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Abstract
Literature and textbooks on capital budgeting endorse net present value (NPV) and generally treat accounting rates of return as not being reliable tools. This paper shows that accounting numbers can be reconciled with NPV and fruitfully employed in real-life applications. Focusing on project finance transactions, an average return on investment (AROI) is drawn from the pro forma financial statements, obtained as the ratio of aggregate income to aggregate book value. We show that such a metric correctly captures a project's economic profitability, as long as it is compared with a comprehensive weighted average cost of capital (WACC) that includes a correction factor that takes account of the capital foregone by the investors. In contrast to the internal rate of return, AROI is unique, and we provide an explicit functional relation that links it to the NPV. The approach holds for levered and unlevered projects, constant and non-constant leverage ratios, and constant and non-constant WACCs.
Acknowledgments
The author thanks two anonymous reviewers and the Associate Editor who provided constructive comments for revising the paper. The author also wishes to sincerely thank Ken Peasnell for help and suggestions in the final revision.
Notes
1 See Küpper (Citation2009), who fruitfully combines an investment-based approach with cost accounting to connect long-term with short-term decisions.
2 The ways in which accounting rates of return might be used in project appraisal and the pitfalls in doing so have been extensively examined in the literature (see Danielson and Press, Citation2003; Fisher & McGowan, Citation1983; Kay, Citation1976; Peasnell, Citation1982a, Citation1982b, Citation1996; Rajan, Reichelstein, & Soliman, Citation2007; Stark, Citation2004).
3 O'Hanlon and Peasnell (Citation2002) use a different name: unrecovered capital.
4 This excess return is a comprehensive capital charge for the project income: ‘comprehensive’ in the sense that it takes account of the capital given up by the investors. Equation (5) is, as a matter of fact, a ‘residual’ income, which is called lost-capital residual income (see Magni, Citation2009, Citation2010 for a theoretical investigation).
5 Note that the comprehensive cost of capital incorporates information on both exogenous factors (market rate) and endogenous ones (book values).
6 Note that the AROI is just the weighted average of the investment AROI and the financing AROI: . Analogously,
7 It is worth noting that the associated cost of capital is where α
t
is redefined as
. The difference
is just the (accumulated value of the) well-known profitability index.
8 For a more reliable account of the robustness of a project to changes in its drivers, a serious sensitivity analysis is needed (see Borgonovo, Gatti, & Peccati Citation2010).
9 A case that is commonly made for cash flows is that they are objectively determinable, whereas accounting profit and book value require judgment and allocations that are vulnerable to manipulation and management. This is clearly a problem in financial reporting. However, the situation in project appraisal is subtly different. Here, cash flows are not objectively determinable; they must be inferred from forecasts of sales and costs (i.e. from accounting magnitudes). Equation (2) represents this inferential process by specifying cash flows as being derived from the accounting estimates. In particular, in project financing transactions, the accuracy of the estimation process is guaranteed by the fact that several parties intervene in the complex task of estimating the key input variables and building up the pro forma financial statements. Owing to the availability of such financial statements to all the parties involved in a project financing transaction (equity holders, creditors, technical advisors, auditors), the same accounting numbers can be used to derive the AROI and the cash flows (and, therefore, the NPV).
10 See Magni (Citation2013) for a compendium of 18 problems plaguing the IRR.
11 Evidently, due to the nature of the reporting, which reports profitability in the last period, the condition can be replaced by a condition on the last period:
.