ROIC

Corporate Finance Bundle
Return on Invested
Capital + Cost of Capital
Author: J.J.P. (Joris) Kersten MSc BSc RAB

July 2023 Uden/ The Netherlands
Table of Contents
Return on Invested Capital (ROIC) ......................................................................2
Analysing ROIC (return on invested capital) ......................................................2
ROIC linked to growth ! ..................................................................................7
Valuation: Issues with calculating ROIC .......................................................... 10
Valuation: Intangible assets & ROIC............................................................... 13
Cost of Capital (WACC) .................................................................................... 15
Valuation: The cost of debt ! ......................................................................... 15
Valuation & the equity risk premium .............................................................. 19
Betas & Valuation ......................................................................................... 22
WACC & Capital Structure ............................................................................. 26
Corporate Finance - Various.............................................................................. 29
M&A in stages/ The Pre-Exit Strategy ............................................................. 29
Business Valuation & Debt Leverage .............................................................. 32
Article: Why is EBITDA so popular ??? ............................................................ 35
Introduction Kersten Corporate Finance ............................................................. 38
Introduction Joris Kersten................................................................................. 39
1
Return on Invested Capital (ROIC)
Analysing ROIC (return on invested capital)

Author: Joris Kersten MSc / Owner Kersten Corporate Finance
Kersten Corporate Finance: M&A advisory in The Netherlands + Business Valuations

+ Valuation training over the globe.
Source used: Morgan Stanley Investment Management: Counterpoint Global

Insights/ Return on Invested Capital/ How to calculate ROIC and handle common
issues. October 2022. M.J. Mauboussin, D. Callahan.
Introduction
A company creates value when the present value of the cash flows, from the
investment, is higher than the cost of the investment.
This happens when the return of the investment is higher than the cost of capital of
the investment.
To study this in a little more detail, we need to know how to calculate a measure
called ROIC (return on invested capital).
ROIC (return on invested capital)
ROIC is calculated by dividing NOPAT (net operating profit after tax) by IC (invested
capital).
Let’s first look at what NOPAT is, and means.
And then let’s look at what IC entails.
NOPAT
NOPAT is the numerator in the ROIC calculation.
It is the cash earnings a company has when it does not have debt or excess cash.
So NOPAT is the same whether a company is financed with debt or equity.
So removing the concept “capital structure” in NOPAT enables it to compare NOPAT

across different companies.
NOPAT starts with earnings before interest and taxes (EBIT).
You then add amortisation from acquired intangible assets.
2
And you add the embedded interest component of the operating lease expense. And
you do this because this is not an operating item, but a financing item.
At last you subtract cash taxes, and this includes the tax provision, deferred taxes
and the tax shield.
So summarized: NOPAT = EBITA -/- cash taxes.
A little more detail on NOPAT: Amortisation
Maybe it is strange to add back amortisation but not depreciation.
But the reason is that depreciation is an operating expense.
And amortisation of acquired intangibles just reflects “accounting”.
When for example a company acquires a customer list, the list would be put on the
balance sheet as an intangible asset and amortised over its useful life.
But the money spent to maintain and grow the list is an expense in the income
statement.
So the company should not be panellised twice with both the expenses and
amortization.
( more about intangible assets, and amortisation, later in this ROIC blog series, in
upcoming weeks )
Embedded interest in lease
Adding back embedded interest from operating lease is a relatively new adjustment.
Most companies nowadays under US GAAP and IFRS must reflect operating lease on
the balance sheet.
This was not the case in the old days.
( I am from The Netherlands, and under Dutch GAAP we still have operating lease
not capitalised on the balance sheet )
Under US GAAP, the entire lease expense including embedded interest is still
expensed.
And under IFRS the lease payments are allocated under depreciation and the
interest expense.
So for companies under US GAAP you need to separate the lease payments into
these two parts (deprecation & interest), and “embedded interest” needs to be
adjusted in NOPAT.
3
Cash tax
The cash tax calculation has three components:
-Tax provision;
-Deferred taxes;
-Tax shield.
With the tax provision you start with what you see in the income statement.
But you need to adjust this number for “unusual items” like for example a
restructuring charge.
And with companies that spend a lot on R&D, in the US this needs to be amortised,
instead of being expensed straight away.
Then there are deferred taxes.
A company has 2 annual statements, one for tax purposes and one for financial
reporting.
Typically straight line depreciation is used for financial reporting, and accelerated
depreciation for tax purposes.
This creates timing differences, that results in a company’s reported tax that is
higher than the cash taxes.
( with accelerated depreciation you have less profit = less tax )
Eventually this tax needs to be paid, and this is captured as a deferred tax liability
(DTL) on the balance sheet.
The increase in the DTL reduces cash taxes.
( so take the DTL increase from the reported tax, in order to arrive at cash tax )
At last, the tax shield is removed from NOPAT, because NOPAT is not influenced by
capital structure.
And the tax shield comes from interest deductible for corporate tax.
So this increases cash taxes for leveraged companies, in order to be able to

compare them well with other companies.
Concerning taxes, the quick and dirty way to deal with it is by taking EBITA * ( 1 -/-
cash tax rate ). And the cash tax rate is as a (very rough) rule of thumb 95% of
reported tax.
4
Invested capital
IC ( invested capital ) is the denominator of ROIC, and this can be calculated in 2

ways.
You can look at net assets (operating approach), and you can look at how these
assets are financed (financing approach).
IC – Operating approach
With this approach we start with net working capital; a measure of liquidity, and
this is calculated as current assets minus NIBCL’s (non interest bearing current
liabilities).
Within the current assets accounts receivables and inventories are the largest
components.
But you need to subtract excess cash and marketable securities from the current
assets, since this is not “operating”.
NIBCL’s are basically all current liabilities that are not debt, and the main
components are accounts payables and other current liabilities.
Then we add PP&E (property, plant & equipment).
( Concerning intangible assets, I will discuss this issue in great detail in this blog
sequence on ROIC in the upcoming weeks )
Leases longer than a year also are shown on the balance sheet, and stand for the
right to use the asset.
Accountants quantify this by estimating the present value of future lease payments.
Next we add intangible assets and goodwill from M&A transactions.
At last, all other long term (operating) assets need to be taken up.
So invested capital should reflect all the assets needed for a company to run its
operating business.
NON operating assets like access cash, marketable securities, equity investments,
non consolidated securities, finance subsidiaries, overfunded pension funds, tax loss
carry forwards etc., should be taken care of in the “equity bridge of valuation” and
NOT in IC !
IC – Financing approach
Within this perspective we start with all the sorts of interest bearing debt.
Operating lease obligations also need to be taken into account.
5
And we need to add shareholders equity, preferred stock and other equity linked
securities.
At last, other long term liabilities like deferred tax, underfunded pension funds,
unearned revenue etc. should also be taken up.
When both NOPAT and IC is calculated, we can calculate ROIC !

