Capitalizing Expensed Investments  471
Note that for PharmaCo’s historical years, free cash flows cannot change 
when R&D expenses are capitalized (see Exhibit 24.4). The amortization is a 
noncash charge in NOPAT and is added back to calculate gross cash flow. This 
effectively moves R&D expenses from gross cash flow to investments, leaving 
free cash flow unchanged.
Based on the new measures for invested capital, with capitalized R&D 
investments and for NOPAT with R&D amortization instead of expenses, 
we derive an adjusted ROIC. The adjusted ROIC with R&D capitalized rep-
resents PharmaCo’s return on capital, including intangible investments. It 
can be compared with an unadjusted ROIC with R&D expensed, as shown 
in Exhibit 24.5. Because the R&D asset lifetime was estimated at eight years, 
at least as many years of constant growth must elapse for capital and ROIC 
to reach a steady state and provide a meaningful indication of true economic 
returns. As Exhibit 24.5 shows, the adjusted ROIC computed on total capi-
tal stabilizes at around 9.5 percent, dramatically lower than the 33 percent 
ROIC derived from the unadjusted financial statements. As long as the R&D 
investments needed to support earnings remain unchanged, PharmaCo’s 
adjusted ROIC is the better estimate of its true economic return and under-
lying performance.6
One of the key assumptions made in capitalizing intangible investments is 
the asset lifetime. Although it may be hard to come up with an accurate estimate, 
this should not keep you from capitalizing the R&D expenses. Asset lifetime 
has less impact on ROIC than you might expect. In the PharmaCo example, we 
EXHIBIT 24.4  PharmaCo: Free Cash Flow
$ million
R&D expensed, unadjusted
2017
2018
2019
2020
NOPAT
121
125
129
133
Depreciation
37
38
39
40
Gross cash flow
158
163
168
174
Capital expenditures
(48)
(49)
(51)
(52)
Free cash flow
110
114
118
122
R&D capitalized
2017
2018
2019
2020
Adjusted NOPAT
186
189
192
195
Depreciation
37
38
39
40
Amortization of R&D
177
185
193
200
Gross cash flow
400
412
424
436
Capital expenditures
(48)
(49)
(51)
(52)
Investment in R&D
(242)
(248)
(255)
(262)
Free cash flow
110
114
118
122
6 That is, ROIC is the better estimate of the investments’ value creation, as explained in Chapter 25.

472  Measuring Performance in Capital-Light Businesses
assumed an asset life of eight years. In Exhibit 24.6, we stress-test this assump-
tion by varying asset life between two and 12 years. Even an asset life of just two 
years dramatically reduces PharmaCo’s ROIC from 33 percent when R&D is ex-
pensed to 16 percent when it is capitalized. Increasing the asset life continues to 
lower ROIC, but by smaller amounts as asset life increases. So choosing an asset 
life of 12 rather than eight years (a reasonable range for the life of most R&D 
EXHIBIT 24.5  PharmaCo: ROIC, 1997–2020
%
–60
–40
–50
–30
–20
–10
0
10
20
30
40
2002
2007
2012
2017
R&D expensed
R&D capitalized
1997
EXHIBIT 24.6  PharmaCo: ROIC at Different Estimates of R&D Asset Lifetime, 2020
%
R&D = 10% of revenues
R&D = 20% of revenues
33.0
33.0
20.6
16.1
15.9
10.4
12.5
9.4
11.9
9.1
11.5
8.9
12
10
8
6
4
2
0
R&D asset lifetime, years
11.8
13.7