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Accounting and economic measures:An integrated theory of capital budgeting

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  • Carlo Alberto Magni

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Abstract

Accounting measures are traditionally considered not significant from an economic point of view. In particular, accounting rates of return are often regarded economically meaningless or, at the very best, poor surrogates for the IRR, which is held to be “the” economic yield. Likewise, residual income does not enjoy, in general, periodic consistency with the project NPV, so residual income maximization is not equivalent to NPV maximization. This paper shows that the opposition accounting/economic is artificial and, taking a capital budgeting perspective, illustrates the strong (formal and conceptual) connections existing between economic measures and accounting measures. In particular, the average accounting rate of return is the correct economic yield of a project; the traditional IRR is (whenever it exists) only a particular case of it. The average accounting rate generates a decision rule which is logically equivalent to the NPV rule for both accept/reject decisions and project ranking. The paper also shows that maximization of the simple arithmetic mean of residual incomes is equivalent to NPV maximization, owing to its periodic consistency in the sense of Egginton (1995). Such an index may then be used for incentive compensation as well. Moreover, asset pricing may be interpreted in accounting terms as the process whereby the market determines the income impact on the assets’ value. As a result, the paper harmonizes the notions of accounting rate of return, internal rate of return, residual income, net present value: they are just different ways of cognizing the same notion. This conciliation stems in a rather natural way from three sources: (i) a fundamental accounting identity, which links income and cash flow in a comprehensive way, (ii) the definition of Chisini mean, (iii) a notion of residual income which takes account of the “real” (comprehensive) cost of capital.

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Bibliographic Info

Paper provided by Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi" in its series Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) with number 09121.

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Length: pages 49
Date of creation: Dec 2009
Date of revision:
Handle: RePEc:mod:wcefin:09121

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Web page: http://www.economia.unimore.it
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Keywords: Capital budgeting; accounting rate of return; economic yield; internal rate of return; residual income; net present value; average; Chisini mean; cost of capital;

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Cited by:
  1. C. Pederzoli & C. Torricelli, 2013. "Efficiency and unbiasedness of corn futures markets: new evidence across the financial crisis," Applied Financial Economics, Taylor & Francis Journals, vol. 23(24), pages 1853-1863, December.
  2. Elisabetta Gualandri & Valeria Venturelli, 2013. "The financing of Italian firms and the credit crunch: findings and exit strategies," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) 13101, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".
  3. Stefano Cosma & Elisabetta Gualandri, 2013. "The sovereign debt crisis: the impact on the intermediation model of Italian banks," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) 13102, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".
  4. Chiara Pederzoli & Costanza Torricelli, 2010. "A parsimonious default prediction model for Italian SMEs," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) 10061, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".

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