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Depreciation and Amortization in DCF Analyses and the Impact of the New Tax Law

Authors:
  • Sutter Securities Financial Services, San Francisco

Abstract

This presentation discusses (i) the relationship between capital expenditures and depreciation; (ii) the appropriate treatment of amortization and other limited life items in a terminal value calculation; and (iii) how changes in the Tax Cuts and Jobs Act of 2017 regarding tax rates, net operating losses, interest deductions, and depreciation write-offs can affect DCF analyses.
DEPRECIATION AND AMORTIZATION IN DCF ANALYSES
AND
THE IMPACT OF THE NEW TAX LAW
GILBERT E. MATTHEWS, CFA
DEPRECIATION AND AMORTIZATION IN DCF ANALYSES
AND
THE IMPACT OF THE NEW TAX LAW
GILBERT E. MATTHEWS, CFA
Business Valuation Resources
Webinar
February 15, 2018
SUTTER SECURITIES GIL@SUTTERSF.COM
1-415-352-6336
TOPICS TO BEDISCUSSED
1. The normal relationship between capital expenditures
and depreciation – why capex = depreciation is a flawed
assumption
2. The appropriate treatment of amortization and other
limited life items in a terminal value calculation
3. How changes in the new tax law regarding tax rates, net
operating losses, interest deductions, and depreciation
write-offs can affect DCF analyses
2
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
The Relationship Between
Depreciation and
Capital Expenditures
3
TERMINAL VALUE
Terminal value is the dominant component of most DCF
valuations
The preferred method of academics and most valuation
practitioners for determining terminal value is a growth
model
With 5-year projections, terminal value usually accounts for
70% or more of the aggregate value
4
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
A COMMON ERROR
When calculating terminal value in the Gordon growth
model, it has been common practice for valuators to assume
that depreciation equals capital expenditures in perpetuity
[I]n corporate finance and valuation, once a practice has
become established, it becomes difficult to challenge,
even if the original reasons for it have long disappeared.
Aswath Damodaran, “The Small Cap Premium: Where is the Beef,
34 Bus. Val. Rev. 152 (2015)
5
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
THIS ERROR OVERSTATES VALUATIONS
In fact, due to growth and inflation, capex must be greater
than depreciation in a growth model
The understatement of capex is a common error in
calculations of terminal value
Some analyses even have capex < depreciation in perpetuity!
Understating future capex in relation to projected
depreciation necessarily results in overstated terminal values
6
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
MORE PRACTITIONERS NOW RECOGNIZE
THAT CAPEX SHOULD EXCEED DEPRECIATION
Jim Hitchner has asked valuators in a webinar audiences,
How do you typically handle depreciation and cap ex when
calculating cash flows?” and has published the results in his bi-
monthly Financial Valuation and Litigation Expert
The responses in the last three surveys were:
2013 2015 2017
Capex less than depreciation[!]: 4% 6% 2%
The same or very similar: 68% 55% 45%
Capex more than depreciation: 28% 38% 53%
7
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
FCF FOR TERMINAL VALUE
SHOULD BENORMALIZED
Although capital expenditures in any given year can be less
than depreciation, a growing companys normalized capex
should exceed its depreciation
The analyst must always review projected capex and
depreciation in the terminal year to determine whether
normalizing adjustments to free cash flow (FCF) are needed
Equipment costs and evolving technology costs may affect the
relationship of the depreciation rate to the growth rate
oTo the extent that new equipment is less expensive or more efficient,
the ratio of capex to depreciation may decrease
oIf a single-facility company built and equipped a factory, depreciation
could exceed capex until major new investments are required
8
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
5-YEAR STRAIGHT LINE DEPRECIATION
Example: a company depreciates its assets on a straight-line basis over a
five-year period to zero residual value and is growing at 5% annually
Capex in year 6 (2023) is 112.7% of depreciation [1,276.3 ÷ 1,132.8]
Sample calculations of the 15-
year relationship between capital expenditures and depreciation
using straight line, double declining balance, and sum-of-the-digits depreciation are appended
9
5-Year Straight Line Depreciation with 5% Growth
Year Purchased Capital Expenditures Depreciated in 2023
% Amount
2018 1,000.0 10% 100.0
2019 1,050.0 20% 210.0
2020 1,102.5 20% 220.5
2021 1,157.6 20% 231.5
2022 1,215.5 20% 243.1
2023 1,276.3 10% 127.6
1,132.8
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
5-YEAR DOUBLE DECLINING DEPRECIATION
Five-year double declining depreciation to zero residual value
10
5-Year Double Declining Depreciation with 2% to 5% Growth
2% Growth 3% Growth 4% Growth 5% Growth
Year Capex
Depreciated
in 2023 Capex
Depreciated
in 2023 Capex
Depreciated
in 2023 Capex
Depreciated
in 2023
2018 1,000 57.6 1,000 57.6 1,000 57.6 1,000 57.6
2019 1,020 117.5 1,030 118.7 1,040 119.8 1,050 121.0
2020 1,040 119.9 1,061 122.2 1,082 124.6 1,103 127.0
2021 1,061 203.8 1,093 209.8 1,125 216.0 1,158 222.3
2022 1,082 346.4 1,126 360.2 1,170 374.4 1,216 389.0
2023 1,104 220.8 1,159 231.9 1,217 243.3 1,276 255.3
Depreciation in
2023 1,065.9 1,100.3 1,135.7 1,172.1
Capex in 2023 1,104.1 1,159.3 1,216.7 1,276.3
Difference 38.2 59.0 81.0 104.2
Capex as % of
Depreciation 103.6% 105.4% 107.1% 108.9%
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
EFFECT OF 15-YEAR DEPRECIATION
With a 15-year depreciable life, capex is always materially
