There is something I don’t finish to understand. FCFE is calculated this way:
FCFE = NI + NCC - FCInv - WCInc + Net Borrowings
Then, net borrwings are calculated as:
Net borrowings = (Debt Ratio)*(FCInv - Dep) + (Debt ratio)*(WCInv),
where (FCInv - Dep) is called “net fixed capital expenditures” or “incremental fixed capital expenditures”.
The thing I don’t understand well is why we call this incremental FC expenditures when in fact we are investing in total the FCInv amount and not only (FCInv - Dep).
I see FCInv as “gross investment”, but the effective new investment made is only the excess investment over depreciation, so that is indeed called net fixed capital expenditures.
Knowing this, why would we just borrow the proportion of debt to assets (debt ratio) to net investment?
Numeric example:
Debt ratio = 40%
FCInv = 500
Dep = 300
Net investment = 500 - 300 = 200
Borrowing on Fixed Capital is 0.40 * 200 = 80
So the company invest 500 but only borrows 80… Why? The effective debt ratio is 16% (80/500). This does not make sense for me. I see in most of the examples that Net FCInv is given as input.
CFAI book does not explain this procedure clearly, does anyone have any idea?
the depr exp is not actually spent, and is available for use to the company
so even though they spend fcinv for fixed capital purchases - the actual amount they spent would be (FCINV - DEP).
It is assumed that a mature company would be having a fixed proportion of expense on Debt (the debt ratio) - so amount of debt would be DR * (FCINV - DEP) - so Actual FCFE component would be (1-DR)*(FCINV-DEP).
Likewise for WCInv … DR *WCINV = Component of Net borrowings, (1-DR)*WCINV = Component of FCFE.
Really appreciate your comment, its really accurate, thanks a lot.
However, the part I don’t still understand is why the actual amount they spent would be only (FCInv - Dep). Depreciation espense is a noncash charge, so despite of it represents the portion of the assets that get depleted at each period of time, it cannot net against an effective cash outflow as FCInv really is.
Depreciation is something used by accountants to apportion your fixed investment across multiple periods that the investment would be used for. No company actually ever spends that money (or sets it aside).
For a mature company - the depreciation charge is a “Savings” account (if I may use that term) to take money out of - to spend for the new FCINV. So FCINV - Depr is what is actually “spent”.
Depreciation is a non-cash charge but it causes cash to increase since you pay less taxes than you otherwise would have paid without the depreciation expense.