6
ROIC linked to growth !
Kersten Corporate Finance: Buy side and sell side M&A in The Netherlands (deals: 5
– 50 million euro enterprise value) + Business Valuations + Corporate Finance
training over the globe.

Investments in growth
The value of a company can be calculated by projecting the free cash flows (FCF)
and discounting it back to the present.
And FCF equals NOPAT -/- the investments for future growth.
Investments in future growth capture:
-Changes in net working capital;
-Capital expenditures net of depreciation;
-Other investments like acquisitions.
So investments in future growth are equivalent to the change in IC (invested

capital).
Link to a DCF model
The observations above give us a nice link to a DCF model.
When you have estimated your initial IC, and your DCF model is estimating future
NOPAT, and additional investments ( capex net of depreciation + net working
capital ), than you can easily calculate ROIC in any future year.
This by taking future NOPAT and dividing it by future IC, both will be created by
your DCF model.
For example, a company has a NOPAT of 100 USD, and IC of 500 USD, than ROIC
is 20%.
With 10% NOPAT growth, your NOPAT in 2 years is 100 USD * 1,10 ^ 2 = 121
USD.
When you assume investments (capex net of depreciation + NWC) are 25 USD per
year, than ROIC in 2 years is:
121 / ( 500 + 25 + 25 ) = 22%.
7
ROIC linked to valuation
ROIC is linked to valuation by “economic profit”.
This is a measure of “residual income”, and this means income after all costs have
been taken into account, even including the cost of capital !!!
The cost of capital is the same as WACC ( weighted average cost of capital ).
Economic profit can be calculated in 2 ways ( with similar outcomes ):
-Economic profit = ( ROIC -/- WACC ) * invested capital;
-Economic profit = NOPAT -/- ( invested capital * WACC ).
ROIC linked to growth
ROIC is also linked to growth.
This because ROIC is the maximum supportable growth rate of a company

WITHOUT external financing !
Let’s take a look at this with a simple numerical example, but first let’s look at a
formula:
-Growth = ROIC * ( 1 -/- payout ratio ).
The payout ratio is the part of NOPAT a company pays out to its shareholders in the
form of dividends and share buybacks.
And of course, this leaves less money available to reinvest.
With 100 USD NOPAT, and IC of 500 USD, ROIC was 20%.
Without any payout, the 100 NOPAT makes again: 20% * 100 = 20 USD (additional
NOPAT).
In total: 500 IC + 100 IC ( from nopat ) = 600 IC.
600 IC * 20% ROIC = 120 NOPAT ( 100 + 20 ).
And another year later:
720 IC ( 600 + 120 ) * 20% ROIC = 144 USD NOPAT ( 100 * 1,20 ^ 2 )
Growth rates higher/ lower than ROIC
Companies with a growth rate lower than ROIC will be able to payout cash without
compromising on growth.
For example, if the company of the example only grows with 10%, than it can pay
out 50 USD of NOPAT.
8
100 NOPAT / 500 IC = 20% ROIC
When growth is 10%:
NOPAT * ( 1 + 10% ) = 110 NOPAT
110 / 20 * 100 = 550 IC is needed.
So 50 can be paid out: 100 nopat + 500 IC -/- 50 pay out = 550 IC needed
On the other hand, companies with growth above ROIC need additional financing.
With a growth of 2 times ROIC, NOPAT grows with 40%.
100 nopat * ( 1 + 40% ) = 140 nopat
140 / 20 * 100 = 700 IC needed.
700 IC needed -/- 500 IC -/- 100 NOPAT = 100 IC ( additional capital needed )
But of course, a ROIC of 20% is likely above WACC, so getting 100 new IC most
likely creates lots of value in this example !!

9
Valuation: Issues with calculating ROIC
Author: Joris Kersten MSc/ Owner Kersten Corporate Finance
Kersten Corporate Finance: M&A Advisory Netherlands (mid caps/ small caps) +
Business Valuation (large caps/ mid caps/ small caps) + Valuation/ Financial
Modelling training over the globe (New York, London, Middle East, Asia)

Practical issues
When making ROIC calculations there are a few practical issues:
1. Excess cash & marketable securities;
2. Restructuring, write offs and litigation charges;
3. Minority interests;
4. Share buybacks.
Let’s now discuss these issues.
Excess cash & marketable securities (1)
Companies hold cash for their operations, they simply need some liquidity in order
to do business.
Young businesses need a little more cash for this, because for them access to
capital can be more difficult.
A (very rough) rule of thumb is to take 2% of revenue as cash needed for the
operations, and then the rest is excess cash.
With a M&A deal the exact number of excess cash is calculated with the DD (due
diligence), based on an average level of net operating working capital.
For less predictable companies with larger growth prospects, a ratio of cash to
revenue up to 5% can be more suitable to use.
Restructuring (2 A)
Companies take restructuring charges when they plan to change the organisation of
their business.
For example to cut costs by reducing the work force or by closing facilities.
And these charges mostly require a cost upfront.

