Accounting Rate of Return vs. Economic Rate of Return

The accounting rate of return (ARR) has traditionally been used as a surrogate for the economic rate of return (IRR) in evaluating the effectiveness of managements' capital investment decisions. Over the years, some question has been raised as to the validity of using the ARR as an approximation of the IRR. Several papers have recently come to grips with this question with varying degrees of success. This paper is intended to expose the conceptual differences between these rates of return, with the goal of clearly pointing out just how useful the ARR can be to management.     

An Empirical Study of the Adoption of Sophisticated Capital Budgeting Practices and Decision-Making Effectiveness

This paper examines the trend towards greater sophistication in investment selection techniques and control processes, and their impact on capital budgeting decision effectiveness. Based on a sample of 100 large UK firms, the study examines the capital budgeting practices employed over an 11-year period. Very significant increases in the uptake of sophisticated investment methods are reported, particularly in the analysis of project risk. These developments are partly explained by the rapid developments in computing within capital budgeting. Clear evidence is found to suggest that senior finance executives believe that the adoption of sophisticated investment practices gives rise to improved effectiveness in the evaluation and control of large capital projects.     

The Role of Payback in the Investment Process

This study examines the use of the payback (PB) method as a means of evaluating a proposed asset's risk and its joint application with profit-oriented capital budgeting models. Previous research studies indicating a linkage between the PB method and risk analysis are reviewed. A certainty-equivalent model is used to demonstrate this relationship and the properties of the relationship exploited by PB when used as a heuristic. Results of the analysis indicate that using a hurdle PB as a filter for identifying proposals with acceptable risk and return attributes is consistent with more quantitatively oriented investment techniques under certain conditions. The study then examines the conceptual relationship between PB and profit-oriented capital budgeting models. Results suggest that PB and profit-oriented capital budgeting techniques measure different attributes of an investment and complement one another in describing and analysing its cash flows.     

A Simulation-Based Investigation of Errors in Accounting-Based Surrogates for Internal Rate of Return

Accounting-based measures of a firm's ex post performance represent accessible, albeit imperfect, surrogates for its internal rate of return (IRR). Using a cross-sectional data set obtained via computer simulation, this study calculated the error with which the accounting rate of return (ARR) and conditional estimate of internal rate of return (CIRR) estimate IRR. The study compared the error with which both surrogates measure IRR, as well as the ability of growth in unit demand (gD), inventory cost flow assumption (INV) and depreciation method (DEP) to explain the measurement error in both surrogates.     

Accounting and economic rates of return: Additional Australian evidence

The key issue addressed in my paper is whether accounting rate of return (ARR) performs as an effective monitoring surrogate for internal rate of return (IRR). Financial information derived from a sample of 44 Australian corporations between 1968 and 1990 was utilized to accomplish this objective. The Kelly-Tippett (1991) technique was employed to analyze the data set. Results confirm earlier work in the area in that the ARR was found to be an unreliable substitute for the IRR.     

The practice of investment valuation in emerging markets: Evidence from Argentina

This paper discusses the challenges of applying traditional valuation techniques to emerging markets, and reports on how CFOs, financial advisors and private equity funds meet those challenges in Argentina, a major Latin American emerging economy. On many fronts, our findings show that there is substantial alignment with U.S. valuation practices. We find that: (a) discounted cashflow techniques like NPV, IRR and payback are very popular among corporations and financial advisors; (b) the CAPM is the most popular asset pricing model, yet it is frequently modified to account for country-specific risk; (c) capital budgeting analyses are performed in U.S. dollars by non-dollar companies; (d) financial advisors tend to apply U.S. betas to the emerging market, yet they rarely adjust betas for cross-border asymmetries; and (e) corporations tend to disregard the effects of small size and illiquidity. We provide tentative explanations for our findings.     

Accounting Returns Revisited: Evidence of their Usefulness in Estimating Economic Returns

Accounting information is used for measuring firm performance in various financial applications—a practice supported by empirical studies demonstrating the value relevance of accounting numbers, but disputed by theoretical papers arguing that a firm's accounting rate of return (ARR) serves poorly as a proxy for its internal rate of return (IRR). We derive a new model of the ARR–IRR relation, and describe how the conservatism of GAAP constrains a firm's IRR to fall in a range bounded by its historical growth rate and ARR. Using cross-sectional data, we demonstrate that economic returns can be estimated from accounting numbers for many firms. We link empirical results to underlying economic theory, and thus contribute to understanding why accounting information is value relevant.     

