Deriving the internal rate of return from the accountant's rate of return:
a simulation testbench
Timo Salmi and Ilkka Virtanen
Abstract
This paper presents a realistic simulation testbench for evaluating the
various methods used to estimate the long-term profitability of firms in terms
of the internal rate of return (IRR) on their capital investments. The
simulation model extends the earlier, rigid approaches by incorporating
business cycles and capital investment shocks. Kay's IRR estimation method is
used to demonstrate the improved simulation approach. When the growth rate and
profitability are near each other, Kay's method yields accurate estimates as
is expected by theory. The more growth and profitability differ, the less
accurate the estimates will be. The magnitude (and even the direction) of the
error depends on the depreciation method applied and the capital investments'
contribution distribution. It is also seen that Kay's method is insensitive to
full business cycles, whereas it is disrupted by excessive capital investment
shocks.
Key words: Long-term profitability, accountant's rate of return, internal
rate of return, Kay's IRR estimation model, simulation.
(Proceedings of the University of Vaasa. Research Papers 201, 1995,
29p. Also available from World Wide Web: <URL:http://www.uwasa.fi/~ts/simu/>).