Question

1. How does return on invested capital (ROIC) affect a company's cash flow? Explain the relationship between ROIC, growth, and cash flow.

2. If value is based on discounted cash flows, why should a company or investor analyze growth and ROIC?

3. Under what circumstances does growth destroy value?

Answer 1

How does return on invested capital (ROIC) affect a company’s cash flow? Explain the relationship between ROIC, growth, and cash flow.

Firstly let us see how to calculate ROIC, the formula of RIOC is (Net Operating Profit after Tax/ Invested Capital)

Net Operating Profit after Tax= EBIT*(1-Tax Rate)

According to the above formula we can see that ROIC will increase when Net Operating Profit After Tax will increase and which will means Our Cash Flow will increase too; because Cash Flow rise with the Inflow of Cash and when Net Operating Profit after Tax will increase cash of the firm will also increase, Their is a direct correlation between RIOC and Cash flow. But if Cost of capital is higher than ROIC, Then increase in growth rate will decrease in the company value. Hence we can say that increase in both ROIC and growth rate drives the company’s value the most

If value is based on discounted cash flows, why should a company or investor analyze growth and ROIC?

ROIC (Return on Invested Capital) and Growth is one of the best indicators for the investor which will create wealth of the investor because ROIC take into the account "Total Capital" which will include both Debt and Equity and it gives a more clear picture of the performance of the company and growth is important for the calculation of future cash flow which will help us to calculate valuation of the company.

Under what circumstances does growth destroy value?

AS stated above Growth destroy value, when Return On Invested Capital is lower than the Cost Of Capital.