Recasting Expenses For ROIC: PharmaCo Example (2/2)

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Here are some additional observations on the PharmaCo example to be mindful of as you apply these adjustments going forward:

Amortization Schedule

In the calculation of invested capital in Exhibit 24.2 of McKinsey Valuation 7th Edition on page 502, the authors are actually reducing accumulated R&D investment each year by 10% of invested capital for the prior year to account for amortization (see footnote 4 page 501) instead of using a full amortization schedule. This is a shortcut – a more precise approach would be to pick a number for the useful life of the R&D.  How should one think about a reasonable number of years to use – is it 2 years or 20? This is something I will get into later when we explore capitalizing intangible assets beyond R&D. But the touchstone for thinking about this should always be to try to make a reasonable assessment of how long the company will actually benefit from that investment through revenue and income, and it can really vary.  There is also an interesting discussion of the impact on the adjusted ROIC of varying the asset life on page 504 of McKinsey Valuation 7th Edition.

The Magnitude of Adjusted ROIC Change

Keep in mind the variables that will influence how much the adjusted ROIC changes. These include the useful life, or amortization schedule – more years means the asset stays higher for longer and vice versa but also a lower ding to NOPAT in any given year, how far you go back in time to include expenses in building up to the capitalized expense amount (the further you go back, the bigger the asset/invested capital amount will be), how big the new intangible asset is relative to the rest of the invested capital base is, how big the new intangible amortization expense is vs. what the GAAP expense was previously, and what portion of overall expenses those amounts are. You can end up with either negligible or massive changes to ROIC in both directions based on these variables, and you will get a feel for this after you make the adjustments a few dozen times to different companies. 

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