported the median beta for the
28 companies in SIC Code 138 at 0.79. Based on the perceived risk, a beta of
0.79 was selected, which means that the Equipment would have a somewhat lower
risk than the market in general, which has a defined beta of 1.00. This lower
risk, relative to the market, is justified by the demand inelasticity for the
final product to which the units are related, i.e., natural gas. Demand
inelasticity is manifested in relatively sharp price changes with little inverse
change in the quantity demanded, as presently demonstrated in the industry.
The risk premium (Rp) is the return on the market in excess of the risk-free
rate (Rf). The risk premium is based on the average premium over the risk-free
rate that investors in common stocks have earned since 1926. Ibbotson Associates
(Stocks, Bonds, Bills, and Inflation - 2001 Yearbook) reported the current risk
premium at 7.8%.
The unsystematic or additional risk premium (Ru) may be necessary to reflect
size, diversification, depth of management, lack of a public market,
aggressiveness of forecast, or a variety of factors that may make the company
more or less risky than the comparable companies. Ibbotson Associates
investigated the relationship between company size and average annual returns
from 1926 to the present. The results of this study are presented in the
following table:
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Capitalization Average Annual Return in Excess of
Decile(1) Less Than Capitalization Return(2) CAPM
($ Millions) ($ Millions) (%) (%)
- -----------------------------------------------------------------------------------------
1st (Largest) 524,351.6 49,608.0 12.1 -0.20
2nd 10,343.8 6,860.4 13.6 -0.31
3rd 4,143.9 3,034.6 14.2 -0.47
4th 2,177.5 1,671.9 14.6 0.62
5th 1,327.6 1,100.1 15.2 0.93
6th 840.0 695.7 15.5 1.08
7th 537.7 459.8 15.7 0.88
8th 333.4 266.4 16.6 1.47
9th 192.6 134.3 17.4 1.74
10th (Smallest) 84.5 38.6 20.9 4.63
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(1) Based on New York Stock Exchange stocks
(2) Arithmetic mean since 1926
As shown in the above table, smaller companies have higher returns, indicating
higher risk levels, than larger companies. Also, the study indicates that CAPM
tends to progressively underestimate the returns of public companies as they get
smaller.
An investment in the Equipment would require an equity investment amount up to
$300 million, which places the Equipment in the eighth decile. Since CAPM tends
to underestimate the eighth decile's actual returns by 1.47%, this amount was
included with our unsystematic risk premium to more accurately reflect the
expected return to a hypothetical buyer. We also assumed that there would be
additional risk characteristics due primarily to the instability of and recent
spikes in energy costs, and that a prudent investor would require a
significantly greater return in exchange for an investment in this industry. We
have therefore assigned an additional risk premium of 5% to the calculation of
cost of equity under CAPM.
Using the modified CAPM equation, the cost of equity is calculated as follows:
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Ke = 5.71% + (0.79 x 7.8%) + 1.47% + 5.0% = 18.342%
The WACC is thus computed as follows:
WACC = [7.5% x 60% x (1 - 40.0%)] + (18.342% x 40%) = 10.037%
As such, a discount rate of 10.0% (rounded) was selected as appropriate and used
to discount the expected debt-free net cash flow of the Equipment. Overall, this
rate was judged to fairly reflect the risk associated with the successful
achievement of the forecast in comparison with the risks related to the return
on investment for comparable publicly traded companies that would be the most
likely buyers of the Equipment.
Summary - The projected debt-free net cash flows were discounted to present
value to account for the return expectations of a prudent investor. The
debt-free net cash flows are discounted to present value assuming they are
received, on average, midway through the projection period.
