Capital and return on capital pdf

Capital and Return on Capital

Learning Objec-ves

¨  Understand key finance concepts based on the balance sheet and income statement ¤  Capital and Invested Capital ¤  Return to and rate of return on invested capital ¤  Rate cost of invested capital

¨  Understand opera-ng and financing contribu-ons to return ¨  Understand basic financial decision making criterion

¤  Rate of return on invested capital must be greater than the rate cost of invested capital

¨  Understand accoun-ng informa-on in algebraic form for financial calcula-ons

2

Financial Statements

¨  Balance Sheet ¤  Presents an organiza-on’s financial status via historical and adjusted

costs

¨  Income Statement ¤  Presents financial flows on an accrual basis

n  Matches revenue and cost / expense

¨  Statement of Cash Flows ¤  Presents financial flows on a cash basis

3

Asset Account Adjustments

¨  Asset account adjustments ¤  Marked to fair or market value

n  e.g., inventory, accounts receivable, financial assets for trading or available for sale

¤  Depreciated e.g., plant and equipment ¤  Depleted e.g., natural resources ¤  Amor-zed e.g., intangible assets under some condi-ons ¤  Marked down due to impairment e.g., goodwill

¨  AOer adjustments, do the balance sheet total assets represent the fair value of the firm? ¤  Fair value is

n  the present value of the expected future cash flows and n  The fair value of the firm’s capital

4

Balance Sheet 5

Assets 2010 2011 ChangeCurrent assets:

Cash and cash equivalents…………………………………………….230$ 326$ 96$ Accounts receivable………………………...………………………………….586$ 673$ 87$ Inventories……………………...…………………………………………………..610$ 657$ 47$ Total current assets………………………………………………….1,426$ 1,656$ 230$

Long-‐term assets:Property, plant, and equipment, at cost…………………………………….2,000$ 2,350$ 350$ Accumulated depreciation……………………….………………………………..(1,000)$ (970)$ 30$ Property, plant, and equipment, net………………………………………………1,000$ 1,380$ 380$ Investment securities…………………………………………..…………………..450$ 400$ (50)$ Total noncurrent assets……………………………………………1,450$ 1,780$ 330$

Total assets……………………………………..………………………………………………..2,876$ 3,436$ 560$

Liabilities and Shareholders' EquityCurrent liabilities:

Accounts payable…………………………….…………………………………….332$ 388$ 56$ Income taxes payable………………………….…………………………………….9$ 10$ 1$

Short-‐term debt……………………………...….…………………………………….147$ 126$ (21)$

Total current liabilities………………………………………………..488$ 524$ 36$

Long-‐term debt…………………………...…………………………………………………….500$ 835$ 335$

Deferred taxes………………………………………………………………………..65$ 70$ 5$

Total liabilities……………………………...……………………………..1,053$ 1,429$ 376$ Shareholders' equity:

Common stock ($1 par) …………………………………………...…………….50$ 60$ 10$ Additional paid-‐in capital…………….…………………………………….133$ 167$ 34$ Retained earnings…………………………………..………………………………1,640$ 1,780$ 140$ Total shareholders' equity…………………………..………………..1,823$ 2,007$ 184$

Total liabilities and shareholders' equity………………………………….………..2,876$ 3,436$ 560$

FAIRWAY CORPORATIONBalance Sheet

As of December 31, 2010, and 2011(in thousands)

Balance Sheet

6

Assets 2011Current assets:

Cash and cash equivalents……………………………………………. 326$ Accounts receivable………………………...………………………………….673$ Inventories……………………...…………………………………………………..657$ Total current assets………………………………………………….1,656$

Long-‐term assets:Property, plant, and equipment, at cost…………………………………….2,350$ Accumulated depreciation……………………….………………………………..(970)$ Property, plant, and equipment, net………………………………………………1,380$ Investment securities…………………………………………..…………………..400$ Total noncurrent assets……………………………………………1,780$

Total assets……………………………………..………………………………………………..3,436$


Accounts payable…………………………….…………………………………….388$ Income taxes payable………………………….…………………………………….10$