10
Workforce reduction costs show up in the income statement, and this reduces
NOPAT. And additional capital expenditures come up as a liability, affecting invested
capital.
An asset write off reduces invested capital, and an additional capital expenditure
increases invested capital.
In this case, it would make sense to cut out the “accounting adjustments” for the
restructuring, but to leave in the actual additional capital spending.
( so restructuring charges are seen as one offs, but be careful here, these charges
need to be studied in detail first )
Further, most likely the restructuring comes along with cost savings, and these need
to be taken up (when they make sense obviously) in future NOPAT calculations.
Write offs (2B)
A write off occurs when a company recognises that it overstated an asset’s useful
life.
Reasons could be failing to consider 1) technological obsolescence and 2) inflation.
Depreciation is often used as a proxy for maintenance capital spending.
And gaps between real maintenance CAPEX and accounting depreciation is a

predictor of future asset write offs.
For companies that write off assets regularly, adding it back to invested capital is
suitable.
And when occurrence is rare, then you can let it go without an adjustment to
invested capital.
Concerning goodwill and intangible impairment charges, it should be added back to

invested capital.
This since management should be held accountable for past capital allocations in
the form of M&A.
Litigation (2C)
Concerning litigation, companies add the estimated liability on the balance sheet.
This provision reduces equity, and comes back as debt, so invested capital is not
changed (total of equity + debt).
NOPAT can be affected do by damage of reputation, and this is a matter of

professional judgement.
11
Minority interests (3)
If a company owns part of the firm you are analysing, you can deal with ROIC as
usual. There only might be a few tax implications.
At last, with DCF valuation, you minus this minority interest by another firm (in
market value), from the enterprise value.
When the company you are analysing has a minority stake in another business, then
you can also normally calculate ROIC, apart from some potential tax issues.
Although be careful, when the proceeds from the minority stake are not in NOPAT,
then take out the minority interest from invested capital, otherwise the calculation
goes wrong.
With DCF valuation, you add the (market value) of the minority stake on top of
enterprise value.
Share buybacks (4)
When excess cash is used to buyback shares, buybacks have NO impact on ROIC.
This because then neither NOPAT or invested capital is affected.
Funding a buyback with debt also does not influence NOPAT, and invested capital.
Buybacks can influence "return on equity", but this only happens through changes
in the capital structure (leverage).

12
Valuation: Intangible assets & ROIC
Kersten Corporate Finance: M&A advisory + Business Valuation + Valuation Training

Tangible versus intangible assets
Accountants record tangible investments on the balance sheet as assets.
And these assets are depreciated over their useful lives.
So these investments show up in the “invested capital” (IC) of a company.
And also depreciation is taken up in NOPAT.
On the other hand, accountants treat most intangible investments as expenses.
Take R&D as an example.
Accountants decided that companies should expense R&D because the benefits
were uncertain.
And the link between R&D costs and sales was unclear.
And this logic applied to R&D was extended to:
-Advertising;
-Employee training;
-Creation of software.
Capitalising intangible assets
The above creates a situation where (on average) companies that are “tangible
asset intensive” have high NOPAT and high invested capital.
And companies that are “intangible asset intensive” have low NOPAT and low
invested capital. These companies are called “asset light companies”.
But this does not enable us to compare company ROICs consistently !
So in order to do this you need to put the intangible assets on the balance sheet
and amortise them over their useful lives.
And therefore you need to estimate the percentage of the various SG&A items (e.g.
R&D, sales & marketing, general & administrative etc.) that should be considered an
intangible investment.
13
This including their yearly amortisation !
By these adjustments, both NOPAT and invested capital, will be higher.
ROIC obviously is the ratio between the two.
And capitalising intangibles lowers ROIC for most profitable companies !
An important point to mention is that “free cash flow” will NOT change !
This because NOPAT and invested capital increase by the same amount.
So capitalising intangible investments does not change the value of the business.
But it does provide us with better insights into the company returns, and timing of
the returns !
And it enables us to compare normal and asset light companies.

14
Cost of Capital (WACC)
Valuation: The cost of debt !

Kersten Corporate Finance: M&A Advisory + Business Valuations + Valuation

Training
Source used: Morgan Stanley Investment Management, Counterpoint Global

Insights: Cost of Capital – A practical guide to measuring opportunity cost. 2023.
M.J. Mauboussin & D. Callahan.
Introduction
In this blog series I will talk about:
-The cost of debt;
-The cost of equity;
-Betas;
-WACC;
-Capital structure.
But let’s first start with the cost of debt !
Effective after tax rate
The cost of debt is the effective after tax rate a company has to pay on its long
term debt.
The yield to maturity on a company’s long term option free bonds is a good
estimate for the pre tax cost of debt.
And this for a company with securities rated as “investment grade”.
This is debt with a relatively low risk of default and therefore receives a higher
rating from the credit agencies:
-Baa or above from Moody’s;
-BBB or above from S&P Global and Fitch.
Indirect approach
For companies with only short term or illiquid debt, you can take some steps to
estimate the cost of debt indirectly.
15
Here fore determine the credit rating on the company’s unsecured long term debt
first.
Then look at the average yield to maturity on a portfolio of bonds with a similar
credit rating.
Bond investors often express this as a spread over a treasury rate, usually the 10
year note.
And the treasury yield is a proxy for the so called risk free rate.
Some companies finance themselves mostly with short term debt.
The problem here is that short term debt rates do not reflect expectations about
long term inflation.
And the time horizon for estimating the cost of capital should match the time
horizon of the forecasted cash flows.
This is in practise seldom less than 10 years.
The long term debt rate is a better estimation of the interest costs, and long term
rates also capture the costs of repeated (short term) borrowing.
So when a company majorly relies on short term debt, then use its credit rating to
estimate the cost of long term debt.
Tax shield
Net operating profit after taxes (NOPAT) less investment needs is equal to “free
cash flow”.
But this does not reflect (financial) leverage !
Debt creates a valuable tax shield, because interest expense is generally tax
deductible (at least to some extent).
To capture this you adjust the debt rate from a pre tax to a post tax number.
And you do this with the “marginal tax rate”, and this is the tax rate a company
pays on its last dollar of taxable income.
Yield to maturity
The book value of debt is mostly a good estimate for the market value of debt.
But make an adjustment when the debt is trading at a substantial premium or

