Return on invested capital or ROIC is an important output of a merger model The generic definition says you take NOPAT divided by your invested capital NOPAT is our net operating profit after tax and the tax rate we've adjusted by is the effective tax rate Because we're applying it to all of our profits You're invested capital is all of your sources of finance or alternatively the capital employed Now the rule of thumb with ROIC is that you compare it to the WACC If your ROIC equals the WACC then fantastic, your company is making a return equal to that required by your financiers If your ROIC is greater than the WACC, all the better It changes slightly in a merger context, we start here with the NOPAT of the target But you then add on synergies post tax, because that's the improvement in your post tax To note here, we're going to use your synergies adjusted at your target's marginal tax rate (not your effective tax rate) Why? Because we're applying the tax rate to an item that makes a marginal different to your profits Whereas before on the left hand side, we were applying a tax rate to all of our profits You then divide that by your transaction invested capital, that's your acquisition enterprise value plus any transaction costs The rule of thumb is quite similar You compare your transaction ROIC to the target's WACC Let's have a look at this using some numbers Here we've got a target EBIT at the top and in year 1 that's 100 We've also got synergies pre tax of 10 So we start by calculating the NOPAT at your effective tax rate And that is the EBIT of 100 Take 30% off, gives you NOPAT of 70 We then need to take those synergies pre tax of 10 and tax them. And we're going to tax them at the marginal tax rate In this case it's 35%, so the synergies of 10 become synergies post tax 6.5 So my adjusted NOPAT is now the NOPAT of 70 plus the synergies post tax, gives me an adjusted NOPAT of 76.5 We then need to calculate the invested capital and we start off with 1,000 at the deal date and that's your acquisition EV plus transaction fees What then happens in year 1? Well we're going to be calculating ROIC on the average invested capital, so I want my invested capital from last year of 1,000 And the from the end of year 1 In year 1, we start with the beginning invested capital of 1,000 and we then ask does it go up or down? Well it goes down due to depreciation, we've lost some of the value of that invested capital. But it then goes back up again due to capex And in this case, an increase in OWC A useful source of all of these items is from the cash flow statement, however we do need to note that the signs of these operational investments are reversed from the cash flow statement That gets me to invested capital at the end of year 1 to 1,150 I then take my average invested capital, the average of the 1,000 and the 1,150 Divide it into the adjusted NOPAT and that gets me my ROIC In year 1, 7.1% If I compare that to the WACC of 7.5%? Oh dear, it's the wrong way round We'd really want that ROIC to higher than the WACC. So if I basing my deal purely on year 1, I'd have to say the deal was off However, I'm being a little bit quick here. Because if we look at year 2, the ROIC improves and it's above the WACC Same in year 3, in fact it's improved even more If we look further up the page, we can see the reason for this and a primary reason is that the synergies pre tax have improved from 10 to 30 in year 2, to 50 in year 3 You might also notice that the EBIT has been improving as well