An average-based accounting approach to capital asset investments: The case of project finance (Working Paper)

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. 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

ROI and profitability index: A note on managerial performance

This note deals with the case of a principal (e.g., a firm\u2019s board of directors) which delegates execution of an economic activity to a business unit (or a subsidiary firm) managed by a manager. It is assumed that the manager has no control over the cash flows injected into the unit or withdrawn from it: such decisions are made by the principal. The principal aims at measuring the manager\u2019s performance in a given interval of time. Neither the Net Present Value (NP V ) nor its companion Net Terminal Value (NT V ) are appropriate measures for this purpose, because they depend on the cash flows injected and withdrawn by the principal. We introduce the manager\u2019s profitability index (MP I), which is invariant under changes in the cash flows, so neutralizing the effect on value creation of the principal\u2019s decisions. We also break down the project\u2019s NT V into two components, which measure the manager\u2019s contribution and the principal\u2019s contribution to value creation