Capital Expenditures pose a challenge to Investors while valuing a business. The puzzle is to figure out what would be the return on these investments and when they will be realized. Following is a basic example that tries to explain how we need to differentiate the two main types of Capital expenditures and how to value them:
- Capital Expenditures that maintain current earning power.
- Capital Expenditures that increase the earning power.
EXAMPLE – Hotel sea view is a nice hotel. It has 50 rooms. The hotel generates a net profit of $25 per room per night. The average occupancy rate is 75%.
Thus the net profit generated by the hotel per year = ($25 x 50 x 365) x 0.75 = $342,187. Following are two different capital expenditures planned by the hotel.
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- Spend $25,000 to remodel the swimming pool.
- Spend $100,000 to construct 5 extra rooms.
How should we value for the two capital expenditures?
As each and every hotel in the area has a swimming pool, thus the addition of swimming pool more became a necessity than an add-on. The up-keep of the swimming pool becomes mandatory to just support the current business. If the hotel does not do it then it will see its net profit decline because its customers will choose other hotels that have better swimming pool.
Thus this kind of Capital Expenditure can be tagged as “Capital expenditure that maintain current earning power” . While calculating the FREE CASH FLOW, one needs to deduct the full amount in the year the expenditure is made.
When the hotel spends $100,000 on building 5 extra rooms, the expenditure instantly increases Hotel's earning power. Thus this kind of Capital Expenditure can be tagged as “Capital expenditure that increases earning power”. Following is how we will account for it.
If we assume that the occupancy rate continues at 75% and the hotel makes a net profit of $25 per room per night and these rooms don’t need to be re-modeled for next 5 years. Following is how we will account for this kind of Capital expenditure.
Increase in Net profit because of the 5 additional rooms ($25 x 5 x 365) x 0.75 = $34,218.
Total profit that these 5 rooms will generate for next 5 years = $34,218 x 5 = $171,090.
As these are future profits, thus we will need to discount it for uncertainty. If we discount it by 5% per year, the total discounted cash flow by these five additional rooms for next 5 years = $154,815.
Thus the net effect of this Capital Expenditure was an increase of ($154,815 - $100,000) = $54,815 to the Discounted free Cash Flow.
One needs to be very conservative while accounting for capital expenditures that increase the earning power, because after certain point the returns diminish and thus the risk increases.
Article by Dayanand Menashi, Safe Multiple