greater than depreciation
Excess of Capital Expenditures over Depreciation,
Assuming 15-Year Life with No Residual Value
11
0%
10%
20%
30%
40%
50%
2% 3% 4% 5%
Growth Rate
Straight Line
Depreciation
Double Declining
Depreciation
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
A SUMMARY TABLE (1)
The table below summarizes the relationships between
capex and depreciation for different lives, growth rates,
and depreciation methods (zero residual value)
12
Excess of Capital Expenditures Over Depreciation
Depreciation Method Growth rate:
2% 3% 4% 5%
5-year life
Straight line 5.03% 7.56% 10.11% 12.67%
Double declining 3.58% 5.36% 7.13% 8.89%
Sum of the digits 3.66% 5.49% 7.31% 9.12%
10-year life
Straight line 10.22% 15.50% 20.87% 26.35%
Double declining 7.73% 11.62% 15.52% 19.43%
Sum of the digits 7.05% 10.60% 14.17% 17.76%
15-year life
Straight line 15.58% 23.79% 32.27% 40.99%
Double declining 11.95% 18.03% 24.16% 30.34%
Sum of the digits 10.48% 15.83% 21.24% 26.69%
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
A SUMMARY TABLE (2)
Alternatively, we can look at depreciation as a percent of capital
expenditures
13
Depreciation as % of Capital Expenditures
Depreciation Method Growth rate:
2% 3% 4% 5%
5-year life
Straight line 95.2% 93.0% 90.8% 88.8%
Double declining 96.5% 94.9% 93.3% 91.8%
Sum of the digits 96.5% 94.8% 93.2% 91.6%
10-year life
Straight line 90.7% 86.6% 82.7% 79.1%
Double declining 92.8% 89.6% 86.6% 83.7%
Sum of the digits 93.4% 90.4% 87.6% 84.9%
15-year life
Straight line 86.5% 80.8% 75.6% 70.9%
Double declining 89.3% 84.7% 80.5% 76.7%
Sum of the digits 90.5% 86.3% 82.5% 78.9%
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
COURTS OFTEN HAVE ACCEPTED
CAPEX ≤ DEPRECIATION
Many federal and Delaware court decisions have accepted
DCF valuations in which depreciation = capex
In most of these cases, neither side used a projection when
capex ≥ depreciation
Only a handful of decisions have recognized the reality that
capex should exceed depreciation
A few federal and Delaware court decisions have even
accepted DCF valuations in which depreciation ≥ capex
Two Delaware decisions have accepted DCF valuations where
projected capex were less than half of projected depreciation!
14
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
COURT USED CAPEX<25% OF D&A
In a 2004 case, the projection used by the Court of Chancery
assumed capex of $100,000 per year and D&A averaging more
than $430,000 per year*
Lane v. Cancer Treatment Centers of America, Inc., 2004 Del. Ch. LEXIS 108 (Del. Ch.
July 30, 2004) at *111
*The Court did not indicate how much was depreciation and how much was amortization
15
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
Cash Flow [$000]
1991 1992 1993 1994 1995
Net Income After Tax 871 905 938 729 759
Additions
Depreciation & Amort[ization] 487 492 451 389 368
Interest 235 171 107 52 5
Subtractions
Capital Expenditures (100) (100) (100) (100) (100)
[Change in] Working Capital (53) (36) (34) (2) (40)
Cash Flow 1,440 1,433 1,362 1,068 991
THUS THE EQUITY WAS MASSIVELY OVERVALUED
The Cancer Centers opinion calculated terminal value based
on 5% perpetual growth of projected free cash flow
This effectively assumed that capex and D&A both would grow
at the 5% rate
The Court valued the company at $5.00 million using DCF
Debt was $3.99 million – thus equity was $1.01 million
If capex = D &A, the calculated DCF value of the equity would
have been barely above zero
16
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ANOTHER EXAMPLE
In another 2004 case, the Court explicitly accepted a terminal
value based on a growth model in which capital expenditures in
the final year on the projection period were $9.1 million and
depreciation was $21.8 million
The Court wrote:
Nor is there merit to the defendants' criticism (articulated through [Expert B])
that in [Expert A]’s terminal year (2002), depreciation exceeds CapEx, a state of
affairs that cannot go on forever. The flaw in this criticism is that [Expert A]
projected cash flows only; he did not forecast the individual components of free
cash flow, including CapEx or depreciation. Accordingly, there is no basis to
conclude that [Expert A] forecasts perpetual divergent depreciation and CapEx.
In re Emerging Communications, Inc. Shareholders Litig., 2004 Del. Ch. LEXIS 70 (Del. Ch.
May 3, 2004), at *57, n.56.
17
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ANOTHER OVERVALUATION
This explanation is puzzling since terminal value was
computed by applying a growth rate of 2.9% to FCF, adding
depreciation to, and deducting capex from, projected EBIT
Thus, the calculation of terminal value was, in reality, on a
forecast in which depreciation perpetually dwarfed capex, a
clear impossibility.
This error more than doubled the DCF value
The company was unable to appeal the decision
18
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
SOME COURTS HAVE ACCEPTED
CAPEX > DEPRECIATION
In a 2010 U.S. District Court case, the Court accepted expert
testimony that capex would exceed depreciation and rejected
testimony that they would be equal:
[Expert B] assumes that capital expenditures will equal depreciation in the
terminal period. . . . According to [Expert A], [Expert B] 's analysis is flawed
because it implicitly assumes revenue growth without additional investment
in ATS's asset base. [Expert B] responds that . . . this is a "steady state"
business that will grow at the rate of inflation.
[Expert A] assumes capital expenditures of approximately 109% of
depreciation. This follows from . . . a belief that capital expenditures must
outpace depreciation if the company intends to manufacture the number of
units necessary to achieve terminal value revenue assumptions. . . .
