nvested capital is a source of funding that enables them to take on new opportunities such as expansion. It has two functions within a company. First, it is used to purchase fixed assets such as land, building, or equipment. Secondly, it is used to cover day-to-day operating expenses such as paying for inventory or paying employee salaries. A company may choose invested capital funding over taking out a loan from a bank for several reasons.

For example, when a company issues stock shares, it has no obligation to issue dividends. This makes it a cheap source of capital compared to paying interest on a bank loan. A company may also prefer to obtain funding through shares and bonds if they do not qualify for a large bank loan at a low-interest rate.

For an investor, invested capital is evaluated using metrics such as the return on investment capital ratio (ROIC). This ratio is used by an investor to determine the value of a company. A relatively higher ratio indicates a company is a value creator and is capable of utilizing invested funds to generate higher profits, as compared to other companies.

By dividing revenue by capital invested, the ratio shows the ability of a company to drive sales through its capital. A company that has a higher ratio compared to its peers means they are operating more efficiently.

Let's take a look at two companies that appear to be performing quite differently at first glance:

Company A is generating a substantially higher return on equity than Company B. At first glance it could be tempting to think that Company A is a better investment or should justify a higher share price. If we assumed that the Cost of Equity of each company is 10% and that neither company will grow any further (stagnant), then the equity of Company A is worth 44.1%/10% x 400m = $1764m and has an Enterprise Value (debt + equity) of $2364m, and Company B has an equity value of 24.9%/10% x 800m = $1992m and an Enterprise Value of $2192m. So apparently Company A is worth $172m more than Company B.

ROIC (Return on Invested Capital) attempts to assess companies based on their operating performance, independent of their capital structure. ROIC is a measure that removes the effect of leverage, and allows you to compare companies based on the performance of their assets, independent of any additional financial risk the management have taken in running their companies. ROIC ignores the effects of the capital structure on the financial statements. As such on the balance sheet instead of differentiating between Debt and Equity, we add them together to get Invested Capital. On the profit & loss statement we ignore the effects of debt, so below the EBIT line we ignore interest and recalculate tax as if no interest was charged. The resulting version of N0PAT that we arrive at is referred to as Net Operating Profit After Tax (NOPAT). To get ROIC, we then divide NOPAT by Invested Capital.

In your analysis of the two companies, how do you explain or reconcile the differences between them when they both have the same ROIC? Do the companies have a difference in value of equity? If so, please explain.