Capitalizing Expensed Investments  469
computed directly from the balance sheet. But this ROIC does not represent the 
company’s true economic performance, because the invested capital includes only 
purchased capital and not the intellectual capital created internally from R&D.
To estimate ROIC with capitalized investments in R&D, use the following 
three-step process:
1. Capitalize and amortize the R&D asset, using an appropriate asset lifetime.
2. Adjust invested capital upward by the historical cost of the R&D asset, 
net of cumulative amortization.
3. Adjust NOPAT by replacing R&D expense with R&D amortization. (Do 
not adjust operating taxes.)
To capitalize the R&D asset, choose a starting year, and begin accumulat-
ing R&D expenses. Choose the earliest year feasible, as the model requires 
accumulated R&D to reach a steady state before the adjusted ROIC calcula-
tion becomes meaningful. Exhibit 24.2 starts in 1995, assuming straight-line 
amortization and an eight-year R&D asset life. PharmaCo spent $22 million 
on R&D in 1995, which we capitalize and add to invested capital and start to 
amortize in 1996. By adding R&D expenses to the prior year’s net asset value 
and then deducting amortization charges in each year, we arrive at a capital-
ized R&D asset base of $1,666 million in 2020.4
To adjust invested capital for the intangible investments, add the capital-
ized R&D asset to invested capital. On this basis, PharmaCo’s total capital 
amounts to $2,070 million in 2020, most of it in the form of capitalized R&D.5
EXHIBIT 24.1  PharmaCo: Reorganized Financial Statements
$ million
Partial income statement
2015
2016
2017
2018
2019
2020
Revenues
1,045
1,077
1,109
1,142
1,176
1,212
Fixed at 60% 
of revenues
Cost of sales
(627)
(646)
(665)
(685)
(706)
(727)
R&D expense
(229)
(235)
(242)
(248)
(255)
(262)
Operating profit
189
195
202
208
215
222
Taxes
(76)
(78)
(81)
(83)
(86)
(89)
NOPAT1
113
117
121
125
129
133
Partial balance sheet
2015
2016
2017
2018
2019
2020
Fixed at 3 times 
capital turnover
Invested capital
348
359
370
381
392
404
NOPAT/revenues, %
10.9
10.9
10.9
10.9
11.0
11.0
ROIC, %
32.6
32.7
32.8
32.8
32.9
33.0
1 Net operating profit after taxes.
4 In this example, for illustration purposes, we approximate amortization at 10 percent of the preceding 
year’s ending balance. Advanced models use straight-line amortization of actual R&D expense.
5 If we add capitalized R&D to operating assets, total funds invested will no longer balance. To balance 
total funds invested, add capitalized R&D to equity equivalents. For more on total funds invested and 
their reconciliation, see Chapter 11.

470  Measuring Performance in Capital-Light Businesses
Adjust NOPAT by replacing R&D expense ($262 million in 2020) with R&D 
amortization ($200 million), computed as outlined in Exhibit 24.3. Operating 
taxes remain unchanged, because capitalization and amortization of R&D 
expense does not change taxable income for fiscal purposes. For PharmaCo, 
replacing R&D expense with amortization raises NOPAT in 2020 from $133 
million to $195 million. This is quite common for growth firms, as current 
R&D is typically higher than the amortization of historical R&D. As the com-
pany’s growth rate tapers off, however, amortization will catch up with ex-
pense, and NOPAT adjustments will be small.
EXHIBIT 24.2  PharmaCo: Capitalization of R&D
$ million
Estimated R&D asset lifetime: 8 years
Partial income statement
1995
1996
1997
2018
2019
2020
Revenues
10
22
43
…
1,142
1,176
1,212
R&D expense
(22)
(24)
(29)
…
(248)
(255)
(262)
Capitalized R&D asset
Capitalized R&D, starting
–
22
44
…
1,477
1,541
1,604
R&D expense
22
24
29
…
248
255
262
Amortization
-
(3)
(5)
…
(185)
(193)
(200)
Capitalized R&D, ending
22
44
67
…
1,541
1,604
1,666
Partial balance sheet
1995
1996
1997
2018
2019
2020
Invested capital, unadjusted
3
7
14
…
381
392
404
Capitalized R&D
22
44
67
…
1,541
1,604
1,666
Invested capital, adjusted
25
51
81
…
1,922
1,996
2,070
EXHIBIT 24.3  PharmaCo: NOPAT Adjusted for R&D Capitalization
$ million
2016
2017
2018
2019
2020
Revenues
1,077
1,109
1,142
1,176
1,212
Cost of sales
(646)
(665)
(685)
(706)
(727)
R&D expense
(235)
(242)
(248)
(255)
(262)
Operating profit
195
202
208
215
222
Operating taxes
(78)
(81)
(83)
(86)
(89)
NOPAT
117
121
125
129
133
Add back: R&D expense
235
242
248
255
262
R&D amortization
(168)
(177)
(185)
(193)
(200)
Adjusted NOPAT
184
186
189
192
195
ROIC, %
32.7
32.8
32.8
32.9
33.0
ROIC adjusted for R&D capitalization, %
10.4
10.1
9.8
9.6
9.4