While this calculation is rather straightforward for a 1-year project, it becomes more involved for multi-year projects, where both the operating income and the book value of the investment change over time. In these cases, the return on capital can either be estimated each year and then averaged over time or the average operating income over the life of the project can be used in conjunction with the average investment during the period to estimate the average return on capital.

The after-tax return on capital on a project has to be compared to a hurdle rate that is defined consistently. The return on capital is estimated using the earnings before debt payments and the total capital invested in a project. Consequently, it can be viewed as return to the firm, rather than just to equity investors. Consequently, the cost of capital should be used as the hurdle rate.

If the after-tax return on capital > Cost of Capital -> Accept the project If the after-tax return on capital < Cost of Capital -> Reject the project For instance, if Disney in the example, above, had a cost of capital of 10%, it would view the investment in the new software as a good one.

Illustration 5.7: Estimating and Using Return on Capital in Decision Making: Disney and Bookscape

In illustration 5.4 and 5.5, we estimated the operating income from two projects -an investment by Bookscape in an on-line book ordering service and an investment in a theme park in Bangkok by Disney. We will estimate the return on capital on each of these investments using these estimates of operating income. Table 5.7 summarizes the estimates of operating income and the book value of capital at Bookscape.

Table 5.7: Return on Capital on Bookscape On-line
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