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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 these concepts.
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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
1. Spend $25,000 to remodel the swimming pool. How should we account for the two capital expenditures? Each and every hotel in the area has a swimming pool, thus the swimming pool is more of 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 “Mandatory capital expenditure to support current profit stream” . 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 its earning power. Thus this kind of Capital Expenditure can be tagged as “Discretionary 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, then following is how we will account for the Capital expenditure.
Increase in Net profit because of the 5 additional rooms ($25 x 5 x 365) x 0.75 = $34,218. 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 profit for next 5 years = $154,815. Thus the accounting for this would be to add ($154,815 - $100,000) = $54,815 to the FREE CASH FLOW. Thus it was interesting to see that the Capital expenditures that increase the earning power and if their net return is greater than the total expenditure then they have a net positive effect in the 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. If this was not the case then the hotel could borrow $10 million and build 500 extra rooms and earn $5.4 million. Even if the interest charged is 5% on the $10 million and the hotel ends up paying $500,000 x 5 = $2.5million as interest , the net profit still would be $5.4 million - $2.5 million = $2.9 million. But the hotel would be skeptical in doing this large expenditure because it might not be assured of 75% occupancy rate. If you have any doubts on this concept then please e-mail me : valuationtrg at gmail.com |
