When is the cost approach acceptable for computing the value of a lost business?

After an explosion destroyed a waste treatment facility for an oil refinery, the plaintiff insurance company paid the owners $6.1 million and then sued the defendants for causing the damages. The defendants admitted liability; the only issue was the fair market value of the plant just before the explosion, using the applicable “willing buyer, willing seller” standard.

At the same time, the business was composed of a specialized, integrated, and patented set of systems for which no market exists; each facility had proprietary component parts that were not regularly bought or sold as new, only used. Under these circumstances, the plaintiff’s expert used the cost approach. He spoke with former employees to determine that the facility had depreciated by 35%, yielding a remaining useful life of 65%. He also relied on the plaintiff’s industry consultant to apply a multiplier of 2.5 to replacement costs to account for reconstruction and reinstallation, and ultimately calculated $6.1 million in damages—or precisely the amount the plaintiffs had already paid out for lost value.

By contrast, the defendants’ expert simply summed up the value of used component parts to assess damages at $878,000, without any multiplier. The trial court roughly split the difference, awarding $3.8 million, and the defendants appealed, challenging the plaintiff’s cost approach as well as the multiplier. Although both were highly “disfavored,” the U.S. Court of Appeals for the 5th Circuit said that when no market exists to determine lost value—and when credible expert testimony supports the cost approach and its inputs, including depreciation—the $3.8 million award for replacement damages was appropriate. Read the complete digest of Factory Mutual Insurance Co. v. Alon USA, 2013 U.S. App. LEXIS 1481 (Jan. 23, 2013) in the May Business Valuation Update; the court’s decision will be posted soon at BVLaw.

Best practices for calculating business losses. On April 2, join Neil Beaton (Alvarez & Marsal) and Tyler Farmer (Calfo Harrigan Leyh & Eakes) as BVR’s Online Symposium on Economic Damages continues with Lost Profits vs. Lost Business, a complete discussion of when each damages theory is appropriate (are they always mutually exclusive?) and the best methods to support each to the requisite degree of certainty.