It is a common belief that Capital Expenditure (Capex) and Depreciation must converge over time when looking at the projection window. In this article, we will try to explore the possible reasoning behind this approach and situations this might not necessarily be the right way to go forward.
It is important to note that, D&A and Capex might be higher or lower to the other anytime during the projection period. But what we are trying to understand is their relation to the other right at the terminal year in DCF analysis.
Firstly, let us understand what both the scenarios imply:
- Capex > D&A: This reflects expansionary scenario, where the company is growing its assets base faster than it is depreciation them
- Capex < D&A: This reflects the opposite of above scenario, where company’s asset base is declining as it is depreciating faster than it is growing and will eventually become zero
As a refresher, there are broadly 2 types of Capex – Maintenance or replacement and Expansionary. Maintenance Capex is required to maintain or replace the current asset base and expansionary capex is required to grow the company further such as new product line or new capacity for an existing product line. Thus, any outlays that expand the output capabilities of the firm will fall under expansionary Capex umbrella.
Note 1: When a company undertakes a Capex, the assets so generated is capitalized, meaning they are reflected on the balance sheet only and as the assets are used over their useful life, they get expensed in the form of D&A and then move through the income statement. Note 2: It also essential to always remember that Capex always precedes depreciation. This is intuitive, as one cannot depreciate an asset they don’t own. Hence, it is important to adjust the depreciation to forecasted Capex, instead of doing the reverse.
While trying to ascertain the terminal value, it is important to think of it as – You are trying to project the company’s financial performance forever. Since a perpetual expansionary Capex is not practically viable, it might be prudent to assume that company’s asset base will remain at fairly constant level. This implies that company should invest in maintenance level Capex to maintain the current asset base. Thus, in the terminal year our focus is to determine the “normalized” D&A and Capex.
So, the question is – “Is the simplifying normalization assumption of setting depreciation equal to Capex in the terminal year right assumption?”
This assumption is typically appropriate in zero-growth/inflation scenarios. If growth is projected in the cash flow forecast, capex should typically exceed depreciation in the terminal period. The reason for the same is quite straightforward. Capex has a direct correlation to both growth and depreciation expense.
Increased levels of Capex should in turn lead to increased future growth. Likewise, increased Capex will raise future levels of depreciation expense. As long as a company earns a positive return on its capital investment, then capital Capex in excess of maintenance capital requirements should result in some level of future growth.
Please note, some models might assume that Capex drives revenue, but this is not necessarily true. Capex grows as revenue grows, but it doesn’t always drive revenue. Eg: Software companies are far less dependent on Capex to boost its revenue.
Let’s discuss this further to get a better understanding:
Projected capital expenditures should always reflect the expected long term growth rate assumed (LTG Rate), or conversely, a selected LTG rate should be supported by a certain level of Capex and an assumed rate of return on that investment (ROI). If growth expectations are increased or decreased, then either Capex need to be adjusted accordingly or new assumptions needs to be established regarding return on invested capital. Assuming the rate of return on invested capital is held constant, then any change to the LTG rate assumption should require the adjustments to the assumptions for both Capex and depreciation.
Note: Formula for calculating the sustainable long term growth rate for a company is, g = b x ROE, where, g = LTG Rate, b = Reinvestment Rate or plowback ratio and ROE = Return on Equity This formula also illustrates the connected relationship between Capex and the LTG rate (i.e., that the two variables increase or decrease in tandem).
Nearly all company projections and discount rate data are presented in nominal terms. Thus, the LTG rates is based on nominal LTG rates that is including the impacts of both inflation and real returns.
Now consider a scenario where expected inflation of Country A is say 4%,
- LTG Rate = 4%; inherent assumption of 0% real growth rate
- LTG Rate = 3%; implies negative real growth rate
- LTG Rate = 5%; implies 1% real growth rate
Thus, for normalized cash flow projections that include an assumption of a positive nominal LTG rate, equating Capex and depreciation expense may be flawed. When the estimated LTG rate is positive (i.e., any selected LTG rate greater than 0%, even if that growth rate results in negative or zero expected real growth) Capex may exceed depreciation expense.
Financial Fudge 