Replacement Cost Approach

Suppose you wanted a business exactly like the one in front of you — same plant, same stock, same licences, already running. What would it cost to build it from scratch today? That cost is its replacement value.

The workbook lists three asset-based approaches: (1) book value or net asset value, (2) replacement cost and (3) break-up value. Under the replacement cost approach, "the value of the business is estimated at the cost of replacement of the entire business on as-is-where-is basis". The market cost of the assets and liabilities, with suitable adjustments for their current position, is considered — and on top of the cost of acquiring the assets, the costs of establishing the business as a going concern in its present state are added.

That last part is what makes it different from simply marking the assets to market. A new entrant would have to pay for licences, registrations and approvals and for pre-operative costs, and a business that already has them is worth that much more.

When it fits. The workbook says the method "is appropriate for businesses that have high entry barriers or setting up costs". More generally, asset-based valuation is most appropriate for asset-heavy businesses and distressed companies facing liquidation, and is ideal for financial businesses such as banks and financial or investment companies.

What it ignores. Like all asset-based methods, it "does not take into account any future value attributable to the business". It is not considered an independent method; when it is used, it is more often than not combined with other methods, with appropriate weightage.

The workbook's computation (Illustration 11.4, Alpha Ltd — going-concern adjustments only):

Notice what is not adjusted. Receivables are not cut by 25% and fixed assets are not taken at 40% scrap value — those are liquidation adjustments, and they belong to the break-up approach, not this one.

Work the Alpha Ltd figures through all three asset-based methods to see where replacement cost sits.

The replacement figure is by far the largest, for two reasons. It starts from total assets of Rs 2 crore rather than net worth, so no debt or payables have been deducted; and it adds Rs 20 lakh of set-up costs that only a going concern already has.

Illustrative figures. A Category II AIF is looking at a licensed cold-chain warehouse operator in Pune whose assets have a going-concern market cost of Rs 64 crore. A new entrant would also need about Rs 6 crore for approvals, registrations and pre-operative costs. Replacement value = 64 + 6 = Rs 70 crore (an enterprise value). With borrowings of Rs 22 crore, the equity value implied is Rs 48 crore — a floor the fund can use to test whether a DCF-based asking price makes sense for a business that is hard to replicate.

Chapter 11 (Valuation) sets out the three asset-based approaches at 11.5 and works all three on the same balance sheet in Illustration 11.4. The examinable points are the definition ("cost of replacement of the entire business on as-is-where-is basis"), the addition of set-up costs, the kind of business it suits (high entry barriers or setting-up costs), and the fact that asset-based valuation is not treated as an independent method.

• Replacement cost is a going-concern method; break-up value is a liquidation method. Scrap values and receivables recovered at a discount belong to break-up, not replacement.
• Set-up costs are added, not ignored — that is the defining feature of the approach.
• The workbook labels the replacement result as enterprise value, while book value and break-up value are labelled equity value.
• Asset-based valuation ignores future earning power and is used alongside other methods, with weightage, rather than on its own.
• The Alpha Ltd balance sheet is headed "Rs. crore" but its figures are in rupees — the computations that follow (Rs 2,16,50,000 and so on) treat them as rupees. Read the numbers, not the heading.