Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 11 Figure 6: Components of Invested Capital Using invested capital as “net assets” to determine capital adequacy presents considerable advantages, yet its weaknesses should also be considered (Table 1). Table 1: Strengths and Weaknesses of Net Assets Measured with the Invested Capital Alternative Strengths Weaknesses ▪ Accounting value is easy for outsiders to validate ▪ Provides links to many traditional performance metrics such as return on invested capital ▪ Can help to present to stakeholders the robustness of balance sheet ▪ May not reflect true economic value of assets available (i.e., market value) ▪ May not take into account the value of “intangibles” such as R&D, patents, trademarks, copyrights, brand names, human capital, distribution channels, and processes ▪ Is fairly static to changes in the marketplace and company performance 2.2 Alternative 2: Net Assets Based on Estimated Market Value The alternative approach is to estimate the expected present value of cash flows based on the earning power of the assets. This can be done by estimating the expected cash flows from the assets and then discounting back to the present. There may be some significant embedded options that influence the behavior and absolute level of cash flows. These options are most likely driven by market, operational/operations, and credit risks. These risks and modeling their impact are discussed later in this document and were discussed in Section IV – Risk Capital of the CCRO “Valuation and Risk Metrics” white paper, released in November 2002. Table 2 weighs the strengths and weaknesses of this alternative method. Total Capital Invested in the Company, Shareholders, and Creditors Net Assets Other Long-term Assets Net PP&E Operating Working Capital Long-term Risk Management Assets or Liabilities Short-term Book Value Non-interest- bearing Credit Liabilities Operating Current Assets Short-term Risk Management Liabilities Short-term Risk Management Assets Other ST Liabilities Accrued Expenses Margins Accounts Payable Other Cash Margins Inventories Accounts Receivable