Replacement cost method

The replacement cost method involves arriving at an asset’s value by reference to the present-day cost, in an arms-length transaction, of replacing that asset with a similar asset in a similar condition¹ (plus, if appropriate, payment of any taxes due).² The method is based on the principle that a buyer will not pay more for an asset—and a seller will not accept less—than the price of a similar asset.³ The method can be used to value both an entire business and its individual assets.⁴

The replacement cost method is an example of an asset-based approach to valuation (rather than an income-based or market-based approach). An asset-based approach to valuation entails (i) identifying each individual asset of a business, (ii) using a specific valuation approach to value each such asset, and (iii) aggregating the values, to arrive at the value of the business.⁵

The product of the replacement cost method, i.e., the replacement value, tends to be:

• lower than the actual amounts invested, as the price of acquiring an asset of a similar condition typically decreases over time;⁶
• higher than liquidation value, as replacement value does not include a distress discount;⁷ and
• higher than book value, as for accounting purposes assets tend to be depreciated more quickly than they age.⁸

The replacement cost method is often considered a deficient method of valuing a business, as it “assumes that it is possible to reconstruct the value of the entire investment simply by replacing its physical assets.”⁹ It does not incorporate a business’s “goodwill.”¹⁰ In the words of one investment treaty tribunal, “[t]he ‘replacement value’ approach to valuation looks to what the investor has put in, not what the investor could expect to derive from the investment . . .”¹¹

Due to its drawbacks, the replacement cost method is rarely used as the primary method of valuing a business on a going-concern basis. As Ripinsky and Williams write, “for the purposes of valuing a business, asset-based methods [such as the replacement cost method] generally produce a less reliable result than income-based or market-based methods and are only used when these other methods are considered inappropriate . . . .”¹²

Asset-based approaches, including the replacement cost method, can sometimes be applied when valuing “start-ups”, where projections of future cash flows are deemed insufficiently certain. Asset-based approaches can also be used, in certain circumstances, to value companies that have gone into liquidation, and will never operate again.¹³

The replacement cost method can be effectively used to value individual assets, such as equipment¹⁴ —particularly where the asset is easily replaceable¹⁵ and/or does not directly produce an income. Indeed, that is the purpose for which the method has been applied by the Iran-US Claims Tribunal¹⁶ and some investment-treaty tribunals.¹⁷

The replacement value can constitute a “floor” on the valuation of a business whose know-how is easily replicable and which has no unique intellectual property.¹⁸ Conversely, the replacement value can operate as a “ceiling” on the valuation of a business the break-up value of whose assets exceeds its income-generating value.¹⁹