 Welcome to Wall Street Prep! Use code at checkout for 15% off. # Reinvestment Rate

Guide to Understanding the Reinvestment Rate ## How to Calculate Reinvestment Rate?

The expected growth rate in operating income is a byproduct of the reinvestment rate and the return on invested capital (ROIC).

The calculation of the rate of a company’s reinvestment is a three-step process:

1. First, we calculate net CapEx, which is equal to capital expenditures minus depreciation.
2. Next, the change in net working capital (NWC) is added to the result from the prior step, representing the dollar amount of reinvestment.
3. Lastly, the value of the reinvestment is divided by the tax-affected EBIT, i.e. net operating profit after taxes (NOPAT).

## Reinvestment Rate Formula

The formula for calculating the reinvestment rate is as follows.

Reinvestment Rate = (Net Capex + Change in NWC) ÷ NOPAT

Where:

• Net Capital Expenditure (Capex) = Capex – Depreciation
• NOPAT = EBIT × (1 – Tax Rate %)

## What is a Good Reinvestment Rate?

The change in NWC is considered a reinvestment because the metric captures the minimum amount of cash necessary to sustain operations.

• Increase in NWC ➝ Less Free Cash Flow (FCF)
• Decrease in NWC ➝ More Free Cash Flow (FCF)

Note that the net working capital (NWC) calculation includes only operating items, and thereby excludes cash and cash equivalents, as well as debt and any related interest-bearing liabilities.

Why? Neither cash nor debt are operating items.

## How Do Reinvestment Rate Impact Expected EBIT Growth?

Once calculated, the expected growth in operating income (EBIT) can be calculated by multiplying the rate of reinvestment by the return on invested capital (ROIC).

Expected EBIT Growth = Reinvestment Rate × ROIC

In practice, a company’s implied rate of reinvestment can be compared to that of industry peers, as well as a company’s own historical rates.

Companies with higher reinvestment activity should exhibit higher operating profit growth – albeit, the growth might require time to realize.

If a company consistently has an above-market rate of reinvestment, yet its growth lags behind peers, the takeaway is that the capital allocation strategy of the management team could be suboptimal.

While increased spending by a company can drive future growth, the strategy behind where the capital is being spent is just as important.

A clear trend of reduced reinvestment, in contrast, could simply mean that the company is more mature, as reinvestment opportunities tend to decline in the later stages of a company’s life cycle.

## Reinvestment Rate Calculator

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## 1. Capex, Depreciation and Working Capital Assumptions

Suppose we’re tasked with calculating the reinvestment rate of a company using the following assumptions.

Financials, Year 1:

Financials, Year 2:

• Capex = \$2.5 million
• Depreciation = \$2.0 million
• Net Working Capital (NWC) = \$840k

From the financials listed above, we can reasonably assume the company is relatively mature, given how depreciation as a percentage of CapEx is 80%.

If the company were unprofitable at the operating income line, using the reinvestment rate is not going to be feasible.

## 2. Reinvestment Rate Calculation Example

The change in NWC is equal to –\$40k, which represents a cash outflow (“use” of cash), as more cash is tied up in operations.

• Change in Net Working Capital (NWC) = \$800k Prior Year NWC – \$840k Current Year NWC
• Change in NWC = –\$40k

Since a negative change in NWC is a cash “outflow,” the -\$40k increases the reinvestment needs of our company.

With the numerator complete, the final step before arriving at our company’s rate of reinvestment is calculating the tax-affected EBIT, or “NOPAT”.

Here, we assume our company had \$20 million in EBIT for Year 2, which at a 25% tax rate, results in \$15 million of NOPAT.

In closing, the reinvestment rate of our company is 3.6%, which we calculated by dividing the sum of the net Capex and the change in NWC by NOPAT.  Step-by-Step Online Course

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Inline Feedbacks
Derek
February 10, 2023 7:50 pm

Hi, very detailed explanation!

Btw, can I check the reason for minus the depreciation from CAPEX?

Thanks!

February 12, 2023 9:48 pm

Hi, Derek,

The reason is that some capex has to be allocated to maintaining the equipment the company already has, and this is taken to be the equivalent of depreciation; the remainder of capex is the ‘growth’ capex or the net reinvestment.

BB

Ramesh
March 29, 2023 10:26 am

Is it 3.6% or 3.06%?

March 29, 2023 2:00 pm

Hi, Ramesh,

It is 3.6% (540 of net reinvestment divided by 15,000 of NOPAT).

BB

Alfred
February 3, 2023 1:53 am

Hi, thank you fir the post!
How do you arrive at the expected growth rate equaling the product of ROIC and reinvestment rate? Thanks!

February 5, 2023 8:42 pm

Hi, Alfred,

Using this approach, new income is a result of earning a return (ROIC) on new investment. So, if you take your reinvestment rate (% of historical income) and multiply it by the ROIC, you will get the growth in income. Does that make sense?

BB

Somya
August 26, 2023 5:01 am

Hi, thankyou for clarification, can you explain it brief as i am not connecting with with ROIC and Reinvestment rate and how it will give growth rate.

Somya
August 26, 2023 5:50 am

Thankyou for post, and this explanation. This explanation arises one question to me , as how these are related to growth as we have considered this year reinvestment rate and this year ROIC. When we reinvest today it will benefit in future not today, so why we taken this year… Read more »

August 31, 2023 8:19 pm

Hi, Somya, The idea is that the return we earn on reinvested capital (ROIC is NOPAT / Invested Capital)) is what causes our NOPAT to grow. The ROIC is not necessarily just one year, but in general what kind of return we will earn on reinvestment, and we expect that… Read more »

Marcial
August 10, 2022 6:37 pm

Hello, nice work!!
I would like to ask; If the Change in WC were +40 instead of -40, would you add it to Net CAPEX or would you subtract it from the Net CAPEx?
Thanks

August 13, 2022 9:43 am

Thanks, Marcial! If the change in WC was positive, then it would be an addition to net reinvestment, and it would be modeled as a use of cash and reduction of free cash flow.

BB

Marcial
August 13, 2022 10:06 am

Thanks for your reply. Then, it doesn’t matter if the change in WC is positive or negative it will always be added to net reinvestment,right?

August 14, 2022 8:35 pm

Hi, Marcial,

Yes, any change in NWC is part of net investment, but if it is an addition to NWC, it is an increase in net investment and a use of cash, and vice versa for a reduction in NWC.

BB

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