Conservatism, growth, and return on investment

Return on Investment (ROI) is widely regarded as a key measure of firm profitability. The accounting literature has long recognized that ROI will generally not reflect economic profitability, as determined by the internal rate of return (IRR) of a firm’s investment projects. In particular, it has been noted that accounting conservatism may result in an upward bias of ROI, relative to the underlying IRR. We examine both theoretically and empirically the behavior of ROI as a function of two variables: past growth in new investments and accounting conservatism. Higher growth is shown to result in lower levels of ROI provided the accounting is conservative, while the opposite is generally true for liberal accounting policies. Conversely, more conservative accounting will increase ROI provided growth in new investments has been “moderate” over the relevant horizon, while the opposite is true if new investments grew at sufficiently high rates. Taken together, we find that conservatism and growth are “substitutes” in their joint impact on ROI.     

USING BAYESIAN BETAS TO ESTIMATE RISK RETURN PARAMETERS: AN EMPIRICAL INVESTIGATION

Since its original development by Sharpe (1964), the Capital Asset Pricing Model (CAPM) has been the focus of great interest, practical usage, modifications, testing, and controversy. The basic hypothesis of the CAPM is that the minimum expected return required by investors on any asset will equal the risk-free rate plus a premium for the asset's contribution to the variance risk of a diversified portfolio as measured by the asset's beta. The model is often utilized by investors to calculate the relevant risk and required return on an asset, while corporate officers widely employ the theory to compute the appropriate discount rate to use in estimating the net present value of capital budgeting projects when evaluating spending decisions (Gitman and Mercurio, 1982).     

The Role of Real Options in Capital Budgeting: Theory and Practice1

Most discussions of capital budgeting take for granted that discounted cash flow (DCF) and real options valuation (ROV) are very different methods that are meant to be applied in different circumstances. Such discussions also typically assume that DCF is “easy” and ROV is “hard”—or at least dauntingly unfamiliar—and that, mainly for this reason, managers often use DCF and rarely ROV. This paper argues that all three assumptions are wrong or at least seriously misleading. DCF and ROV both assign a present value to risky future cash flows. DCF entails discounting expected future cash flows at the expected return on an asset of comparable risk. ROV uses “risk‐neutral” valuation, which means computing expected cash flows based on “risk‐neutral” probabilities and discounting these flows at the risk‐free rate. Using a series of single‐period examples, the author demonstrates that both methods, when done correctly, should provide the same answer. Moreover, in most ROV applications—those where there is no forward price or “replicating portfolio” of traded assets—a “preliminary” DCF valuation is required to perform the risk‐neutral valuation. So why use ROV at all? In cases where project risk and the discount rates are expected to change over time, the risk‐neutral ROV approach will be easier to implement than DCF (since adjusting cash flow probabilities is more straightforward than adjusting discount rates). The author uses multi‐period examples to illustrate further both the simplicity of ROV and the strong assumptions required for a typical DCF valuation. But the simplicity that results from discounting with risk‐free rates is not the only benefit of using ROV instead of—or together with—traditional DCF. The use of formal ROV techniques may also encourage managers to think more broadly about the flexibility that is (or can be) built into future business decisions, and thus to choose from a different set of possible investments. To the extent that managers who use ROV have effectively adopted a different business model, there is a real and important difference between the two valuation techniques. Consistent with this possibility, much of the evidence from both surveys and academic studies of managerial behavior and market pricing suggests that managers and investors implicitly take account of real options when making investment decisions.     

On the validity of accounting rates of return in cross-sectional analysis: Theory, evidence, and implications

This paper reports the results of an empirical examination of the relationship between firm accounting rate of return (ARR) and firm internal rate of return (IRR). The evidence presented shows that some of the analytically derived properties of the ARR-IRR relationship hold in a sample of U.S. manufacturing firms. This evidence can be interpreted as documenting the existence of a potentially important degree of measurement error in the ARR for a sample of actual firms and increases the credibility of those who have questioned the use of accounting rates of return as the dependent variable in cross-sectional studies of firm profitability.     

Capital Allocation in Financial Firms

This paper develops a theory of capital allocation in financial intermediaries where the cost of "risk capital" is a critical consideration. The implication for capital budgeting is that financial firms should use a modified NPV rule in which projects are valued by calculating the NPV of cash flows using marketdetermined discount rates and then subtracting a deadweight cost of capital that reflects the project's marginal contribution to firm-wide risk.
By taking account of deadweight costs—mainly monitoring and moral hazard costs associated with having too little equity capital as well as "free cash flow" agency costs and higher taxes associated with having too much—the capital allocation model predicts that financial firms will diversify across businesses with similar deadweight costs. Such diversification reduces the cost of risk capital for the individual businesses, thereby creating more profitable investment opportunities at the margin and enabling the businesses to operate on a larger scale. The authors note that their model has similarities to but also important differences from the standard applications of RAROC models.     

