Question

You are the CFO of a steel company, considering investing in a new steel plant. The plant is expected to cost $100 million to build and have a 20-year life, at the end of which it is expected to have a salvage value of $20 million. The average annual after-tax operating income is expected to be $9 million and the average annual net income is expected to be $ 5 million. Your decision rule is to accept any investment that generates an average return on capital that exceeds the cost of capital over its life. Assuming straight-line depreciation, what is the return on capital on this project?

Answer 1

We know that average capital invested over the life of the investment when a straight-line depreciation method is used is:

Average capital invested = (Starting book value of capital invested + Ending book value capital invested) / 2

Average capital invested = ($100 million + $20 million) / 2 = $60 million

Return on Capital = Net After-tax operating income / Average capital invested

Net After-tax operating income = $9 million

Return on Capital = $9 million / $60 million = 0.15 = 15.0%

The return on capital on this project will be 15.0%.