1. INTRODUCTION AND REVIEW OF THE PROBLEM

This paper presents further results on measuring profitability by estimating the internal rate of return (IRR) of the capital investments constituting the firm.

Estimating the profitability of a single capital investment project is straight-forward. In external financial analysis, however, only the published financial statements are available. The expenditures and revenues of the capital investments making up the firm are then completely mixed. In order to estimate the long-run profitability of the firm it is customary to assume a single internal rate of return for the series of capital investments constituting the firm. Several authors_1 have tackled this profitability measurement problem, often in the framework of establishing the relation between the internal rate of return and the accountant's rate of return.

Ruuhela (1972) and (1975) presented in Finnish a model for measuring the long-run profitability of the firm by estimating the IRR from published financial statements. A major characteristic of Ruuhela's model is that in assessing the long- run profitability, it takes into account the growth trend of the capital expenditures thus avoiding a potential bias. Salmi (1982) improved and streamlined the derivation of Ruuhela's model. The results and concepts described in Salmi (1982) are the background for this paper.

In this paper we improve Ruuhela's method for estimating the IRR in two important respects. First, we do away with necessity of choosing a depreciation theory by modelling the relationship (called contribution distribution) between the capital expenditures and the corresponding revenues using an Anton distribution. Earlier, the contribution distribution used included a depreciation parameter (denoted by d). This parameter had to be estimated by a cumbersome procedure involving the selection of a depreciation theory (discounted revenue depreciation), choosing another contribution distribution, and equating the cumulative depreciation formulas indicated by each contribution distribution. The application of the Anton distribution was first presented by Ruuhela (1981) in Finnish. The functional form of this contribution distribution is compatible with the pattern of net receipts assumed in Anton (1956, 125).

Second, it was earlier assumed that all the capital investments making up the firm have the same life-span (denoted by N). We develop the estimation method to include the more general case of capital investments with differing life-spans.

If it is accepted that there is a long-run consistency in the financial policy of the firm, the long-run financing behavior can be characterized by average ratios of the different sources and uses of financing. Based on Ruuhela (1981) we also present the derivation of the theoretical depreciation ratio when the Anton distribution is used. For this purpose, naturally, a selection of the depreciation theory has to be made. When compared with the theoretical depreciation ratio the ratio of the depreciation on books describes the depreciation policy of the firm.

Forest industry is a central branch of industry in Finland. The branch's share of Finland's total manufacturing was 23.1 per cent in 1980 in terms of value added. We estimate the growth, profitability, and financing behavior of eight major Finnish pulp and paper firms for the 1970's.

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1 See Salmi & Luoma (1981) for the references.


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Department of Accounting and Finance, University of Vaasa,
Finland

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