Corporate and Project Finance Modeling

Chapter 24Computing the Return on Invested Capital for Historical and Projected Periods in Corporate Models

The value of any investment comes from the ability to earn a return above the cost of capital as well as the growth rate in sales or income applied to the premium return. Given this most basic proposition in finance, the return on investment and the growth rate should be prominently presented and analyzed in a corporate financial model. You could compute hundreds of different ratios from financial statements generated by a model, but the key ratio that ultimately drives the value of a company and also demonstrates the reasonableness of the assumptions you have made in the model is the return on equity and/or the return on invested capital. These rate of return statistics compare to the amount of investment that providers of capital have made in the company to the profit that is generated. The invested capital that is put into a company comes either directly from capital provided or indirectly through shareholders not taking dividends when earnings are created.

To illustrate how returns are important in verifying assumptions, pretend that the return on investment was 10 percent in historical periods, but your forecast assumes the return will increase to 30 percent in the next few years. For the return to increase like this you had better have a very good story using economic fundamentals—competitive position, cost analysis, industry structure, and so forth—and proving that ...