3.4. REINVESTMENT NEEDS

The cash flow to the firm is computed after reinvestment. Two components go into estimating reinvestment. The first is net capital expenditures, which is the difference between capital expenditures and depreciation. The other is investment in working capital.

3.4.1. Net Capital Expenditures

In estimating net capital expenditures, we generally deduct depreciation from capital expenditures. The rationale is that the positive cash flows from depreciation pay for at least a portion of capital expenditures and it is only the excess that represents a drain on the firm's cash flows. While information on capital spending and depreciation is usually easily accessible in most financial statements, forecasting these expenditures can be difficult for three reasons. The first is that firms often incur capital spending in chunks—a large investment in one year can be followed by small investments in subsequent years. The second is that the accounting definition of capital spending does not incorporate those capital expenses that are treated as operating expenses such as R&D expenses. The third is that acquisitions are not classified by accountants as capital expenditures. For firms that grow primarily through acquisition, this will result in an understatement of the net capital expenditures.

3.4.1.1. Lumpy Capital Expenditures and the Need for Smoothing

Firms seldom have smooth capital expenditure streams. Firms can go through periods when capital expenditures are very ...

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