The indicated fair market values in continued use of the Original Equipment, the
Revised Original Equipment, the Updated Equipment, and the Excess Equipment, in
each case, at the inception of the Lease Term, as determined through the income
approach, are reasonably presented in the following table:
- ---------------------------------------------------------------------------------------------------
Fair Market Value in Continued Use - Income Approach (U.S.$)
- ---------------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
- ------------------ --------- ----------------- ----------------
404,250,700 468,122,715 404,250,700 63,872,015
- ---------------------------------------------------------------------------------------------------
Correlation - In determining our opinion of the fair market values in continued
use of the Original Equipment, the Revised Original Equipment, the Updated
Equipment, and the Excess Equipment, in each case, at the inception of the Lease
Term, we considered the indications of value produced by applying the cost
approach and the income approach, as follows:
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Fair Market Value in Continued Use - Summary (U.S.$)
- -------------------------------------------------------------------------------------------------
Revised
Approach to Original Original Updated Excess
Value Valuation Valuation Valuation Valuation
- -------------------------------------------------------------------------------------------------
Cost Approach 298,467,100 345,630,759 298,471,900 47,158,859
- -------------------------------------------------------------------------------------------------
Income
Approach 404,250,700 468,122,715 404,250,700 63,872,015
- -------------------------------------------------------------------------------------------------
These approaches to value have varying degrees of applicability depending on the
situation. For example, the cost approach is relied upon primarily in situations
in which the assets are new, or nearly new, and fully utilized
for their designed intent. The income approach is predicated on projected
operating results based on current and expected future market conditions. The
income approach typically yields the upper value limit, or cash flow potential,
of a property. For this appraisal, it is our opinion that the cost approach
should be given more weight than the income approach; due to the cost approach
being deemed a more reliable indication of value. The income approach value
indication is subject to certain proforma assumptions concerning the levels of
earnings the Equipment will generate over its economic useful life. Therefore,
it is our opinion that the cost and income approaches should be weighted as
follows:
Cost Approach 90%
Income Approach 10%
Accordingly, it is our opinion that the fair market values in continued use of
the Original Equipment, the Revised Original Equipment, the Updated Equipment,
and the Excess Equipment, in each case, at the inception of the Lease Term, are
reasonably presented in the following table, distributed as shown in Exhibit C
of this report.
American Appraisal Associates Page 27
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Fair Market Value in Continued Use - Correlated (U.S.$) (Rounded to Nearest Million)
- ---------------------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
- ---------------------------------------------------------------------------------------------------------
309,000,000 358,000,000 309,000,000 49,000,000
- ---------------------------------------------------------------------------------------------------------
Residual Value in Continued Use (Opinion 3)
Cost Approach - Residual value in continued use of the Equipment as of the Lease
Termination Date has been estimated assuming a sale to an unrelated third-party
owner/operator. To determine the residual value in continued use of the
Equipment assuming an unrelated third party will operate the Equipment during
the period following the Lease Term, we applied the same methodology used to
develop the current fair market value in continued use. Since all
causes of depreciation were taken into account for estimating the original
economic useful life of the Equipment, residual value in continued use of the
Equipment can be established based on its remaining economic useful life and
effective age as of the Lease Termination Date.
Hanover's and POC's maintenance policies call for continuous
predictive/preventive maintenance. A comprehensive predictive/preventive
maintenance procedure must be performed every 30 to 45 days for each high-speed
compressor unit and every 60 days for each Ajax compressor unit in each service
technician's territory. Further, each compressor is subject to additional
predictive/preventive maintenance every six months. Also, compressor units of at
least 500 hp currently undergo electronic analysis, measuring performance
factors such as load, engine compression, tolerances, crankshaft blow-by, and
others. This information is maintained in a computer database for each unit,
along with the service technician's regularly scheduled maintenance notes. This
information then is analyzed, and the extent and timing of an overhaul is
determined. In the near future, Hanover plans to add units of at least 300 hp to
the group undergoing electronic testing.
With this extensive inspection and maintenance policy in place, major equipment
failures are rare. If a service technician finds a potential problem during a
routine maintenance procedure, the affected unit is either repaired immediately
or scheduled for repair within a two-week period to
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prevent any interruption of service for Hanover, POC, or their customers. The
predictive/preventive maintenance policy enhances the overall condition of each
compressor unit as a whole, thereby reducing all aspects of depreciation and
increasing the economic usefulness of the unit. With such a program in place, a
Hanover or POC compressor unit is expected to have a significantly longer life
than other typical compressors.
To determine the residual value in continued use in inflated dollars, the
uninflated residual value in continued use as of the Lease Termination Date was
multiplied by an inflation factor determined through researching historical
trends for the various components of the Equipment.
The inflation analysis included researching inflation information concerning the
general economy, the general machinery and equipment industry, and the petroleum
and natural gas industry. Inflation rate information was obtained from published
industry data such as the Producer Price Index, as well as through discussions
with Hanover representatives and other knowledgeable industry sources. The
analysis also included researching historical inflation data for the above
categories, comparing the inflation rates, and correlating the most appropriate
rates to determine a suitable historical inflation rate to project future
inflation. This analysis determined an average historical inflation rate over
the past five years in excess of 1.50% per year, over the past 10 years in
excess of 1.75% per year, and over the past 15 years in excess of 2.00% per
year. Accordingly, an inflation factor of 2.0% was estimated and used to
calculate the residual value of the Equipment.
