Definition: The Replacement Cost is the cash outlay that firm has to pay in order to replace an old asset at the current market price. Simply, the amount paid to replace the existing property with the new one having the similar utility, without considering the depreciation constitutes the replacement costs.
The replacement cost is used while taking the business decisions of renovating the firm. Often, these are greater than the book value of the item to be replaced and therefore it is also called as the replacement value. The companies, well in advance, estimate the funding requirements for the replacement so as to locate all the possible price points from where the replacement costs or value can be paid off.
If the prices of assets are stable over time, then the replacement cost and historical cost is at par with each other i.e. both are same. While the costs differ, if the prices vary.
The term replacement cost is widely used in the insurance sector. The insurance companies offer the replacement policy to cover the damage of a company’s assets. Here, the insurer guarantees to pay the insured entity the replacement cost of the asset insured, if it is damaged or destroyed. The insurer pays the full amount needed to replace the damaged asset without taking depreciation into account.
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