Replacement Value Method of Equity Valuation

Replacement value method takes into account ‘the amount required to replace the existing company’ as the valuation of a company. In other words, if one is to create a similar company in the same industry; all costs required to do so will form part of the value of the firm. This is also called as “Substantial Value”. Let us now understand this topic with the help of an example.

Replacement Value Method Example

Sample Balance Sheet (Table I)

Liabilities $ (Mio) Assets $ (Mio)
Equity Share Capital 1500 Fixed Assets 3000
Preference Share Capital 600 Inventories 1350
Reserves and Surplus 300 Cash and Bank Balance 150
Long-term Debt 900 Debtors 300
Short-term Debt 300
Creditors 1200
Total 4800 Total 4800

 

Book Value Calculation $ Mio
Total Assets 4800
Less Long-Term Debt 900
Less Short Term Debt 300
Less Creditors 1200
Book Value 2400

As per the table above, the book value comes out to be $ 2400 Mio.

In the same case, let us calculate the replacement cost, given the following assumptions:

  1. 20% of the fixed assets are unused.
  2. The market value of the assets is 50% higher than the accounting value carried in the balance sheet.

The replacement cost adjusted balance sheet will now have fixed assets value as follows:

Fixed Assets $ Mio
Original carrying cost 3000
Less: Unused Assets (20%) 600
Balance Fixed Assets 2400
After revaluation (at 150%) 3600

The asset value has therefore increased by $ 600 Mio i.e. ($ 3600 Mio less $ 3000 Mio)

Replacement Cost Adjusted Balance Sheet (Table II)

Liabilities $ (Mio) Assets $ (Mio)
Equity Share Capital 1500 Fixed Assets 3600
Preference Share Capital 600 Inventories 1350
Reserves and Surplus 300 Cash and Bank Balance 150
Adjustment 600 Debtors 300
Long-term Debt 900
Short-term Debt 300
Creditors 1200
Total 5400 Total 5400

Replacement Cost Value Calculation using following Formula

(Table III)

Replacement Cost Value Calculation $ Mio
Total Assets (now higher) 5400
Less Long-Term Debt 900
Less Short Term Debt 300
Less Creditors 1200
Replacement Cost Value or Net Substantial Value 3000

Hence, as per replacement value method, the value of the company is $3000 Mio (refer Table III). Let us now have a look at different types of substantial value using the same example.

Types of Substantial Value / Replacement Value

Gross Substantial Value

It is the total asset value at replacement value which in our example will be $ 5400 Mio (see “Table I” assets side total)

Net Substantial Value

It is the replacement cost value based on the replacement value for adjusted balance sheet which in our example will be $ 3000 Mio (See Table III)

Reduced Gross Substantial Value

It is the total asset value less cost-free debt (Here, creditors) which in our example will be $ 5400 Mio less $ 1200 Mio (creditors) = $ 4200 Mio.

We shall now compare and understand Liquidation Value Method v/s Replacement Cost Method (substantial value).

Comparison between Liquidation and Replacement Value Method

  • Replacement cost method of equity valuation assumes that the company continues to operate as against shutting down of business. Whereas liquidation value method of equity valuation assumes that the company will be shutting down its business and hence the value of the company under this method will be its salvage value.
  • In the case of replacement cost method, generally, replacement cost excludes those assets which are not being used by the company for its daily operations; while in the case of liquidation value method all assets are taken into consideration.
  • Liquidation value method may be prone to distress pricing which is not the case with replacement cost method.

Conclusion

Replacement value method is the more refined way of calculating the value of the company; however, it comes with the drawback of incorrect estimation. The use of replacement value method will be incomplete if we do not compare it with Q ratio, which is also called Tobin’s Q. Using Q ratio based on replacement cost adds value to the investment decision process.

References:

http://www.iese.edu/research/pdfs/DI-0449-E.pdf

http://thismatter.com/money/stocks/valuation/book-liquidation-value-q-ratio.htm

Last updated on : August 7th, 2018

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