Albert Trostel & Sons Co. v. Notz, 2010 U.S. Dist. LEXIS 108778 (E.D. Wisc., Sept 28,
2010) at *41; affd, 679 F.3d 627 (7th Cir., 2012)
19
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
SUMMARY: DEPRECIATION AND AMORTIZATION
As a general rule, capital expenditures should be greater than
depreciation in a terminal value calculation
The relationship is a function of depreciation rates, company
growth rates and technological innovation
The courts have generally not yet recognized this analytical
fact, in part because many experts do not present this point in
their testimony and in part because of the limited literature
on the subject (see attached bibliography)
20
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
The Appropriate
Treatment of Amortization
in DCF Valuations
21
AMORTIZATION
Amortization and depreciation are both non-cash charges that
reduce reported income
Most amortizable intangible assets are created through either
acquisitions or creation of intellectual property
Tax-deductible amortization is similar to depreciation in that it
reduces both reported net income and taxes
Non-tax-deductible amortization reduces only net income
22
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
AMORTIZATION HAS A LIMITED LIFE
An important difference between amortization and
depreciation must be recognized by valuators when
calculating terminal value: amortization has a limited life
A common error is to project growth of amortization in
perpetuity
Amortizable intangible assets such as goodwill are not
systematically replaced in the ordinary course of business
Since amortization, unlike depreciation, does not grow in
perpetuity, it must be separately valued in terminal value
calculations
23
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
THE VALUE OF AMORTIZATION IS THE PRESENT
VALUE OF FUTURE TAX BENEFITS
Even though amortization should be excluded from the
computation of terminal value, any tax benefit it generates
has value and should be included in enterprise value
An appropriate manner to value amortization subsequent
to the projection period is to determine the risk-adjusted
present value of the future tax benefits of the remaining
amortization
24
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
AMORTIZATION MUST BESEPARATED
FROM DEPRECIATION IN D&A
Companies customarily lump depreciation and amortization
(“D&A”) as a single line item in their income and cash flow
statements
For public companies, information re amortization can often be
found in footnotes or in the Management Discussion and Analysis
Because of the different analytical treatment of amortization
and depreciation, it is important that valuators determine
how much of the projected D&A is amortization
If possible, valuators should obtain a schedule of amortization
from management when the amount is material
25
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
OTHER NORMALIZING ADJUSTMENTS
FCF must be also be normalized to exclude any other
items that are not growing over time or which have a
finite term, such as tax-loss carryforwards, limited-life
royalties, and non-compete agreements
26
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
BENEFITS OF LIMITED-LIFE ITEMS SHOULD
BEINCLUDED IN TERMINAL VALUE
The present value of future positive or negative cash
flows from limited-life items after the projection period
should be included in terminal value
The value of tax-loss carryforwards is the risk-adjusted
present value of future tax benefits
The value of future limited-life income streams is the present
value of the income net of taxes
The value of future limited-life obligations is the negative
present value of the expense net of taxes
27
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
A SIMPLE FORMULA
These adjustments are achieved by adding the present value
of these net cash flows after the terminal year to enterprise
value, as shown in the following equation:
EV = PVF+ PVT+ PVA
EV = enterprise value at the valuation date;
PVF= present value of free cash flows from the valuation date
through the terminal year of the projection;
PVT = present value of terminal value based on normalized FCF
PVA= present value of net benefits (costs) of amortization,
tax-loss carryforwards, and limited-life income and
expense items after the terminal year of the projection
28
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ANEXAMPLE OF ERRONEOUS TREATMENT OF
LIMITED LIFE ITEMS IN COURT
A 2007 Delaware decision exemplified two errors in the
treatment of limited life items*
The cash benefits of tax loss carryforwards was double counted
Amortization projected to grow in perpetuity
* Crescent/Mach I Partnership, L.P. v. Turner, 2007 Del. Ch. LEXIS 63 (Del. Ch. May 2,
2007), modified, Crescent/Mach I P'ship, L.P. v. Dr Pepper Bottling Co., 2008 Del. Ch.
LEXIS 68 (Del. Ch., June 4, 2008); modification rev'd on other grounds, 962 A.2d 205,
2008 Del. LEXIS 541 (Del. 2008)
29
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
THE COURT DOUBLE-COUNTED THE VALUE OF
TAX-LOSS CARRYFORWARDS
The Court included the present value of the carryforwards
after the end of the projection period in its valuation
However, the cash flow benefit of the tax loss carryforward
was also included in the forecast on which terminal value was
based
Thus, the carryforward was capitalized as if were growing in
perpetuity
This error overstated the valuation by about 8%
30
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
THE COURTSDCF CALCULATION
GREW AMORTIZATION IN PERPETUITY