Therefore, it is our opinion that, at the end of the Lease Term, the residual
values in continued use of the Original Equipment, the Revised Original
Equipment, the Updated Equipment, and the Excess Equipment, in each case, as
determined by the cost approach, taking into account inflation at an estimated
rate of 2.0% per year, are reasonably represented in the following table:
American Appraisal Associates Page 29
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Residual Value in Continued Use - Cost Approach (U.S.$)
- --------------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
- --------------------------------------------------------------------------------------------------
296,823,200 342,028,727 296,828,100 45,200,627
- --------------------------------------------------------------------------------------------------
Income Approach - The income approach was also used to estimate the residual
values in continued use of the Equipment at the Lease Termination Date. The
methodology used is virtually identical to that described above for estimating
fair market values in continued use at the Valuation Date. However, we adjusted
only the following items in the course of our analysis.
First, any cash flows projected to occur prior to the Lease Termination Date
were discarded and do not influence the projected residual values. Next,
depreciation and the tax benefits of depreciation were calculated as if a
transfer of ownership occurs at the Lease Termination Date. Finally, present
value factors were calculated, considering the Lease Termination Date as the
date to which all cash flows are discounted.
Therefore, it is our opinion that, at the end of the Lease Term, the residual
values in continued use of the Original Equipment, the Revised Original
Equipment, the Updated Equipment, and the Excess Equipment, in each case, as
determined by the income approach, taking into account inflation at an estimated
rate of 2.0% per year, are reasonably represented in the following table:
- --------------------------------------------------------------------------------------------------
Residual Value in Continued Use - Income Approach (U.S.$)
- --------------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
- --------------------------------------------------------------------------------------------------
437,266,200 503,852,572 437,266,200 66,586,372
- --------------------------------------------------------------------------------------------------
Correlation - In determining our opinion of the residual values in continued use
of the Equipment as of the Lease Termination Date, we considered the indications
of value produced by applying the cost approach and the income approach, as
follows:
American Appraisal Associates Page 30
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- --------------------------------------------------------------------------------------------------------------
Residual Value in Continued Use - Summary (U.S.$)
- --------------------------------------------------------------------------------------------------------------
Approach Revised
to Original Original Updated Excess
Value Valuation Valuation Valuation Valuation
- --------------------------------------------------------------------------------------------------------------
Cost Approach 296,823,200 342,028,727 296,828,100 45,200,627
- --------------------------------------------------------------------------------------------------------------
Income
Approach 437,266,200 503,852,572 437,266,200 66,586,372
- --------------------------------------------------------------------------------------------------------------
These approaches to value have varying degrees of applicability depending on the
situation. For example, the cost approach is relied upon primarily in situations
in which the assets are new, or nearly new, and fully utilized for their
designed intent. The income approach is predicated on projected operating
results based on current and expected future market conditions. The income
approach typically yields the upper value limit, or cash flow potential, of a
property. For this appraisal, it is our opinion that the cost approach should be
given more weight than the income approach; due to the cost approach being
deemed a more reliable indication of value. The income approach value indication
is subject to certain proforma assumptions concerning the levels of earnings the
Equipment will generate over its economic useful life. Therefore, it is our
opinion that the cost and income approaches should be weighted as follows:
Cost Approach 90%
Income Approach 10%
Accordingly, it is our opinion that the residual values in continued use of the
Original Equipment, the Revised Original Equipment, the Updated Equipment, and
the Excess Equipment, in each case, at the end of the Lease Term, are reasonably
presented in the following table, distributed as shown in Exhibit C of this
report.
American Appraisal Associates Page 31
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Residual Value in Continued Use - Correlated (U.S.$) (Rounded to Nearest Hundred)
- ------------------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
- ------------------------------------------------------------------------------------------------------
310,871,900 358,211,100 310,871,900 47,339,200
- ------------------------------------------------------------------------------------------------------
100.6% 100.1% 100.6% 96.6%
- ------------------------------------------------------------------------------------------------------
Limited-Use Property (Opinion 4)
The relevant Revenue Procedures require that during and at the end of the Lease
Term, the Equipment be useful to or usable in a commercially feasible manner by
a third party unrelated to the lessee or lessor.
To demonstrate that this requirement can be fulfilled, the following questions
are applicable as of the Lease Termination Date:
1. Would the Equipment be capable of continued economical
operation, assuming investment, repair, and maintenance at
levels consistent with those generally used in the industry?
