Distortions caused by inflation, asset structure etc.

• It has been proved many times in financial literature that ROI (or any other accounting return) is also on average a poor estimator of the true underlying rate of return (Harcourt (1965), Salomon and Laya (1967), Livingston and Salomon (1970), Kay (1976), Van Breda (1981), Fischer and McGowan (1983), Fisher (1984), Kay and Mayer (1986), Rappaport (1989), De Villiers (1989, 1997)
• That is because
  • Historical asset-values can not describe accurately the current value of assets tied into business (inflation, different depreciation schedules etc.)
  • ROI itself does not take into account the time value of money -> therefore e.g. the decision to activate R&D costs or to subtract them at once in the income statement effects ROI (ROI is bigger in the long run if R&D cost are subtracted at once and not activated on the balance sheet)
• The extent of this distortion in accounting rate of return (and thus in EVA) depends on the asset structure (the relative proportions of current assets, depreciable assets, undepreciable assets) and on the length of the investment period, depreciation policy etc.