BV of Debt + BV of Equity

Decomposing Return on Capital

The return on capital of a firm can be written as a function of its operating profit margin and its capital turnover ratio.

BV of Capital Sales BV of Capital

= After - Tax Operating Margin * Capital Turnover Ratio

Pre - Tax ROC = Pre - Tax Operating Margin * Capital Turnover Ratio

Thus, a firm can arrive at a high ROC by either increasing its profit margin or more efficiently utilizing its capital to increase sales. There are likely to be competitive constraints and technological constraints on increasing sales, but firms still have some freedom within these constraints to choose the mix of profit margin and capital turnover that maximizes their ROC. The return on capital varies widely across firms in different businesses, largely as a consequence of differences in profit margins and capital turnover ratios.

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