2. Would the period of operation available to a potential
purchaser be sufficient to permit normal economical operation
of the Equipment and a return on investment consistent with
prudent business practice?
3. Will a market exist for the products provided by the Equipment
such that the sale of the products will yield a reasonable
economical return?
4. Are any internal or external factors likely to cause operation
of the Equipment to be uneconomical by a third party?
The first question is answered positively by our economic useful life analysis,
which shows that, at the end of the Lease Term, the Equipment will have a
remaining economic useful life in excess of 134% of the Lease Term. The major
assumption used in this analysis is that the Equipment will be operated, while
under lease, subject to the terms of the Lease.
American Appraisal Associates Page 32
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The second question is answered positively by our economic useful life and
residual value in continued use analyses.
The third question is best answered by the fact that the worldwide consumption
of natural gas is expected to continue to grow, as discussed in the industry
analysis. Also, Hanover is continually expanding its fleet for the future
through acquisition of smaller companies in the same field.
Relative to the fourth question, we are not aware of any current or pending
legislation or other factors that would negatively limit the use of the
Equipment.
A third party might wish to purchase used equipment rather than purchase new for
several reasons. First and foremost, the Equipment is immediately available and
capable of producing income during the lead time necessary to construct a new
compressor. Second, it has been debugged and has predictable performance
characteristics. Third, buying used is less expensive than buying new. The
design of the Equipment represents the current state of the art, and any future
technical advancements are expected to be minimal.
Based on the above analysis, it is our opinion that the Original Equipment, the
Revised Original Equipment, the Updated Equipment, and the Excess Equipment, in
each case, will not be limited-use property as defined by the relevant Revenue
Procedures and that a person other than the lessee or lessor could purchase or
lease the Equipment and operate it in a commercially feasible manner.
Impairment of Value of the Security (Opinion 5)
Based on our comparison of the data contained herein to the Original
Summarization Letter and the Original Report, there is no impairment of the
value of the Original Equipment, as set forth in the Original Summarization
Letter and the Original Report, compared to the value of the Updated Equipment,
as set forth herein.
American Appraisal Associates Page 33
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Summary of Conclusions
Based on our investigation and analyses, and subject to the following
assumptions and limiting conditions and general service conditions, our opinions
are as follows:
1) The economic useful life of the Original Equipment, the
Revised Original Equipment, the Updated Equipment, and the
Excess Equipment, in each case, is estimated to be at least 20
to 25 years, which is greater than 134% of the Lease Term;
2) The fair market values in continued use of the Original
Equipment, the Revised Original Equipment, the Updated
Equipment, and the Excess Equipment, in each case at the
inception of the Lease Term, are reasonably presented in the
following table:
- -----------------------------------------------------------------------------------------------
Fair Market Value in Continued Use - Correlated (U.S.$) (Rounded to Nearest Million)
- -----------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
- -----------------------------------------------------------------------------------------------
309,000,000 358,000,000 309,000,000 49,000,000
- -----------------------------------------------------------------------------------------------
3) The residual values in continued use of the Original
Equipment, the Revised Original Equipment, the Updated
Equipment, and the Excess Equipment, in each case, at the end
of the Lease Term, taking into account the effects of
inflation at the rate of 2.00% per year, are reasonably
presented in the following table:
- -----------------------------------------------------------------------------------------------
Residual Value in Continued Use - Correlated (U.S.$) (Rounded to Nearest Hundred)
- -----------------------------------------------------------------------------------------------
Revised Original
Original Valuation Valuation Updated Valuation Excess Valuation
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310,871,900 358,211,100 310,871,900 47,339,200
100.6% 100.1% 100.6% 96.6%
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4) At the end of the Lease Term, the Original Equipment, the
Revised Original Equipment, the Updated Equipment, and the
Excess Equipment, in each case, will not be limited-use
property as defined by the relevant
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Revenue Procedures and that a person other than the lessee or
lessor could purchase or lease the Equipment and operate it in a
commercially feasible manner; and
5) Based on our comparison of the data contained herein to the
Original Summarization Letter and the Original Report, there is
no impairment of the value of the Original Equipment, as set
forth in the Original Summarization Letter and the Original
Report, compared to the value of the Updated Equipment, as set
forth herein.
Assumptions and Limiting Conditions
No responsibility is assumed for matters legal in nature. No investigation has
been made of the title to or any liabilities against the property appraised. In
the appraisal it is presumed, unless otherwise noted, that the owner's claim is
valid, the property rights are good and marketable, and there are no
encumbrances which cannot be cleared through normal processes.
