CP

452 CHAPTER 12 Corporate Valuation, Value-Based Management, and Corporate Governance

Another important metric in the corporate valuation model is the expected return

on invested capital (EROIC), defined as the expected NOPAT for the coming year di-

vided by the amount of operating capital at the beginning of the year (which is the end

of the preceding year). Thus, EROIC represents the expected return on the capital

that has already been invested. To illustrate, the EROIC of the Bell Memory division

for 2007, the last year in the forecast period, is:

To see exactly how the four value drivers and expected ROIC determine value for

a constant growth firm, we can start with Equation 12-2,

(12-2)

and rewrite it in terms of the value drivers:

(12-3)

Equation 12-3 shows that the value of operations can be divided into two components:

(1) the dollars of operating capital that investors have provided and (2) the additional

value that management has added or subtracted, which is equivalent to MVA.

Note that the first bracket of Equation 12-3 shows the present value of growing

sales, discounted at the WACC. This would be the MVA of a firm that has no costs

and that never needs to invest additional capital. But firms do have costs and capital

requirements, and their effect is shown in the second bracket. Here we see that, hold-

ing g constant, MVA will improve if operating profitability (OP) increases, capital re-

quirements (CR) decrease, or WACC decreases.

Note that an increase in growth will not necessarily increase value. OP could be

positive, but if CR is quite high, meaning that a lot of new capital is needed to support

a given increase in sales, then the second bracket can be negative. In this situation,

growth causes the term in the first bracket to increase, but it is being multiplied by a

negative term in the second bracket, and the net result will be a decrease in MVA.

We can also rewrite Equation 12-2 in terms of EROIC:

. (12-4)

Equation 12-4 also breaks value into two components, the value of capital and the

MVA, shown in the second term. This term shows that value depends on the spread

between the expected return on invested capital, EROIC, and WACC. If EROIC is

greater than WACC, then the return on capital is greater than the return investors ex-

pect, and management is adding value. In this case, an increase in the growth rate

causes value to go up. If EROIC is exactly equal to WACC, then the firm is, in an eco-

nomic sense, “breaking even.” It has positive accounting profits and cash flow, but

these cash flows are just sufficient to satisfy investors, causing value to exactly equal

the amount of capital that has been provided. If EROIC is less than WACC, the term

in brackets is negative, management is destroying value, and growth is harmful. Here

the faster the growth rate is, the lower the firm’s value.

We should also note that the insights from Equations 12-3 and 12-4 apply to all

firms, but the equations themselves can only be applied to relatively stable firms

whose growth has leveled out at a constant rate. For example, Home Depot has been

growing at more than 20 percent per year, so we cannot apply Equations 12-3 and

12-4 directly (although we can always apply Equation 12-1). Home Depot’s

Vop(at time N)CapitalN

CapitalN(EROICNWACC)

WACCg

Vop(at time N)CapitalN
c

SalesN (1
g)

WACCg

dcOPWACCa

CR

1 
g

bd.

Vop(at time N)

FCFN
 1

WACCg

,

EROIC 2007 

NOPAT 2008

Capital 2007



$100.3(1.05)

$1,110.4

9.5%.

Corporate Valuation, Value-Based Management, and Corporate Governance 449