BIBLIOGRAPHY AND REFERENCES
5. Net Debt
4.5 FORECASTING CAPEX AND DEPRECIATION
Percentage of sales Fixed & variable costs
Approach
Regression analysis
EXHIBIT 4.23 Forecasting SG&A costs (OPEX) with 3 different approaches
the forecast OPEX as a percentage of sales would be: 6.9%, 7.6%, 8.2%, and 8.9% for years 2014, 2015, 2016, and 2017 respectively. This would give the highest increase in OPEX as a percentage of sales.
So far we have covered the Selling, General, and Administrative costs (SG&A) which are classified as periodic expenses. In the next section we will cover another cost category, Capital Expenditure (CAPEX), which gives rise to the fixed assets of a company. Only a portion of CAPEX and fixed asset costs, in contrast to SG&A costs, are classified through depreciation as periodic expenses.
▪Land improvements (e.g. fences) have a 15-year useful life; however land is not depreciated.
▪Assets used in construction have a 5-year useful life.
▪Nonresidential real estate, including offices and warehouses, has a useful life of between 20 and 33 years.
Let us assume now that we have to prepare a CAPEX and depreciation plan for a new com-pany (NewCo). This comcom-pany plans to have in place the following fixed assets during its first year of operation:
▪Land
▪Building (for office purposes)
▪Building (warehouse for production purposes)
▪Transportation (5 company cars and a truck)
▪Equipment (machinery for production purposes)
▪Office equipment (furniture, fixtures, and fittings)
▪IT equipment (hardware and software).
The founders of the company have agreed to buy a piece of land for €400k in order to build the company’s offices and the warehouse. The main office building is estimated to cost around
€480k and will be ready in May whereas the warehouse will cost approximately €500k and will be ready in August. They also plan to buy various office fixtures and fittings in May and a welding machine in August when the office building and the warehouse respectively will be ready. Finally, they plan to buy 5 company cars and a truck for distribution purposes and some IT infrastructure in order to equip both their offices and the warehouse.
Exhibit 4.24 shows the CAPEX plan of NewCo during its first year of operation. Next we need to define the useful lives of the different asset classes presented in NewCo’s CAPEX plan and derive the depreciation rate. The land is assumed to be freehold (as opposed to leasehold) and is not depreciated as we mention previously, that is, it has an infinite useful life. Buildings have a useful life of 20 years in the case of the offices and 33 in the case of the warehouse. For the cars and tracks we will use a 6-year useful life and for the equipment a 10-year useful life.
Finally, for the office equipment and the IT infrastructure we will use a 7-year and a 5-year useful life respectively. The depreciation rate is the inverse of the useful life and is given by the following equation:
Depreciation Rate
Estimated Useful Life
= 1
The depreciation using the straight-line method is derived as follows:
Depreciation Cost of Asset Estimated Residual Value Estimated Us
= –
eeful Life
=(Cost of Asset−Estimated Residual Value)×Depreciation Rate,
where the useful life is the period over which the company intends to use the asset and is not necessarily equal to the physical life of the asset, and the residual value is the amount received after disposal of the asset. That is, depreciation is computed by dividing
the depreciable amount of the asset by the expected number of the accounting periods of its useful life.
There are also other methods that could be used to calculate the depreciable cost of an asset over its life. The most commonly used depreciation methods are the following although a detailed description will not detain us here:
▪ Straight-line method
▪ Reducing balance method
▪ Revaluation method
▪ Sum of digits method
▪ Units of production method.
Based on the useful life of the various asset categories the depreciation rate for the main office building is 1/20 = 5%, the rate for the warehouse is 1/33 = 3% and so on. Exhibit 4.25 shows a similar table to that of Exhibit 4.24 but with the depreciation schedule attached. This file in Excel can be found on the website accompanying the book. We can see the depreciation rates in the depreciation schedule in the column next to the description of the assets.
We see that for reasons of simplicity the depreciation starts in the month the expense is incurred. For example, the company plans to buy 2 cars costing €22k each in February. The depreciation that corresponds to this purchase for the month of February is 2×22*17%/12 =
€0.6k assuming that the residual value of the cars is nil. The depreciation for March (cell E28) will be the same as for February since there are neither acquisitions nor disposals of any cars. That is, the depreciation expense in any given month is made up of 2 components, the depreciation on the existing assets and the depreciation on any new asset. For example, the depreciation in April equals the depreciation which arises from February’s purchase plus the depreciation of the new purchase in April (2×22*17%/12 + 22*17%/12 = €0.9k).
From the above schedule we have both the gross value of the fixed assets that will form the first account of the balance sheet and the depreciation that will be subtracted from the EXHIBIT 4.24 Timing plan of the CAPital EXpenditures (CAPEX) of NewCo
gross fixed assets to give the net fixed assets. At the same time, depreciation will be charged to the income statement to offset against the cost of the asset on the balance sheet (Exhibit 4.26).
