Wiki Note: Replacement cost method (2024)

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

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 219.

Rubins, N., Sinha, V. and Roberts, B., Approaches to Valuation in Investment Treaty Arbitration, in Beharry, C.L. (ed.), Contemporary and Emerging Issues on the Law of Damages and Valuation in International Investment Arbitration, 2018, p. 199; Propositions and Conclusions on Compensation for Business Losses: Types of Damages and Their Valuation, UN. Doc No. S/AC.26/1992/9, Decision 9, 6 March 1992, para. 15.

Grenada Private Power Limited and WRB Enterprises, Inc. v. Grenada, Award, 19 March 2020, para. 309.

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 305.

Rubins, N., Sinha, V. and Roberts, B., Approaches to Valuation in Investment Treaty Arbitration, in Beharry, C.L. (ed.), Contemporary and Emerging Issues on the Law of Damages and Valuation in International Investment Arbitration, 2018, p. 199.

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 219.

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

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, pp. 193, 218.

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

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 231.

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 219.

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 219.

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

Williams, J., The Theory of Investment Value, 1938, p. 179.

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 219.

Sistem Mühendislik Inşaat Sanayi ve Ticaret A.Ş. v. Kyrgyz Republic, ICSID Case No. ARB(AF)/06/1, Award, 9 September 2009, para. 160;OAO Tatneft v. Ukraine, PCA Case No. 2008-8, Award on the Merits, 29 July 2014, para. 593.

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

Ripinsky, S., Williams, K., Damages in International Investment Law, 2015, p. 219.

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 circ*mstances, to value companies that have gone into liquidation, and will never operate again.¹³

MacGregor, G., Maclay, A. and Mitchell, D., Overview of Damages and Accounting Basics, in Trenor, J.A., The Guide to Damages in International Arbitration, pp. 179–180.

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

Ripinsky, S. and Williams, K., Damages in International Investment Law, 2015, p. 219.

Caldwell, R., Chodorow, D. and Dorobantu, F., Valuing Natural Resources Investments, in Beharry, C.L. (ed.), Contemporary and Emerging Issues on the Law of Damages and Valuation in International Investment Arbitration, 2018, p. 301, n. 24.

For instance, the Iran-US Claims Tribunal has adopted this method for blowout converters, drilling equipment and containers. See:

Oil Field of Texas, Inc. v. The Government of the Islamic Republic of Iran and National Iranian Oil Company, IUSCT Case No. 43, Award (Award No. 258-43-1), 8 October 1986, paras. 43–45; Petrolane, Inc., Eastman Whipstock Manufacturing, Inc. and others v. Islamic Republic of Iran, Iranian Pan American Oil Company and others, IUSCT Case No. 131, Award (Award No. 518-131-2), 14 August 1991, paras. 106–108;Uiterwyk Corporation v. Iran, IUSCT Case No. 381, Partial Award (Award No. 375-381-1), 6 July 1988, para. 98.

For instance, investor-State tribunals have adopted this method for vehicles and an airplane, as well as various other fixed assets. See:

Vestey Group Ltd v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/06/4, Award, 15 April 2016, paras. 415, 419, 426; Antoine Abou Lahoud and Leila Bounafeh-Abou Lahoud v. Democratic Republic of the Congo, ICSID Case No. ARB/10/4, Award, 7 February 2014, paras. 572, 578-582.

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

Haberman, P. and Perks, L., Overview of Methodologies for Assessing Fair Market Value, in Trenor, J.A., The Guide to Damages in International Arbitration, p. 198.

Schumacher, K.and Wabnitz, M., M&A and Shareholder Arbitrations, in Trenor, J.A., The Guide to Damages in International Arbitration, p. 419.