Question

Company A. is preparing a cash flow forecast for a potential acquisition target, Company B. A question has arisen as to how fast the company can grow. An analyst argues that the company, Company B., will need to raise capital to achieve its growth target of 10%. You are not sure. You have analyzed Company B., over the last five years: Consistently, the company earns a return on invested capital (ROIC) of 22%. Furthermore, the company has an average investment rate (IR) of 75% over the last five years. IF, the company continues with the same ROIC and IR over the next few years, do you agree with the analyst?

Answer 1

Average investment rate = 75%

return on invested capital =22%

therefore return on investment = average investment * return on invested capital =75*22/100 = 16.5%

If we want growth rate of 10%; then return on investment = 16.5(1+0.10) = 18.15%

average investment =return on investment/ return on invested capital =18.15/22.00 = 82.5%

SO from above calculations; if the return on invested capital and average investment rate remains same then the overall return will be constant having no growth rate. As per the Analyst, if we raise the investment rate to 82.5% by increasing the capital, then the growth rate is possible (10%)