Adjusted cost capital employed

What Is Adjusted Cost Capital Employed?

Adjusted Cost Capital Employed refers to the total capital invested in a business, which has been modified to account for certain economic or accounting adjustments, and then factored against the cost of that capital. This concept is a specialized application within financial analysis, aiming to provide a more accurate picture of a company's true profitability and value creation by considering the actual economic cost of employing its capital. While "capital employed" generally represents the sum of a company's debt and equity used to generate profits, the "adjusted cost" aspect introduces refinements to reflect economic realities beyond statutory accounting figures.

The core idea behind using an Adjusted Cost Capital Employed figure is to align financial metrics more closely with economic principles, particularly in measuring the actual wealth generated for shareholders' equity. It moves beyond traditional accounting profits by explicitly deducting a charge for the use of all capital, whether it's equity or debt financing. This adjusted approach emphasizes that capital is not free and has an implicit cost of capital, which must be covered before a business can claim to have created true corporate profitability.

History and Origin

The underlying principles behind adjusting capital and incorporating its cost into performance measurement gained prominence with the development of metrics like Economic Value Added (EVA). While "Adjusted Cost Capital Employed" is a descriptive term rather than a single trademarked metric, its methodology is deeply rooted in the concept of economic profit, which asserts that a business only truly creates value when its returns exceed its cost of capital. The consulting firm Stern Stewart & Co., now Stern Value Management, notably developed and trademarked the EVA metric in the 1990s, popularizing the idea of making numerous accounting adjustments to financial statements to arrive at a more economically accurate picture of a firm's capital and its profitability. Their work emphasized that reported accounting profits could often obscure whether a company was genuinely creating wealth or merely covering its cost of capital. Stern Value Management continues to advocate for value-based management principles that incorporate these adjustments. [EXTERNAL LINK 1]

Key Takeaways

• Adjusted Cost Capital Employed seeks to refine traditional capital figures by factoring in the true economic cost and making specific accounting adjustments.
• The goal is to provide a more accurate measure of a company's wealth creation, beyond standard accounting profits.
• It highlights that capital is not free and requires a return that covers its cost for value to be generated.
• The concept is foundational to economic profit measures, evaluating managerial effectiveness and capital allocation.
• A positive outcome indicates that the business is generating returns in excess of its total cost of financing.

Formula and Calculation

Calculating Adjusted Cost Capital Employed often involves starting with conventional definitions of capital employed and then applying a series of specific adjustments. While there isn't one universal formula for "Adjusted Cost Capital Employed" as it's a conceptual term, it typically forms the base for calculating economic profit, which explicitly includes a capital charge. This capital charge is determined by multiplying the Adjusted Capital Employed by the Weighted Average Cost of Capital (WACC).

The basic conceptual formula for economic profit measures, which rely on an adjusted capital employed, is:

$\text{Economic Profit} = \text{Adjusted NOPAT} - (\text{Adjusted Capital Employed} \times \text{WACC})$

Where:

• Adjusted NOPAT: This represents net operating profit after taxes, with adjustments made for non-cash expenses, operating leases, and other items to reflect true economic performance.
• Adjusted Capital Employed: This is the total capital (equity + debt) invested in the business, adjusted for items such as deferred taxes, goodwill, or operating leases to better represent the true capital base. It can be calculated by taking total assets and subtracting current liabilities, with further specific adjustments.⁸
• WACC: This is the average rate a company expects to pay to finance its assets, considering the proportionate weight of each capital source (debt and equity). BDC.ca provides a detailed explanation of WACC calculation. [EXTERNAL LINK 2]

The specific adjustments to capital employed and NOPAT can vary but often aim to:

• Capitalize items typically expensed (e.g., research and development, brand building) if they provide future economic benefits.
• Adjust for non-cash provisions and reserves.
• Reclassify operating leases as financial leases to include the associated assets and liabilities on the balance sheet.

Interpreting the Adjusted Cost Capital Employed

Interpreting an Adjusted Cost Capital Employed involves assessing whether a company is generating sufficient returns to cover its true economic cost of capital. A positive result from a calculation that uses adjusted cost capital employed (such as economic profit) indicates that the company is creating value above and beyond the minimum required return for its investors. Conversely, a negative result suggests that the company is destroying value, as its returns are not enough to compensate providers of capital for the risks undertaken.

This metric is particularly insightful because it forces managers and analysts to consider the full economic cost of all the capital utilized, not just the explicit interest payments on debt. It provides a more holistic view of performance, encouraging efficient capital allocation and management of the underlying fixed assets and working capital.

Hypothetical Example

Consider "InnovateTech Inc.," a software company.
Financial Data (simplified):

• Net Operating Profit After Tax (NOPAT, before adjustments): $15,000,000
• Total Invested Capital (Book Value): $100,000,000
• Weighted Average Cost of Capital (WACC): 10%

Adjustments identified by a financial analyst:

1. R&D Capitalization: InnovateTech historically expenses all R&D. The analyst determines that $5,000,000 of R&D should be capitalized and amortized over 5 years. This adds $5,000,000 to the Adjusted Capital Employed.
2. Operating Lease Adjustment: The company has off-balance-sheet operating leases with a present value of $2,000,000, which are reclassified as financial leases. This adds $2,000,000 to the Adjusted Capital Employed and increases NOPAT by the implied interest savings (simplified for this example, assume NOPAT remains largely unchanged after other adjustments net out).

