What Does Sustaining Capital Reinvestment Mean?
Sustaining capital reinvestment is the periodic addition of capital to the business that is required to maintain operations at existing levels. The investment amount is net of the present value of income tax deductions available (tax sheild), and is deducted during computation of annual cash flows while determining a firm's valuation. Sustaining capital reinvestment is sometimes called maintenance capex.
Divestopedia Explains Sustaining Capital Reinvestment
Under the discounted cash flow or capitalized cash flow approach, sustaining capital reinvestment is deducted from after tax cash flows to determine a discretionary cash flow after tax. A capitalization or discount rate is then applied to determine the business value.
An important issue to consider is the determination of an appropriate level of sustaining capital reinvestment required to maintain a company's current operations and profitability. This determination is usually based on analysis of historical levels of capital expenditure.
This analysis becomes more difficult when there has been a significant capital outlay to facilitate growth or expansion. Capital investment for growth would theoretically only be incurred once, but revenue and profitability would continue to be positively impacted for years to come by the one-time spending. Obviously this would also positively impact business valuation, so sellers are inclined to argue that most capital investment should be considered growth vs. sustaining.
How much is considered to be growth capital vs. sustaining capital? This is a difficult and tricky question that is often an area of debate between buyers and sellers. Analysis to substantiate between growth and sustaining capital reinvestment might include:
- Historical comparison of year-over-year capital expenditure growth vs. revenue growth; or
- Year-over-year analysis of actual fleet size. The purchase of a new piece of equipment that is replacing an old piece would be considered sustaining vs. growth.