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Definition: Replacement Cost
Replacement Cost (or Replacement Value) is the amount it would cost to replace the assets of a firm at current prices. When the replacement cost of the asset is lower than the cost incurred at the time of buying the asset, then it means that the asset has decreased in its value and the firm might not want to replace it.
This term is more frequently used in the context of insurance. It is used to determine the cost of a property which is insured. For example if a factory building is damaged due to a natural disaster, replacement cost would give the value of the building before the accident occurred. It might not be equal to the market value of the building.
Using the replacement asset, Tobin’s q ratio is derived. This is the ratio of current market value of the company divided by replacement costs of all the assets of that company. A lower ‘q’ ratio means that the stock of the company is ‘undervalued’. If the ratio is higher, it means that the stock of the company is ‘overvalued’.