Approaches to Forecasting a Company’s Capital Investments and Capital Structure

Long-term Assets Projections

Long-term assets projections are primarily based on the cash flow statement and income statement projections. The net Property, Plant, and Equipment (PP&E) and intangible assets on the balance sheet mainly increase due to capital expenditures and decrease due to depreciation and amortization expenses.

Types of Capital Expenditures

Capital expenditures can be divided into two categories:

• Maintenance capital expenditures: These are necessary to sustain the current business. Forecasts for these are often based on historical depreciation and amortization expenses, usually with a small upward adjustment to account for inflation in capital goods. For businesses with low fixed asset turnover, maintenance capital expenditure requirements can be quite high.
• Growth capital expenditures: These are needed to expand the business. These forecasts are more discretionary and are tied to management’s expansion plans and revenue growth.

Projection for Depreciation and Amortization Forecasts

Projections for depreciation and amortization hinge on the net value of property, plant, and equipment (PP&E) and intangible assets listed on the balance sheet, which grow as a result of capital expenditures. These projections align with the estimated useful lifespans established by management’s accounting policies. One way to estimate this is by considering the ratio of gross fixed assets to depreciation and amortization expenses. Further details can often be located in the financial statements accompanying notes.

Future Capital Structure Projections

Analysts must also make projections about a company’s future capital structure. Leverage ratios–such as debt to capital, debt to equity, and debt to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)–are often used as the forecast object to project future debt and equity levels.

When projecting the future capital structure, analysts should consider historical company practices, management’s financial strategy, and the capital requirements implied by the capital expenditure assumptions. Management may provide guidance on target capital structure, debt covenant ratios (e.g., net debt to EBITDA), and capital expenditures, sometimes broken down into maintenance, growth, and acquisitions.

Question 

Which of the following factors should analysts most likely consider when projecting the future capital structure of a company?

1. Company’s product portfolio, marketing strategy, and customer base.
2. Company’s market share, competitive landscape, and industry growth rate.
3. Historical company practice, management’s financial strategy, and the capital requirements implied by the capital expenditure assumptions.

The correct answer is C.

When projecting the future capital structure, analysts should consider historical company practices, management’s financial strategy, and the capital requirements implied by the capital expenditure assumptions. Historical company practice provides insights into the company’s past financial decisions and can serve as a guide for future capital structure decisions.
Management’s financial strategy is crucial as it outlines the company’s approach to financing its operations and growth, including its preferences for debt versus equity financing. The capital requirements implied by the capital expenditure assumptions are also important as they indicate the amount of funding the company will need to support its planned investments. These factors are directly related to the company’s capital structure and can significantly influence its future capital structure decisions.
A is incorrect.  The company’s product portfolio, marketing strategy, and customer base can influence its revenue and profitability, but they do not directly determine its capital structure. The capital structure is a financial decision made by the company’s management based on factors such as the company’s financial strategy, capital requirements, and historical practice.
B is incorrect.  While the company’s market share, competitive landscape, and industry growth rate can influence its financial performance and, thus, its ability to raise capital, they are not directly related to the company’s capital structure. The capital structure is determined by the company’s financing decisions, not its market position or industry dynamics.