Short-‐term debt……………………………...….…………………………………….126$

Total current liabilities………………………………………………..524$

Long-‐term debt…………………………...…………………………………………………….835$

Deferred taxes……………………………………………………………………….. 70$

Total liabilities……………………………...……………………………..1,429$ Shareholders' equity:

Common stock ($1 par) …………………………………………...…………….60$ Additional paid-‐in capital…………….…………………………………….167$ Retained earnings…………………………………..………………………………1,780$ Total shareholders' equity…………………………..………………..2,007$

Total liabilities and shareholders' equity………………………………….………..3,436$

Current Assets Current Liabilitites CE 326$ AP 388$ AR 673$ ITP 10$ INV 657$ SD 126$ CA 1,656$ CL 524$

Long-‐term Assets Long-‐term Liabilities

GC 2,350$ LD 835$ AD (970)$ T 70$ NC 1,380$ LL 905$ IS 400$ LA 1,780$ Shareholders' Equity

TA 3,436$ PAR 60$ APC 167$ RE 1,780$ EB 2,007$

LE 3,436$

Assets Liabilties and Shareholders' Equity

FAIRWAY CORPORATION Balance Sheet

As of December 31, 2011 (in thousands)

Balance Sheet 7

TA = CA + LA CA = CE + AR + INV LA = NC + IS WC = CA – CL

LE = CL + LL + EB

CL = AP + ITP + SD

LL = LD + T

EB = PAR + APC + RE

DB = SD + LD $-‐

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

$2,250

$2,500

$2,750

$3,000

$3,250

$3,500

IS

NC

INV

AR

CE

RE

PAR APC

LD

APITP

SD

T

EB

DBCA

CL

LL

LA

Opera-ng Assets

Group assets by • Assets necessary to support business opera-ons, OA • Other assets, NOA • TA = OA + NOA At Fairway Corp. • IS are non-‐opera-ng assets • Frac-on, f, of the CE are non-‐opera-ng cash & equivalents CE = NOCE + OCE NOCE = f·∙CE OCE = (1-‐f)·∙CE

8

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

$2,250

$2,500

$2,750

$3,000

$3,250

$3,500

NOCECE

OCEAR

AR

INV

INV

N

NC

IS

IS

CA

LA

NOA

OA

OCA

TA TA

NC

‘Non-‐opera-ng’ liabili-es

Debt (DB=SD+LD)

Deferred Tax (T)

Finance View of Balance Sheet 9

Opera-ng current liabili-es (OCL)

Equity (EB)

Assets (TA) Liabili6es and Equity (LE)

Opera-ng current assets (OCA)

Opera-ng long-‐term assets (OLA)

Capital

(C )

TA = OA + NOA = (OCA+OLA) + ( NCA+NLA)

LE = OCL + DB + T + EB C = DB + EB + T

Non-‐opera-ng current assets (NCA)

Non-‐opera-ng long-‐term assets (NLA)

OA

NOA

OWC ≡ OCA – OCL IC = OWC + OLA = OWC + NC = C – NOA

1,069$ OWC 3,038$ C1,380$ OLA (589)$ NOA2,449$ IC 2,449$ IC

IC = OWC + NC ΔIC = ΔOWC + ΔNC

Finance View of Balance Sheet

10

TA = OA + NOA = (OCA+OLA) + ( NCA+NLA)

OWC ≡ OCA – OCL ≡ OCE + AR + INV – AP -‐ ITP

LE = OCL + SD + LL + EB = OCL + DB + EB + T ≡ OCL + C

C = DB + EB + T IC = C – NOA IC = OWC + OLA

OWC: opera-ng working capital C: Capital IC: invested capital or opera-ng capital

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

$2,250

$2,500

$2,750

$3,000

$3,250

$3,500

APITP

OCE OCL

AR

T

INV

EBN

C

IS

SD

OLA

NCA

LLOCA

TA LE

NC

NOCE

NLA

NOA

OA

LDDB

IC= OWC + NC

Invested Capital 11

$-‐ $250 $500 $750

$1,000 $1,250 $1,500 $1,750 $2,000 $2,250 $2,500 $2,750 $3,000 $3,250 $3,500

ICIC

OCL

OCLNOA

NOA

OA C

TA = LE

EB

DB

TOCL

TA LE

TA = IC + NOA + OCL = C + OCL

Note: Assume NOA funded by capital, C, not OCL

Working Capital 12

WC ≡ CA -‐ CL = AR + INV + CE – AP – ITP –STD

OWC ≡ OCA -‐ OCL ≡ AR + INV + OCE – AP – ITP

NWC ≡ AR + INV – AP – ITP

Working Capital Opera-ng Working Capital

Net Working Capital

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

OCE

AR

INV

APITP

OWCAR

INV

APITP

WC

SD

CE

AR

INV

APITP

NWC

Balance Sheet

13

Assets 2010 2011 ChangeCurrent assets:

Cash and cash equivalents…………………………………………….230$ 326$ 96$ Accounts receivable………………………...………………………………….586$ 673$ 87$ Inventories……………………...…………………………………………………..610$ 657$ 47$ Total current assets………………………………………………….1,426$ 1,656$ 230$

Long-‐term assets:Property, plant, and equipment, at cost…………………………………….2,000$ 2,350$ 350$ Accumulated depreciation……………………….………………………………..(1,000)$ (970)$ 30$ Property, plant, and equipment, net………………………………………………1,000$ 1,380$ 380$ Investment securities…………………………………………..…………………..450$ 400$ (50)$ Total noncurrent assets……………………………………………1,450$ 1,780$ 330$

Total assets……………………………………..………………………………………………..2,876$ 3,436$ 560$


Accounts payable…………………………….…………………………………….332$ 388$ 56$ Income taxes payable………………………….…………………………………….9$ 10$ 1$

Short-‐term debt……………………………...….…………………………………….147$ 126$ (21)$

Total current liabilities………………………………………………..488$ 524$ 36$

Long-‐term debt…………………………...…………………………………………………….500$ 835$ 335$

Deferred taxes………………………………………………………………………..65$ 70$ 5$

Total liabilities……………………………...……………………………..1,053$ 1,429$ 376$ Shareholders' equity:

Common stock ($1 par) …………………………………………...…………….50$ 60$ 10$ Additional paid-‐in capital…………….…………………………………….133$ 167$ 34$ Retained earnings…………………………………..………………………………1,640$ 1,780$ 140$ Total shareholders' equity…………………………..………………..1,823$ 2,007$ 184$

Total liabilities and shareholders' equity………………………………….………..2,876$ 3,436$ 560$

Current Assets Current Liabilitites ∆CE 96$ ∆AP 56$ ∆AR 87$ ∆ITP 1$ ∆INV 47$ ∆SD (21)$ ∆CA 230$ ∆CL 36$

Long-‐term Assets Long-‐term Liabilities

∆GC 350$ ∆LD 335$ ∆AD 30$ ∆T 5$ ∆NC 380$ ∆LL 340$ ∆IS (50)$ ∆NCA 330$ Shareholders' Equity

∆TA 560$ ∆PAR 10$ ∆APC 34$ ∆RE 140$ ∆EB 184$

∆LE 560$

FAIRWAY CORPORATION Balance Sheet Changes

For Year Ending December 31, 2011 (in thousands)

Assets Liabilties and Shareholders' Equity

Balance Sheet Nota-on

Accoun-ng periods span -me Δt Δt = ti – ti-‐1

An account X has value Xi at -me ti and value Xi-‐1 at -me ti-‐1

The change in account value over Δt is ΔX ΔX = Xi -‐ Xi-‐1

X may be an abbrevia-on for the account type or the value of the account, for example AR is Accounts Receivable or AR = $673,000

Subscripts are omiked for simplicity except when necessary for clarity

14

i-‐1 i i+1 ti-‐1 Δt ti ti+1

Xi-‐1 ΔX Xi Xi+1

Property, Plant, & Equipment (PPE)

¨  GCi gross (total) capital investment at -me ti (PPE at cost)

¨  CX capital expense (“capex”) over ∆t

¨  CG gross cost of PPE sold off over ∆t

¨  GCi = GCi-‐1 + CX – CG

¨  ΔGC = CX -‐ CG

ti-‐1

GCi-‐1

ti

GCi

Δt

CX

CG

15

Property, Plant, & Equipment (PPE)