Risk-Adjusted Discount Rates and Projects of Unequal Lives

When evaluating mutually exclusive projects of unequal lives and with differing risk, standard approaches such as the constant chain of replacement, lowest common multiple and equivalent annual value techniques are usually applied. In using these techniques to rank projects, a critical issue is the manner in which uncertainty in the cashflows is resolved through time. We explore the applicability of net present value techniques to the problem of valuing assets with unequal lives, emphasising the use of equivalent annual value and lowest common multiple methods, and the correct choice of discount rate. Our results have direct application to practical capital budgeting problems such as choosing the optimum lifespan for a single asset, choosing between assets with different lifespans, and deciding whether to "run an asset for another year".     

Investment appraisal practices: A comparative study of conventional and Islamic financial institutions

This paper compares the use of capital budgeting techniques of conventional and Islamic financial institutions, using data obtained from a survey of 105 conventional and Islamic financial institutions. Our main aim is to analyze the use of capital budgeting and risk techniques by the two types of financial institutions from a comparative perspective to see whether prohibition of riba makes a difference. Standard difference-of-means tests of the mean scores methods were used to test the hypotheses of the study. The results reveal a number of important conclusions. First, discounted cash flow techniques are found to be more widely used by financial institutions, and among those techniques internal rate of return is the most common. Second, Islamic financial institutions are found to adopt traditional methods that do not comply with the principles of Islamic Sharia'a. Third, a huge gap is found between the theory base of Islamic institutions and some of the practices of those institutions. Fourth, firms' characteristics, such as size, listing status, sources of revenue and government ownership, have some impact on their decisions to adopt capital budgeting criteria, methods of estimating costs of capital and risk. Finally, the decisions to select particular capital budgeting techniques, cost of capital estimation methods, and risk assessments are partly related to the characteristics of the chief financial officers.     

Can happiness predict future volatility in stock markets?

In this paper, we use the Twitter based happiness index as a proxy for investor sentiment in order to examine whether happiness influences future market volatility of country VIX indexes. Our sample includes the major stock markets of the USA, Canada, UK, Germany, France, Netherlands, Switzerland, Japan, China, Hong Kong, India, Brazil, South Korea, and South Africa. Using linear and nonlinear causality tests, we find that Twitter happiness significantly causes the future volatility of the sample countries. The robustness checks show no divergence from our primary findings and provide strong evidence of a nonlinear relationship between investor sentiment and future stock market volatility.     

Capital budgeting techniques and firm specific contingencies: A correlational analysis

By combining analytic developments in the financial theory of capital budgeting with contingency theory, an empirically testable contingent theory for DCFT (discounted cash flow techniques) was constructed. This theory was tested by correlating an effectiveness measure for DCFT, based on stock return data of the sample firms, with hypothesized contingent variables, measured via interview and questionnaire. The results indicated positive correlations between the effectiveness of DCFT and predictable environments, the use of long-term reward systems, and the degree of decentralization of the capital budgeting process.     

The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom

We report the results of a survey of capital budgeting techniques used by United Kingdom firms. Where possible, the evidence is combined with data collected over a 22 year period to provide a basis for the discussion of causes of trends. We observe that there has been a substantial narrowing of the theory-practice gap in the use of project appraisal methods. The gap has also narrowed in other areas: the analysis of risk, inflation adjustment, capital budget preparation, WACC calculation and post-auditing. However, there are other elements of capital budgeting theory, e.g. probability and beta analysis which have been adopted by very few practising managers. We also discuss non-economic projects, capital rationing and hurdle rates.     

What is an Investment Project's Implied Rate of Return?

How to measure a project's implied rate of return has long been an unresolved problem, except for some special cases. This paper derives return on present cost (ROPC) as the correct measure of an investment project's implied rate of return. The IRR is a biased measure except for projects classified as simple projects, and this bias is likely to be substantial in many real‐world applications. Thus while net present values should be used to determine whether to accept/reject projects, I recommend that analysts use ROPC in place of the IRR as a measure of a project's true rate of return.     

THE CAPITAL BUDGETING BEHAVIOUR AND CORPORATE CHARACTERISTICS OF CAPITAL-CONSTRAINED FIRMS

This paper addresses (1) the nature and pervasiveness of organisational constraints, frnancial and otherwise, on investment, and (2) the corporate characteristics and capital budgeting behaviour of capital-constrained firms for a sample of 126 UK companies. The results indicate that corporate size, risk and profitability are important corporate characteristics in this regard, and that financially-constrained firms tend to adopt naive capital budgeting methods in resolving the capital rationing problem.