Valuation & Investment Policy (CAPEX)

Valuation & Investment Policy (CAPEX)

Tuesday 22nd December 2020

Joris Kersten, MSc RAB

Kersten Corporate Finance

Uden – The Netherlands

Source used – book: Werken aan waardestuwers, Peter Schuitmaker 2017, BBO&F Breda.

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Introduction

The investment policy of a company, or capital expenditures (CAPEX), is crucial for the continuity of any business.

But you need to be careful with CAPEX, because in valuation, as we know, is has a negative effect on “free cash flow”, so also on the EV (enterprise value).

In order to check whether CAPEX make sense it is important to check the “occupancy rate” of the investment.

For example, a production company can have different machines for for example 1) preparation of raw materials, 2) adjustments to semi-finished products, 3) finishing products, 4) transportation and 5) office inventory assets.

So with a certain investment plan in the above assets it is important to asses to what extend (percentages) money is invested in the different asset classes.

And even more important, it is crucial to check what the “occupancy rate” is for the investments in the different asset classes.

This means: How much time is a machine/ asset relatively (so with a percentage) used ?

When the “occupancy rate” of a machine is relatively low then its returns are generally low.

So the “cash out” from the investment then generally leads to a relatively low “cash in”.

This because the machine is then earned back over a relatively long time period.

(P. Schuitmaker, 2017)

Analysis of occupancy rates

So with a certain investment policy, or investment plan, you first take the total amount of money that is planned to be invested into account.

Secondly, you then divide the money over the different asset classes like for example machines for 1) preparation of raw materials, 2) adjustments to semi-finished products, 3) finishing products, 4) transportation and 5) office inventory assets.

Thirdly, you then check the relative amounts invested with the “occupancy rate” per asset class.

And after that you make adjustments based on your analysis.

Let’s now take a look at these adjustment in a revised investment plan.

(P. Schuitmaker, 2017)

Revised investment plan: Savings

Let’s assume that you conclude that 40% of the money invested with the investment plan is used for machines for “preparation of raw materials”.

On top of that, let’s assume that you conclude that these machines will have an occupancy rate of only 20%.

You then get a clear signal that some savings can be made here.

For example, maybe you can outsource this "preparation work" by ordering the prepared products straight away.

This instead of doing this preparation work yourself.

On top of that, maybe you can invest in just some machine “revisions” in order to lengthen their life span.

This instead of buying new ones, because the occupancy rate is so low.

And maybe you can “tackle” some of the investments to meet “environmental-standards” by outsourcing some more of the work. Work like for example coating/ painting your product.

(P. Schuitmaker, 2017)

Revised investment plan: Additional CAPEX

On the other hand, maybe you find out by analyzing the “occupancy rate” per asset class, that some machines are heavily used.

And this might mean that because of this “throughput time” increases, which leads to efficiency losses.

For these asset classes it might be wise to use (part of) the savings.

This in order to invest more heavily in these ‘high-occupancy-rate’ asset classes to increase efficiency.

And in the end, total CAPEX can potentially still be reduced due to the savings.

(P. Schuitmaker, 2017)

Pros & cons of savings in CAPEX: Cons

The ‘con’ of savings in CAPEX is increased vulnerability of the operational business.

Reason is that savings decrease 'error margins'.

Moreover, with savings in CAPEX companies often “outsource”. And this means that they become more dependent on outside parties.

So management needs to carefully assess whether the CAPEX savings will NOT hurt:

1.     Quality, and,

2.     Efficiency.

(P. Schuitmaker, 2017)

Pros & cons of savings in CAPEX: Pros

Increased costs due to additional “handling” and “quality control” of outsourced activities (which lower CAPEX) apparently look as a ‘con’.

This is true, but as long as quality and efficiency is still good, it can still have a positive effect on a business !

Let me explain that from a valuation perspective:

From our valuation theory, you might remember that firms create value when:

·       ROIC > WACC, so when ROIC is higher than the WACC.

This because when a company makes more return on its assets (ROIC), than what the capital costs (WACC), the company creates value !

ROIC = Return on invested capital, and,

WACC = Weighted average cost of capital.

ROIC is calculated as:

NOPAT (net operating profit after tax/ EBIT – tax)/ (long term assets + NWC).

And the WACC is the cost of equity + cost of debt, calculated pro rata on a target capital structure.

Conclusion:

With a very strict investment plan based on “occupancy rates” long term assets are decreased.

NOPAT might go down a little due to increased “handling & quality control” costs, but it will also go up again due to less deprecation (due to less CAPEX).

With a higher, or similar, NOPAT and decreased assets ROIC will go up !

And the higher the ROIC the more value created, or with a ROIC below WACC, the least value destroyed. ??

(P. Schuitmaker, 2017)

Source used – book: Werken aan waardestuwers, Peter Schuitmaker 2017, BBO&F Breda.

Please leave your email address in the comments below when you want to receive my monthly valuation/ M&A articles (100% free and also free of any subscription) in your email box in PDF.

Kersten Corporate Finance

Joris Kersten (1980) buys and sells SMEs (small & medium sized companies) for his clients in The Netherlands.

And he conducts business valuations.

In addition he provides training all over the globe on business valuation and mergers & acquisitions (M&A) at leading investment banks in New York, London and Hong Kong (“bulge bracket”), corporates and universities.

Right now (in the middle of covid-19) Joris’ full focus in on M&As of SMEs in The Netherlands.

Feel free to contact him when you need M&A advise in both sell side and buy side transactions.

By the way, the new website of KCF is ready soon ??, this in December 2020 or January 2021.