Question

When a company has an ROIC greater than its cost of capital, faster growth increases value, but when it has an ROIC less than its cost of capital, what is the effect on value? a. Faster growth creates value O b. Faster growth destroys value O c. Growth doesn't affect value creation O d. None of the above are true

Answer 1

ROIC stands for Return On Invested Capital

The formula of ROIC:

NOPAT ROIC = 7 Invested Capital where: NOPAT = Net operating profit after tax

Invested capital = Book value of Debt + Book Value of Equity + Minority Interest

Return on Invested Capital is a profitability or performance measure of the return earned by those who provide capital, namely the firm’s bondholders and stockholders.

To see how well the company is actually generating a return, then we should compare the ROIC to the WACC (Weighted Average Cost of Capital) / Cost of Capital. Thus, the company which had more ROIC than Cost of capital is generating more profits to keep operations going. So a faster growth would mean the company value is also increasing.

Whereas, if a company is having an ROIC less than the Cost of capital would mean that they are having a negative return, which would mean that a faster growth destroys value, as the cost of the funds invested would be more than the return that is earned by the company. This means that growth is undesirable; unless companies keep up with their industries, or else they will likely destroy value. But they shouldn't pursue growth at the expense of a reduction in ROIC.