5. Capital Expenditure and Depreciation

Overview

Depreciation projections are ideally based on capital expenditure, which you will learn how to do in this lesson.

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Summary

  1. Lesson Goal (00:04)

    The goal of this lesson is to learn how to create detailed projections for depreciation.

  2. Overview of Depreciation Strategy (00:12)

    The best method of calculating depreciation for a company is to build a full Property, Plant, and Equipment schedule, and to depreciate each asset individually. However, we won’t always have enough information to do this. A common compromise is to assume a constant level of capital expenditure for each future year, then depreciate a percentage of that capital expenditure each year.

    In our example, we depreciate existing PP&E and new PP&E separately. The company tells us the depreciation rates to apply to existing PP&E. They also tell us the amount of capital expenditure for each year in the future, and the usable life of new PP&E. Using this information we can project the total depreciation expense for each year.

  3. Depreciating Existing PP&E (02:25)

    To depreciate existing PP&E over the future years, we multiply the value of existing PP&E, found in the Balance Sheet, by the specified depreciation rate. We repeat this calculation each year to find the total depreciation for existing PP&E.

  4. Depreciating New PP&E (03:14)

    We are given an annual capex expenditure forecast for each year in our projection. There are many methods of calculating depreciation, but we use the straight-line method in our example. In this method, we divide the annual capex by the usable life of the asset to find the annual depreciation expense. This expense is incurred each year of our financial projection.

    In our example, we depreciate each year’s capex separately. To find the total depreciation on new PP&E, we add the depreciation on each year’s capex together. In this case, we spend a constant amount on PP&E each year. This means that our stock of PP&E grows each year. As a result, the total depreciation expense grows each year. 

    Finally, we can calculate the total depreciation expense by adding the depreciation on existing PP&E and the depreciation on new PP&E. It’s also useful to calculate the depreciation expense as a percentage of revenue. In our case, this percentage stays relatively constant over time. This suggests that our depreciation calculations are reasonable.

  5. Updating the Income Statement Projection (05:31)

    After calculating the total depreciation expense for each year of our projection, we add this expense projection to the Income Statement. In our case, the new projection is lower than the initial depreciation projection based on revenue. 

Transcript

Depreciation projections are based on both the existing assets of the company, and future levels of capital expenditure. If you recall from the previous course, depreciation is a non-cash expense that represents a reduction in the value of assets over time, due in particular to wear and tear. In a simplified model, we can assume that depreciation is a percentage of revenue. But in certain situations, it's not hard at all to improve the accuracy of this projection, particularly when companies such as Marco Co, often disclose future plans for capital expenditure. If you have access to internal information in a company, the most detailed approach is to build a full property plant and equipment schedule. With different capital expenditure apportioned to each individual asset within PP&E. Each individual asset is then depreciated individually, however we often won't have all this information to hand. Particularly if we are reliant on public filings for our information. A common compromise is to assume a total capital expenditure amount for each year from 2016 and base depreciation as a percentage of that capital expenditure. Using this method, we will separate existing capital expenditure from new capital expenditure when calculating depreciation. From the recent comments of Marco Co's CEO, he actually intends to at least double the annual expenditure for the next five years, to pursue a new product that will be released in late 2020. If we go to the cash flow statement, we can see the existing PP&E acquisitions of 3.7 million in 2015 will increase to 7.4 million annually from 2016 onwards.

In addition, the company has also told us, that existing property plant and equipment will depreciate at the following rate for the next five years. 35% in 2016 25% in 2017 20% in 2018 15% in 2019 and 5% in 2020.

The useful life for new capital expenditure will be eight years and the company will be using a straight line method. So given this information, how do we calculate depreciation projections for Marco Co? Let's start by calculating depreciation for our existing property plant and equipment. And to do this, I'll first need to find the value of net PP&E for 2015, which of course, I'll find in the balance sheet.

And here I have a value of 5.6.

And now spread the depreciation on this 5.6 across the next five years using the appropriate percentage. So I'll select net PP&E, anchor the cell, and multiply by this percentage. And I'll copy across for the remaining cells. And this gives me depreciation on our existing net PP&E.

Now let's find depreciation on our future CapEx.

We know that annual CapEx for each of these years will be 7.4 million, so I'll copy across for the remaining cells. For the CapEx in year one, we're going to encourage depreciation of 7.4 divided by the useful life.

Now I'll anchor this cell with F4.

And the CapEx in year one will be depreciated in a straight line method, so the depreciation will be the same for the next four years. The same applies for year two. So the depreciation on CapEx spent in year two, will be 7.4 divided by the useful life.

And that CapEx will be depreciated each year by the same amount.

I'll repeat for year three.

Year four.

And of course year five.

Let's now calculate the total depreciation on new CapEx. By summing these values.

And I'll copy across for the remaining cells. Calculate total depreciation, by simply add depreciation to new CapEx to the depreciation on the existing CapEx. Copy across for the remaining cells. And as a cents check, let's see what this works out as a percentage of revenue. So we'll divide total depreciation by revenue from continuing operations. Now as you can see, it actually stays pretty constant with the revenue. Primarily due to the fact that both numbers are growing quite quickly over time. Let's now replace our existing depreciation calculation in the income statement. So in the income statement, I'll go to depreciation and amortization. And will replace my formula with this new calculation.

Copy across for the remaining cells. And as you can see, the new depreciation calculation lowers our depreciation costs. And this results in lower total operating expenses. Note then in this example, I'm assuming that Marco Co has no amortization costs, and our calculation for this line item, is purely based on depreciation. And other companies, you may need to take into account amortization projections as well.