FREE online courses on Financial Management and Creating Value - Chapter 3 -
Calculating CFROI
CFROI adjusts for inflation by marking-up gross investments
made each year based on comparing the GDP deflator to changes in purchasing
power. The useful life of assets is estimated by dividing gross investments by
depreciation charges. Cash flows are determined by starting with gross cash
flows or net income and making several adjustments, such as adding back interest
expense. Assets that are not capitalized are separated out from capitalized
investments in order to properly calculate the CFROI rate (calculated similar to
Internal Rate of Return). CFROI like EVA attempts to remove accounting
distortions in arriving at cash in and cash out, such as the following:
Net Income Book Value of Assets
+ Rent Expense (Operating Leases)
+ Accumulated Depreciation
- FIFO Profits
+ Operating Leased Assets
+ Interest Expense
- Net Deferred Tax Assets
CFROI is calculated by translating the ratio of cash in to
cash out as an internal rate of return. The calculation uses the economic life
of investments and considers non-capitalized assets (such as land) as residual
values at the end of the valuation period. The following example will illustrate
these points.
Example 2 - Calculate Cash Flow Return on Investment (CFROI)
Some important points: Gross assets is the sum of non
depreciable and depreciable assets. Useful life of assets is calculated based on
the relationship of gross assets to depreciation charges. We will assume this is
15 years. At the end of 15 years, non-depreciable assets are released. Gross
cash flows are adjusted for monetary gains and (losses) as well as a non-LIFO
inventory adjustment.
Step 1: Calculate Gross Cash Flows and express this amount in
current dollars (adjusted for inflation). Non cash items such as depreciation
are added back, interest on debt is reversed out since cost of capital is
ignored, and payments on operating leased assets are reversed out since off
balance sheet assets are included in capital.
Net Income
$ 41,000
Depreciation
20,000
Interest Expense 6,000
Rental Expense 6,000
+ / - Monetary Holding Gain (Loss) (3,000)
Gross Cash Flows in Current Dollars
$ 70,000
Step 2: Calculate Gross Assets (Capital) and express this
amount in current dollars (adjusted for inflation).
Monetary Current Assets
$ 161,000
Less Non Interest Current Liabilities ( 84,000)
Net Monetary Assets 77,000
Inventories
68,000
Adjust Inventories to Current $ 49,000
Land 9,000
Adjust Land to Current $ 3,000
Non Capitalized Assets in Current $ 206,000
Gross Plant Assets 348,000
Adjust Gross Plant to Current $ 106,000
Leased Property 66,000
Capitalized Assets in Current $ 520,000
Total Gross Assets in Current $
$ 726,000
Summary: Cash Inflows are $ 70,000 per year over 15 years +
residual value of $ 206,000 for non-capitalized assets. Outflows are $ 726,000
for capital deployed (gross assets).
Step 3: Calculate CFROI like you would calculate Internal
Rate of Return; i.e. the rate where inflows ($ 70,000 & $ 206,000) equals
outflows ($ 726,000). We can use a Microsoft Excel Spreadsheet to solve for
CFROI.
Enter -726,000 in cell A1 followed by +70,000 in cells A2
through A15 and finally enter +276,000 (70,000+206,000) in cell A16. Enter the
IRR function in cell A17 as =irr(a1:a16) and Excel calculates a CFROI of 6.73%.
