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return are used by investors and equity research analysts to assess to overall performance
of firms, these same measures of return will be used in project analysis.

capbudg.xls: This spreadsheet allows you to estimate the average return on capital
on a project

Returns on Capital and Equity for Entire Firms
The discussion of returns on equity and capital has so far revolved around
individual projects. It is possible, however, to calculate the return on equity or capital for
an entire firm, based upon its current earnings and book value. The computation parallels
the estimation for individual projects but uses the values for the entire firm:
EBIT(1" t)
Return on Capital (ROC or ROIC) =
(Book Value of Debt + Book Value of Equity)
Net Income
Return on Equity =
Book Value of Equity
We use book value rather than market value because it represents the investment (at least
as measured by investments) in existing investments. This return can be used as an
approximate measure of the returns that the firm is making on its existing investments or
assets, as long as the following assumptions hold:
1. The income used (operating or net) is income derived from existing projects and is
not skewed by expenditures designed to provide future growth (such as R&D
expenses) or one-time gains or losses.


2. More importantly, the book value of the assets used measures the actual investment
that the firm has in these assets. Here again, stock buybacks and goodwill
amortization can create serious distortions in the book value.5
3. The depreciation and other non-cash charges that usually depress income are used to
make capital expenditures that maintain the existing asset™s income earning potential.
If these assumptions hold, the return on capital becomes a reasonable proxy for what the
firm is making on its existing investments or projects, and the return on equity becomes a
proxy for what the equity investors are making on their share of these investments.
With this reasoning, a firm that earns a return on capital that exceeds it cost of
capital can be viewed as having, on average, good projects on its books. Conversely, a
firm that earns a return on capital that is less than the cost of capital can be viewed as
having, on average, bad projects on its books. From the equity standpoint, a firm that
earns a return on equity that exceeds its cost of equity can be viewed as earnings “surplus
returns” for its stockholders, while a firm that does not accomplish this is taking on
projects that destroy stockholder value.

Illustration 5.9: Evaluating Current Investments
In table 5.10, we have summarized the current returns on capital and costs of
capital for Disney, Aracruz and Bookscape. The book values of debt and equity at the
beginning of the year (2003) were added together to compute the book value of capital
invested, and the operating income for the most recent financial year (2003) is used to
compute the return on capital.6 Considering the issues associated with measuring debt
and cost of capital for financial services firms, we have not computed the values for
Deutsche Bank:

5 Stock buybacks and large write offs will push down book capital and result in overstated accounting
returns. Acquisitions that create large amounts of goodwill will push up book capital and result in
understated returns on capital.
6 Some analysts use average capital invested over the year, obtained by averaging the book value of capital
at the beginning and end of the year. By using the capital invested at the beginning of the year, we have
assumed that capital invested during the course of year is unlikely to generate operating income during that


Table 5.10: Return on Capital and Cost of Capital Comparison
Cost of
EBIT (1- BV of BV of BV of Return on Cost of
t) Debt Equity Capital Capital Capital Capital
Disney $1701 14130 23879 38009 4.48% 8.59% -4.12%
Aracruz BR 586 2862 6385 9248 6.34% 9.00% -2.66%
Bookscape $ 1200 0 4500 4500 26.67% 12.14% 14.53%

The marginal tax rates used in chapter 4 are used here as well. While this analysis
suggests that only Bookscape is earning excess returns, the following factors should be
1. The book value of capital is affected fairly dramatically by accounting decisions. In
particular, Disney™s capital invested increased by almost $20 billion from 1995 to
1996 as a result of the acquisition of Capital Cities, and Disney™s decision to use
purchase accounting. If they had chosen pooling instead, they would have reported a
return on capital that exceeded their cost of capital by a healthy amount.
2. We have used the operating income from the most recent year, notwithstanding the
volatility in the income. To smooth out the volatility, we can compute the average
operating income over the last 3 years and use it in computing the return on capital;
this approach generates a “normalized” return on capital of 4.36% for Disney and
3.40% for Aracruz. Both are still below the cost of capital.
3. We did not adjust the operating income or the book value of capital to include
operating leases that were outstanding at the end of the prior year. If we had made the
adjustment for Disney and Bookscape, the returns on capital would have changed to
4.42% and 12.78% respectively.7
4. For Aracruz, we are assuming that since the book values are adjusted for inflation, the
return on capital is a real return on capital and can be compared to the real cost of

7 To adjust the operating income, we add back the operating lease expense from the most recent year and
subtract out the depreciation on the operating lease asset. To adjust the book value of capital, we add the
present value of operating leases at the end of the previous year to debt.
8 Brazilian accounting standards allow for the adjustment of book value for inflation.


The analysis can also be done in purely equity terms. To do this, we would first compute
the return on equity for each company by dividing the net income for the most recent year
by the book value of equity at the beginning of the year and compare it to the cost of
equity. Table 5.11 summarizes these results:
Table 5.11: Return on Equity and Cost of Equity Comparisons
ROE - Cost of
Company Net Income BV of Equity ROE Cost of Equity Equity
Disney 1267 23879 5.31% 10.00% -4.70%
Aracruz 428 6385 6.70% 10.79% -4.09%
Bookscape 1320 4500 29.33% 13.93% 15.40%
Deutsche Bank 1365 29991 4.55% 8.76% -4.21%

The conclusions are similar, with Bookscape earning excess returns, whereas the other
companies all have returns that lag the cost of equity.

