Reinvestment is often overlooked or omitted in capital budgeting and cash flows forecast of a business. This newsletter seeks to explain how reinvestment is a key ingredient in business' growth equation.
Reinvestment is an amount taken proportionately from the Net Operating Profit After Tax (“NOPAT”), to be re-deployed into growing the business, instead of being retained as profits for distribution to equity holders.
The relationship between Reinvestment Rate ("RR"), Return on Capital ("ROC") and Growth Rate ("g") can be meaningfully described as below:
(Exhibit A)
Growth Rate, Return on Capital and Reinvestment Rate can be further broken down into their respective formulas in Exhibit B.
(Exhibit B)
When all 3 components are combined as one equation, there explains how reinvestment becomes a key component in Growth (Exhibit C).
(Exhibit C)
To estimate the reinvestment amount - Assuming Company Z wants to achieve an annual growth of 8% of its NOPAT in next year in order to meet the required return of its investors at ROC of 10%. For simplicity, it is also assumed that Total Capital invested in Company Z (which includes Invested Capital0 and NOPAT0 ) are fixed at $9,800 and $1,000 respectively so that the expected amount NOPAT1 can be determined, which worked out to be $1,080. Using the equation provided in Exhibit A, Company Z can then calculate the reinvestment amount needed in Year-1 for its capital expenditure plan intended for improving productivity of its manufacturing plant and overall profitability of the Company.
Based on these information (also laid out in Exhibit D), reinvestment rate of 80% applied on the estimated NOPAT1 gives reinvestment amount of $864. This amount will then be allocated to Company Z's planned capital expenditure taking into consideration of its working capital requirements.
(Exhibit D)
The rationale is this - In supporting Company Z's plan to improve its profitability by 8%, that is to achieve NOPAT1 of $1,080 in order to meet the return on capital for its investors at 10% in next year (or Year-1), Company Z worked out the reinvestment amount (ie $864) based on the estimated NOPAT1 . This amount ie $864 is to be put back into its business in today, at year-0 to generate the 8% growth in NOPAT1 . Reinvestment will be implemented by Company Z through capital investment (-$1,004) and its adaptation of working capital requirements (-$80). Conversely, if the growth rate is reduced to 6% while ROC remains at 10%, a lower RR ie 60% will be required to support a lower growth. In this simplified illustration, one should take note that some adjustments were made to gel certain numbers . In reality, the reinvestment amount estimated may not be the same as that resulted from of RR*NOPAT. One of the reasons would be the computation of reinvestment amount may be based historical RR * NOPAT in year-0, as suggested in many literatures.
To sum up, the illustration above reiterates that reinvestment is a key determinant to fuel & sustain growth in a business, and therefore ought to be carefully thought through and included in the cash-flows budgeting & forecasts as well as applying the same in projecting the value of business into perpetuity.
Guided by this principle, one will be able to grasp two points here:
(1) Future stream of cash flows generated by a business is built on the basis of growth; and that it is through incorporating reinvestment equation in budgeting process only will the growth assumption and value creation in a business be supported.
(2) Reinvestment is part of the sustenance for business growth. By missing this component out of growth equation, the financial model will not hold, making the entire cash-flow budgeting & forecast process a mere "random number crunching" exercise.
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