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Capital employed 4 3.5 2.9 2.3 1.7 1.1

ROACE 10.2% 13.4% 18.5% 26.8% 42.6%

Funds flow

Profit 0.4 0.4 0.5 0.5 0.6 0.0

Amortisation 0.6 0.6 0.6 0.6 0.6 0.0

Working capital âˆ’0.1 0.0 0.0 0.0 0.0 0.1

Capital investment âˆ’4.0 0.0 0.0 0.0 0.0 0.0 1.0

Funds flow âˆ’4.0 0.9 1.0 1.1 1.1 1.2 1.1

Remem er that R CE is the r

Remember hat ROCE s he return on capital employ d while R

n api l employed le ROACE is the return on average cap-

E s he r n ave ge a -

16

ital employed. The calculation is profit after tax but before any finance charges as a percentage of

capital employed.

At this stage we will ignore the additional factors which were introduced in the individual work

17

assignment and focus just on the numbers that were shown in the main section.

127 Building block 4: Planning and control

Now remember that this was the financial outlook for a single project. We

noted when we first reviewed the ROACE line that there was not a lot which

we could do with this number. It started at zero and then rose to well over

40%, but so what?

Now some businesses are, in effect, just a single project.18 The majority

of companies, however, are built from a series of projects. So a more typical

situation might be of a scaffolding company that started one new scaffolding

rental outlet each year. If each individual project was exactly like the one

shown above and if one new project was started each year then eventually the

company would reach a steady-state position. What would its accounts look

like at this time?

The first step towards answering this question is to change the column

titles from the calendar years 2007â€“2013 to project years 1â€“7. Next one thinks

of the company as reaching steady-state in its seventh year. This is because in

year 8, although it would once again be starting a new project, the original

project started in year 1 would no longer feature at all.

From year 7 onwards the company would own one project in each year

of its project life. This means that it would have a set of accounts which

was equal to the sum of the seven project years above. The accounts would

therefore look like the table which follows. In this table each dollar number

is simply the sum of the numbers in the relevant row of the project spread-

sheet. The only complication concerns ROACE. This needs to be worked

out rather than simply be obtained by summing the project year ROACE

numbers.19

Sum of all projects â€“ No growth $m

Income Statement

Sales Revenue 9.4

Variable Costs âˆ’1.9

The company running the Channel Tunnel which links France and England is an example.

18

Remember that ROACE is post-tax profit divided by average capital employed. The profit number

19

is easy but obtaining average capital employed requires an additional calculation since at this stage

we only have the closing balance sheet and not the opening one. The opening capital employed must

be back-calculated given the capital investment, amortisation and working capital change. The for-

mula becomes ROACE = two times profit divided by two times capital employed plus capital invest-

ment, amortisation and working capital change. This may well seem strange but it is right as long as

cash inflows are always shown as positive numbers with outflows such as capital investment being

negative.

128 The five financial building blocks

Table (cont.)

Contribution 7.5

Fixed costs âˆ’1.0

Amortisation âˆ’3.0

Pre-tax profit 3.5

Tax âˆ’1.0

Profit 2.4

Balance sheet

Fixed assets 15.0

Accounts receivable 1.2

Inventories 0.5

Accounts payable âˆ’1.2

Working capital 0.5

Capital employed 15.5

ROACE 15.6%

Funds flow

Profit 2.4

Amortisation 3.0

Working capital 0.0

Capital investment âˆ’3.0

Funds flow 2.4

We should note first that for this business which has reached a steady-state

situation, the funds flow is equal to the profit. This is exactly what we should

expect since we know that funds flow is equal to profit less growth in capital

employed and at steady-state, capital employed remains the same.

Consider now the ROACE of 15.6%. When we first introduced this scaf-

folding example I showed in a footnote how the IRR could be calculated as

18.1% or 14.8% depending on the exact timing of the initial capital invest-

ment and the receipt of the residual value. The figure of 18.1% corresponded

to the capital investment being incurred at the very end of 2007 and the

residual value coming at the start of 2013. The figure of 14.8% was for when

the capital spend was in the middle of 2007 and the residual value in the

middle of 2013.

This latter IRR figure is the one which I would quote for our steady-state

example which shows a total of seven yearsâ€™ worth of cash flows with it taking

in effect a full year to â€˜buildâ€™ the project and a year to terminate it. So we can

see that the IRR of 14.8% is quite close to the ROACE of 15.6%.

129 Building block 4: Planning and control

If we now â€˜playâ€™ with our assumptions we can investigate the relationship

between steady-state ROACE and individual project IRR. For example, a sell-

ing price of $1,50020 gives an IRR of 10.1% and a ROACE of 10.5% while selling

for $1,900 gives an IRR of 19.5% and a ROACE of 20.9%. Changing the sales

growth rate from 5% to 15% increases IRR to 20.4% and ROACE to 23.4%.

What we observe is that steady-state ROACE is a reasonable first order

approximation for IRR. The relationship is not as good for high IRRs as it

is for low IRRs but the normal situation is that if ROACE is greater than the

CoC then a project has an IRR of above its CoC and so must have a positive

NPV.21

There are good reasons why this should be the case and these will be

explained later in this building block. For the present, however, we can sim-

ply note the empirical evidence that steady-state ROACE calculated in the

manner above is a reasonable estimate for IRR, particularly if IRR is close to

the CoC.

Here, then, is a way of testing for consistency of words and music. If the

words describe a good business that is staying about the same size then the

ROACE should, over time, be above the CoC.

What would the effect of growth be? Do you think that growth would

increase or decrease ROACE compared with my simple steady-state calcula-

tion? Suppose the scaffolding company gradually got bigger and each year it

invested in a project which was 5% larger than the one before. What do you

think would happen to its ROACE?

You might think that because increasing ROACE is good and investing in a

positive NPV project is good22 then growth would increase ROACE. Well, the

exact opposite happens. Growth lowers ROACE. This is because the growth

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