Replacement cost definition
/What is Replacement Cost?
Replacement cost is the price that an entity would pay to replace an existing asset at current market prices with a similar asset. If the asset in question has been damaged, then the replacement cost relates to the pre-damaged condition of the asset. The replacement cost of an asset may vary from the market value of that specific asset, since the asset that would actually replace it may have a different cost; the replacement asset only has to perform the same functions as the original asset - it does not have to be an exact copy of the original asset. The concept is used in the areas noted below.
Replacement Cost in Insurance Policies
Replacement cost is a common term used in insurance policies to cover damage to a company's assets. The definition is critical, since the insurer is committing to pay the insured entity for the replacement cost of covered assets, if those assets are damaged or destroyed.
Replacement Cost in Acquisitions
Replacement cost can also be used to estimate the amount of funding that might be required to duplicate another business. This concept can be used to establish one of several possible price points that can be used in the formulation of a proposed price to pay the shareholders of a target company as part of an acquisition.
Replacement Cost in Capital Budgeting
The concept is also used in capital budgeting, when formulating estimates of the funding needed to replace existing assets as they wear out. A business might even set aside cash for several years prior to actually replacing a major asset, based on the amount of its estimated replacement cost.
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Replacement Cost Budgeting
Businesses with a large asset base may engage in replacement cost budgeting. Under this approach, they anticipate when their key assets are going to require replacement, and then set up a plan to set aside the necessary funds for them, so that they can be replaced in an orderly fashion. For example, a manufacturer of precision widgets knows that a widget lathe will wear out in three years, and so develops a plan for how to come up with its $30,000 expected replacement cost. When the lathe wears out, the manufacturer will have the money to buy a new one.
Terms Similar to Replacement Cost
Replacement cost is also known as replacement value.