Since amortization was part of the projected free cash flow
that both testifying experts used in their growth models, they
(and the Court) effectively assumed that the amortization
was perpetual
Amortization was about 22% of D&A in the projections
The error was compounded by effectively assuming that
amortization would grow the same growth rate, thereby
further overstating terminal value
31
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
COURTSOPINION WAS MODIFIED
BUT TOO LATE
The Court of Chancery agreed to reconsider its opinion at
the request of respondents counsel
It modified its opinion as to the tax loss carryforwards, but
did not discuss the amortization error
The Supreme Court reversed the modification, ruling that a
post-trial settlement had closed the case
32
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
SUMMARY: LIMITED LIFE ASSETS AND LIABILITIES
Amortization of intangible assets, loss carryforwards, and
other limited-life assets (and liabilities) should be excluded
from normalized FCF in terminal value and should be
separately valued
Failure to separate amortization from depreciation results in
overvaluations
Since data supplied by management often lumps depreciation
and amortization together, the valuator must obtain the
granular information necessary for an appropriate analysis
33
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
The Impact of
the New Tax Law
on DCF Analyses
34
CHANGES IN THE NEW TAX LAW
Several changes in the new tax law passed in December will impact
DCF calculations
We will discuss two substantive changes that have a positive effect
on cash flow:
C corp tax rate dropped from 35% to 21%
Accelerated depreciation
oThis has will have complex effects on DCF analyses and will be discussed last
We also will discuss two substantive changes that, when relevant,
have a negative effect on cash flow:
Use of net operating losses (NOLs or tax loss carryforwards) is capped at
80% of net income
Deductibility of interest is limited
35
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
OTHER CHANGES
Some of the changes will not be discussed here, e.g.:
Amortization of R&D over 5 years instead of write-off
Higher tax on dividends received
End of corporate alternative minimum tax
Liberalization of taxes on repatriation of foreign earnings
Application of U.S. tax to certain foreign income
Certain provisions applying to banks or insurance companies
36
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
TAX RATES FOR C CORPS AND
FLOW-THOUGH ENTITIES
The analytical effect of the lower marginal tax rate is simple –free
cash flow (FCF) will increase due to lower taxes
The corporate tax rate in FCF calculations (before the effect of loopholes)
will be 21% plus 79% of relevant state income tax rate[s]
State income taxes will still be deductible expenses for C corps (unlike for
persons)
The tax rate on flow-through entities is in most situations reduced to
80% of the rate on ordinary income through 2025
Marginal S corp federal tax rate = 80% x 37% = 29.6%
State income taxes will generally no longer be deductible for owners of
flow-through entities
37
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
GAAP FINANCIAL STATEMENTS
ARE NOT SUFFICIENT FOR DCF CALCULATIONS
The impact of some of the tax changes will not be shown in
GAAP income statements
For example, depreciation will be based on GAAP rules and not on
the accelerated schedule permitted for tax purposes
Therefore, the cash savings will not be directly shown
It will be necessary to ask clients for projections not only on a
GAAP basis but also on a tax basis
GAAP financials are appropriate for the market method but usually
will not suffice for the income method
38
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
LIMITATION ON USE OF NOLS
Under the new law, NOLs arising in tax years beginning after
12/31/17, are limited to offsetting 80% of taxable income,
cannot be carried back, but can be carried forward
indefinitely
The prior provision that NOLs could offset 100% taxable
income in any year, and that unused NOLs could be carried
back 2 years and forward 20 years, has been grandfathered
39
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
IMPACT OF NOL CHANGES
DCF models will have to be tweaked to treat NOLs deriving
from tax years beginning before 12/31/17 (old NOLs)
differently than those from later tax years (new NOLs)
Valuators will need information from management as to
which NOLs are old and which are new
Old NOLs, which are more valuable, will be used first
Calculations should be based on tax accounting, not GAAP
In a few situations, expiration dates of old NOLs may be relevant
40
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ADJUSTING FOR NOLS
NOLs that are not applied during the projection period (or in a
later stage in a multistage model) should be present-valued
and added to terminal value
If terminal value determined with a growth model is “sanity-
checked” by using a P/E ratio, the valuator should normalize
net income by excluding the benefits of NOLs
Including the benefit of NOLs in a valuation assumes that there will
be no ownership change (as defined in the tax law*) since all NOLs
are subject to severe limitations in the event of a deemed ownership
change
* §382 defines an ownership change as a more than 50% increase in ownership
by 5% owners during a three-year period
41
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
LIMITATIONS ON DEDUCTIBILITY OF INTEREST (1)
Under the new tax law, a business’s allowable deduction for
