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{{Unreferenced, date=February 2007 Return of capital (ROC) refers to
principal Principal may refer to: Title or rank * Principal (academia) The principal is the chief executive and the chief academic officer of a university A university ( la, universitas, 'a whole') is an educational institution, institution of higher ...
payments back to "capital owners" (shareholders, partners, unitholders) that exceed the growth (net income/taxable income) of a business or investment. It should not be confused with Rate of Return (ROR), which measures a gain or loss on an investment. Basically, it is a return of some or all of the initial investment, which reduces the basis on that investment. The ROC effectively shrinks the firm's equity in the same way that all distributions do. It is a transfer of value from the company to the owner. In an efficient market, the stock's price will fall by an amount equal to the distribution. Most public companies pay out only a percentage of their income as dividends. In some industries it is common to pay ROC. *Real Estate Investment Trusts (REITs) commonly make distributions equal to the sum of their income and the depreciation (capital cost allowance) allowed for in the calculation of that income. The business has the cash to make the distribution because depreciation is a non-cash charge. *Oil and gas
royalty trust A royalty trust is a type of corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entity recognized by private and public law "born ...
s also make distributions that include ROC equal to the drawdown in the quantity of their reserves. Again, the cash to find the O&G was spent previously, and current operations are generating excess cash. *Private business can distribute any amount of equity that the owners need personally. *Structured Products (closed ended investment funds) frequently use high distributions, that include returns of capital, as a promotional tool. The retail investors these funds are sold to rarely have the technical knowledge to distinguish income from ROC. *Public business may return capital as a means to increase the debt/equity ratio and increase their leverage (risk profile). When the value of real estate holdings (for example) have increased, the owners may realize some of the increased value immediately by taking a ROC and increasing debt. This may be considered analogous to
cash out refinancing Cash out refinancing (in the case of real property In English common law, real property, real estate, realty, or immovable property is land which is the property Property (''latin: Res Privata'') in the Abstract and concrete, abstract i ...
of a residential property. *When companies spin off divisions and issue shares of a new, stand-alone business, this distribution is a return of capital.


Tax consequences

There will be tax consequences that are specific to individual countries. As examples only: *Governments may want to prevent the shrinking of the business base of their economy, so they may tax withdrawals of capital. *Governments may want to stimulate the exploration for O&G. They may allow companies to "flow-through" the exploration expense to the shareholders so it can be redeployed. *REITs may also flow through the depreciation expense they do not need to shareholders. It may be decades before the property is sold and taxes payable. It is better to give the excess cash and the tax write-off to the shareholders. *Since the ROC shrinks the business and represents a return of the investors' own money, the ROC payment received may not be taxed as income. Instead it may reduce the cost base of the asset. This results in higher capital gains when the asset is sold, but defers tax.


Example

You start a delivery business with one employee and one contract. Your initial investment of $12,000 goes to buy a vehicle. *The contract is for four years and pays you $7,000 each year. *The employee is paid $2,000 each year. *Gas to run the vehicle will cost $1,000 each year. *With perfect foresight the accountant knows the vehicle will die at the end of the four years, so he expenses it at $3,000 each year. At the end of each year: *Cash flow will be $4,000 (= 7,000-2,000-1,000). It is paid out to you. *Net income will be $1,000 (= 7,000-2,000-1,000-3,000). *The ROC is $3,000 (= cash received - net income) (= 4,000-1,000). At the end of four years: *You have received cash payments of $16,000 (= 4,000*4). *Total ROC payments equal $12,000 (= 3,000*4). *Total income payments equal $4,000 (= 1,000*4). *Your initial investment has been 100% recovered by the ROC (= 12,000-12,000). *Your vehicle is now dead and worth nothing.


Conclusions

*Cash flows do not measure income. They measure only cash flows. *Depreciation, depletion and amortization cannot be ignored as "non-cash expenses". They are valid allocations of a one-time cash flow over the time period that the asset helps generate revenues. *In the process of normalizing rates of return between different investment opportunities, ROC should not be included in the consideration of 'income' or 'dividends'.


Time value of money

Some people dismiss ROC (treating it as income) with the argument that the full cash is received and reinvested (by the business or by the shareholder receiving it). It thereby generates more income and compounds. Therefore, ROC is not a "real" expense. There are several problems with this argument. *No one is arguing that the income earned on the full cash flow reinvested is not additional real income. *If the original asset purchase had not been made, its cash cost would have been invested and earning returns in that same way. *If you consider that depreciation is an allocation of the original cost of the asset, then you must agree that
time value of money The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, ...
considerations make the original cost HIGHER than the sum of the subsequent ROC expenses not realized until many years in the future. *If you consider that depreciation measures the amount of cash that must be retained in order to finance the eventual replacement asset, then you must agree that the cost of that replacement will have increased in cost in the interim by inflation for that asset. Inflation (among other things) is the basis for the time-value-of-money.


See also

*
Recovery of capital doctrineIn United States tax law the recovery of capital doctrine protects a portion of investment receipts from being taxed, namely the amount that was initially invested. This is because the investor is receiving his or her own money which is being returne ...
*
Return on capital Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and ...
Financial ratios