## What is the Reinvestment Rate?

The **Reinvestment Rate** measures the percentage of a company’s after-tax operating income (i.e. NOPAT) that is allocated to capital expenditures (CapEx) and net working capital (NWC).

- What is the definition of the reinvestment rate?
- How can the reinvestment rate be calculated?
- What is the relationship between the reinvestment rate and return on capital?
- For which types of companies is the reinvestment rate most accurate?

Table of Contents

## How to Calculate the Reinvestment Rate

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

**Reinvestment Rate:**The proportion of NOPAT re-invested into capital expenditures (CapEx) and net working capital (NWC).**Return on Invested Capital (ROIC):**The profitability (%) earned by a company using its equity and debt capital.

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

- First, we calculate net CapEx, which is equal to capital expenditures minus depreciation.
- Next, the change in net working capital (NWC) is added to the result from the prior step, representing the dollar amount of reinvestments.
- Lastly, the value of the reinvestments 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 Formula

The formula for calculating the reinvestment rate is shown below.

- Reinvestment Rate = (Net CapEx + Change in NWC) / NOPAT
Where:

- Net CapEx = CapEx – Depreciation
- NOPAT = EBIT / (1 – Tax 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 the net working capital (NWC) excludes cash & cash equivalents, as well as debt and any related interest-bearing liabilities.

## Reinvestment Rate Impact on Expected Growth

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

## Expected Operating Income Growth Formula

- Expected EBIT Growth = Reinvestment Rate * ROIC

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

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

If a company consistently has high reinvestment rates, yet its growth lags behind peers, the takeaway is that the capital allocation strategy of the management team could be sub-optimal.

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

A low reinvestment rate could also just mean that the company is more mature, as reinvestments rates tend to decline in the later stages of the company life cycle.

## Reinvestment Rate Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

## Reinvestment Rate Calculation Example

For our illustrative scenario, we will calculate the reinvestment rate of a company using the following assumptions.

## Model Assumptions

Year 1 Financials

- CapEx = $2 million
- Depreciation = $1.6 million
- Net Working Capital (NWC) = $800k
Year 2 Financials

- 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.

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

Remember, a negative change in NWC is a cash “outflow,” so the –$40k increases the reinvestment needs of our company.

With the numerator complete, the final step before arriving at the reinvestment rate 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.

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