net business interest expense in a particular tax year is
limited to 30% of “adjusted taxable income”
Adjusted taxable income” generally corresponds to EBITDA for tax
years beginning before Jan. 1, 2022
Thereafter, it generally corresponds to EBIT
Regulated utilities are generally exempt from this limitation
For flow-through entities, this limitation is applied at the
entity level rather than at the owner level
Taxpayers (other than tax shelters) with average annual gross receipts
of $25 million or less for the three previous tax years are exempt from
the interest deduction limitation
42
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
LIMITATIONS ON DEDUCTIBILITY OF INTEREST (2)
These limitations on interest deductions have no grandfather
provision for existing debt
Any unused business interest expense can be carried forward
indefinitely
Interest expense carryforwards are not treated as NOLs
The entire interest expense carryforward is available in any tax year,
subject to the 30% limitation
However, they are potentially subject to limitation if there is an
ownership change
43
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
IMPACT OF LIMIT ON INTEREST DEDUCTIONS
The limitation on interest deductions should be included a
DCF model
The limitation is on net interest (interest expense minus interest
income)
The model should reflect the 2022 switch from EBITDA to EBIT in
the denominator for the annual interest limit
The growth model should be based on EBIT
Adjustments for state income tax may differ
oSome states expressly follow federal law in determining deductions
oSome states may continue to allow 100% deductibility
44
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ACCELERATED DEPRECIATION (1)
For qualified tangible property (and certain computer
software) placed in service between Sept. 28, 2017 and
Dec. 31, 2022 that has a depreciable life of up to 20 years,
the first-year bonus depreciation percentage is 100% (up
from 50%)
This accelerated depreciation will not be permitted under many
states’ tax laws
This 100% deduction is allowed for both new and used
qualifying property
45
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ACCELERATED DEPRECIATION (2)
In subsequent calendar years, the bonus depreciation will be:
2023 : 80%
2024 : 60%
2025 : 40%
2026 : 20%
For certain property with longer production periods, the 100%
write-off extends through 2023 and scales down from 2024
through 2027
46
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
MANAGEMENT PROJECTIONS OF
CAPEX AND DEPRECIATION
The work of the valuator is simplified if management supplies
adequate schedules as to capex and depreciation for the
projection period
It is even more helpful if longer-term schedules are made
available
When management has supplied information, the valuator
should review the data for reasonableness and internal
consistency
47
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
THE NEW LAW MATERIALLY CHANGES THE
CAPEX/DEPRECIATION RELATIONSHIP
The table below shows the impact of accelerated write-offs
on annual depreciation, assuming a straight-line 10-year
depreciation and 3% growth in capex
48
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
2016 2017 2018 2019 2020 2021 2022
Depreciation 841 1,103 1,845 1,798 1,750 1,700 1,649
CapEx 971 1,000 1,030 1,061 1,093 1,126 1,159
2023 2024 2025 2026 2027 2028 2029
Depreciation 1,369 1,099 837 586 358 457 598
CapEx 1,194 1,230 1,267 1,305 1,344 1,384 1,426
2030 2031 2032 2033 2034 2035 2036
Depreciation 742 891 1,045 1,191 1,317 1,423 1,505
CapEx 1,469 1,513 1,558 1,605 1,653 1,702 1,754
THE CHANGE IN GRAPHIC FOM
This chart shows the extreme fluctuation in depreciation
even if capex is consistent
49
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
0
250
500
750
1,000
1,250
1,500
1,750
2,000
2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038
Capital Expenditures and Depreciation
10-Year Straight Line Depreciation, 3% Growth
Depreciation
CapEx
ABNORMAL CAPEX/DEPRECIATION RATIOS
With 10-year depreciation, the relationship between capex and
depreciation does not normalize until 2037
If assets are depreciated over a 15-year period, the relationship of
depreciation to capex does not normalize until 2042
50
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
86.6%
110.3%
179.2%
169.5%
160.2%
151.1%
142.3%
114.7%
89.3%
66.1%
44.9%
26.7% 33.0% 41.9%
50.5% 58.9%
67.1%
74.2%
79.7%
83.6%
85.8%
86.6%
86.6%
0%
25%
50%
75%
100%
125%
150%
175%
200%
2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038
Depreciation as % of CapEx
10-Year Straight Line Depreciation, 3% Growth
NORMALIZING FOR TERMINAL VALUE
For terminal value calculations, capex and depreciation
should be normalized
The ability of companies to write off capital expenditures in
the first year rather than depreciating them materially
complicates the treatment of capex/depreciation in
calculating terminal value
51
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ADJUSTING FOR
ABNORMAL CAPEX/DEPRECIATION RATIOS
The Gordon growth model necessarily assumes that FCF in
the base year is normalized and does not include non-
recurrent or limited-life items
The new tax law will cause depreciation to follow an
irregular pattern for a period much longer than the length of
most management projections
The basic issue here is the impact of timing differences on
present value
52
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
CALCULATING TERMINAL VALUE (1)
There are various ways in which this can be addressed
One approach is to use a multi-stage model with, e.g.,
