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M. Bart Wasiak

Senior Associate, International Arbitration - Arnold & Porter

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Replacement cost method

I. Definition

1.

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

II. An example of an asset-based approach valuation

2.

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

III. Comparison to other values

3.

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

IV. Use of the replacement cost method

A. Drawbacks

4.

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

B. Not a primary valuation method when valuing a business

5.

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

C. Use in the context of "start-ups" and liquidated businesses

6.

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

D. Use as a method of valuing individual assets

7.

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

E. Use as a "floor"or "ceiling" on a valuation

8.

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

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