8CHAPTERReturnonInvestedCapitalMcGraw-Hill/Irwin©2004TheMcGraw-HillCompanies,Inc.,AllRightsReserved.•Jointanalysisiswhereonemeasureisassessedrelativetoanother•Returnoninvestedcapital(ROI)isanimportantjointanalysisReturnonInvestedCapitalImportanceofJointAnalysisReturnonInvestedCapitalROIRelation•ROIrelatesincome,orotherperformancemeasure,toacompany’slevelandsourceoffinancing•ROIallowscomparisonswithalternativeinvestmentopportunities•RiskierinvestmentsareexpectedtoyieldahigherROI•ROIimpactsacompany’sabilitytosucceed,attractfinancing,repaycreditors,andrewardownersReturnonInvestedCapitalApplicationofROI(1)evaluatingmanagerialeffective-ness(2)assessingprofitability(3)earningsforecasting(4)planningandcontrolROIisapplicableto:ReturnonInvestedCapitalEvaluatingManagerialEffectiveness•Managementisresponsibleforallcompanyactivities•ROIisameasureofmanagerialeffectivenessinbusinessactivities•ROIdependsontheskill,resourcefulness,ingenuity,andmotivationofmanagementReturnonInvestedCapitalMeasuringProfitability•ROIisanindicatorofcompanyprofitability•ROIrelateskeysummarymeasures:profitswithfinancing•ROIconveysreturnoninvestedcapitalfromdifferentfinancingperspectivesReturnonInvestedCapitalAssistsinForecastingEarnings•ROIlinkspast,current,andforecastedearningswithinvestedcapital•ROIaddsdisciplinetoforecasting•ROIhelpsidentifyoptimisticorpessimisticforecasts•ROIaidsinevaluatingpriorforecastperformanceReturnonInvestedCapitalForPlanningandControlROIassistsmanagerswith:•Planning•Budgeting•Coordinatingactivities•Evaluatingopportunities•ControlComponentsofROIDefinitionReturnoninvestedcapitalisdefinedas:capitalInvestedIncomeComponentsofROIInvestedCapitalDefined•Nouniversalmeasureofinvestedcapitalexists•Differentmeasuresofinvestedcapitalreflectdifferentfinanciers’perspectivesComponentsofROIAlternativeMeasuresofInvestedCapitalFiveCommonMeasures:•TotalAssets•Long-TermDebtPlusEquity•Equity•MarketValueofInvestedCapital•InvestorInvestedCapitalComponentsofROITotalAssets•Perspectiveisthatofitstotalfinancingbase•Calledreturnonassets(ROA)ROA:measuresoperatingefficiency/performancereflectsreturnfromallfinancingdoesnotdistinguishreturnbyfinancingsourcesComponentsofROITotalAssetsSomeadjustthisinvestedcapitalbasefor:1.UnproductiveAssets2.IntangibleAssets3.AccumulatedDepreciationComponentsofROITotalAssetsUnproductiveAssetAdjustment•Assumesmanagementnotresponsibleforearningareturnoncapitalnotinoperations•Excludesidleplant,facilitiesunderconstruction,surplusplant,surplusinventories,surpluscash,anddeferredchargesfrominvestedcapitalAdjustmentisnotvalidasitfailsto:recognizethatmanagementhasdiscretionoverallinvestmentassessoverallmanagementeffectivenessComponentsofROITotalAssetsIntangibleAssetAdjustment•Assumesskepticismofintangibleassetvalues•ExcludesintangibleassetsfrominvestedcapitalAdjustmentisnotvalidas:LackofinformationorincreaseduncertaintydoesnotjustifyexclusionComponentsofROITotalAssetsAccumulatedDepreciationAdjustment•Assumesplantassetsmaintainedinprimecondition•Assumesinappropriatetoassessreturnrelativetonetassets•Concernwithadecreasinginvestedcapitalbase•IncludesanaddbackforaccumulateddepreciationondepreciableassetsAdjustmentisnotvalidas:ROAanalysisfocusesontheperformanceoftheentirecompanyItisinconsistentwithcomputationofincomenetofdepreciationexpenseAcquisitionsofnewdepreciableassetsoffsetadecliningcapitalbaseItfailstorecognizeincreasedmaintenancecostsasassetsageComponentsofROILong-TermDebtPlusEquityCapital•Perspectiveisthatofthetwomainsuppliersoflong-termfinancing—long-termcreditorsandequityshareholders•Referredtoaslong-termcapitalization•ExcludescurrentliabilityfinancingComponentsofROIEquityCapital•Perspectiveisthatofequityholders•Capturestheeffectofleverage(debt)capitalonequityholderreturn•ExcludesalldebtfinancingandpreferredequityComponentsofROIMarketValueofInvestedCapital•Assumescertainassetsnotrecognizedinfinancialstatements•Usesthemarketvalueofinvestedcapital(debtandequity)ComponentsofROIInvestorInvestedCapital•Perspectiveisthatoftheindividualinvestor•Focusisonindividualshareholder,notthecompany•UsesthepurchasepriceofsecuritiesasinvestedcapitalComponentsofROIComputingInvestedCapital•Usuallycomputedusingaveragecapitalavailablefortheperiod•Typicallyaddbeginningandendinginvestedcapitalamountsanddivideby2•Moreaccuratecomputationistoaverageinterimamounts—quarterlyormonthlyComponentsofROIIncomeDefined•Definitionofincome(return)dependsondefinitionofinvestedcapital•Measuresofincomeincomputingreturnoninvestedcapitalmustreflectallapplicableexpensesfromtheperspectiveofthecapitalcontributors•IncometaxesarevaliddeductionsincomputingincomeforreturnoninvestedcapitalExamples:•Returnontotalassetscapitalusesincomebeforeinterestexpenseanddividends•Returnonlong-termdebtplusequitycapitalusesincomebeforeinterestexpenseanddividends•ReturnoncommonequitycapitalusesnetincomeafterdeductionsforinterestandpreferreddividendsComponentsofROIAdjustmentstoInvestedCapitalandIncomeNumbersManyaccountingnumbersrequireanalyticaladjustment—seepriorchaptersSomenu