discount to par.
16
And the yield to maturity is a fair estimate for the pre tax cost of debt. This for
companies with debt rated as investment grade.
And the yield is expressed as a spread over a risk free rate.
Components of a estimated return include:
-The real yield on the 10 year US treasury note;
-inflation expectations;
-For example the BBB credit spread.
And the nominal yield on the 10 year US treasury note equals: Real yield + inflation
expectations.
High yield debt/ debt rated below investment grade
Yield to maturity overstates the pre tax cost of debt for companies issuing high yield
debt, or below investment grade rated debt.
This since high yield bonds have a significant probability of default.
The base rate of default over 10 years is about 2% for an investment grade bond
(BBB- or higher).
But 23% for a speculative grade bond (BB+ or lower).
So here the cost of debt is somewhere between the promised yield and the risk free
rate.
Leases
Leases should also be considered as debt.
Nowadays the accounting principles mostly require to reflect leases longer than one
year on the balance sheet.
With US GAAP the entire lease payment, including embedded interest, is reflected in
the calculation of EBIT.
But with debt, the interest expense shows up below EBIT.
So a company that leases will have a lower EBIT than a company that finances the
asset with debt, even though pre tax income will stay the same.
So this lease interest needs to be separately analysed !
At last, total net debt should includes:
17
-Leases;
-Unfunded retirement benefits;
-Minus excess cash.
And as a rule of thumb, you can treat cash & marketable securities above 2% to
5% of revenue as “excess cash”.
Summarised, estimating the cost of debt is very do-able, but it will get more
complex with debt rated below investment grade, and when a company has
significant leases !

18
Valuation & the equity risk premium
Kersten Corporate Finance: M&A advisory + Business Valuations + Valuation

Training

Cost of equity model
The cost of equity is the expected total return on a company’s stock.
The cost of equity is higher than the cost of debt since equity is a junior claim on
the value of the firm.
We can not observe the cost of equity directly, so we need an asset pricing model.
The best known model is the “capital asset pricing model” (CAPM).
Financial executives rely on CAPM, but in the investment community (quantitative

funds) models with more variables are used.
Let’s now look at CAPM since this is the model most practitioners use.
CAPM
The CAPM estimates the expected return of a security by multiplying the equity risk
premium (ERP) with the security’s Beta.
And the risk free rate (RFR) is added on top.
The ERP equals the difference between the expected return for the market and the
RFR.
Think about it as a “credit spread”.
The ERP is the same for all stocks in the CAPM because it captures what is known
as “systematic risk”.
This means risk that can not be diversified away.
And Beta measures how a company’s risk contributes to the portfolio risk.
And this is “unsystematic risk” and can be reduced through portfolio diversification.
19
Risk free rate & equity risk premium
A proxy for the risk free rate is a yield on a long term default free government fixed
income security.
The yield on the 10 year US treasury note is suitable for businesses in the US.
The ERP is the difference between the return on the equity market and the return
of the risk free asset.
Surveys show that ERP estimates are in a range from 3% to 10%.
Other insights provide an estimate range from 0 to 7% with an average of about

4%.
(check the article I have used as a source for this blog for full details, find this
source below, or above, this blog)
Equity risk premium estimates
There are 3 common approaches to estimate the ERP:
1. One can look at historical results and assume the future will be similar to the
past;
2. One can survey investors about their expectations;
3. One can estimate a rate the market implies by reverse engineering

assumptions.
Historical results are supported by lots of data but are heavily influenced by time
period selection, and they include “survivorship bias”, and they are different when
using “arithmetic” or “geometric” averages.
Expectations by experts provide snapshots of attitudes at a specific moment.
And an ERP implied by the market uses current prices, but requires forecasts for
drivers such as cash flow growth and return on capital.
Historical ERP
For valuation ERP’s are needed that look forward, but it is still helpful to study the
past for historical averages.
To study the past judgement is needed for:
1. Which RFR to use;
2. Time period to use;
3. Arithmetic or geometric returns.
20
Damodaran finds that the historical ERP falls in the range of 3 % to 12 %
depending on how is measured.
For equity less bond returns in the US from 1928 – 2022 the arithmetic return was
6,6 % and the geometric return was 5,1 %.
ERP by market prices
One can also estimate the ERP by market prices.
The idea is that the key drivers of value, including earnings & dividends, follow long
term trends that are predictable to some extent.
By estimating future cash flows, and knowing the current price, it is possible to
solve for the “discount rate”.
When looking at august 2008 to 2022, Damodaran used the 10 year treasury note
as the risk free rate and estimated the ERP.
The average ERP over this period was 5,5% with a high of 7,7% and a low of 3,9%.
Expected return (RFR + ERP) ranged from 10,7% and 5,1% in this time period.
These numbers are not adjusted for inflation.
Damodaran on the ERP: Overall insights
Aswath Damodaran posts an updated estimate of the risk premium on his website
every month.
He has annual estimates for the ERP from 1961.
The range goes from 2,1 % to 6,5 %.
These estimates are not adjusted for inflation.

21
Betas & Valuation

Training

Beta & popularity
CAPM (the capital asset pricing model) is very popular among practitioners.
But the concept of “Beta” has been challenged on both empirical & intellectual
grounds.
The empirical problem is that beta does not predict expected returns the way it
should.
Specifically, stocks with low betas generate higher returns than the model predicts.
And stocks with high betas deliver lower returns than the model predicts.
And the intellectual issue is that “volatility” is a poor way to measure risk.
Value investors generally define risk as potential permanent loss of capital.
And they argue that the volatility of asset prices does a poor job on capturing that
risk.
The measure Beta
Beta measures the return of an individual security relative to the return on the
market index.
It reflects the “financial elasticity”.
You calculate a historical beta by doing a regression analysis with the market’s total
returns as the independent variable (X-axis).
And the asset’s total returns as the dependent variable (Y-axis).
And now the slope of the best fit line is the beta.
The slope of the regression line is the rise (up or down) over the run (left to right).
And the beta is 1.0 for a security that goes up and down the same as the market.
22
The beta is 2.0 for a security that goes up and down at a percentage twice that of
the market.
So this security is considered riskier than the market.
And the beta is 0.5 if the security goes up and down at a rate that is one half of the
market’s percentage.
So this security then is less risky than the market.
Measuring Beta
Similar to the ERP (equity risk premium), beta should be a measure that looks
forward.
But this is unobservable.
Therefor we have to examine historical relationships and make some adjustments to