a second stage for declining depreciation, a third stage
as it increases, and a final stage when the normal
capex/depreciation relationship is restored
Because of the scale-down in accelerated depreciation from 80%
in 2023 to none in 2027, the second stage should run through
2027, the year in which depreciation is at its low point
The length of the third stage would be a function of the
depreciation period for the company’s assets
53
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
CALCULATING TERMINAL VALUE (2)
Another approach is to calculate terminal value based on
normalized data in the year following the end of the
projection period, and then to adjust for the present-value
of the abnormal capex/depreciation differences in the same
manner as discussed earlier for limited-life items
54
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
CALCULATING TERMINAL VALUE (3)
A 3rd alternative is to use a second stage model through
2027, to normalize the data for 2028, to compute terminal
value based on the normalized data, then to adjust for the
present-value of the remaining capex/depreciation
differences
If the company’s fiscal year is not a calendar year, the second
stage should end with the 2027/28 fiscal year
Thus, the second stage will include the entire period of declining
depreciation
55
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ANEXAMPLE
Assume we have management projections though 2022
Let’s look at an example of calculating terminal value using the 3rd
alternative, using the following assumptions:
Projected revenues in 2022 = 200
Growth rate = 5% from 2022 to 2027, 3% thereafter
Discount rate = 12%
EBITD [not EBITDA] margin = 20%
No interest
Capex = 10, growing at growth rate
Accelerated depreciation per new tax law
Normalized depreciation = 10-year straight line
State income tax = 6% = 4.74% net of federal tax*
Δ working capital = 5% of Δ revenues
Amortization = 5 per year through mid-2024
*Assuming the state’s tax law follows federal law; many states do not
56
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
STAGE 2
Present Value of FCFs, 2023–2027
2022 2023 2024 2025 2026 2027
Revenues 200.0 210.0 220.5 231.5 243.1 255.3
EBITDA 45.0 47.0 46.6 46.3 48.6 51.1
Depreciation 14.2 12.0 9.8 7.6 5.5 3.4
Amortization 5.0 5.0 2.5 0.0 0.0 0.0
EBIT 25.8 30.0 34.3 38.7 43.2 47.6
Tax at 25.74% 6.6 7.7 8.8 10.0 11.1 12.3
Net income 20.4 23.7 27.1 30.5 34.1 37.6
Capital expenditures (10.0) (10.5) (11.0) (11.6) (12.2) (12.8)
Change in working capital (1.0) (1.0) (1.1) (1.1) (1.2) (1.2)
Free cash flow 27.4 27.8 25.7 23.7 24.2 24.8
Discount Factor @ 12% 0.6005 0.5362 0.4787 0.4274 0.3816 0.3407
Present Value 14.9 12.3 10.1 9.2 8.5
Sum of Present Values of FCFs, 2023-2027 46.6
57
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
NORMALIZED FCF FOR GROWTH MODEL
Now we determine the normalized FCF for 2027
As shown earlier, normalized depreciation is 86.6% of capex
58
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
Normalized FCF for Growth Model
2027 2028
Revenues 255.3 262.9
EBITDA 51.1 52.6
Depreciation (normalized) 11.1 11.4
EBIT 40.0 41.2
Tax @ 25.74% 8.4 8.7
Net income 29.7 30.6
Capital expenditures (12.8) (13.1)
Change in working capital (1.2) (0.8)
Normalized free cash flow 26.8 28.1
PRESENT VALUE OF DIFFERENCE BETWEEN
ACTUAL AND NORMALIZED DEPRECIATION
We can then compare annual depreciation based on the tax
law with normalized depreciation and calculate the present
value of the differences (net of tax)
59
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
Present Value of Underdepreciation
2028 2029 2030 2031 2032 2033 2034 2035 2036
Revenues 262.9 270.8 278.9 287.3 295.9 304.8 313.9 323.4 333.1
EBITDA 52.6 54.2 55.8 57.5 59.2 61.0 62.8 64.7 66.6
Depreciation (actual) 4.3 5.7 7.0 8.5 9.9 11.3 12.5 13.5 14.3
Depreciation (normalized) 11.4 11.7 12.1 12.4 12.8 13.2 13.6 14.0 14.4
Difference (7.0) (6.0) (5.0) (4.0) (2.9) (1.9) (1.1) (0.5) (0.1)
Difference net of 25.74% tax (5.2) (4.5) (3.7) (2.9) (2.1) (1.4) (0.8) (0.4) (0.1)
Discount Factor @ 12% 0.3042 0.2716 0.2425 0.2165 0.1933 0.1726 0.1541 0.1376 0.1229
Present Value (1.6) (1.2) (0.9) (0.6) (0.4) (0.2) (0.1) (0.1) (0.0)
Sum of Present Values of Underdepreciation, 2028-2036 (5.2)
ADJUSTED TERMINAL VALUE
We then calculate terminal value based on projected 2028
FCF, add the present value of the Stage 2 FCFs, and deduct
the present value of overdepreciation to arrive at the
appropriate terminal value
The value of the company is the terminal value plus the present
value of the FCFs during the projection period ending in 2022
60
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
Terminal Value at End of Stage 1
Long-term growth rate 3.0%
Discount rate 12.0%
Normalized free cash flow in 2028 28.1
Terminal value unadjusted 311.8
Discount Factor @ 12% 0.3042
Present value of unadjusted terminal value 94.9
Present value of Stage 2 FCFs 46.6
Adjustment for underdepreciation (5.2)
Terminal value 136.2
APPLICATION OF OTHER APPROACHES
This model can be used in three stages by treating 2028-2036
as stage 3 and calculating terminal value with a growth model
based on 2037
In that case, the adjustment for overdepreciation would not be
needed since it would be subsumed that the intermediate stages
If terminal value is calculated with a growth model based on
2023, a calculation of the present value of overdepreciation in
the early years and subsequent underdepreciation would
need to be performed
61
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
