Investment, Financing and the Role of ROA and WACC in Value Creation
European Journal of Operational Research, DOI: 10.1016/j.ejor.2015.02.010
35 Pages Posted: 9 Feb 2015 Last revised: 23 Feb 2015
Date Written: February 4, 2015
Evaluating an industrial opportunity often means to engage in financial modelling which results in estimation of a large amount of economic and accounting data, which are then gathered in an economically rational framework: the pro forma financial statements. While the standard net present value (NPV) condenses all the available pieces of information into a single metric, we make full use of the crucial information supplied in the pro forma financial statements and give a more detailed account of how economic value is created. In particular, we construct a general model, allowing for varying interest rates, which decomposes the project into investment side and financing side and quantifies the value created by either side; an equity/debt decomposition is also accomplished, which enables to appreciate the role of debt in adding or subtracting value to equity holders. Further, the major role of accounting rates of return as value drivers is highlighted, and new relative measures of worth are introduced: the project ROA and the project WACC, which aggregate information deriving from the period rates of return. To achieve these results, we make use of the Average-Internal-Rate-of-Return (AIRR) approach, recently introduced, which rests on capital-weighted arithmetic means and sets a direct relation between holding period rates and NPV.
Keywords: Value creation, net present value, Return On Assets, WACC, weighted mean, equity, debt
JEL Classification: G11, G12, G31, G32, C0, D4, D92, M41
Suggested Citation: Suggested Citation