American Appraisal Associates, Inc., did not conduct a physical inspection of
the property appraised. We have made the assumption that the Equipment will be
maintained in good operating condition, with normal preventive maintenance
performed, and that the Equipment is currently in use and in normal working
condition.
Even with proper preventive maintenance, including lubrication, cleaning, and
replacement of component parts as required by the original equipment
manufacturer, equipment will eventually show signs of wear requiring possible
service ranging from a minor reconditioning to a major refurbishing. The
duration between these periods of downtime is a function of maintenance, working
conditions, operator diligence and surveillance, and overall equipment design.
We have assumed the property will be in normal working condition at the end of
the Lease Term.
Our opinions of economic life and residual value in continued use are based on
expectations of events that cannot be predicted with certainty and for which we
assume no responsibility. We have assumed the market for used equipment of this
nature at the end of the Lease Term will not demonstrate unusual conditions of
supply and demand.
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To the best of our knowledge, all data set forth in this report are true and
accurate. Although gathered from reliable sources, no guarantee is made nor
liability assumed for the accuracy of any data, opinions, or estimates
identified as being furnished by others which have been used in formulating this
analysis and opinion.
No environmental impact study has been ordered or made. Full compliance with
applicable federal, state, and local environmental regulations and laws is
assumed unless otherwise stated, defined, and considered in the report. It is
also assumed all required licenses, consents, or other legislative or
administrative authority from any local, state, or national government or
private entity organization either have been or can be obtained or renewed for
any use which the report covers.
The value or values presented in this report are based upon the premises
outlined herein and are valid only for the purpose or purposes stated.
The date of value to which the conclusions and opinions expressed apply is set
forth in this report. The value opinion herein rendered is based on the status
of the national business economy and the purchasing power of the U.S. dollar as
of that date.
Testimony or attendance in court or at any other hearing is not required by
reason of this appraisal unless arrangements are previously made within a
reasonable time in advance for such testimony, and then such testimony shall be
at American Appraisal Associates, Inc.'s, prevailing per diem for the
individuals involved.
Possession of this report or any copy thereof does not carry with it the right
of publication. No portion of this report (especially any conclusion to use, the
identity of the appraiser or the firm with which he/she is connected, or any
reference to the American Society of Appraisers or the designations awarded by
this organization) shall be disseminated to the public through prospectus,
advertising, public relations, news, or any other means of communication without
the written consent and approval of American Appraisal Associates, Inc.
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General Service Conditions
The services provided by American Appraisal Associates, Inc., have been
performed in accordance with professional appraisal standards. Our compensation
is not contingent in any way upon our conclusions of value. We assumed, without
independent verification, the accuracy of all data provided to us. We have acted
as an independent contractor and reserved the right to use subcontractors. All
files, work papers, or documents developed by us during the course of the
engagement are our property. We will retain this data for at least five years.
Our report may only be used for the specific purposes stated herein and any
other use is invalid. No one should rely on our report as a complete substitute
for their own due diligence. Except as provided in the engagement letter, no
reference to our name or our report, in whole or in part, in any public document
or debt/equity offering document you prepare or distribute to third parties may
be made without our prior written consent.
You agree to indemnify and hold us harmless against and from any and all losses,
claims, actions, damages, expenses, or liabilities, including reasonable
attorneys' fees, to which we may become subject in connection with this
engagement. You will not be liable for our negligence, malpractice, fraud, or
gross negligence. You agree that in the event American Appraisal Associates,
Inc., is judicially determined to have acted negligently in the execution of
this engagement, damages shall be limited to an amount not to exceed three times
the fee received by American Appraisal Associates, Inc., for this engagement.
Your obligation for indemnification and reimbursement shall extend to any
controlling person of American Appraisal Associates, Inc., including any
director, officer, employee, subcontractor, affiliate, or agent.
We reserve the right to include your company/firm name in our client list, but
we will maintain the confidentiality of all conversations, documents provided to
us, and the contents of our reports, subject to legal or administrative process
or proceedings. In the event we are legally compelled to disclose such
confidential information, we shall provide you with prompt written notice so
that you may seek any protective remedies you may have available These
conditions can only be modified by written documents executed by both parties.
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American Appraisal Associates, Inc., is an equal opportunity employer.
Respectfully submitted,
AMERICAN APPRAISAL ASSOCIATES, INC.
/s/ Richard P. Meyer
October 31, 2001 Richard P. Meyer, ASA
047117 Managing Director, Structured Finance Group
Investigation and Report by
Leo J. Dorsey, ASA
Randall C. Cook