Download (direct link):
account. This essentially equals the dividends paid to the minority investors less any contributions from them.
Post-Retirement Medical Benefits
Financial Accounting Standards Board Statement No. 106 requires companies to record as a liability the present value of expected post-retirement medical benefits for employees. These are conceptually similar to unfunded pension plans that are recorded on a company's financial statements and should be treated the same way.
Capitalizing Expensed Investments
Accounting rules require the immediate write-off of expenditures for marketing and research and development. Yet clearly these expenditures are investments for the future. A case can be made that, in analyzing the performance of a company, these investments should be capitalized, rather than written off. Suppose we were to capitalize Hershey's advertising spending and then amortize it over a four-year period (other marketing and promotion expenditures are not specifically disclosed). If we did this, Hershey's 1998 NOPLAT would increase by only $6 million (because spending is stable from year to year), and its invested capital would increase by $283 million to $2,113 million, resulting in a decline in Hershey's ROIC from 23.0 percent to 21.0 percent.
While sensible in theory, it is difficult to decide how to capitalize and amortize these expenditures.
If spending on these investments varies considerably from year to year, or deviates significantly from peers, then it is probably worth the extra time to make this adjustment, to better understand the trend in performance or performance against peers (despite its inherent inaccuracy).
Adjustment for Property, Plant, and Equipment Lumpiness and Asset Life
For companies with lumpy capital expenditures, ROIC may vary considerably from year to year. In certain situations, it may be helpful to consider a more complex approach to measuring ROIC.
Consider Company R, a restaurant company that invests $1,000 every four years to rebuild its one restaurant (assume zero taxes as well). At the beginning of every four-year period its invested capital is $1,000. But every year, its invested capital declines by $250 of depreciation. Assuming a constant $350 of profits before depreciation every year, its results would look like the following:
0 1 Year 2 3 4
EBITDA $350 $350 $350 $350
Depreciation 250 250 250 250
NOPLAT $100 $100 $100 $100
Net PPE $1,000 750 500 250 0
ROIC (beg. of yr) 10% 13% 20% 40%
Company R's ROIC varies from 10 percent to 40 percent, despite its constant earnings. Assuming a 13 percent cost of capital, Company R would appear to destroy value in the first year, break even in the second year, and create value in years 3 and 4. Ideally, the ROIC each year would equal the internal rate of return on the investment. Using the classic IRR formula, you would find that Company R earns an average ROIC of 15 percent over the life of the restaurant.
To correct for this discrepancy, you could mimic the IRR by employing an approach described in CFROI Valuation, by Bartley Madden.2 Exhibit 9.11 summarizes the approach for Hershey using 1997 results. For any year, set investment equal to the gross property, plant, and equipment (PPE) of the company (before accumulated depreciation) plus any other assets like working capital. Set cash flow equal to NOPLAT plus depreciation. Assume that this cash flow is earned every year for the life of the PPE (estimate the average life by dividing depreciation into gross PPE). For the last year, assume cash flow is the same as the other years plus a return of working capital and other assets. Now solve for the IRR of this stream of cash flows (we
Exhibit 9.11 Hershey Foods—Estimation of CFROI, 1997
2 B. Madden, CFROI Valuation: A Total System Approach to Valuing the Firm (Oxford, England: Butterworth-Heinemann, 1999).
will call this result cash flow return on investment, or CFROI, as referred to by its originators).
As you can see from Exhibit 9.11, Hershey's CFROI for 1997 is 21.3 percent, compared with an ROIC of 23.9 percent (using average beginning and ending invested capital). Exhibit 9.12 compares Hershey's ROIC and CFROI for the years 1990 to 1998. In most years the difference is within the normal error range for these imprecise calculations. And the trends are similar. One thing you will note is the divergence toward the end of the period attributable to a significant increase in average plant age.
The CFROI captures the lumpiness better than ROIC but is complex to calculate and more difficult to explain to non-finance managers. Weighing the benefits and costs of CFROI versus ROIC, we suggest using CFROI when it makes a big difference in the result. Big differences will occur in the following situations:
• Companies with very long-lived fixed assets (over 15 years on average).
• Companies with large fixed assets relative to working capital.
• Companies whose fixed assets are very old or very new.