remove some “noise”.
In order to calculate beta a few judgements have to be made, like:
1. Which index to compare to;
2. How far back in history to go;
3. Measurement history (e.g. daily, weekly, monthly, quarterly or at a yearly

basis).
The S&P 500 is a sensible index for investors in the United States.
And the benefit of going back further in time is that there is more data, and the
regression result is more reliable.
The drawback is that the company may over time has changed its:
· Business model;
· Business mix,
· Level of financial leverage;
· Or the company simply may have matured.
A longer time period to measure beta is better for companies with stable business
models and stable capital structures.
And you can consider a shorter time period if you notice that the beta changes
materially during the period you measure.
At last, more frequent measures create more data.
23
But a good place to start with measuring beta is by monthly returns over 60 months
(5 years).
Industry beta
You can improve beta by using an industry beta rather than the beta of an
individual company.
The rationale is that “business risk” (the variability of the cash flows), is the same
for all companies within an industry.
For an industry beta you need to take three steps:
1. Unlever the industry company betas;
2. Calculate the average unlevered beta for the industry;
3. Relever the beta for the specific company.
A company’s beta combines business risk + financial risk.
We want to measure business risk first, so we need to remove the effect from
“financial leverage” from the industry betas.
The formula is:
Beta unlevered = Beta levered / ( 1 + D / E * ( 1 -/- Tc ) )
Then calculate the average unlevered beta for the industry.
And the trick is here to define “the industry”.
Ideally, it is a group of companies:
1. With similar business risk because they are exposed to the same markets;
2. That create comparable products;
3. That deal with similar customers.
And the average can be weighted by market capitalisation.
And taking the “median” helps to check for outliers that might distort the average.
Unlevering betas isolates the “business risk”, but we still need to set back the
“financial risk”.
This is done by using the target company’s "expected long term capital structure".
And the formula to relever beta is:
24
Beta levered = Beta unlevered * ( 1 + D / E * ( 1 -/- Tc ) )
And this levered beta can then be used for your specific target company.
At last, the motivation to calculate an industry beta is to come up with a (more)

accurate and (more) stable estimate of a company’s risk.

25
WACC & Capital Structure

Training

WACC
WACC (Weighted Average Cost of Capital) combines the opportunity cost of the
sources of capital (debt & equity) based on target weights.
An average WACC for companies in the Russel 3000 from 1985 to 2022 was about 8
%.
(see the source I have used for this blog - Morgan Stanley - Counterpoint Global
Insights)
WACC is used to discount the future free cash flows of a firm.
This is called free cash flow to firm, and outcome is the “Enterprise Value” (EV).
Please never forget that the weighting of debt and equity should be done based on
market values !
And NOT on book values !
So you need to use a “target capital structure” here, based on market values !
The debt to total capital ratio for the Russell 3000 from 1985 to 2022 was on
average 30 %.
So roughly 30 % market value of debt, and roughly 70 % market value of equity,

on average.
The Russel 3000 shows a decline in debt levels from 2008 to about 18% debt to
total capital in 2022.
Debt & equity are by far the largest sources of capital for US public companies.
And by the end of 2022, the total value of corporate debt (and leases) was roughly
USD 10 Trillion.
And the market value of equity was roughly USD 40 Trillion.
26
( roughly 20 % debt / roughly 80 % equity at the end of 2022 )
Debt to total capital ratio
In general, businesses with low “business risk” are good candidates to use debt.
Business risk reflects the volatility of operating profits and is measured with
“unlevered beta”.
The valuation expert; Aswath Damodaran, analyses the relationship between

unlevered beta and the ratio of debt to total capital.
He does this for more than 90 industries.
And as the theory predicts, the outcomes are:
• Companies with low business risk (low unlevered beta) tend to have higher
debt to total capital ratios than firms with high business risk (high unlevered
beta).
This is consistent with so called “trade off theory”.
This theory tells us that firms will use a significant level of debt, if possible, because
debt is cheaper than equity.
And this lowers the WACC !
But of course, you can only use debt to a certain extent.
On debt you pay interest.
And think of interest as a fixed cost, it declines operating profit, and can result in
losses, when there is too much debt (interest).
Low risk businesses can handle this (interest) cost better, as above research shows.
So they have an intention to use more cheap debt !
Capital structure
Concerning capital structure, you can finance a business internally through cash
from operations.
And you can raise debt and/ or equity.
A company can rely on internal financing when its (NOPAT) growth rate is equal, or
lower, than its return on invested capital (ROIC).
(see my previous blogs on ROIC to find out how this works mathematically, I have
explained this extensively before)
Expert valuator Aswath Damodaran tested this.

27
The hypothesis was that (with holding growth constant):
• Businesses with high ROICs have lower debt to total capital ratios compared
to businesses with low ROICs.
Reason would be that companies would use internal financing before debt financing,
because it comes first in the "pecking order".
So this way of reasoning is called “pecking order theory”.
And research shows that this (basic pattern) holds true:
Many of the best businesses in the world (as measured by ROIC), have very
conservative capital structures !

