Glossary
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Principle of Substitution
« Back to Glossary IndexThe Principle of Substitution, in the context of business valuations, is a fundamental concept in appraisal theory. This principle asserts that a rational investor or buyer will not pay more for an asset than the cost of obtaining a substitute asset with equal utility or functionality. In other words, it suggests that the value of a property or business is influenced by the availability of alternative investments that offer similar benefits. When applied to business valuations, the Principle of Substitution implies that the value of a particular business or asset is constrained by the existence of comparable alternatives in the market. If a similar business can be acquired or developed at a lower cost or provides better returns, a rational investor would opt for the more economical or advantageous option. For example, if a buyer is considering the purchase of a restaurant, the Principle of Substitution would suggest that the buyer would compare the potential acquisition with other available restaurants in the market. If a similar restaurant is available at a lower price or offers better prospects, the buyer may choose the more cost-effective or lucrative option.
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