The Cost Approach to Fair Value
Valuation is an art, not an exact science. Mathematical certainty is not demanded, nor indeed is it possible.
—Viscount Simon (1873–1954), British jurist
THE COST OF ANY PARTICULAR ASSET does not normally represent its fair value. But in practice, replacement cost of an asset adjusted for time to use establishes a ceiling for its fair value, as it is the maximum amount a prudent investor will pay. There may be exceptions for unique items such as antiques, but fair value is intended to overrule sentiment and emotion. Hence the cost approach is most useful as a sanity check.
CURRENT REPLACEMENT COST
Obtaining a current replacement cost for an existing item is done by first determining the expenditure needed to re-create its functionality as new using the latest technologies, then deducting amounts for each of four factors: functional deterioration, technical obsolescence, physical decline, and economic deprivation. None, either individually or in total, will be the same as the familiar accounting depreciation used to amortize the capitalized costs of an asset over its useful life. If the actual item is less useful than an ideal replacement, the amount must be lowered. Replacement cost is not the same as duplication (sometimes called reproduction) cost, which refers to re-creating an identical asset. Nor is it the same as creation cost that adjusts the original expenditures for changes in price levels.
The current replacement cost method ...