28
Corporate Finance - Various
M&A in stages/ The Pre-Exit Strategy

Kersten Corporate Finance: M&A boutique in The Netherlands, focus: sell side & buy
side deals with an EBITDA of in between 1 million euro and 5 million euro
(enterprise value 5 to 50 million euro ) in all industries.
Kersten CF also provides business valuations, and provides training in valuation all
over the globe (new york, london, middle east, asia etc.)
Source used: Article – Pre-exit: een gefaseerde bedrijfsverkoop, 2019, Menno

Stuker, Tijdschrift Familie Bedrijven.
Introduction
With a pre-exit transaction an entrepreneur sells a part of his company to an

investment firm.
This to cooperate with the investor in order to sell the full company 4 to 6 years
later.
In general a new holding is set up (newco) that buys the company, and this newco
is financed by equity of the investment firm, equity of the entrepreneur, and bank
financing.
Let’s say bank financing counts for 50% of the transaction, and the rest is done by
the current entrepreneur and the investment company in the form of equity.
This would imply that the entrepreneur, and investment company, both hold 50% of
the shares in the Newco. And in addition the newco attracts 50% bank debt for the
purchase price.
With an equity purchase price of 7 million euro, the current entrepreneur would still
hold 50% of the shares for 1,75 million euro ( 7 -/- 3,5 debt = 3,5. 50% * 3,5 =
1,75 ).
The investment firm would also hold 50% of the shares for 1,75 million euro, and
the newco attracts 3,5 million euro bank financing for the transaction.
The transaction
This transaction results in that the entrepreneur would save a large part of his
capital that actually was trapped in his company.
The equity purchase price was 7 million euro, and he keeps for 1,75 million euro
shares in his company. This implies that he receives 5,25 million euro ( 7 -/- 1,75 ).
29
This comes from the bank ( 3,5 million ) plus from the investment company ( 1,75
million ).
Also note that the investment company buys 50% of the company shares by brining
in only 25% ( 1,75 / 7 * 100% ) of the equity purchase price.
Let's now take a look at the financial dynamics more closely !
Internal rate of return
Let’s take a look at another example to analyse the financial dynamics.
An entrepreneur sells 70% of his company to an investment firm. ( so he keeps

30% of the company )
The EBITDA is 1,5 million, there is 500k debt, and the EBITDA multiple is 5.
5 times EBITDA = 7,5 million enterprise value.
Enterprise value minus debt = 7,5 -/- 0,5 = 7 million for 100% of the company.
The deal is financed for 50% with debt = 3,5 million.
7 million -/- 3,5 million debt = 3,5 million equity value.
30% for the entrepreneur = 1,05 million equity ( 30% * 3,5 million ).
70% for the investment company = 2,45 million equity ( 70% * 3,5 million ).
This implies that the entrepreneur receives 5,95 million at the moment of the
transaction ( 3,5 bank financing + 2,45 from the investment firm = 5,95 ).
And this obviously is the price of the transaction minus the amount he keeps in the
company ( 7 -/- 1,05 = 5,95 ).
But now we are curious about total future returns, and the expected IRR (internal
rate of return) of this deal !
Expected EBTIDA + future Debt
The value of the shares of a company is calculated out of an enterprise value.
Enterprise value = EBITDA * factor.
Value of the shares = enterprise value -/- net debt.
When the entrepreneur and the investment company can together grow the
company from an EBITDA of 1,5 million to an EBITDA of 2,5 million, then they are
(likely) creating value !
30
And higher EBITDA companies ( in general ) also have a higher EBITDA multiple!
So when they can sell the company in 5 years ( after the initial transaction ) for 6
times the EBITDA, this would result in 6 times 2,5 million EBITDA = 15 million
enterprise value.
And when debt is build down in this 5 year time period, and when cash accumulated
due to net profits (taking CAPEX and net working capital into account), then ideally
also some cash is generated in these 5 years.
Let’s assume that after paying back debt, CAPEX, and net working capital, 2 million
in cash is generated.
Value of the shares at exit then is:
15 million minus -/- 2 million ( accumulated cash ) = 17 million for 100% of the
shares.
30% is exit value for the entrepreneur: 5,1 million ( 30% * 17m )
70% is exit value for the investment firm: 11,9 million ( 70% * 17m )
The IRR then is calculated by comparing “equity in” and “equity out”:
IRR entrepreneur: ( 5,1 / 1,05 ) ^ ( 1 / 5 years ) = 37 % IRR
IRR investment firm: ( 11,9 / 2,45 ) ^ ( 1 / 5 years ) = 37 % IRR
Total return for the entrepreneur:
5,95m at the initial transaction + 5,1m at exit = 11,05 m in total.
So this was a numerical example of a staged M&A by using a so called pre-exit

strategy.
Source used: Article – Pre-exit: een gefaseerde bedrijfsverkoop, 2019, Menno

Stuker, Tijdschrift Familie Bedrijven.
31
Business Valuation & Debt Leverage
Kersten Corporate Finance:
M&A boutique (incl. Business Valuations) in the Netherlands with deal focus of 5
million to 50 million enterprise value (EBITDAs from 1 million to 5 million) in all
industries, both sell side and buy side.
Source used: Article – De impact van schuld op de waardering, Chris Denneboom,

januari 2021, Tijdschrift Familie Bedrijven.
Introduction
With discounted cash flow (DCF) valuation returns are very important next to free
cash flows.
With DCF valuation there are different returns:
WACC = weighted average cost of capital;
CEU = cost of equity unlevered;
CEL = cost of equity levered.
In a company with a yearly free cash flow of 150, this free cash flow is available for
the suppliers of the capital of the company.
When 50% of this free cash flow is available for the equity holders, and 50% for the
debt holders (in the form of debt repayment and interest), then the free cash flow
would be divided in 75 for equity and 75 for debt.
When the free cash would be 10% lower, so 135 ( 150 -/- 10% ) instead of 150,
then still 75 would be for the debt holders and 60 ( 135 -/- 75 ) would be for the
equity holders.
So then the return of the equity holders lowers with 20% ( 15 / 75 * 100% ), while
the free cash flow only lowers with 10% !
This is the result of debt leverage, in other words, the return on equity becomes
more risky with the use of debt.
Modigliani & Miller 1958
In 1958 Modigliani & Miller published an article with new insights on investment
theory.
32
One of the most important insights tells us that the economic value of a company is
not influenced by its capital structure, when we live in a world without taxes.
According to this theory, the equity holders should receive an additional return
when debt is attracted by a company.
And this extra return is captured in the CEL with the following formula:
CEL = CEU + ( CEU -/- Cd ) * debt/ equity
Cd = cost of debt
Debt/ equity = The market value of debt / the market value of equity
( do not forget to use market values here !! )
Let’s say the CEU is 15% for a specific business, Cd is 3%, the market value of debt
is 125, and the market value of equity is 360, then we can calculate the CEL:
CEL = 15% + ( 15% -/- 3% ) * ( 125 / 360 ) = 19,17 %
When we calculate the WACC, the formula is:
WACC = CEL * ( equity / TC ) + Cd * ( debt / TC ) * (1 -/- tc )
TC = Total capital based on market values
tc = corporate tax
In first instance we calculate the WACC without corporate tax:
WACC = 19,17% * ( 360 / 485 ) + 3% * ( 125 / 485 ) * ( 1 -/- 0 ) = 15 %
With this calculation the essence of the Modigliani & Miller theory is given.
With any capital structure, the weighted average return is equal to CEU !
The additional risk for the equity holders, by attracting debt, is taken care of in the
CEL.
And herewith WACC always stays the same, including the value of a company !
But this is the situation of a theoretical world without taxes.

