We recently came across a question on Quora about why Prof. Damodaran subtracts “depreciation from capex when computing the reinvestment rate of a business.”
It further goes on to state the following:
“In his book, [Prof. Damodaran] seems to argue that depreciation is a cash inflow that pays for a part of capex, but I don’t see how it reduces the cash that you [plough] back in the firm. Intuitively it would not matter what pays for capex. The amount that is reinvested in a firm is the cash amount that is reinvested in it, which should be capex, not capex net of depreciation.”
For the uninitiated, reinvestment rate is used for the purpose of computing the expected growth in earnings of a firm and it is a function of the following two elements:
- Reinvestment, i.e. how much a firm puts back into its business; and
- Return on capital
When return on capital remains constant over time, Growth = (Reinvestment Rate)*(Return on Capital).
Depreciation, however, represents the part of capex which is made to just maintain the asset base of a firm in place and not towards growing that asset base. Therefore, it comes to reason that for growth to be positive, the capex that matters is that which is over and above the depreciation.
I’ve tried to capture this relation mathematically in the following table and I hope it makes it easier to understand this concept: