Closing Thoughts  465 this may seem inconsistent for a company with pensions, it is not. We have eliminated pensions from free cash flow and the cost of capital, and there is no reason to reintroduce pensions, or the risk associated with them, into the value of operations. Instead, value pensions separately, and sum the parts. Incorporating Pensions into the Value of Equity Pension plans and other obligations, such as promised medical benefits, will affect a company’s value in two ways. First, service cost will be embedded within free cash flow. Since only cash contributions and not service costs are tax deductible, make sure to adjust taxes appropriately for companies that systematically underfund their obligations. Not every country provides tax relief on pension contributions, so check local tax law to determine the mar- ginal tax rate for contributions. Second, past over- or underfunding must be incorporated into value as a nonoperating asset or debt equivalent. For an ongoing enterprise, excess pension assets can be netted against unfunded liabilities to determine net assets (or liabilities) outstanding. If the company is being valued for liquidation or the pension plan is being termi- nated, net unfunded liabilities cannot be netted against excess pension assets, as most countries charge a significant penalty for withdrawing excess funds from pension plans. Instead, add after-tax excess pension assets at the penalty rate, and deduct after-tax unfunded pension liabilities at the marginal tax sav- ings for pension contributions. To value companies with net unfunded liabilities, reduce enterprise value by the product of (1 – marginal tax rate) times net pension liabilities. To incor- porate pensions for a company with net excess assets, increase enterprise value by the product of (1 – marginal tax rate on pensions) times net pension assets, as excess pension assets will lead to fewer required contributions in the future. In 2018, Kellogg recognized $440 million in unfunded pension liabilities and $71 million in prefunded other benefits (see Exhibit 23.1), for a net total liability of $369 million. Assuming a marginal tax rate of 24 percent, the after- tax liability equals $280 million. To determine equity value, deduct the after- tax liability from enterprise value. Closing Thoughts The International Accounting Standards Board and the U.S.-based Financial Ac- counting Standards Board have worked to eliminate the distortions caused by pension accounting. For most companies, the income statement now separates service cost from nonoperating pension expenses, and the balance sheet recog- nizes the market value of unfunded pension obligations. The result is better bench- marking, requiring fewer adjustments, and a valuation that is easier to carry out. 467 24 Measuring Performance in Capital-Light Businesses In this book, our primary measure of return on capital is return on invested capital (ROIC). We define ROIC as net operating profit after taxes (NOPAT) divided by invested capital. We derive ROIC from items on a company’s fi- nancial statements, with some adjustments, such as separating operations from financing and separating operating items from nonoperating items.1 ROIC correctly reflects return on capital in most cases, but special circum- stances require alternative measures. For example, a young biotech company could spend a billion dollars on research and development (R&D) before its product is launched. Since R&D is expensed, not capitalized, the company would show a negative ROIC in its early years and a very high ROIC once the product is launched. The actual economic return on capital over the life of the product would lie at some average level in between. In this chapter, we show how to deal with such investments in R&D and in marketing and sales that are expensed when they are incurred. Creating pro forma financial statements that capitalize these expenses can provide more insight into the underlying economics of a business. In addition, we discuss businesses with very low capital requirements, where we recommend using eco- nomic profit or economic profit scaled by revenues to measure return on capital. Capitalizing Expensed Investments When a company builds a plant or purchases equipment, it capitalizes the asset on the balance sheet and depreciates it over time. Conversely, when a company invests in intangible assets such as a new production technology, a brand name, or 1 In Chapter 11, we explain why we use ROIC instead of other accounting-based metrics like return on equity (ROE) or return on assets (ROA).