Kay's method is now applied on a Finnish Business Firm, Rauma-Repola, in order to estimate its long-run profitability for 1962-1978 by the internal rate of return. Rauma-Repola is chosen for the emlpirical application because a previous estimate of the internal rate of reburn for the period under obser vation is available in Salmi (1980), where Ruuhela's method was used for the estimation.
The book values of assets and operating incomes needed in estimation are assessed as follows from the financial statements in the annual reports of the business firm under observation.
Book value of assets = net current assets + undisclosed reserves + fixed assets ./. cumulative write-ups in fixed assets Operating income = profit (loss) for the period ("the bottom line") + direct taxes + interest and other expenses on debt + disclosed increases in reserves + undisclosed increases in reservesThe net current assets are defined as financial assets plus inventories less short term liabilities involving no interest cost (accounts payable, advance payments received, and adjusting entries). The undisclosed reserves are due to the inventory write-off possibility allowed by the Finnish tax laws up to 50 %. A foreign reader is referred to Jägerhorn (1980) for financial reporting practices in Finland and to the Price & Waterhouse manual (1979) for relevant Finnish legislation or Järvinen and Sihto (1974) for a short review.
* RUN KAY'S ALGORITHM BY TIMO SALMI WITH I+A AS DISCOUNTING FACTOR IDENTIFICATION ? RAUMA-REPOLA GIVE THE NUMBER OF YEARS, AND THE FIRST YEAR ? 17,1962 GIVE THE BOOK VALUES GIVE THE OPERATING INCOMES 1962 ? 208916 1962 ? 21401 1963 ? 235770 1963 ? 22494 1964 ? 266483 1964 ? 22060 1965 ? 275891 1965 ? 24906 1966 ? 279373 1966 ? 23921 1967 ? 276294 1967 ? 25003 1968 ? 305821 1968 ? 45481 1969 ? 392473 1969 ? 65933 1970 ? 502916 1970 ? 71745 1971 ? 752163 1971 ? 72231 1972 ? 851326 1972 ? 95231 1973 ? 1009203 1973 ? 115466 1974 ? 1269257 1974 ? 185345 1975 ? 1482696 1975 ? 128359 1976 ? 1716983 1976 ? 185855 1977 ? 1969858 1977 ? 383909 1978 ? 2180760 1978 ? 377246 ESTIMATED INTERNAL RATE OF RETURN A = 12.2733 % NUMBER OF ITERATIONS = 9 STOP AT 0420 *As can be seen in the computer run given below, Kay's method yields 12,3 % as the estimate of the IRR. Ruuhela's method gives 17,6 % when the depreciation is computed using the discounted revenue depreciation method. When the depreciation shown on books is used in the estimation, Ruuhela's method gives 16,2 %. There is a difference of 3,9 % in the results. Naturally, this can be due to a bias in either (or both) of the methods, since in our empirical application we have no way of knowing the underlying true internal rate(s) of return.
In this paper we scrutinized Kay's method and demonstrated sources of bias in it. Furthermore, we contested its applicability, our empirical estimation notwithstanding. Testing Ruuhela's model in a similar framework remains the subject of future research work. Similarly, testing the cash-flow based procedure suggested in Finland by Artto (1978) and (1980) remains intended further research.