Did the DE Chancery draw a ‘bright-line rule’ requiring normalization of capex/depreciation in terminal values?


Should depreciation equal capital expenditures (capex) in the terminal year? Yes, say nearly half (44%) of respondents to our DCF analytics survey—but only 29% say “no.”  The remaining 27% fall somewhere between the absolutes, saying the answer turns on assumptions of company growth and inflation, as these comments reveal:

  • “A steady growth assumption implies that the company will always be expanding its capital base, even if only slightly. Not to mention that inflation would cause future replacement cost to always exceed historical cost.”
  • “Expenditures should slightly exceed depreciation so as not to deplete the asset base and allow for inflation.”
  • “In an economy with an expectation of inflation that is greater than zero, capital expenditures will typically exceed depreciation because replacement of assets will likely be greater than historical cost (depreciation). This is true even for a company with no real growth (units of product/service). If the company is expected to have real growth in perpetuity, then the difference between capital expenditures and depreciation would typically be even greater than in a no-growth scenario.”
The Delaware Court of Chancery might also fall on the side of “it depends.” In a current statutory appraisal action, the expert for the minority shareholders submitted a late, supplemental report in which he normalized cash flows for his terminal value. (In an earlier report, he simply presented this as an alternate approach without relying on it.)  To support the last-minute change, the minority shareholder argued that the recent decision In re Appraisal of Orchard Enterprises, Inc. “established a Court of Chancery valuation preference, bordering on a bright-line rule,” for this approach.

“Orchard did no such thing,” says Vice Chancellor Laster, in a letter ruling. Instead:

Orchard recognized that ‘typically’ normalization of capital expenditures and depreciation in the terminal value calculation is appropriate. And it is for many (likely most) mature companies. Early stage ventures and capital-intensive businesses, however, can endure extended periods, longer than the traditional five-year [DCF] projection period, during which capital expenditures outpace depreciation. For such a company, rote normalization after five years would be inappropriate, and Orchard does not require normalization when the operative reality of the company calls for a different approach” (emphasis added).
The court also excluded the expert’s 11th hour “alternative” DCF approach, saying the concept of normalizing cash flows “is not novel” and he should have considered this in his original analysis. Read the complete digest of IQ Holdings, Inc. v. Am. Commercial Lines, Inc., Case No. 6369-VCL (Aug. 30, 2012) in the December Business Valuation Update; the court’s letter ruling will be posted soon at BVLaw.


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