¨  ADi accumulated deprecia-on on current PPE at -me ti ¨  DX deprecia-on expense over ∆t ¨  CC book value (carry cost) of PPE sold off over ∆t ¨  ADi = ADi-‐1 + DX – (CG -‐ CC)

¤  (CG -‐ CC): Gross cost – carry cost of PPE sold off over Δt ¤  Accumulated deprecia-on of PPE sold off over Δt

¨  ΔAD = DX – CG + CC

¨  Accoun-ng income on the sale of PPE over Δt is ¤  DG = CS – CC ¤  CS is cash received on sale of PPE

16

ti-‐1

ADi-‐1

ti

ADi

Δt

DX

CG-‐CC

Property, Plant, & Equipment

¨  NCi = GCi -‐ ADi (Net PPE)

¨  ∆NC = ΔGC -‐ ΔAD = CX – CG – (DX – CG + CC) = CX – (DX + CC)

¨  ∆IC = ∆NC + ∆OWC = CX – DX – CC + ∆OWC

17

ti-‐1

NCi-‐1

ti

NCi

Δt

CX

DX+CC

Income Statement 18

Sales revenues…………………………………………………………...…………………….3,190$ R…………………………….3,190$ RevenueCost of sales…………………………………………...……………………………………….2,290$ COGS 2,290$ Cost of goods sold Gross margin…………………………………..…………………………………….900$ GM………………….. 900$ Gross marginExpenses: OX 449$ Operating expenses Depreciation…………………………………………… 120$ NX (39)$ Other expenses (income) Other expenses………………………………………. 477$ * EBITDA………………………490$ Earnings before int, tax, and depre Income taxes………………………………………….. 103$ 700$ DX 120$ Depreciation expenseNet Income………………………………………..……………………………………………200$ EBIT…………………. 370$ Earnings before interest and tax

IX 67$ Interest expenseRetained earnings, December 31, 2010…………………………………….…………1,640$ IT 103$ Income tax expenseAdd: 2007 net income…………………………………...…………………………….200$ NP……………………………. 200$ Net profitLess: Cash dividends……………………………………….……………………………..(60)$ Retained earnings, December 31, 2011……………………………………………….…………1,780$ RE2010 1,640$ Previous retained earnings

NP 200$ Net profit*Net of $20,000 gain on disposal of equipment DIV (60)$ Cash dividends

RE2011 1,780$ Current retained earnings

FAIRWAY CORPORATIONIncome Statement and Statement of Retained Earnings

For the Year Ended December 31, 2011(in thousands)



DG=CS-‐CC=$20,000-‐$0

Opera-ng Cash Flow: Direct Method 19

Cash flows from operating activities:Cash received from customers…………………………………………..…………………………3,103$ RC

Dividends and interest received……………………………………….………………………………………19$ IDI

Total cash from operations ………………………………………………….3,122$ RC + IDI

Cash paid to suppliers and employees ……………………………………………………………………….2,730$ COGSC + OX

Interest paid ………………………………………………………………………………………………67$ IX

Income tax paid …………………………………………………………………………………………97$ ITC

Cash disbursed for operating activities ………………………………………………2,894$ Net cash flow from operating activities …………………………………………………….228$ CFO

FAIRWAY CORPORATIONStatement of Cash Flows

For the Year Ending December 31, 2011(in thousands)

Supplement to support income statement rearrangement

Income Statement

¨  Income statements for different firms show a variety of income and expense categories

¨  Reconcile the text and course income statements

¨  NX is other expenses and income ¤  IDI = Interest and Dividends Income, $19K

n  Dividends from IS and interest from NOCE n  OCE is in a non-‐interest bearing bank account at Fairway

¤ DG = gain from disposal of equipment, $20K n  DG = CS – CC = $20K -‐ $0 = $20K

20

Operating Expenses 449.00$ OX SG&A, R&D, Other expenses (income) (39.00)$ NX NX = -‐IDI -‐ DGInterest expense 67.00$ IXOther Expenses 477.00$

Net Profit

¨  NP: Net profit ¨  EBIT: Earnings before interest and taxes ¨  IX: Interest expense ¨  IT: Income tax expense, τ average income tax rate ¨  NP = EBIT – IX – IT

