Accounting and economic measures:An integrated theory of capital budgeting
AbstractAccounting 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 InfoPaper 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.
Length: pages 49
Date of creation: Dec 2009
Date of revision:
Capital budgeting; accounting rate of return; economic yield; internal rate of return; residual income; net present value; average; Chisini mean; cost of capital;
Other versions of this item:
- Carlo Alberto Magni, 2009. "Accounting and economic measures: an integrated theory of capital budgeting," PROYECCIONES FINANCIERAS Y VALORACION 005983, MASTER CONSULTORES.
- M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- M52 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
This paper has been announced in the following NEP Reports:
- NEP-ACC-2009-12-11 (Accounting & Auditing)
- NEP-ALL-2009-12-11 (All new papers)
- NEP-CFN-2009-12-11 (Corporate Finance)
- NEP-PPM-2009-12-11 (Project, Program & Portfolio Management)
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