Timo Salmi
Professor of Accounting and Business Finance

Ilkka Virtanen
Professor of Operations Research and Management Science

Measuring the Long-Run Profitability of the Firm: A Simulation Evaluation of the Financial Statement Based IRR Estimation Methods

Abstract

Four methods for estimating the firm's long-term profitability as the internal rate of return (IRR) of the firm's capital investments are revisited and evaluated using simulated financial statements. The methods of Kay, Ijiri-Salamon, Ruuhela and the averaged accountant's rate of return (ARR) are analyzed. Our findings indicate that the methods are disrupted by large deviations between the firm's growth and profitability, but in most cases they are insensitive to cyclical fluctuations and to major capital investment shocks. Kay's method fares marginally best in numerical performance, and it is theoretically very well founded. The average ARR method comes a close second. The Ijiri-Salamon method fares reasonably well numerically, but its error is unpredictable. Theoretically, it is the most ad-hoc of the methods. Ruuhela's method has a strong theoretical background, but when its strict assumption of steady state growth is violated, numerically it fares the worst. In the literature's long-standing dispute about the validity of the ARR as a proxy for the IRR, our simulation results strongly support the school of thought siding with the validity. Our research conclusion is to recommend applying the average ARR method in the practice of financial analysis. It is in a class of its own as regards pragmatic applicability because the ARR is based on well-established accounting practice.

Key words: Long-term profitability, accountant's rate of return, internal rate of return, return on investment, IRR estimation methods, Kay, Ijiri, Salamon, Ruuhela, simulation.

JEL: M40 G31 C88 C15

Acknowledgments: Our thanks are due to Professor Erkki K. Laitinen and Professor Reijo Ruuhela for their useful comments. We gratefully acknowledge the financial support for our research project from the Jenny ja Antti Wihurin Rahasto foundation.

Published as Salmi, Timo and Ilkka Virtanen (1997). Measuring the Long-Run Profitability of the Firm; A Simulation Evaluation of the Financial Statement Based IRR Estimation Methods. Acta Wasaensia, No. 54, University of Vaasa, Finland. Also published on the Word Wide Web: <URL:http://www.uwasa.fi/~ts/smuc/smuc.html>


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Departments of Accounting and Mathematics, University of Vaasa,
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