¤  IT = τ ·∙(EBIT – IX) = τ ·∙EBIT – τ ·∙ IX

¨  NP = EBIT – IX – τ ·∙EBIT +τ ·∙ IX ¨  NP = EBIT(1 – τ) – IX(1 – τ)

= (EBIT– IX)·∙(1 – τ)

τ ·∙ IX =Tax shield, TS

21

Marginal corporate income tax rates by country

Avg corporate income tax rates by industry

Income Tax Expense

IT Income tax expense

Cash paid out, ITC

Accrues to income tax payable, ΔITP (NIBCL)

Accrues to deferred tax, ΔT (Capital)

22

IT = ITC + ΔITP + ΔT

Actual, levered Fairway

Hypothetical, unlevered, "all equity" Fairway

Earnings before interest and tax EBIT 370.00$ 370.00$ Average income tax rate τ 34.0% 34.0%Income from operations EBIT·∙(1 -‐ τ) 244.22$ 244.22$

Interest expense IX 67.00$ -‐$ Income tax expense (EBIT-‐IX)·∙τ 103.00$ 125.78$

Tax shield IX·∙τ 22.78$ -‐$ Effective interest paid IX(1 -‐ τ) 44.22$ -‐$

Net profit (EBIT-‐IX)(1-‐τ) 200.00$ 244.22$

Income From Opera-ons and Finance

¨  Consider two “versions” of Fairway ¤  One with and one without debt ¤  Leveraged and unleveraged

23

Fairway’s average tax rate is actually 33.993%

NP = EBIT(1 – τ) – IX + IX·∙τ

Income From Opera-ons and Finance 24

R 3,190.00$ RevenueCOGS 2,290.00$ Cost of goods sold

GM 900.00$ Gross marginOX 449.00$ Operating expensesNX (39.00)$ Other expenses (income)

EBITDA 490.00$ Earnings before interest, tax, and depreciation DX 120.00$ Depreciation expense

EBIT 370.00$ Earnings before interest and taxτ·∙EBIT 125.78$ Hypothetical income tax on EBIT

EBIT·∙(1-‐τ) 244.22$ Hypothetical after tax income on EBITIX 67.00$ Interest expenseTS 22.78$ Tax shield (IX·∙τ)

IX·∙(1-‐τ) 44.22$ Effective interest expense (IX -‐ TS)NP 200.00$ Net profit

For the Year Ended December 31, 2011

FAIRWAY CORPORATIONIncome Statement With Separation of Operations and Finance

(in thousands)

NP = EBIT – τ ·∙EBIT – IX +τ ·∙ IX

Income From Opera-ons and Finance 25

R 3,190.00$ RevenueCOGS 2,290.00$ Cost of goods sold

GM 900.00$ Gross marginOX 449.00$ Operating expensesDG (20.00)$ Loss on sale of equipment

EBITDA 471.00$ Earnings before interest, tax, and depreciationDX 120.00$ Depreciation expense

EBIT 351.00$ Operating income τ·∙EBIT 119.32$ Hypothetical income tax on operating income

EBIT·∙(1-‐τ) 231.68$ Hypothetical after tax operating incomeIX 67.00$ Interest expense IX·∙τ 22.78$ Tax shield (TS)

IX·∙(1-‐τ) 44.22$ Effective interest expenseIDI 19.00$ Investment (non-‐operating) income

IDI·∙τ 6.46$ Tax on investment income IDI·∙(1-‐τ) 12.54$ After tax investing income

NP 200.00$ Net operating profit



26

Income Statement Flows

Assets Revenue genera-ng

economic resources

‘Invest’ capital

Capital Debt Equity

Raise capital

Return capital

Return to retained earnings

RE

Opera-ng income EBIT

Interest expense to banks and

bondholders IX

Income tax expense

IT

Dividends to shareholders

DIV

26

Important Ra-os

¨  Return on Assets ¤  roa is a measure of asset produc-vity

n  how much net profit, NP, is generated from $1 of total book value of assets, TA?

