Principles of Corporate Finance_ 12th Edition

318 Part Three Best Practices in Capital Budgeting

bre44380_ch12_302-326.indd 318 09/11/15 07:55 AM

Thus we still have a problem even in the long run. The extent of the error depends on how

fast the business grows. We have just considered one steady state with a zero growth rate.

Think of another firm with a 5% steady-state growth rate. Such a firm would invest $1,000

the first year, $1,050 the second, $1,102.50 the third, and so on. Clearly the faster growth

means more new projects relative to old ones. The greater weight given to young projects,

which have low book ROIs and negative apparent EVAs, the lower the business’s apparent

profitability.^19

What Can We Do about Biases in Accounting Profitability Measures?

The dangers in judging profitability by accounting measures are clear from these examples.

To be forewarned is to be forearmed. But we can say something beyond just “be careful.”

It is natural for firms to set a standard of profitability for plants or divisions. Ideally that

standard should be the opportunity cost of capital for investment in the plant or division. That

is the whole point of EVA: to compare actual profits with the cost of capital. But if perfor-

mance is measured by return on investment or EVA, then these measures need to recognize

accounting biases. Ideally, the financial manager should identify and eliminate accounting

biases before calculating EVA or net ROI. The managers and consultants that implement

❱ TABLE 12.4 Book ROI for a group of stores like the Nodhead store. The steady-state book ROI

overstates the 10% economic rate of return. The steady-state EVA is also biased upward.

Note: a There are minor rounding errors in some annual figures.

bBook income = cash flow – book depreciation.

cSteady-state book ROI.

Steady-state EVA.

5

6

3

4

1

2

Year

5

6

3

4

1

2

Book income for storea

Total book income

Book ROI for all stores

EVA

Book value for store

Total book value

1

267

267

2 0.067

2 166.73

1,000

1,000

2

267

33

233

2 0.018

2 216.79

1,000

834

1,834

3

33

83

267

50

0.020

2 200.19

834

667

1,000

2,501

4

83

131

267

33

181

0.060

2 118.91

667

500

1,000

834

3,001

5

131

131

33

267

83

312

0.094

2 20.96

500

333

834

1,000

667

3,334

6

131

130

83

33

267

131

443

0.126b

92.66c

333

167

667

834

1,000

500

3,501

Steady state

(^19) We could repeat the steady-state analysis in Table 12.4 for different growth rates. It turns out that book income will overstate eco-
nomic income if the growth rate is less than the internal rate of return and understate economic income if the growth rate exceeds the
internal rate of return. Biases disappear if the growth rate and internal rate of return are exactly equal.