The Measurement of Corporate Rates of Return: A Generalized Formulation
Volume: Volume 2, No. 2
Issue: Autumn 1971
Pages: pp. 434-469
Authors: Thomas R. Stauffer
Title: The Measurement of Corporate Rates of Return: A Generalized Formulation
Abstract:
General conditions are derived under which accounting ratios, such as the
conventionally defined accounting rate of return, deviate from the economic
rate of return for a firm. Cash revenue streams of arbitrary time-shape,
non-depreciable capital, and corporate income taxes are considered. The sign
and magnitude of the bias in the accounting rate of return depend upon the
depreciation schedule, the revenue timestream, the firm's growth rate, and its
capital structure.
There exists a unique depreciation schedule for which the accounting rate of
return is unbiased. However, where the firm's capital structure involves
working capital, "exact" depreciation yields a biased accounting rate of
return. Thus accounting and economic criteria are irreconcilable unless an
intuitively unattractive generalization of "depreciation" for financial assets
is introduced.
Where pretax and taxable income differ, the error in the accounting rate of
return may no longer converge to zero as the growth rate increases. Regulated
utilities and mining companies are particularly susceptible to this error
component.