Corporate Finance

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Corporate Finance

where
EBIT = Earnings before interest and tax
T = Marginal Tax Rate, and
Average BV = (Beginning book value + Ending book value)/2

A variant of the above formula is:

ROI = (Net Income/Average BV)

ROI computed by the second method will be higher if equity financing is substituted for debt financing. This

is because less interest expense increases net income (PAT). To separate investment and financing decisions

it is better to use the first method. Consider a one-year project with an investment of Rs 10 lac. The project

is expected to generate Rs 400,000 in pre-tax earnings. The applicable tax rate is 36 percent and the salvage

value of the project is Rs 600,000.

ROI = [400000 (1– 0.36)/800000]

= 32 percent

Note that ROI is a percent return measure. Now consider a multi-period project which has a life of 5 years.

Initial investment = Rs 10 lac

Salvage value = Nil

Life = 5 years

Depreciation is provided on straight-line basis.

The project is expected to generate earnings of Rs 40,000 (loss), Rs 60,000, Rs 100,000, Rs 150,000 and

Rs 200,000. How should the ROI be computed in this case? Should the ROI be measured for each of the

years and averaged out or the average earnings and average book value of assets be used? ROI computed

under the two methods is shown here:

Method 1

1. After tax operating earnings (40,000) 60,000 100,000 150,000 200,000


2. Beginning BV 1,000,000 800,000 600,000 400,000 200,000


3. Depreciation 200,000 200,000 200,000 200,000 200,000


4. Ending BV 800,000 600,000 400,000 200,000 0


5. Average BV 900,000 700,000 500,000 300,000 100,000


6. ROI = (1)/(5) – 4.5 8.5 20 50 100
   percent percent percent percent percent

The ROI increases from –4.5 percent in the first year to 100 percent in the fifth year. The average ROI is
35 percent:

Average ROI = [–4.5 + 8.5 + 20 + 50 + 100]/5 = 35 percent