33
Taking tax into account
Now we have to take corporate tax into account.
Let’s say corporate tax is 25%, and then the casus would be as follows:
WACC = 19,17% * ( 360 / 485 ) + 3% ( 125 / 485 ) * ( 1 -/- 25% ) = 14,81 %
This results in a lower WACC.
Lower WACC = higher company value.
This due to the ability to deduct the interest expense for corporate tax.
So debt increases the value of the company ( a little ), and this depends on the
capital structure, interest rate and corporate tax level.
Although, take into account that from a tax perspective there can be limits on tax
deductibility.
Source used: Article – De impact van schuld op de waardering, Chris Denneboom,

januari 2021, Tijdschrift Familie Bedrijven.
34
Article: Why is EBITDA so popular ???
Author: Joris Kersten MSc
Kersten Corporate Finance:
Joris Kersten (1980) buys and sells companies in The Netherlands with an
enterprise value of in between 5 million and 50 million euro (SME market + mid
market). Moreover he conducts lots of Business Valuations for all kinds of settings.
Introduction
Earnings before interest tax depreciation and amortisation (EBITDA) is used all over
the globe for business valuation with for example M&As (Mergers & Acquisitions).
But why is EBITDA so popular ?
When we look at the profit & loss statement (P&L) of a company it all starts with
revenue.
Revenue
Revenue is P * Q (price times quantity) of for example a product that you sell.
But we all know that there are costs involved: COGS (costs of goods sold) and OPEX
(operating expenses).
And revenue minus COGS is the gross margin.
First, something funny happens with revenue, because so called “revenue

recognition” applies.
This basically means that you can speak of revenue under certain circumstances, for
example when you are sure the product is sold (even when the money is not paid
yet).
So it is very important that you know for every company that you analyse when,
and how, revenue is recognised.
This since this number comes up in the P&L (again, even when the money is not
paid yet).
COGS
With product sales, at the moment when revenue is recognised, also the COGS
need to be matched with the revenue recognised.
So when you can legally recognise the sales of 10 products (even when the money
is not yet paid by the customer), you need to match the “buy in price” for the 10
products as well in the COGS (even when they are not paid yet to the supplier).
35
And what is left is called the gross margin !
And by the way, this matching of costs is called the “matching principle”.
So be careful, it is possible that money is not yet paid by the customers, and it is
possible that the company has not paid their suppliers either.
Gross margin
Another thing with gross margin is that depending on how cost price is set (variable
costing or absorption costing), more or less costs can be taken up in the COGS,
which will result in hard to compare gross margins of different companies.
Some take up additional costs in the COGS, and other companies take them in the
SG&A (sales, general and administrative expenses).
So revenue misses the important involved costs (COGS + OPEX), and gross margins
are difficult to compare because cost prices are calculated differently.
SG&A
Out of the SG&A we need to clean D&A (depreciation and amortisation).
Depreciation is writing down tangible assets and amortisation is writing down

intangible assets.
We call these costs, but no cash outs, so we want to neglect them (for now),
because D&A is a bookkeeping concept.
Gross profit minus ( SG&A -/- D&A ) = EBITDA.
At EBITDA basically the most important costs are taken in the form of COGS and
OPEX (SG&A).
So EBITDA seen as a percentage of revenue really tells something about the

operating efficiency of a company !
Again, be careful, the matching principle also applies for SG&A, so some costs are
matched in the P&L (so also in EBITDA), but they might not be paid yet !
EBIT
We can still go further down to EBIT, and here we take the D&A from EBITDA.
But the problem with D&A is that it is still subjective, because it is set by the board
(although signed off by the auditors).
And on top of that D&A is a cost but not a cash out (is has a little effect on
corporate tax do).
So basically at EBIT we are down one step too far.