COMPANIES MAY ACCELERATE CAPEX
Our example assumes that capex will grow steadily
In practice, companies may accelerate capex to take
advantage of accelerated depreciation
However, given the gradual 20% annual decrease from 2022
through 2027, the impact of accelerated capex is unlikely to
be material
Valuators should ascertain management’s plans for capex as part
of their due diligence
62
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
SUMMARY: IMPACT OF TAX LAW CHANGES
The new 21% C Corp tax rate increases earnings and cash flow
Use of future NOLs will be limited to 80% of taxable net income
Interest expense for tax purposes will be limited to 30% of EBIT
(30% of EBITDA until 2022)
Accelerated depreciation will add to FCF until about 2024 and
then reduce it until the capex/depreciation relationship is
normalized
DCF analyses will have to be modified to account for the present
value of cash flow changes deriving from accelerated depreciation
The valuator should supplement GAAP data with information from
financial statements on a tax basis
63
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
Sample Calculations of Relationship between
Capital Expenditures and Depreciation
64
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
65
3% Growth – 15 Year Straight Line Depreciation
Year Capital
Expenditures 2028 2029 2030 2031 2032 2033 2034
2018 1,000.0 50.0
2019 1,030.0 103.0 51.5
2020 1,060.9 106.1 106.1 53.0
2021 1,092.7 109.3 109.3 109.3 54.6
2022 1,125.5 112.6 112.6 112.6 112.6 56.3
2023 1,159.3 115.9 115.9 115.9 115.9 115.9 58.0
2024 1,194.1 119.4 119.4 119.4 119.4 119.4 119.4 59.7
2025 1,229.9 123.0 123.0 123.0 123.0 123.0 123.0 123.0
2026 1,266.8 126.7 126.7 126.7 126.7 126.7 126.7 126.7
2027 1,304.8 130.5 130.5 130.5 130.5 130.5 130.5 130.5
2028 1,343.9 67.2 134.4 134.4 134.4 134.4 134.4 134.4
2029 1,384.2 69.2 138.4 138.4 138.4 138.4 138.4
2030 1,425.8 71.3 142.6 142.6 142.6 142.6
2031 1,468.5 73.4 146.9 146.9 146.9
2032 1,512.6 75.6 151.3 151.3
2033 1,558.0 77.9 155.8
2034 1,604.7 80.2
Annual Depreciation 1,163.6 1,198.5 1,234.4 1,271.5 1,309.6 1,348.9 1,389.4
Capital Expenditures 1,343.9 1,384.2 1,425.8 1,468.5 1,512.6 1,558.0 1,604.7
Capital Expenditures in Excess
of Depreciation 180.3 185.7 191.3 197.1 203.0 209.1 215.3
Difference in % 15.50% 15.50% 15.50% 15.50% 15.50% 15.50% 15.50%
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
66
3% Growth – 15 Year Double Declining Depreciation
Year Capital
Expenditures 2028 2029 2030 2031 2032 2033 2034
2018 1,000.0 32.8
2019 1,030.0 67.5 33.8
2020 1,060.9 69.5 69.5 34.8
2021 1,092.7 71.6 71.6 71.6 35.8
2022 1,125.5 73.8 73.8 73.8 73.8 36.9
2023 1,159.3 85.5 76.0 76.0 76.0 76.0 38.0
2024 1,194.1 110.0 88.0 78.3 78.3 78.3 78.3 39.1
2025 1,229.9 141.7 113.3 90.7 80.6 80.6 80.6 80.6
2026 1,266.8 182.4 145.9 116.7 93.4 83.0 83.0 83.0
2027 1,304.8 234.9 187.9 150.3 120.2 96.2 85.5 85.5
2028 1,343.9 134.4 241.9 193.5 154.8 123.9 99.1 88.1
2029 1,384.2 138.4 249.2 199.3 159.5 127.6 102.1
2030 1,425.8 142.6 256.6 205.3 164.2 131.4
2031 1,468.5 146.9 264.3 211.5 169.2
2032 1,512.6 151.3 272.3 217.8
2033 1,558.0 155.8 280.4
2034 1,604.7 160.5
Annual Depreciation 1,204.10 1,240.10 1,277.50 1,315.70 1,355.30 1,395.90 1,437.70
Capital Expenditures 1,343.90 1,384.20 1,425.80 1,468.50 1,512.60 1,558.00 1,604.70
Capital Expenditures in Excess
of Depreciation 139.80 144.10 148.30 152.80 157.30 162.10 167.00
Difference in % 11.62% 11.62% 11.62% 11.62% 11.62% 11.62% 11.62%
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
67
3% Growth – 15 Year Sum-of-the-Digits Depreciation
Year Capital
Expenditures 2028 2029 2030 2031 2032 2033 2034
2018 1,000.0 9.1
2019 1,030.0 28.1 9.4
2020 1,060.9 48.2 28.9 9.6
2021 1,092.7 69.5 49.7 29.8 9.9
2022 1,125.5 92.1 71.6 51.2 30.7 10.2
2023 1,159.3 115.9 94.8 73.8 52.7 31.6 10.5
2024 1,194.1 141.1 119.4 97.7 76.0 54.3 32.6 10.9
2025 1,229.9 167.7 145.3 123.0 100.6 78.3 55.9 33.5
2026 1,266.8 195.8 172.7 149.7 126.7 103.6 80.6 57.6
2027 1,304.8 225.4 201.6 177.9 154.2 130.5 106.8 83.0
2028 1,343.9 122.2 232.1 207.7 183.3 158.8 134.4 110.0
2029 1,384.2 125.8 239.1 213.9 188.8 163.6 138.4
2030 1,425.8 129.6 246.3 220.3 194.4 168.5
2031 1,468.5 133.5 253.7 227.0 200.3
2032 1,512.6 137.5 261.3 233.8
2033 1,558.0 141.6 269.1
2034 1,604.7 145.9
Annual Depreciation 1,215.1 1,251.6 1,289.1 1,327.8 1,367.6 1,408.6 1,450.9
Capital Expenditures 1,343.9 1,384.2 1,425.8 1,468.5 1,512.6 1,558.0 1,604.7
Capital Expenditures in Excess
of Depreciation 128.8 132.7 136.7 140.8 145.0 149.3 153.8
Difference in % 10.60% 10.60% 10.60% 10.60% 10.60% 10.60% 10.60%
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM 68
CapEx/Depreciation under New Tax Law – 3% Growth, 5-Year Straight Line Depreciation
2016 2017 2018 2019 2020 2021 2022 2023 2024
CapEx Depreciation 902.6 1,154.7 1,834.6 1,685.1 1,531.2 1,372.6 1,234.3 979.1 834.9
2011-15 4,446.3 4,133.7 805.5 635.5 460.4 280.0 94.3
2016 970.9 902.6 97.1 194.2 194.2 194.2 194.2 97.1
2017 1,000.0 1,154.7 325.0 150.0 150.0 150.0 150.0 75.0
2018 1,030.0 1,834.6 1,030.0
2019 1,060.9 1,685.1 1,060.9
2020 1,092.7 1,531.2 1,092.7
2021 1,125.5 1,372.6 1,125.5
2022 1,159.3 1,234.3 1,159.3
2023 1,194.1 979.1 979.1 47.8
2024 1,229.9 834.9 787.1
2025 2026 2027 2028 2029 2030 2031 2032 2033
CapEx Depreciation 728.9 663.5 641.3 890.3 1,098.2 1,262.4 1,380.1 1,448.4 1,491.9
2023 1,194.1 979.1 47.8 47.8 47.8 23.9
2024 1,229.9 834.9 98.4 98.4 98.4 98.4 49.2
2025 1,266.8 728.9 582.7 152.0 152.0 152.0 152.0 76.0
2026 1,304.8 663.5 365.3 208.8 208.8 208.8 208.8 104.4