¨  Return on Equity ¤  roe is a measure of equity produc-vity

n  how much net profit, NP, is generated from $1 of total book equity, EB?

n  measurement of ‘leverage’ – levers roa to roe

TANProa=

EBTAroa

EBTA

TANP

EBNProe

⋅=

⋅==

27

EBTA

EBIT…………………. 370$ IX 67$ IT 103$

NP……………………………. 200$

Current Assets CE 326$ AR 673$ INV 657$ CA 1,656$

Noncurrent Assets

GC 2,350$ AD (970)$ NC 1,380$ IS 400$ NCA 1,780$

TA 3,436$

Important Ra-os

¨  The DuPont formula defines roe as a product of three accoun-ng ra-os to provide insight into 3 aspects of the firm ¤  : net profit margin -‐ How much net profit is produced per $1 of

revenue?

¤  : asset produc-vity rela-ve to revenue -‐ How much revenue is produced per $1 of total assets?

¤  : measure of financial leverage -‐ What is the dollar value of firm

assets per $1 of equity?

EBTA

TAR

RNP

EBNProe ⋅⋅==

RNP

TAR

EBTA

28

Important Ra-os

¨  Capital Structure (leverage)

¨  Interest coverage ra-o

48.02007$961$

EBDB

==

71.12007$3436$

EBTA

==

5.567$370$

IXEBIT

==

29

Current Liabilitites AP 388$ ITP 10$ STD 126$ CL 524$

Noncurrent Liabilities

LTD 835$ T 70$ NCL 905$

Shareholders' Equity

PAR 60$ APC 167$ RE 1,780$ EB 2,007$

LE 3,436$

Liabilties and Shareholders' Equity R…………………………….3,190$

COGS 2,290$ GM………………….. 900$

OX 449$ NX (39)$

EBITDA………………………490$ DX 120$

EBIT…………………. 370$ IX 67$ IT 103$

NP……………………………. 200$

RE2010 1,640$ NP 200$ DIV (60)$ RE2011 1,780$

Bond Ra-ngs From Interest Coverage Ra-o

30

IXEBIT Ra-ngs are illustra-ve not fixed or theore-cal

From Prof. Damodaran’s website at NYU

For large manufacturing firms For financial service firms For smaller and riskier firmsIf interest coverage ratio is If long term interest coverage ratio is

> ≤ to Rating is > ≤ to Rating is > ≤ to Rating is-‐100000 0.199999 D -‐100000 0.049999 D -‐100000 0.499999 D

0.2 0.649999 C 0.05 0.099999 C 0.5 0.799999 C0.65 0.799999 CC 0.1 0.199999 CC 0.8 1.249999 CC0.8 1.249999 CCC 0.2 0.299999 CCC 1.25 1.499999 CCC1.25 1.499999 B-‐ 0.3 0.399999 B-‐ 1.5 1.999999 B-‐1.5 1.749999 B 0.4 0.499999 B 2 2.499999 B1.75 1.999999 B+ 0.5 0.599999 B+ 2.5 2.999999 B+2 2.2499999 BB 0.6 0.749999 BB 3 3.499999 BB

2.25 2.49999 BB+ 0.75 0.899999 BB+ 3.5 3.9999999 BB+2.5 2.999999 BBB 0.9 1.199999 BBB 4 4.499999 BBB3 4.249999 A-‐ 1.2 1.49999 A-‐ 4.5 5.999999 A-‐

4.25 5.499999 A 1.5 1.99999 A 6 7.499999 A5.5 6.499999 A+ 2 2.49999 A+ 7.5 9.499999 A+6.5 8.499999 AA 2.5 2.99999 AA 9.5 12.499999 AA8.50 100000 AAA 3 100000 AAA 12.5 100000 AAA

