CapEx and EV 400 Guide Question
Here is a question from 400 question book.
We’re creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing) in Year 4. Currently the present value of its Enterprise Value according to the DCF is $200. How would we change the DCF to account for the factory purchase, and what would our new Enterprise Value be?
Answer:
In this scenario, you would add CapEx spending of $100 in year 4 of the DCF, which would reduce Free Cash Flow for that year by $100. The Enterprise Value, in turn, would fall by the present value of that $100 decrease in Free Cash Flow.
The actual math here is messy but you would calculate the present value by dividing $100 by ((1 + Discount Rate)^4) – the “4” just represents year 4 here. Then you would subtract this amount from the Enterprise Value.
The explanation makes sense. But if I ask you "But I thought if you buy $100 factory with $100 cash, your EV should increase because you are exchanging $100 non-core asset for $100 asset that is core to your operation." How would you respond to that?
Yeah no I'm confused on this too BUMP
Fellow prospect seeking clarity
Following
You’d want to argue it’s non-discretionary (I.e. needed for the rest of the model we are showing) if it was discretionary you’re right we could carve it out and sell it off.
an important caveat here, if it was non-discretionary and we sold it off we would not be able to achieve plan. If it was discretionary and we invested it in we’d expect our EBITDA to increase.
thus
A) it’s an investment you need for the growth that the revenue is dependent on it
B) it may be also more efficient and thus your margins are dependent on it
notice, it doesn’t really matter if finance the purchase with debt or cash. It’s just CapEx and FCFF so before debt service cost. I’d try to distance yourself from the cap structure with this question it’s not super relevant.
please add on to my answer, need to get back to the bench press.
I could be wrong but I think both parts of the question are partially incorrect which is why the discrepancy arises.
In your DCF, buying the factory in year 4 reduces your year 4 FCF, but presumably it ignores that that this factory should increase FCF in years 4 and beyond (or else why buy this factory?). So the total effect is an increase in your DCF valuation and hence higher EV.
The second part is only correct if you assumes buying the factory today and so it’s measuring today’s impact on today’s cash balance, which is different than projecting a cash outflow 4 years from now.
I think its a very fair counter argument. I have personally found that I run into a lot more trouble when I try to answer a question in a more complex way though, so if the question is premised on the Company already planning to buy the factory I would take that to mean the Company needs to spend the CapEx to execute its plan currently laid out. When I interview candidates I'd probably press them in your direction as well just to see if they understood the concept well enough to make that point.
Also we're probably splitting hairs here, but to lay it out simply: The DCF does not care how your actual capital structure changes throughout the life of the project as in your WACC your weights never reflect actuals, they reflect optimals/targets. Then when we walk from Enterprise Value to Equity Value, we do that with the balances that we have today, day 0. The CapEx investment has not been made, nor has any debt been drawn to finance it (though this would obviously net out with cash ignoring any financing fees/OID etc.), and thus the CapEx in year 4 has no impact on our capital structure (unless of course we want to make an argument on having more fixed assets implies we should have more debt in our target cap structure etc.).
Ultimately: CapEx in your DCF should reflect what is required to achieve the EBITDA you are projecting for your FCF build, if it was a discretionary purchase and had no operating value it wouldn't affect Enterprise Value (forgetting all formulas, EV is just the value of the core operations of your business) and wouldn't show up in your DCF. It'd be synonymous with the owner buying a new lambo for personal use, except this time he bought a factory to make lambos but plans to only use them for personal use and generate no money.
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