PCI

Ratios used by Investors to
determine Investment Returns: 

 

Return On Capital Employed (ROCE)

ROCE =
EBIT / Capital Employed

Whereby:

EBIT = Earnings Before Interest and Tax or Operating Income
Capital Employed = Total assets − Current liabilities​

ROCE is a financial ratio that measures how well a company is generating profits from its capital, w/o considering interest and taxes. ROACE, is the Average between open & close of a report-period, is used for viewing capital-intensive companies.

Unlike Return On Equity (ROE), which relates profitability only to common equity, ROCE considers liabilities as well. This is relevant for companies with significant debt.

High un-invested cash on hand should be subtracted from the Capital Employed figure. Investors prefer companies with stable and rising ROCE numbers over volatile ones.

 

Return On Invested Capital (ROIC)

ROIC =
(NOPATBI) / Invested Capital

NOPATBI = Net Operating Profit After Tax Before Interest.

Invested Capital = total LT debt + total common & preferred equity - cash on hand.

Suppose the company has:

• Shareholder’s total Equity: $75M;
• Operating Profit: $25M;
• Long-term debt: $30M;
• Cash on hand: $10M;
• Tax Rate: 20%

NOPATBI = $25M – (25M * 20%) = $20M

ROIC = $20M / ($30M + $75M - $10M) = .21 or 21%

 

Weighted Average Cost of Capital (WACC)
from all funding sources

There are 3 funding sources for one or more projects:

1. debt,
2. common stock equity,
3. preferred stock equity.

The total cost of capital is the weighted average of each of these costs. The WACC is useful to determine:

• if investments/purchases are worthwhile undertaking;
• if the company can afford the capital needed;
• which sources of capital are the most useful.

Thus it is the minimum return or break-even that a company has to make to repay the capital providers.

WACC =
Kd*(D/(D+E+Ps))*(1-T) + Ke*(E/(D+E+Ps)) + Kps*(Ps/(D+E+Ps))

Whereby:

• Kd = cost of debt;
• Ke = cost of common stock equity;
• Kps= cost of preferred stock equity;
• D = market value of debt;
• E = market value of common stock equity;
• Ps= market value of preferred stock equity;
• D+E+Ps= market value of outstanding stock + liabilities of the Company
• T = tax rate

Whereby:

• Kd reflects the default risk of the company;
• Ke reflects the risks of the equity investment;
• Kps reflects the company's intermediate standing in terms of risk between debt and equity.

Each component's weight reflects their market value and measures how the company is financed.

Suppose the company wants to finance some projects as follows:

• 20% from debt,
• 70% from common stock equity,
• 10% from preferred stock equity, and
• Kd is 4%,
• Ke is 10%,
• Kps is 5%, and
• Tax rate is 20%.

WACC-projects = (20%*4%) x (100%-20%) + (70%*10%) + (10%*5%) = (.8% x 80%) + 7% + 0.5% = 8.1%

So, the company pays 8.1% interest on average for financing its projects.

Thus, the company's proposed project(s) are 21% (ROIC) - 8% = 13% over break-even, or generating 13% more in profits than what it costs to keep the current operations going.

The values of D, E, and Ps have to be established separately in order to determine if the company can afford to take on the capital needed for the project(s).