If interest coverage ratio is

Capital Structure Examples 31

From Prof. Damodaran’s website at NYU

Industry NameNumber of Firms

Average Beta

Market D/E Ratio

Tax Rate

Cash/Firm Value

Advertising 31 2.02 43.3% 10.7% 16.6%Aerospace/Defense 64 1.10 25.7% 20.7% 11.8%Air Transport 36 1.21 24.3% 20.5% 7.6%Apparel 57 1.30 18.4% 16.1% 7.9%Auto Parts 51 1.70 27.6% 19.0% 12.5%Automotive 12 1.59 134.6% 24.1% 17.8%Bank 426 0.77 156.1% 16.0% 11.4%Bank (Midwest) 45 0.93 59.5% 17.8% 14.1%Beverage 34 0.88 26.5% 19.1% 5.1%Biotechnology 158 1.03 13.5% 2.5% 21.5%Building Materials 45 1.50 94.3% 11.2% 7.7%Cable TV 21 1.37 68.1% 27.4% 6.1%Chemical (Basic) 16 1.36 27.3% 20.9% 9.7%Chemical (Diversified) 31 1.51 22.4% 21.7% 7.4%Chemical (Specialty) 70 1.28 21.2% 17.6% 5.3%Coal 20 1.53 28.9% 12.8% 7.7%Computer Software 184 1.04 7.5% 12.3% 17.2%Computers/Peripherals 87 1.30 10.2% 11.8% 10.7%Diversified Co. 107 1.14 102.2% 15.6% 14.3%Drug 279 1.12 15.5% 5.4% 9.2%E-‐Commerce 57 1.03 6.4% 12.3% 10.2%

Return on Invested Capital

¨  For financial decision making, the return to invested capital, roic, NOPAT, is needed ¤  Net Opera-ng Profit AOer Tax

¨  Start with return to equity (net profit, NP) ¤  NP = EBIT·∙(1 – τ) – IX·∙(1 – τ)

¨  For Fairway Corp, three adjustments are needed to transform NP to NOPAT 1.  Subtract ‘non-‐opera-ng’ income

n  Effec-ve return on IDI: IDI·∙(1-‐τ) n  IDI is revenue received in cash from NOCE and IS at Fairway

32

Return on Invested Capital

¨  Three adjustments to transform NP to NOPAT 2.  Add back effec-ve payment to debt providers: IX·∙(1-‐τ)

IX is interest expense and is paid out in cash 3.  Add back any provision for income taxes, IT, that accrues to capital,

ΔT

¨  NOPAT = EBIT·∙(1 – τ) – IX·∙(1 – τ) -‐ IDI·∙(1-‐τ) + IX·∙(1-‐τ) + ΔT = (EBIT– IDI)(1 – τ) + ΔT

¨  For Fairway Corp

NOPAT = ($370 -‐ $19)(1-‐.34) + $5 = $236.68

33

EBIT………………………………370.00$ IDI 19.00$

EBIT-‐IDI…………….. 351.00$ (EBIT-‐IDI)·∙(1-‐τ)…… 231.68$

ΔT 5.00$ NOPAT……………………..236.68$

Income Statement Extended For NOPAT 34

R…………………………………3,190.00$ RevenueCOGS 2,290.00$ Cost of goods sold

GM………………………………900.00$ Gross marginOX 449.00$ Operating expensesNX (39.00)$ Other expenses (income)

EBITDA………………………..490.00$ Earnings before interest, tax, and depreciationDX 120.00$ Depreciation expense

EBIT………………………………370.00$ Earnings before interest and taxIDI 19.00$ Investment (non-‐operating) income

EBIT-‐IDI…………….. 351.00$ (EBIT-‐IDI)·∙(1-‐τ)…… 231.68$

ΔT 5.00$ Increase in deferred tax NOPAT……………………..236.68$ Return to invested capital


FAIRWAY CORPORATIONIncome Statement Extended to Return on Invested Capital

Rate of Return on Invested Capital

( ) ( )%8.10

$1952$244921

$236.68

ICIC21

NOPATroic

ICR

RNOPAT

ICNOPATroic

1ii

=+⋅

=+⋅

=

⋅==

−

35

For Fairway Corp

Essen-al Points

¨  Key finance concepts based on balance sheet and income statements ¤  Capital, C, and Invested Capital, IC ¤  Return on invested capital, NOPAT ¤  Rate of return on invested capital, roic

¨  Key financial decision making criterion: roic > k ¨  Understand financing v. opera-ng contribu-ons to return

NP = EBIT(1 – τ) – IX(1 – τ) = EBIT(1 – τ) – IX + TS

36

References

¨  Accoun-ng: Texts and Cases ¤  Robert Anthony , David Hawkins , Kenneth Merchant ¤  Harvard

¨  On the General Equivalence of Company Valua>on Models ¤  Joakim Levin ¤  Stockholm School of Economics

37

Economy & Finance

Capital and return on capital pdf