Calculation:

1. Adjusted Capital Employed: $100,000,000 (Book Value) + $5,000,000 (R&D) + $2,000,000 (Operating Leases) = $107,000,000
2. Capital Charge: $107,000,000 × 10% = $10,700,000
3. Adjusted Economic Profit: $15,000,000 (NOPAT) - $10,700,000 (Capital Charge) = $4,300,000

In this hypothetical example, InnovateTech Inc. generated an Adjusted Economic Profit of $4,300,000. This positive figure indicates that the company created wealth for its shareholders above the cost of all the capital it employed, including the economically adjusted capital base. This insight is more granular than simply looking at traditional accounting earnings or a raw Return on Capital Employed (ROCE) figure, which might not incorporate these specific adjustments.

Practical Applications

Adjusted Cost Capital Employed is a vital concept in corporate valuation and performance management. Companies utilize this adjusted metric, often through models like EVA, to:

• Internal Performance Measurement: It helps divisions and managers understand the true economic impact of their decisions, encouraging them to consider the cost of capital tied up in their operations. This promotes efficient resource allocation and asset utilization.
• Capital Budgeting Decisions: When evaluating potential projects or investments, calculating the anticipated economic profit based on Adjusted Cost Capital Employed helps determine if the expected returns genuinely exceed the cost of the capital required.
• Incentive Compensation: Tying management compensation to metrics that reflect Adjusted Cost Capital Employed can align managerial incentives with shareholder value creation, promoting long-term financial health.
• Mergers and Acquisitions (M&A): Analysts may use this adjusted approach to assess the true value and potential synergy of target companies, ensuring that the acquisition will genuinely add economic value.
• Strategic Planning: Understanding the true cost of capital and its efficient deployment helps companies formulate strategies that prioritize value-creating activities over those that merely generate accounting profits. Many large global companies use economic value added internally for performance measurement.

Limitations and Criticisms

Despite its benefits, the concept of Adjusted Cost Capital Employed, particularly when applied through metrics like EVA, has limitations. One significant challenge lies in the subjectivity of the accounting refinements themselves. There can be numerous potential adjustments to financial reporting—some sources suggest over 160—and deciding which ones are relevant and how to quantify them can be complex and introduce bias. The determination of inputs like the cost of capital also involves assumptions, which can significantly impact the calculated outcome.

Oth⁷er criticisms include:

• Complexity: Performing comprehensive adjustments can be data-intensive and time-consuming, requiring significant accounting and financial expertise.
• Reliance on Historical Data: Like many business performance metrics, calculations are often based on historical financial data, which may not always accurately reflect current market conditions or future performance.
• ⁵, ⁶Industry Specificity: The relevance and impact of certain adjustments might vary significantly across different industries, making cross-industry comparisons challenging without careful consideration.
• Potential for Manipulation: While designed to counter accounting manipulation, the choice and magnitude of adjustments can still be influenced to present a more favorable picture.

The³, ⁴refore, while Adjusted Cost Capital Employed provides a powerful framework for economic analysis, it should be used in conjunction with other financial metrics and qualitative factors for a comprehensive understanding of a company's performance. FasterCapital discusses common pitfalls in corporate valuation. [EXTERNAL LINK 3]

Adjusted Cost Capital Employed vs. Economic Value Added (EVA)

Adjusted Cost Capital Employed is a foundational concept within broader measures of economic performance, most notably Economic Value Added (EVA). While "Adjusted Cost Capital Employed" describes the specific calculation of the capital base after adjustments, EVA is a proprietary financial performance metric that explicitly incorporates this adjusted capital along with its cost.

In essence, Adjusted Cost Capital Employed is a critical input to calculate EVA, which measures whether a company's Return on Capital Employed (ROCE) exceeds its Weighted Average Cost of Capital. If the return generated from this adjusted capital base is greater than its cost, then positive EVA is achieved.

FAQs

What types of adjustments are typically made to capital employed?

Adjustments often aim to convert accounting data into a more economically representative figure. Common adjustments include capitalizing certain expenses (like R&D or brand building that have long-term benefits), reclassifying off-balance sheet items such as operating leases, and adjusting for deferred taxes or reserves. The goal is to better reflect the true capital investment required to generate profits.

Why is it important to adjust capital employed?

Adjusting capital employed provides a more accurate picture of a company's resource utilization and value creation. Traditional accounting measures can sometimes obscure the full economic cost of operating a business. By adjusting, analysts can determine if a company is truly generating returns above its economic cost of capital, leading to better insights for investment decisions and performance evaluation.

How does Adjusted Cost Capital Employed relate to shareholder value?

The concept is directly tied to shareholder value. When a company's returns on its Adjusted Cost Capital Employed exceed the cost of that capital, it generates positive economic profit, which signifies an increase in shareholder wealth. Conversely, if returns do not cover the adjusted cost of capital, value is being eroded, signaling poor capital allocation or operational inefficiencies. This ultimately impacts shareholder returns and overall corporate valuation.

Is Adjusted Cost Capital Employed the same as Return on Capital Employed (ROCE)?

No, Adjusted Cost Capital Employed is not the same as Return on Capital Employed (ROCE). ROCE is a ratio that measures a company's profitability and efficiency in using its capital, typically calculated as Earnings Before Interest and Taxes (EBIT) divided by capital employed. Adju¹, ²sted Cost Capital Employed, on the other hand, refers specifically to the denominator in such a ratio—the capital base itself—after applying economic adjustments, and often implicitly includes the concept of the cost associated with that adjusted capital. While ROCE uses capital employed, the "adjusted cost" aspect implies a more rigorous, economic definition of the capital base and its implicit cost.