I read in the chapter about the forcasting of FCFE. They said under the method of component of free cashflow, with a target debt-to-asset ratio, the formula should look like: FCFE = NI - (CapEX- Dep) *(1-DR) - WCInv(1-DR), where DR is the debt-to-asset ratio. The rationality behind (CapEx-Dep)*(1-DR) is, that depreciation can be used to finance CapEx. Hence company only needs to raise funds equal to (CapEx-Dp). Why? Depreciation is non-cash component, isn’t it? I did not major in finance in the university, hope my question is not too naive from view of yours:-(.
Depreciation is non-cash, so it is added back from net income. Capital expenditures are not measured in net income, and they are a cash outflow, so they are subtracted to get to FCFE. The rational isn’t that the depreciation pays for capital expenditures, but that they just net off as one is a positive and one is a negative. The excess of CAPEX over depreciation is a real cash expense that must be paid for, while all of the CAPEX before that can essentially take the place of depreciation in the net income calculation. I could go into an explanation about replacement projects vs. growth projects, but eh, I don’t really feel like it.
NI + Dep - CapEx is the same as NI - (CapEx-Dep). I think the reason that use this equation instead of NI+Dep-FCInv(1-DR)-WCInv(1-DR), is that they assume that a portion of the fixed capital investment is what is commonly referred to as “maintenance CapEx”. The assumption is that this expenditure is in the normal course of business and only the “new CapEx” is financed with new debt/equity. Hope this helps. Pretty confusing.
I think this is a little jumbled. I think the point is that, because FCFE is a cash flow measure, you want to add back depreciation, because it is a noncash expense, but you want to subtract off capex, because, in a loose sense, it is the cash version of depreciation. Note that CapEx - Dep is called incremental capex, because it can be thought of as the amount being spent on new assets rather than on replacement assets. Edit: this was in response to the initial post.
THANKS AT FIRST FOR YOUR HELP! So the Dep-equivalent part of the CapEx is used to keep the normal business running. Am I right? Then it comes another stupid question. As per jmac01 said, only “new CapEx” is financed with debt/equity. Where comes the money for the dep-equivalent part (i.e. CapEx - new CapEx)? I guess directly from equity? Thanks
" Then it comes another stupid question. As per jmac01 said, only “new CapEx” is financed with debt/equity. Where comes the money for the dep-equivalent part (i.e. CapEx - new CapEx)? I guess directly from equity? " Whole point is to start with Net Income or somewhere higher up in IS and then start removing stuff you need for Capex and WC