36
EBT
EBIT minus interest is EBT (earning before tax), but here interest comes into play.
And we do not like interest !
Because interest has to do with capital structure, and capital structure is a decision
of the board, and it has not much to do with the operations.
Net income
Here it becomes even worse, because here also tax has been deducted.
But the amount of tax paid is also a decision of the board.
Companies have an “effective tax rate” (ETR) depending on how much tax
optimalisation they are tolerating, again this has not much to do with operations.
EBITDA
So maybe you now start to understand that EBITDA is the "least bad" line in the
P&L.
I consciously say "least bad", because EBITDA says nothing on:
-When customers pay, and when suppliers and stakeholders get paid (net working
capital);
-How, and when, capital expenditures (CAPEX) are done;
-With how many assets this EBITDA is made;
-A normal level of corporate tax, and interest, that always needs to be paid.
37
Introduction Kersten Corporate Finance
Kersten Corporate Finance is an independent M&A consulting firm in The
Netherlands.
Deal segment: Middle sized and SME companies. So companies with an Enterprise
Value (EV) of in between 5 million euro and 100 million euro @ The Netherlands
and Benelux.
Activities:
1. Selling companies;
2. Buying companies;
3. Business Valuation & Financial Modelling;
4. Financing of acquisitions with bank loans and/ or private equity firms;
5. Buy & Build strategies for strategic buyers and private equity;
6. Searching & selecting acquisition targets;
7. Finding multiples for precedent M&A transactions in a certain field.
Website M&A consulting: www.kerstencf.nl
Website M&A training: www.joriskersten.nl
M&A training:
Business Valuation & Deal Structuring – 6 day training – Spring of every year –
Location: Hotel Amsterdam/ The Netherlands – Also online available on live stream.
29 PE points for Registered Valuators (RV) from NIRV;
In addition, Joris provides valuation training all over the globe on (bulge bracket)
investment banks and universities in: New York, London, Hong Kong, Singapore,
Dubai, Saudi Arabia, Kuwait, Mongolia, Surinam and Peru.
130 references on M&A training: https://www.joriskersten.nl/nl/reviews
You can book me for keynotes, training sessions & presentations on M&A
and Valuation all over the globe.
joris@kerstencf.nl
+31 (0)6 8364 0527
38
Introduction Joris Kersten
J.J.P. (Joris) Kersten MSc BSc RAB (1980) is owner of “Kersten Corporate Finance”
in The Netherlands, and this is an independent M&A boutique (Mergers &
Acquisitions) in consulting on M&As and valuations of medium sized companies.
Joris performs business valuations, prepares pitch books, searches and selects
candidate buyers and/ or sellers, organises financing for takeovers and negotiates
M&A transactions in a LOI and later in a share purchase agreement (in cooperation
with (tax) lawyers).
Moreover, Joris is associated to ‘AMT Training London’ for which he provides

training in Corporate Finance & Financial Modelling at leading (“bulge bracket”)
investment banks in New York, London and Hong Kong.
And Joris is associated to the ‘Leoron Institute Dubai’ for which he provides finance
training at leading investment banks and institutions in the Arab States of the Gulf.
This for example at Al Jazira Capital in Saudi Arabia and TAQA in Saudi Arabia.
In addition, Joris provides lecturing in Corporate Finance & Accounting at leading

Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the
Maastricht School of Management (MSM), the Luxembourg School of Business and
SP Jain School of Global Management in Sydney.
Moreover, he provides lecturing at partner Universities of MSM in: Peru, Surinam,

Mongolia and Kuwait. And at partner Universities of SP Jain in Dubai, Mumbai and
Singapore.
Joris graduated in MSc Strategic Management and BSc Business Studies, both from
Tilburg University. In addition, he is (cum laude) graduated as “Registered Advisor
Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s.
Currently Joris is following the “Executive Master of Business Valuation” to obtain

his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for
Registered Valuators” (NIRV). This title will enable Joris to give out business
valuation judgements in for example court cases.
Website M&A consulting + Valuations: www.kerstencf.nl
Website M&A training + Valuation training: www.joriskersten.nl
39
You can book me for keynotes, training sessions &
presentations on M&A and Valuation all over the globe.
joris@kerstencf.nl
+31 (0)6 8364 0527
40
41

ROIC

Uploaded by

Copyright:

Available Formats

ROIC

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ROIC

Uploaded by

Copyright:

Available Formats

Corporate Finance Bundle

Author: J.J.P. (Joris) Kersten MSc BSc RAB

Analysing ROIC (return on invested capital)

Kersten Corporate Finance: M&A advisory in The Netherlands + Business Valuations

Source used: Morgan Stanley Investment Management: Counterpoint Global

ROIC (return on invested capital)

Let’s first look at what NOPAT is, and means.

And then let’s look at what IC entails.

NOPAT is the numerator in the ROIC calculation.

So NOPAT is the same whether a company is financed with debt or equity.

So removing the concept “capital structure” in NOPAT enables it to compare NOPAT

NOPAT starts with earnings before interest and taxes (EBIT).

You then add amortisation from acquired intangible assets.

So summarized: NOPAT = EBITA -/- cash taxes.

A little more detail on NOPAT: Amortisation

Maybe it is strange to add back amortisation but not depreciation.

But the reason is that depreciation is an operating expense.

And amortisation of acquired intangibles just reflects “accounting”.

Embedded interest in lease

This was not the case in the old days.

The cash tax calculation has three components:

Then there are deferred taxes.

( with accelerated depreciation you have less profit = less tax )

The increase in the DTL reduces cash taxes.

So this increases cash taxes for leveraged companies, in order to be able to

IC ( invested capital ) is the denominator of ROIC, and this can be calculated in 2

Then we add PP&E (property, plant & equipment).

Next we add intangible assets and goodwill from M&A transactions.

Operating lease obligations also need to be taken into account.

When both NOPAT and IC is calculated, we can calculate ROIC !

Source used: Morgan Stanley Investment Management: Counterpoint Global

Source used: Morgan Stanley Investment Management: Counterpoint Global

Investments in future growth capture:

-Changes in net working capital;

-Capital expenditures net of depreciation;

-Other investments like acquisitions.

So investments in future growth are equivalent to the change in IC (invested

Link to a DCF model

The observations above give us a nice link to a DCF model.

121 / ( 500 + 25 + 25 ) = 22%.

ROIC is linked to valuation by “economic profit”.

Economic profit can be calculated in 2 ways ( with similar outcomes ):

-Economic profit = ( ROIC -/- WACC ) * invested capital;

-Economic profit = NOPAT -/- ( invested capital * WACC ).

ROIC linked to growth

ROIC is also linked to growth.

This because ROIC is the maximum supportable growth rate of a company

-Growth = ROIC * ( 1 -/- payout ratio ).

And of course, this leaves less money available to reinvest.

In total: 500 IC + 100 IC ( from nopat ) = 600 IC.

600 IC * 20% ROIC = 120 NOPAT ( 100 + 20 ).

And another year later:

Growth rates higher/ lower than ROIC

When growth is 10%:

NOPAT * ( 1 + 10% ) = 110 NOPAT

110 / 20 * 100 = 550 IC is needed.

With a growth of 2 times ROIC, NOPAT grows with 40%.

100 nopat * ( 1 + 40% ) = 140 nopat

140 / 20 * 100 = 700 IC needed.

Source used: Morgan Stanley Investment Management: Counterpoint Global