Financial Ratios Thirty Years Ago a Fortune

Financial Ratios

Thirty years ago a Fortune 500 U.S. company would develop strategies with a focus on capital projects located primarily in this country. With the rise of globalization however, companies must now incorporate multi-country initiatives to take advantage of opportunities in revenue growth as well as cost savings. Evaluating capital investment opportunities can take a myriad of forms: return on investment, service price of capital, payback period, return on capital, return on equity, and internal rate of return. Of these options; return on capital, return on equity, and internal rate of return provide "well-known and trusted benchmarks used by investors and institutions to decide between competing investment options" (Investopedia. Return on Equity vs. Return on Capital N.D.)

Return on equity and return on capital have a commonality to them and describe "how much earnings a company can generate from assets" (Investopedia, N.D.). "Return on equity measures a company's profit as a percentage of the combined total worth of all ownership interests in the company" (Investopedia. Return on Equity. N.D), and is calculated by dividing net income by shareholder's equity. Return on capital uses the same formula however, the denominator "also includes the total value of debts owed by the company in the form of loans and bonds" (Investopedia. Return on Equity vs. Return on Capital N.D.).

Understanding internal rate of return first depends on comprehension of the concept of net present value. Net present value "compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account" (Investopedia. Net Present Value N.D.). Net present value "involves calculating the present value of future expected cash flows from an investment using the company's cost of capital or discount rate" (Marshall, D. & McManus, W. 1996). The discount rate may also be thought of as the hurdle rate "because it represents the minimum rate of return required for an investment to yield a positive net present value" (Marshall, D. & McManus, W. 1996). An investment which yields a positive net present value is likely a capital project that a company will choose to fund.

The internal rate of return of a capital project is "the actual rate of return that will be earned by the proposed investment, and is the discount rate at which the present value of cash flows is equal to zero" (Marshall, D. & McManus, W. 1996). The IRR which is calculated is compared to the firm's discount rate, and if it exceeds this hurdle rate the proposed investment would be considered desirable. An IRR less than the hurdle rate would not be a recommended investment. As an example, assume a company has a cost of capital of 16%, if a future stream of earnings at that discount rate had a net present value of 1,000,000 dollars, then the IRR must exceed 16%. At some point the net present value will equal zero and that is the IRR.