7.16 Adjustments to CAPEX for the Financing Decision

7.16 Adjustments to CAPEX for the Financing Decision

The difference between FCFF and FCFE is to adjust for the fact that debt-holders fund part of the CAPEX. We can estimate what this adjustment is from estimating what proportion of the firm’s assets are funded by debt. To do this we will consider one additional ratio called the Debt Ratio:

Debt to Total Assets (D/A)

As a first pass it can be assumed that this is the proportion of CAPEX funded by debt-holders is measured by the Debt Ratio

IBM Example:

Working from the 2010 10-K annual report and the numbers for 2009 and 2008 are respectively provided below from left to right.

Source 10-K report (Consolidated Statement of Financial Position exported to Excel workbook).

The Debt to Total Assets Ratio (i.e., Debt Ratio) = (21,932 + 4,168)/109,022 = 0.239

FCFE = FCFF + Debt Ratio*Adjusted CAPEX =12.381 +6.519*0.239 =13.939 billion because recall that FCFE is higher than FCFF for a firm financed by both debt and equity. Assumption: IBM has adjusted for interest net of tax.

Cautionary Remark:

Care must be taken when applying this heuristic to a highly leveraged firm. For example, suppose leverage (Debt to Total Assets is around 90%. Under this heuristic virtually all of the CAPEX would be added back! As a result, the Debt ratio actually applied to the CAPEX adjustment should be reduced to be more conservative to allow for the fact that the high D/E is expected to mean revert to some lower long term average. In addition, conservative adjustments also provide insights into the scenario of what if credit suddenly dries up and a firm is no longer able to permanently finance a portion of its CAPEX via debt?

In addition, this adjustment to CAPEX does not apply to a financial institution. For these institutions the investment and financing decisions are merged and so it is inappropriate to attempt to separately account for this when estimating CAPEX.