EXHIBIT 4.26 NewCo’s balance sheet as of end of year 1
You will recall from Chapter 2 that the overall formula for CAPEX and depreciation in relation to fixed assets is:
Beginning Value + CAPEX − Depreciation = Ending Value EXHIBIT 4.25 CAPEX plan and depreciation schedule for the first fiscal year of NewCo
EXHIBIT 4.27 CAPEX plan and depreciation schedule of NewCo for years 2 to 5
When we plan for a new company, we are asked to prepare at least a 5-year plan. For the first couple of years we usually present a CAPEX plan and a depreciation schedule on a monthly basis whereas for the rest of the forecast period an annual presentation is fine. We can extend the Excel worksheet shown in Exhibit 4.25 to include another year presented on a monthly basis plus 3 more years on an annual basis. Exhibit 4.27 presents the additional expenditure of €124k on another welding machine during the second year of operation plus
€10k in various office expenses each year starting from year 2.
We can see that the CAPEX for year 2 is €134k and €10k for each consecutive year whereas the depreciation for year 2 is €121,6k and for the rest of the years €128,9k, €130,3k, and €131,8k respectively. Let us see how these numbers are derived. As we mentioned previously, the depreciation in any given month or year is made up of 2 components, the depreciation of the existing assets and the depreciation of any new asset. So the deprecia-tion of the various assets during the first 4 months of the second year is the same and equals that of the last month of the previous year (year 1) since there are no new assets in place.
The depreciation of the office fixtures and fittings will increase in May of the second year since €5k worth of new assets are put in place. The new depreciated amount for May will be:
60 14* % /12 5 14* % /12
Comes from Year 1
Comes from Y
+
eear 2
= €0 8. k
Similarly, the depreciation of the welding machine is doubled in June of the second year since another machine of equal cost is put in place. Finally when we move to years 3 to 5 the depreciation equals that of the previous year plus the one arising from the new assets put in place for the current year. The balance sheet account of the net fixed assets for the 5-year forecast period would then be as shown in Exhibit 4.28:
EXHIBIT 4.28 Net fixed assets of NewCo for the 5-year forecast period
The gross fixed assets for year 2 are the gross fixed assets for year 1 (€1,862k) plus the CAPEX for year 2 (€134k). The gross fixed assets for the following years are derived similarly.
Please note that if the forecast period was 10 years instead of 5 and you use the con-cept that the depreciation in any given period is made up of the depreciation of the existing assets and the depreciation of any new asset, some of the assets with a shorter useful life than 10 years would be fully depreciated and thus the existing depreciation that comes from the previous periods should be adjusted properly.
4.5.1 Forecasting CAPEX and Depreciation for Existing Companies
So far we have covered the construction of a CAPEX plan and a depreciation schedule for a business where we had inside information about the asset class, cost, and timing of purchases of its various assets. If we are modelling for our own company or the company we work for, such information is normally available. When we want to forecast the financials of a third company, such information is very difficult to find and we have to use other approaches to forecast both CAPEX and depreciation. In the absence of such information, as you have prob-ably guessed, we may forecast CAPEX for further years either by adopting the percent-of-sales approach or by using regression analysis between CAPEX and sales. We could use the historic financials the FP&A manager gathered for SteelCo, described in Chapter 3, to see the effect of these approaches on future CAPEX values although it would not be a good idea since the sales decreased between 2011 and 2012 but CAPEX increased anticipated a market upturn. For example, the percent-of-sales method would result in decreasing CAPEX year after year since sales are decreasing. Nevertheless, for a going concern company there is a minimum CAPEX necessary to keep operations running smoothly. We could have reached similar results by apply-ing regression between CAPEX and sales. In any case the interested reader can easily apply these approaches the way we did for OPEX costs in the previous section.
What we could do to forecast the CAPEX for 2018 is to use a linear trend function on the gross fixed assets of SteelCo for the years 2011 to 2017 and forecast the gross fixed assets for 2018. Then the CAPEX of 2018 can be derived indirectly from the forecast gross fixed assets for 2018:
CAPEX2018= Gross Fixed Assets2018− Gross Fixed Assets2017 = €64,037k
− €63,040k = €997k
To forecast the gross fixed assets of 2018 recall that we simply select all the cells (after being converted to numbers) of CAPEX between 2011 and 2017 and then drag them to the right. Alternatively we could use Excel’s forecast function. The figure of €997k can be eas-ily justified since 2018 was forecast to be the first year with increased sales after 6 years of a downturn (see Section 4.3).
Exhibit 4.29 shows the forecast gross fixed assets of SteelCo for 2018. To forecast the accumulated depreciation we will use the percentage on gross fixed assets first, to estimate the yearly depreciation and then we will add it to the accumulated one of the previous year. You may recall from Chapter 3 that the percentage on gross fixed assets we used to derive depreciation was 3.6%. Then the accumulated depreciation for 2018 is:
Accumulated Depreciation2018= Accumulated Depreciation2017 + Depreciation2018 =
€28,315k + 3.6% * €64,037k = €30,620k
EXHIBIT 4.29 Forecasting CAPEX and depreciation for SteelCo
Thus, in case we want to prepare a full balance sheet statement the net fixed assets would be:
Net Fixed Assets2018= Gross Fixed Assets2018− Accumulated Depreciation2018 =
€64,037k − €30,630k = €33,417k
As a final note to this section we should stress the fact that capital expenditures should always be treated as a function of how fast a company is growing or is expected to grow. High growth companies will have much higher capital expenditures than low growth ones. There-fore assumptions about capital expenditure can never be made independently of assumptions about growth in the future.