4 An Application of Kay's Method on a Finnish Business Firm, and Directions for Further Research

Kay's method is now applied on a Finnish Business Firm, Rauma-Repola, in order to estimate its long-run profitability for 1962-1978 by the internal rate of return. Rauma-Repola is chosen for the emlpirical application because a previous estimate of the internal rate of reburn for the period under obser vation is available in Salmi (1980), where Ruuhela's method was used for the estimation.

The book values of assets and operating incomes needed in estimation are assessed as follows from the financial statements in the annual reports of the business firm under observation.

Book value of assets
  = net current assets
  + undisclosed reserves
  + fixed assets
  ./. cumulative write-ups in fixed assets

Operating income
  = profit (loss) for the period ("the bottom line")
  + direct taxes
  + interest and other expenses on debt
  + disclosed increases in reserves
  + undisclosed increases in reserves
The net current assets are defined as financial assets plus inventories less short term liabilities involving no interest cost (accounts payable, advance payments received, and adjusting entries). The undisclosed reserves are due to the inventory write-off possibility allowed by the Finnish tax laws up to 50 %. A foreign reader is referred to Jägerhorn (1980) for financial reporting practices in Finland and to the Price & Waterhouse manual (1979) for relevant Finnish legislation or Järvinen and Sihto (1974) for a short review.

* RUN

KAY'S ALGORITHM BY TIMO SALMI
WITH I+A AS DISCOUNTING FACTOR

IDENTIFICATION ? RAUMA-REPOLA

GIVE THE NUMBER OF YEARS, AND THE FIRST YEAR ? 17,1962
GIVE THE BOOK VALUES        GIVE THE OPERATING INCOMES
1962        ? 208916          1962      ? 21401
1963        ? 235770          1963      ? 22494
1964        ? 266483          1964      ? 22060
1965        ? 275891          1965      ? 24906
1966        ? 279373          1966      ? 23921
1967        ? 276294          1967      ? 25003
1968        ? 305821          1968      ? 45481
1969        ? 392473          1969      ? 65933
1970        ? 502916          1970      ? 71745
1971        ? 752163          1971      ? 72231
1972        ? 851326          1972      ? 95231
1973        ? 1009203         1973      ? 115466
1974        ? 1269257         1974      ? 185345
1975        ? 1482696         1975      ? 128359
1976        ? 1716983         1976      ? 185855
1977        ? 1969858         1977      ? 383909
1978        ? 2180760         1978      ? 377246

ESTIMATED INTERNAL RATE OF RETURN A = 12.2733 %
NUMBER OF ITERATIONS = 9

STOP AT 0420
*
As can be seen in the computer run given below, Kay's method yields 12,3 % as the estimate of the IRR. Ruuhela's method gives 17,6 % when the depreciation is computed using the discounted revenue depreciation method. When the depreciation shown on books is used in the estimation, Ruuhela's method gives 16,2 %. There is a difference of 3,9 % in the results. Naturally, this can be due to a bias in either (or both) of the methods, since in our empirical application we have no way of knowing the underlying true internal rate(s) of return.

In this paper we scrutinized Kay's method and demonstrated sources of bias in it. Furthermore, we contested its applicability, our empirical estimation notwithstanding. Testing Ruuhela's model in a similar framework remains the subject of future research work. Similarly, testing the cash-flow based procedure suggested in Finland by Artto (1978) and (1980) remains intended further research.


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Department of Accounting and Finance, University of Vaasa,
Finland

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