An Average-Based Accounting Approach to Capital Asset Investments: The Case of Project Finance

Literature and textbooks on capital budgeting endorse net present value (NPV) and generally treat accounting rates of return as not being reliable tools. This paper shows that accounting numbers can be reconciled with NPV and fruitfully employed in real-life applications. Focusing on project finance transactions, an average return on investment (AROI) is drawn from the pro forma financial statements, obtained as the ratio of aggregate income to aggregate book value. We show that such a metric correctly captures a project's economic profitability, as long as it is compared with a comprehensive weighted average cost of capital (WACC) that includes a correction factor that takes account of the capital foregone by the investors. In contrast to the internal rate of return, AROI is unique, and we provide an explicit functional relation that links it to the NPV. The approach holds for levered and unlevered projects, constant and non-constant leverage ratios, and constant and non-constant WACCs.