What is a Replacement Cost
A replacement cost is the cost to replace an asset of a company at the same or equal value, where the asset to be replaced could be a building, investment securities, accounts receivable or liens. The replacement cost can change, depending on changes in market value of the asset and any other costs required to prepare the asset for use. Accountants use depreciation to expense the cost of the asset over its useful life.
Replacing an asset can be an expensive decision, and companies analyze the net present value (NPV) of the future cash inflows and outflows to make purchasing decisions. Once an asset is purchased, the company determines a useful life for the asset and depreciates the asset's cost over the useful life.
BREAKING DOWN Replacement Cost
How Net Present Value Is Used
To make a decision about an expensive asset purchase, companies first decide on a discount rate, which is an assumption about a minimum rate of return on any company investment. A business then considers the cash outflow for the purchase and the cash inflows generated based on the increased productivity of using a new and more productive asset. The cash inflows and outflow are adjusted to present value using the discount rate, and if the net total of all present values is a positive amount, the company makes the purchase.
Factoring in Depreciation
A business capitalizes an asset purchase by posting the cost of a new asset to an asset account, and the asset account is depreciated over the asset’s useful life. Depreciation matches the revenue earned by using the asset with the expense of using the asset over time. The cost of the asset includes all costs to prepare the asset for use, such as insurance costs and the cost of setup. Some assets are depreciated on a straight-line basis, meaning the cost of the asset is divided by the useful life to determine the annual depreciation amount. Other assets are depreciated on an accelerated basis so more depreciation is recognized in early years and less in later years. The total depreciation expense recognized over the asset’s useful life is the same, regardless of which method is used.
Examples of Budgeting for Asset Purchases
Given the cost of replacing expensive assets, well-managed firms create a capital expenditure budget to plan future asset purchases and how the firm generates cash inflows to pay for the new assets. Budgeting for asset purchases is critical, because replacing assets is required to operate the business. A manufacturer, for example, budgets for equipment and machine replacement, and a retailer budgets to update the look of each store.