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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

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.

• Companies with lumpy capital expenditure patterns. Inflation Effects

While ROIC is the best single return measure, like other historical cost accounting measures, it can be distorted by inflation. To remedy this Exhibit 9.12 Hershey Foods—Comparison of Adjusted and Unadjusted ROIC

distortion it is sometimes suggested to adjust net property, plant, and equipment using either of three approaches: replacement cost, market values, or inflation-adjusted costs. Let's explore each in turn.

The replacement cost approach values the plants at the cost to replace them today. We disagree with the replacement cost approach for the simple reason that assets do not have to be and may never be replaced. It may be economically justifiable to continue to use an old asset even though the cost of replacing it with new equipment may outweigh the higher profits that the new asset will eventually generate. Furthermore, a company with a plant built several years before its competitors (assuming the same productivity potential) at a lower cost than its competitors' plants has a real competitive advantage that should be reflected in a higher ROIC. This advantage is similar to a company that has lower labor costs because its workers are nonunionized or a company located in a low tax jurisdiction. These advantages must be reflected in a company's returns.

Using the market values of assets is appropriate when the realizable market value of the assets substantially exceeds the historical cost book value. You are only likely to find tangible assets with such high values in the case of assets that have general uses beyond the company's current use of the assets. Real estate and airplanes are good examples where the realizable market values of the assets might exceed the book values. For most assets, such as equipment, computers, and fixtures, the market values for used assets are generally very low. For most companies, the proportion of assets with market values significantly higher than book values is low, so calculating ROIC based on book values does not introduce significant distortions.

If market values are used, NOPLAT must be adjusted to reflect the annual appreciation of the value of the assets. It would be inconsistent to write up the assets without reflecting the appreciation in profits. This is a common error that we see when analysts argue for using market values. They ignore the economic profit associated with the write-up.

It could be argued that the reason for writing up the assets and for not including the appreciation in profits is to get a sense of whether a company's assets would be better used some other way. Consider a retailer that owns valuable real estate. The retailer might earn less than its cost of capital if the market value of the real estate were used instead of its book value. While this is true, remember we are trying to analyze the company's actual performance, not whether it is making the best use of its assets. Companies should do both, measure actual performance and determine whether or not they are making the best use of their assets.

Finally, adjusting assets for inflation is complex. For every year, you must decompose the fixed assets into layers based on when they were purchased. Then each layer is revalued using an appropriate price index. Depreciation must be revalued using a price index. ROIC can then be estimated by dividing the adjusted NOPLAT by the adjusted invested capital. This ROIC is a real ROIC and must be compared to a real cost of capital (excluding inflation). While this approach is sensible in theory it is complex to apply and difficult to work with. It is particularly useful, however, in high inflation environments. See Chapter 19, Valuation in Emerging Markets, for an example of how to apply this approach.

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