There is a dataset on the web that summarizes, by sector, returns on equity and
capital as well as costs of equity and capital.

In Practice: Economic Value Added (EVA)
Economic value added is a value enhancement concept that has caught the
attention of both firms interested in increasing their value and portfolio managers,
looking for good investments. EVA is a measure of dollar surplus value created by a firm
or project and is measured by doing the following:
Economic Value Added (EVA) = (Return on Capital - Cost of Capital) (Capital Invested)
The return on capital is measured using “adjusted” operating income, where the
adjustments9 eliminate items that are unrelated to existing investments, and the capital
investment is based upon the book value of capital, but is designed to measure the capital
invested in existing assets. Firms that have positive EVA are firms that are creating
surplus value, and firms with negative EVA are destroying value.

9 Stern Stewart, which is the primary proponent of the EVA approach, claims to make as many as 168
adjustments to operating income to arrive at the true return on capital.


While EVA is usually calculated using total capital, it can be easily modified to
be an equity measure:
Equity EVA = (Return on Equity - Cost of Equity) (Equity Invested in Project or Firm)
Again, a firm that earns a positive equity EVA is creating value for its stockholders while
a firm with a negative equity EVA is destroying value for its stockholders.
The measures of excess returns that we computed in the tables in the last
illustration can be easily modified to become measures of EVA:

ROC - Cost BV of ROE - Cost Equity
Company of Capital Capital EVA of Equity BV of Equity EVA
Disney -4.12% 38009 -1565 -4.70% 23879 -1122
Aracruz -2.66% 9248 -246 -4.09% 6385 -261
Bookscape 14.53% 4500 654 15.40% 4500 693
Bank NMF NMF NMF -4.21% 29991 -1262
Note that EVA converts the percentage excess returns in these tables to absolute excess
returns, but it is affected by the same issues of earnings and book value measurement.

5.8. ˜: Stock Buybacks, Return on Capital and EVA
When companies buy back stock, they are allowed to reduce the book value of their
equity by the market value of the stocks bought back. When the market value of equity is
well in excess of book value of equity, buying back stock will generally
a. increase the return on capital but not affect the EVA
b. increase the return on capital and increase the EVA
c. not affect the return on capital but increase the EVA
d. none of the above
Why or why not?

There is a dataset on the web that summarizes, by sector, the economic value
added and the equity economic value added in each.


Cash Flow Based Decision Rules

The payback on a project is a measure of how quickly the cash flows generated by
the project cover the initial investment. Consider a project that has the following cash

The payback on this project is between 2 and 3 years and can be approximated, based
upon the cash flows to be 2.6 years.10
Payback: The payback for a project is
As with the other measures, the payback the length of time it will take for
can be estimated either for all investors in the nominal cash flows from the project to
cover the initial investment.
project or just for the equity investors. To estimate
the payback for the entire firm, the free cash flows
to the firm are cumulated until they cover the total initial investment. To estimate
payback just for the equity investors, the free cash flows to equity are cumulated until
they cover the initial equity investment in the project.

Illustration 5.10: Estimating Payback for the Bookscape Online Service
The following example estimates the payback from the viewpoint of the firm,
using the Bookscape On-line Service cash flows estimated in illustration 5.4. Table 5.12
summarizes the annual cashflows and the cumulated value of the cashflows.
Table 5.12: Payback for Bookscape Online
Cashflow in year
Year Cumulated Cashflow
0 -1150000
1 340000 -810000
2 415000 -395000
3 446500 51500


4 720730 772230

The initial investment of $1.15 million is made sometime in the third year, leading to a
payback of between two and three years. If we assume that cashflows occur uniformly
over the course of the year:
Payback for Project = 2 + (395000/446500) = 2.88 years

Using Payback in Decision Making
While it is uncommon for firms to make investment decisions based solely on the
payback, surveys suggest that some businesses do in fact use payback as their primary
decision mechanism. In those situations where payback is used as the primary criterion
for accepting or rejecting projects, a “maximum” acceptable payback period is typically
set. Projects that pay back their initial investment sooner than this maximum are
accepted, while projects that do not are rejected.
Firms are much more likely to employ payback as a secondary investment
decision rule and use it either as a constraint in decision making (e.g.: Accept projects
that earn a return on capital of at least 15%, as long as the payback is less than 10 years)
or to choose between projects that score equally well on the primary decision rule (e.g.:
when two mutually exclusive projects have similar returns on equity, choose the one with
the lower payback.)

Biases, Limitations, and Caveats
The payback rule is a simple and intuitively appealing decision rule, but it does
not use a significant proportion of the information that is available on a project.
By restricting itself to answering the question “When will this project make its initial

investment?” it ignores what happens after the initial investment is recouped. This is a


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