The key variables which influence the degree of obsolescence risk of an asset will vary according to asset type, environmental influences and the extent to which an asset has been maintained. Thomas and Worrall have extended Vernon’s observation of the obsolescing bargain and propose that the expected future discounted returns to a multinational company decline over time. Vernon terms this an “obsolescing bargaining” approach to multinational decision-making. When a multinational mining firm first enters a foreign territory, it is in a very strong position to accumulate benefits from host country governments in the form of preferential tax treatment and subsidies. Further, within a multi-national context, Vernon has also applied the concept of obsolescence to the bargaining power a multinational enterprise has with a host country government. With regard to the strategic management literature, Vernon was the first to analyze the growth of international trade to be driven by product lifecycle parameters. In this regard, obsolescence risk is inherently related to the lifecycle of an asset which is brought about by technical and commercial factors. It is hoped that the generic valuation model developed in this paper could be used within a variety of business contexts where there is the risk of obsolescence such as oil & gas shipping real estate information technology telecommunications and new energy.
For the purpose of this theoretical valuation paper, we define obsolescence risk as the risk of asset becoming out of date within a future period of time. “technical obsolescence, that is, the process of becoming increasingly out-of-date and, on a comparative basis, inefficient as a result of technological advances and improvements” “commercial obsolescence, that is the process of becoming redundant through a fall in the market demand for the goods or services in the production of which the respective assets are used”. The two main forms that obsolescence can take are technical and commercial. (NB systems that are not maintained undergo “entropy” and become disorderly). Indeed, all systems are subject to wear and tear (or depreciation) and unless maintained fall into disrepair, but a system that is maintained can still become obsolete. All systems, undergo a “lifecycle” and are ultimately replaced by new systems. Obsolescence is a fundamental trait of all systems. This is despite the crucial role in which the assessment of obsolescence risk plays in virtually every decision made within the firm in one form or another. The importance of obsolescence risk and its quantification has been largely ignored in the research literature. Obsolescence is related to the decline and replacement of useful assets so that ultimately firms can survive within a harsh competitive environment, in the long-run. The obsolescing of an asset occurs regardless of whether an asset depreciates or not.
Depreciation is the wear and tear or the using up of an asset. It can be distinguished from depreciation due to the fact that obsolescence originates from events occurring in the firm’s environment that are often beyond the control of the firm. Within a purely accounting and finance context, obsolescence is associated with an asset becoming increasingly out of date due to technical and commercial factors.
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