lowed by small investments in subsequent years. The third is that acquisitions are not
classified by accountants as capital expenditures. For firms that grow primarily through
acquisition, this will result in an understatement of the net capital expenditures.
Firms seldom have smooth capital expenditure streams. Firms can go through pe-
riods when capital expenditures are very high (as is the case when a new product is in-
troduced or a new plant built) followed by periods of relatively light capital expendi-
tures. Consequently, when estimating the capital expenditures to use for forecasting
future cash flows, you should normalize capital expenditures. The simplest normal-
ization technique is to average capital expenditures over a number of years. For in-
stance, you could estimate the average capital expenditures over the last four or five
years for a manufacturing firm and use that number rather than the capital expendi-
tures from the most recent year. By doing so, you could capture the fact that the firm
may invest in a new plant every four years. If instead, you had used the capital ex-
penditures from the most recent year, you would either have overestimated capital ex-
penditures (if the firm built a new plant that year) or underestimated it (if the plant had
been built in an earlier year). There are two measurement issues that you will need to
confront. One relates to the number of years of history that you should use. The an-
swer will vary across firms and will depend upon how infrequently the firm makes
large investments. The other is on the question of whether averaging capital expendi-
tures over time requires us to average depreciation as well. Since depreciation is
spread out over time, the need for normalization should be much smaller. In addition,
the tax benefits received by the firm reflect the actual depreciation in the most recent
year, rather than an average depreciation over time. Unless depreciation is as volatile
as capital expenditures, it may make more sense to leave depreciation untouched.
In estimating capital expenditures, you should not distinguish between internal in-
vestments (which are usually categorized as capital expenditures in cash flow state-
ments) and external investments (which are acquisitions). The capital expenditures of
a firm, therefore, need to include acquisitions. Since firms seldom make acquisitions
every year and each acquisition has a different price tag, the point about normalizing
capital expenditures applies even more strongly to this item.
ILLUSTRATION5:ESTIMATING NORMALIZED NET CAPITAL EXPENDITURES—RELIANCE INDIA.
Reliance Industries is one of India’s largest firms and is involved in a multitude of
businesses ranging from chemicals to textiles. The firm makes substantial invest-
ments in these businesses and Exhibit 9.8 summarizes the capital expenditures and
depreciation for the period 1997–2000.
The firm’s capital expenditures have been volatile but its depreciation has been
trending upward. There are two ways in which we can normalize the net capital ex-
penditures. One is to take the average net capital expenditure over the four year pe-
riod, which would result in net capital expenditures of INR 13,639 million. The prob-
lem with doing this, however, is that the depreciation implicitly being used in the
calculation is INR 8,027 million, which is well below the actual depreciation of INR
12,784. A better way to normalize capital expenditures is to use the average capital
expenditure over the four-year period (INR 21,166) and depreciation from the cur-
rent year (INR 12,784) to arrive at a normalized net capital expenditure value of
Normalized net capital expenditures21,16612,784INR 8,882 million9 • 36 VALUATION IN EMERGING MARKETS