Page 55 - Bankruptcy and Reorganization Services

 Capital Expenditures and Depreciation. Capital expenditures will be a function of how fast a
firm is growing or expecting to grow, as well as the industry, among other factors. Assumptions
about capital expenditures must be consistent with growth assumptions. Capital expenditure
needs should be closely examined. It is common for distressed companies to fall behind in capi-
tal expenditures related to both investment capital expenditures and maintenance capital expendi-
tures. Capital expenditure covenants may have also restricted the company’s ability to invest in
capital assets.

When estimating long-run capital expenditures, average capital expenditures for the industry or a
company’s peer group should be considered, if possible. If the amount of capital expenditures in
recent periods has been depressed, which is frequently true of bankrupt companies, consideration
needs to be given to true maintenance capital expenditure requirements as well as investments in
new technology, which may be required for the firm to effectively compete. Depreciation during
the forecast horizon will be largely determined by the level of capital expenditures. fn 14 Howev-
er, it is important to note that in the long-run, depreciation and capital expenditures should be
roughly equivalent. fn 15

 Working Capital. When estimating working capital needs, it is common to use debt-free net
working capital. fn 16 From a cash flow perspective, this is the difference between noncash cur-
rent assets (such as inventory and accounts receivable) and non-interest-bearing current liabilities
(such as accounts payable and accrued liabilities). An increase or decrease in working capital has
a direct impact on cash and thus must be incorporated into the projected cash flow stream.

If the cash on the balance sheet is currently less than the minimum cash required for working
capital needs, the cash deficiency should be factored into the working capital needs of the com-
pany in the near-term. It is common for distressed companies to deplete cash, stretch payables,
and accelerate receivables collections. In addition, inventory may be depleted due to lack of
funds to replenish inventory. If this is the case, working capital will be below sustainable levels
and cash outflows to build up working capital to normalized levels need to be incorporated in the
cash flow forecast.

Whether to include or exclude cash from working capital calculations is a question often raised
by valuation analysts. To the extent that there is excess or nonoperating cash on the balance
sheet, it should be excluded from working capital calculations and added back to value. Cash is
often excluded entirely from working capital based on the assumption that accounts receivable
collections and cash sales will fund accounts payable and cash payments. Further, the identifica-
tion of free cash flow is the objective of the analysis. Cash balances are typically credited dollar-
for-dollar at the closing of a business sale, which is consistent with a cash-free net working capi-
tal assumption. However, many businesses need cash on hand as an operating asset (for instance,
retail and construction).

fn 14 Amortization of intangibles needs to be considered summarily.

fn 15 If long-term real growth is positive, capital expenditures may be slightly higher than depreciation in the terminal period.

fn 16 Current portion of long-term debt should be removed from working capital.

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