Lumpy Capital Expenditures and the Need for Smoothing
Firmsseldomhavesmoothcapitalexpenditurestreams.Firms
cangothrough periods whencapital expendituresarevery
high(asisthecasewhenanewproductisintroducedora
newplantbuilt)followedbyperiodsofrelativelylightcapital
expenditures. Consequently, when estimating the capital
expenditures to use for forecasting future cash flows, we
shouldnormalizecapitalexpenditures.Thereareatleasttwo
ways in which we can do this.
The simplestnormalization techniqueis to average capital
expendituresoveranumberofyears.Forinstance,wecould
estimatetheaveragecapitalexpendituresoverthelastfouror
five years for a manufacturing firm and use that number
ratherthanthecapitalexpendituresfromthemostrecentyear.
By doing so,we couldcapture thefact thatthe firmmay
investinanewplanteveryfouryears.Ifinsteadwehadused
thecapitalexpendituresfromthemostrecentyear,wewould
either have overestimated capital expenditures (if the firm
builta newplantthatyear)or underestimatedthem(if the
plant had been built in an earlier year). There are two
measurementissuesthatwewillneedtoconfront.Onerelates
tothenumberofyearsofhistorytouse.Theanswerwillvary
acrossfirms andwilldependonhowinfrequentlythefirm
makes large investments. Theother is on the question of
whetheraveragingcapitalexpendituresovertimerequiresus
toaveragedepreciationaswell.Sincedepreciationisspread
out over time, theneedfor normalizationshould be much
smaller. In addition, thetax benefits receivedby the firm
reflecttheactualdepreciationinthemostrecentyear,rather
thananaveragedepreciationovertime.Unlessdepreciationis