Business Valuation: Depreciation and Capital Expenses Not The Same in Terminal Year

There are many reasons for a client to need to determine the value of a company.  Revenue Ruling 59-60 is the impetus for all business valuations (appraisals).  When preparing a forecast, the future capital expenditures (typically equipment needed for growth) and future depreciation needs to be estimated.

Depreciation Based on Generally Accepted Accounting Principles Economic Life

As a company grows, it needs capital expenditures to support the infrastructure of the company.  The estimate of the capital expenditures are made and the assets are depreciated over their economic useful lives.  The assets are depreciated using Generally Accepted Accounting Principles (“GAAP”), not tax accounting.

Capital Expenditures and Depreciation Not Equal

Many analysts continue to equalize capital expenditures and depreciation.  However, while this is a simplifying assumption and convenient to use, in many cases it will result in a higher value.  This is because capital expenditures are made in current dollars and depreciation is based on historical dollars.  As such, in a situation of rising costs, how could they be equal?  When capital expenditures increase, depreciation will always be less than capital expenditures.[1]

When the depreciation expense is equal to the capital expenditures for various years of the forecast, two possible reasons exist.  First, the economic useful life of the asset is not being consideredSecond, Section 179 of the tax code is being used to make an election to expense capital expenditures.

As can be seen by the table below, the capital expenditures would exceed the depreciation expense, after10 years of growth at 3% and historical depreciation by 87.9%.  The capital expenditures and depreciation expense are not equal.

Capital Expenditures and Depreciation Not Equal

[1] Hitchner, James R., “Financial Valuation: Applications and Models:” Fourth Edition, John Wiley & Sons,© 2017, p. 179.

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