2027 1,343.9 641.3 134.4 268.8 268.8 268.8 268.8 134.4
2028 1,384.2 890.3 138.4 276.8 276.8 276.8 276.8 138.4
2029 1,425.8 1,098.2 142.6 285.2 285.2 285.2 285.2
2030 1,468.5 1,262.4 146.9 293.7 293.7 293.7
2031 1,194.1 979.1 151.3 302.5 302.5
2032 1,229.9 834.9 155.8 311.6
2033 1,266.8 728.9 160.5
69SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
CapEx/Depreciation under New Tax Law – 3% Growth, 10-Year Straight Line Depreciation
2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027
CapEx Depr. 840.6 1,103.3 1,845.3 1,798.4 1,750.1 1,700.4 1,649.1 1,369.5 1,098.5 837.0 585.8 358.2
2006-15 8,281.8 7,170.5 792.1 718.7 643.2 565.4 485.3 402.8 317.8 230.2 140.0 47.1
2016 970.9 840.6 48.5 97.1 97.1 97.1 97.1 97.1 97.1 97.1 97.1 97.1 48.5
2017 1,000.0 1,103.3 287.5 75.0 75.0 75.0 75.0 75.0 75.0 75.0 75.0 75.0 37.5
2018 1,030.0 1,845.3 1,030.0
2019 1,060.9 1,798.4 1,060.9
2020 1,092.7 1,750.1 1,092.7
2021 1,125.5 1,700.4 1,125.5
2022 1,159.3 1,649.1 1,159.3
2023 1,194.1 1,369.5 967.2 23.9 23.9 23.9 23.9
2024 1,229.9 1,098.5 762.5 49.2 49.2 49.2
2025 1,266.8 837.0 544.7 76.0 76.0
2026 1,304.8 585.8 313.1 104.4
2027 1,343.9 358.2 67.2
2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038
CapEx Deprec. 457.1 597.6 742.3 891.3 1,044.9 1,191.1 1,317.4 1,422.6 1,505.2 1,563.8 1,610.7
2023 1,194.1 1,369.5 23.9 23.9 23.9 23.9 23.9 11.9
2024 1,229.9 1,098.5 49.2 49.2 49.2 49.2 49.2 49.2 24.6
2025 1,266.8 837.0 76.0 76.0 76.0 76.0 76.0 76.0 76.0 38.0
2026 1,304.8 585.8 104.4 104.4 104.4 104.4 104.4 104.4 104.4 104.4 52.2
2027 1,343.9 358.2 134.4 134.4 134.4 134.4 134.4 134.4 134.4 134.4 134.4 67.2
2028 1,384.2 457.1 69.2 138.4 138.4 138.4 138.4 138.4 138.4 138.4 138.4 138.4 69.2
2029 1,425.8 597.6 71.3 142.6 142.6 142.6 142.6 142.6 142.6 142.6 142.6 142.6
2030 1,468.5 742.3 73.4 146.9 146.9 146.9 146.9 146.9 146.9 146.9 146.9
2031 1,512.6 891.3 75.6 151.3 151.3 151.3 151.3 151.3 151.3 151.3
2032 1,558.0 1,044.9 77.9 155.8 155.8 155.8 155.8 155.8 155.8
2033 1,604.7 1,191.1 80.2 160.5 160.5 160.5 160.5 160.5
2034 1,652.8 1,317.4 82.6 165.3 165.3 165.3 165.3
2035 1,702.4 1,422.6 85.1 170.2 170.2 170.2
2036 1,753.5 1,505.2 87.7 175.4 175.4
2037 1,806.1 1,563.8 90.3 180.6
2038 1,860.3 1,610.7 93.0
Selected Bibliography: Capex, Depreciation & Amortization
Armentrout, Brant H., “A Sanity Test When Estimating Capital Expenditures,22 Business Valuation Review
136 (2003)
Coffey, John F., “The Capex Adjustment,Value Examiner, Nov./Dec. 2009
Lee, Brian H., Daniel L. McConaughy, Mary Ann K. Travers and Steven R. Whitehead, “The Long-term
Relationships between Capital Expenditures and Depreciation and Long-term Net Working Capital to
Sales across Industries,31 Business Valuation Review 87 (2012)
Lee, M. Mark, “The Ratio of Depreciation and Capital Expenditures in DCF Terminal Values,Financial
Valuation and Litigation Expert, Aug.-Sept. 2007, pp. 7-8
McConaughy, Daniel L., and Lorena Bordi, “The Long Term Relationships between Capital Expenditures and
Depreciation Across Industries: Important Data for Capitalized Income Based Valuations,” 23 Business
Valuation Review 14 (2004)
Matthews, Gilbert E., “CapX = Depreciation Is Unrealistic Assumption for Most Terminal Values,Business
Valuation Update, March 2002
Matthews, “Capital Expenditures, Depreciation and Amortization in the Gordon Growth Model,” 33 Business
Valuation Review 113 (2014)
70
SUTTER SECURITIES INCORPORATED GILBERT E. MATTHEWS GIL@SUTTERSF.COM
ResearchGate has not been able to resolve any citations for this publication.
Article
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This article discusses the fallacy of assuming that depreciation should equal capital expenditures in a perpetual growth model.
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This article discusses two common errors when calculating terminal value using the Gordon growth model – overstating depreciation in relation to capital expenditures, and overlooking amortization's time limits. For a growing company, normalized capital expenditures must be materially higher than depreciation. Amortization of intangible assets is worth the present value of the future tax benefits and should be excluded from the base on which terminal value is calculated. Instead, the present value of the benefits should be added to enterprise value. Similar adjustments should be made for tax-loss carryforwards, limited-life royalties, and other limited-life income and expenses.
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This study empirically examines the long-term relationships between Capital Expenditures (CAPX) and Depreciation (DEPR) and Net Working Capital (NWC) to Sales. The CAPX to DEPR and NWC to Sales ratios are frequently used in capitalized earnings and discounted cash flow models. Previously, McConaughy and Bordi documented that CAPX exceeds DEPR expenses in the long-term. Using data from Capital IQ, this article expands on that finding by examining the CAPX to DEPR and NWC to Sales ratios across industries from 1997 to 2011. The long-term behavior of this data may aid in making long-term assumptions in business valuation models.
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Coffey, John F., "The Capex Adjustment," Value Examiner, Nov./Dec. 2009
The Ratio of Depreciation and Capital Expenditures in DCF Terminal Values
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Lee, M. Mark, "The Ratio of Depreciation and Capital Expenditures in DCF Terminal Values," Financial Valuation and Litigation Expert, Aug.-Sept. 2007, pp. 7-8