Return on incremental invested capital (ROIC) is an important financial metric used to evaluate the profitability of potential investments and projects. By calculating the return earned on capital invested in a project incremental to the existing capital base, ROIC helps determine whether pursuing the project will increase or decrease overall company returns. In capital budgeting and corporate finance, properly assessing ROIC is essential for making optimal investment decisions and maximizing shareholder value. This article will provide an in-depth overview of ROIC, how to calculate it, and walk through detailed examples to demonstrate its use and importance as a financial analysis tool, with a focus on the key aspects of incremental invested capital and return.
ROIC Formula and Key Components to Understand
The ROIC formula is:
ROIC = After-Tax Operating Profit / Invested Capital
Where:
– After-Tax Operating Profit is EBIT or NOPAT (net operating profit after tax)
– Invested Capital is the total capital invested in the project
The key is assessing the profitability on the incremental capital invested, not the company’s overall invested capital. This allows properly evaluating project returns separate from existing operations.
For example, say a company has $500 million in invested capital and $100 million in after-tax operating profit, for a 20% total ROIC. If they invest $50 million in a new project forecast to generate $15 million in after-tax operating profit, the ROIC on just the project would be 30% ($15 million / $50 million). This is higher than the current 20% ROIC, signaling the project would increase overall company returns.
Using ROIC to Make Investment Decisions
ROIC is a key input into capital budgeting decisions. Comparing a project’s ROIC to the company’s hurdle rate provides insight into whether it will be value-adding.
– If ROIC > Hurdle rate, the project will increase company value
– If ROIC < Hurdle rate, project value will be destroyed
For example, if a company's hurdle rate is 15%, projects forecast to earn more than 15% ROIC should typically be pursued, while those under 15% ROIC should be avoided.
ROIC is also used to rank projects and determine which offer the best returns on invested capital when capital resources are constrained. Prioritizing the highest ROIC projects will maximize returns on the incremental dollars invested.
ROIC vs. IRR and WACC
ROIC differs from IRR in that it measures return on the specific capital invested in a project rather than overall return. A project could have a high IRR but low ROIC if large capital is required.
ROIC also provides insight into whether a project will earn more than the company’s WACC. A project with ROIC exceeding WACC signals value creation, while ROIC below WACC indicates value destruction. Executives combining ROIC and WACC analysis make better informed capital budgeting decisions.
Detailed Example and Walkthrough of Calculating ROIC
Let’s walk through an example to see ROIC calculation in action:
– Company A is considering a $20 million project
– The project is forecast to generate $5 million in after-tax operating profit (NOPAT)
– The company’s current invested capital is $100 million
– It has after-tax operating profit of $15 million
First, we calculate the company’s current ROIC:
– Current ROIC = $15 million / $100 million = 15%
Now we calculate the project’s ROIC:
– Project ROIC = $5 million / $20 million = 25%
Since the 25% ROIC exceeds the company’s 15% hurdle rate, the project is expected to increase overall company returns and should be approved.
Importance of ROIC in Capital Budgeting
As demonstrated in the example, ROIC plays a pivotal role in capital budgeting and investment analysis:
– ROIC measures the true incremental return of a project, separate from current operations
– Comparing project ROIC to hurdle rates provides a decision-making tool for investment choices
– Ranking projects by ROIC ensures capital is allocated to the highest return investments
For these reasons, executives and financial analysts widely use ROIC to make optimal capital budgeting decisions that maximize shareholder value. Understanding how to properly calculate and apply ROIC is an indispensable financial modeling skill in corporate finance.
Return on incremental invested capital is a vital financial metric that assesses the profitability of potential investments by measuring returns on the incremental capital deployed. Learning how to calculate ROIC and apply it in project analysis enhances capital budgeting decisions and helps maximize shareholder value creation.