I am reading a textbook with this statement:
“Historical depreciation should be increased by the inflation rate when estimating capital expenditure for maintenance because replacement costs can be expected to increase”
Why does depreciation on existing PP&E need to be adjusted for inflation?
Don’t we just need to ensure inflation is factored into maintenance CapEx?
Thanks in advance!
If you want to estimate future capital expenditure for a firm you need ro think what they new machine cost.
The bought a machine 5 years ago For $10,000 with 10 year life , $1,000 a year depr.
When you are estimatng cost of replacement $10,000 is probably too low due to inflation.
There are lots of other problems with using deprc to estimate capx = ie residual values.
But you might say for the long run steady state part of your model capx = depreciation.
What this is saying is the dpeciation is too low an estimate as prices rise.
If you are modeling the income statement growing bu inflation but capx using historical costs you are going to get things wrong.
Hi @MikeyF
Thank you. Yes, I understand that the cost of replacement is going to be more than $10,000 due to inflation.
But why does the depreciation expense per year of $1,000 need to increase?
Look I have no idea what type of book you are reading or the context of the quote yu have given me.
So taking the quote
“Historical depreciation should be increased by the inflation rate when estimating capital expenditure for maintenance because replacement costs can be expected to increase”
It is saying you can’t use historical depreciation as an estimet of future capitial expenditure becuae it is not keeping pace with replacement prices, which will presumably move with inflation.****
I asusme then the book says you just adjust historic depreciation by infllation to get an estimate of future (maintenace) capx.
OK, that makes a lot of sense now. Thanks!