Capital Expenditure (CAPEX) and D&A Converge Over Time
Does anyone have an inuitive answer as to why the two converge over time, regardless of the depreciation method and useful life of pp&e?
Capex and D&A Equivalent in Projection Window
Capital Expenditure and D&A must converge over time when looking at the projection window. D&A or CAPEX can be higher or lower than each other during the projection window (of the discounted cash flow model) implying that the asset base and the company is either growing or contracting. However, in the final year of a discounted cash flow analysis, you are attempting to project the company's financial performance for forever - assuming that it doesn't go out of business. At that point - you want to assume that the business' asset base will stay at a fairly constant level unless you have detailed information telling you otherwise.
With this in mind - a company should invest in maintence level capital expenditure to maintain the current asset base.
So when you are modeling out capex and depreciation and you get to the terminal year calculation they have to equal or else you are implying one of two things:
- Capex greater than depreciation means that the company is expanding into essentially infinity because your assets are growing faster than you are depreciating them
- Capex is less than depreciation means that the company's asset base will go to nothing since you are depreciating more than you are growing
For a review of the concepts mentioned in this explanation please see the sections below.
What is Capital Expenditure?
Capital Expenditure (also known as CapEx) is the amount a company spends on the acquisition or upgrade of physical, tangible assets such as:
- Property
- Factories
- Equipment
Read more about capital expenditure in another thread on WSO.
What is Maintenance Capital Expenditures?
Maintenance CAPEX is the investment that is made to maintain / replace current assets versus growth capital expenditure which is investment in new and different assets that are intended to grow the asset base.
What is Depreciation and Amortization?
Depreciation is when any asset is deemed to have reduced in value. No tangible asset can last indefinitely and therefore at some point, the asset will no longer be usable and will have to be recorded as a loss on the income statement. Depreciation allows a firm to allocate a percentage of that loss to different periods.
Amortization is similar to depreciation except amortization is only applied to intangible assets (patents, contracts, trademarks) whereas depreciation is used for tangible assets (property, plants, equipment etc).
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It's best to look at it by understanding how depreciation comes about and its relation to capex. When you make a capex investment for an asset that you add to your balance sheet, that asset gets depreciated over time until its book value is zero.
So when you are modeling out capex and depreciation and you get to the terminal year calculation they have to equal or else you are implying one of two things: (1) capex is greater than depreciation means that the company is expanding into essentially infinity because your assets are growing faster than you are depreciating them or (2) capex is less than depreciation means that the company's asset base will go to nothing since you are depreciating more than you are growing.
you "add" what you "lose"
If there is a major upfront investment, then EBITDA is a decent quick measure of owners earnings as long as there is not a large amount of maintenance (Owners include bondholders based off of EBITDA). Really you should add back interest expense after taxes to NI because taxes are real, but for comparison sake, EBITDA works.
If there is consistent maintenance such as in a manufacturer, then Depreciation should be added back and maintenance capex should be subtracted.
I have no idea what your two questions mean.
When a company is mature, it doesn't need as much growth capex to continue on its current path as it did when it was less mature. It only needs enough to offset how much they're losing through depreciation.
Depreciation vs Capex (Originally Posted: 06/26/2015)
In his letters, WB discussing owners earnings suggests that maintenance capex be used instead of depreciation. Leaving the "maintenance" part aside for now - I don't really understand why using depreciation is wrong?
I understand that it's an accounting item - not a real cash outflow. But then imagine a company with the following annual capex: Year 1: 2000 Year 2: 0 Year 3: 0 Year 4: 0 Should you decide to use capex instead of depreciation to calculate owners earnings - you would average it out throughout the 4 years, wouldn't you? In which case you are creating another accounting item - which if the capex stayed stable would be exactly same as depreciation. So where's the benefit?
So far I was able to find the following through research: 1 - depreciation look backward, while capex forward 2 - depreciation can be intentionally manipulated by companies wishing to show one figure or another
Are there any other major reasons? Why is (1) a bad thing, given the current state of the company depends on past not future? Does (2) occur often? Can someone give an example?
But this occurs even when capex is left constant.
Because you depreciate only what you spent in capex, i.e. if you buy a car for 10$ with a useful life of 10 years , depr. cost would be 1$/year. Depreciating less would obviously over-value your company and depreciating more would obviously undervalue it (since you are depreciating more than is in fact necessary).
In a model the reason is basic. You can't grow into infinity and you can't depreciate your assets into any negative territory, its just a simple math thing w/ models
really applies only to the terminal value. If capex depreciation then in theory your EBIDA/FCF should be growing since you're investing in more assets, even holding TAT fixed. Thus, set capex = dep and account for growth in free cash flow in the discount rate assuming a growth perp TV.
Model-wise the idea is to increase your net book value by adding assets and increasing depreciation (in absolute terms, stable-ish as a percentage of NBV/revenues what have you); for that to happen it'll tend to have to converge.
An exception to this rule would be if your model plans for a high long-term inflation rate. Then capex will tend to be higher than depreciation in the long-term, as D&A is a book value accounting notion based on past years, and capex is a forward-looking investment decision. To replace an equivalent amount of depreciated assets, you would need a higher capex when inflation is very high (e.g. Nigeria)
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