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An average-based accounting approach to capital asset investments: The case of project finance (Working Paper)
Full text linkLiterature 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. It is shown 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 that includes a correction factor which takes account of the capital foregone by the investors. Contrary to the Internal Rate of Return, AROI is unique and we provide an explicit functional relation which links it to the NPV. The approach holds for levered and unlevered projects, constant and non-constant leverage ratios, constant and non-constant WACCs
Internal rates of return and shareholder value creation
No full textWe propose a genuinely internal approach to project valuation and decision based on the average Return On Investment (ROI), obtained as the ratio of total operating profit (NOPAT) to total invested capital or, equivalently, as the ratio of net cash flow to total invested capital. The approach presented enables decomposing the economic value created into the project scale (total capital invested) and the economic efficiency, obtained as the difference between average ROI and a suitably adjusted weighted average cost of capital (WACC). We show that a project’s average ROI is equal to the weighted mean of the average Return On Equity (ROE) (total net income divided by total equity capital) and the average Return On Debt (ROD) (total interest expenses to total debt outstanding) and show that the average ROE itself correctly measures shareholder value creation when compared with a suitably adjusted cost of equity. We show that the internal average-based approach presented is also valid under the more general assumption of time-varying cost of capital
The Use of NPV and CAMP for Capitai Budgeting Is Nota Good Idea. A Reply to De Reyck (2005)
Full text linkAggregate return on investment for investments under uncertainty
No full textThis paper deals with capital budgeting decisions under uncertainty. We present an Aggregate Return On Investment (AROI), obtained as the ratio of total (undiscounted) cash flow to total invested capital and show that it is a genuine rate of return which, compared with the risk-adjusted cost of capital, correctly signals wealth creation. For choosing between two mutually exclusive projects, we derive an incremental AROI and an incremental risk-adjusted cost of capital, by means of which two unequal-risk projects can be correctly compared. Iterating the incremental procedure, we show that the AROI approach correctly ranks any bundle of different-risk competing projects. Relations with other criteria such as Modified Internal Rate of Return, Average Internal Rate of Return, Cash Multiple, and Profitability Index are provided.
Theoretically, the AROI approach constitutes a link between arbitrage choice theory and corporate investment theory, and shows that explicit discounting is not necessary for measuring economic profitability.
Practically, the AROI is a user-friendly, easy-to-compute rate of return derived from the same set of data required by the net present value (NPV). Also, it does not incur the difficulties met by the internal rate of return: in particular, it is unique and it is based on economically significant capital values (i.e., market-driven values). As such, the AROI significantly expresses the efficiency of the project's invested capital
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