On the Forecasting of Net Property, Plant and Equipment and Depreciation in Firm Valuation by the Discounted Cash Flow Model

In the discounted cash flow model, free cash flow can be viewed as composed of four components: (i) after-tax sales revenue minus cash operating expense, minus (ii) increase in working capital, minus (iii) capital expenditures, plus (iv) tax savings from depreciation. It is unproblematic (although perhaps unimaginative) to forecast the first two components as constant proportions of sales revenue. The same does not hold for the last two components. Due to the long life of property, plant, and equipment (PPE), capital expenditures and tax savings from depreciation, which are derived from net PPE and depreciation, depend not only on the current revenue level, but also on the company's past growth history. Naive forecasting of net PPE and depreciation (meaning, in particular, that net PPE is a constant proportion of sales revenue) can noticeably bias the valuation result when the company expects rapid real growth in the initial explicit forecast period years, but only moderate (or no) real growth in the post-horizon period. This paper shows how net PPE and depreciation can be forecasted in an approximate fashion without explicit knowledge of the company's plans for capital expenditures. A stylized example is used throughout, in particular for demonstrating the effect of naive forecasting.