Forecasting capital expenditure and capital structure

How do you forecast capital expenditure?

Long-term assets on the balance sheet grow with capital spending and shrink with depreciation and amortization, so their forecasts come from the cash flow statement and the income statement. Capital spending itself splits into two kinds with different drivers.

Capital expenditureon the cash flow statement; builds net PP&E and intangibles

• Maintenance capex Memorize sustains today's business; roughly D&A plus capital goods inflation
• Growth capex Memorize expands the business; discretionary, follows plans and revenue growth
• Acquisitions Know the idea forecast as a separate object

• Maintenance capital expenditures sustain the current business. They are often forecast from historical depreciation and amortization (D&A), nudged upward for inflation in the price of capital goods. Businesses with low fixed asset turnover need a lot of it.
• Growth capital expenditures expand the business. They are discretionary, tied to management’s strategy, expansion plans and revenue growth, so guidance and company plans matter most. Management tends to forecast items it controls, like capex, better than outsiders can.

$$K_m \approx DA\,(1 + i)$$

How do depreciation and the asset base roll forward?

The depreciation and amortization forecast rests on the net PP&E and intangible assets on the balance sheet, which new capex increases, and on their useful life under management’s accounting policy. A rough estimate of the life is gross PP&E divided by annual depreciation. The notes to the accounts often give the actual lives and planned capex. Some analysts instead forecast D&A as a percentage of beginning-of-year net PP&E.

$$\text{Life} \approx \frac{\text{Gross PP\&E}}{\text{Annual depreciation}}$$

The net PP&E roll-forward ties the three statements together: capex appears in cash flow from investing, depreciation in the income statement and the new net balance on the balance sheet.

$$PPE_{end} = PPE_{begin} + \text{Capex} - \text{Depreciation} \;(-\text{disposals})$$

How do you forecast the capital structure?

The leverage ratio is the usual forecast object: debt to capital, debt to equity, debt to EBITDA or net debt to EBITDA. Fix the ratio, then derive the levels of debt and equity from it. Three things guide the choice, as the tree shows.

Capital structure forecastpick a leverage ratio, then derive debt and equity

• Forecast object: a leverage ratio Memorize debt to capital, debt to equity, debt to EBITDA, net debt to EBITDA
• Inputs Memorize what sets the target
  • History Use it the company's usual ratio
  • Financial strategy Use it stated target, covenants, guidance
  • Capex plan Use it the funding the plan needs

• History. Companies tend to keep to their own habits.
• Financial strategy. Management may state a target capital structure , a covenant ratio (often net debt to EBITDA) or guidance on capex split into maintenance, growth and acquisitions.
• The capex plan. If cash flow after capex and dividends falls short, the gap is funded by debt, up to the target, or by equity if the target would otherwise be broken.

$$\text{Debt} = L \times \text{EBITDA}$$

Exam tip Capex, depreciation and debt are one story told across three statements. Change the capex plan and all three move.

Go deeper Why capex below depreciation for years is a warning sign

If a company spends less than its depreciation year after year, its net asset base shrinks. That may be sensible in a declining business, but in an ongoing one it means the plant is ageing and the profit is flattered, because depreciation is counted but the spending to renew assets is not. A forecast that keeps capex at that low level while growing revenue is inconsistent: sooner or later a catch-up in spending is needed.

Go deeper Acquisitions as a separate forecast object

Acquisitions are lumpy, strategic and hard to predict, so analysts rarely fold them into maintenance or growth capex. Forecast them only when announced or guided, and show their effect on revenue, margins and debt on their own line. A forecast that quietly assumes ongoing acquisitions will overstate organic growth.