Depreciation Classes, Return on Investment and Economic Profitability

Abstract

This paper aims to provide a foundation for the notion of economic rate of return and investigate its relations with accounting rates of return. Introducing the notion of depreciation class (the set of depreciation schedules with the same aggregate book value) it is shown that the mean of the Return On Investments (ROI) determined by the project’s depreciation class (weighted by book values) captures the project’s economic profitability. Such a rate of return spans a space of infinitely many economic rates of return: each of them is an average ROI resulting from a well-specified depreciation class. Any project’s IRR is itself a mean of (generally non-constant) ROIs generated by an idealized (neutral) depreciation class. As a result, a project is not uniquely associated with one economic return rate; rather, it is uniquely associated with one economic return function, which maps depreciation classes into economic rates of return. Among them, the project’s average ROI should be regarded as the basic economic rate of return, since it always exists and is unique.

Keywords: Economic Rate of Return, Internal Rate of Return, Return on Investment, Depreciation Class, Uniqueness, Cost of Capital

JEL Classification: M41, G31, G12