Return On Investment: The Relation Of Book-Yield To True Yield

Abstract

Publication Rights Reserved This paper is to be presented at the 38th Annual Fall Meeting of the Society of Petroleum Engineers of AIME in New Orleans, La., on October 6–9, 1963, and is considered the property of the Society of Petroleum Engineers. Permission to publish is hereby restricted to an abstract of not more than 300 words, with no illustrations, unless the paper is specifically released to the press by the Editor of the JOURNAL OF PETROLEUM TECHNOLOGY or the Executive Secretary. Such abstract should contain conspicuous acknowledgment of where and by whom the paper is presented. Publication elsewhere after publication in the JOURNAL OF PETROLEUM TECHNOLOGY or SOCIETY OF PETROLEUM ENGINEERS JOURNAL is granted on request, providing proper credit is given that publication and the original presentation of the paper. Discussion of this paper is invited. Three copies of any discussion should be sent to the Society of Petroleum Engineers office. Such discussion may be presented at the above meeting and considered for publication in one of the two SPE magazines with the paper. Abstract The paper analyses the relationship between the book-yield on investment (measured as the conventional ratio of net book-income to net book-value of assets) and the true yield on investment. It examines the effect on this relationship of variations in capitalization policy, depreciation methods, revenue patterns and investment growth rates. It discusses the potential error in the conventional book-measure of rate of return for the oil and gas producing industry and the implications of this error for managerial evaluation and F. P. C. regulation. Introduction The rate of return on investment is a key concept which is widely used for a number of significant business and financial purposes. it is of central importance for the evaluation of an individual investment project; the financial evaluation of a company's performance evaluation of managerial efficiency for a division or a product-line, and finally as a guide for establishing ceiling prices in the regulated industries. The most commonly used multi-purpose measure for return on investment is the ratio of net book income, as this is conventionally measured by the accounting process, to net book value of assets employed, similarly measured. The measure has several names such as "the accounting rate of return," "the book rate of return)" "the conventional rate of return," but for purposes of this paper we will refer to it as "book-yield." One reason for the widespread use of book-yield as a measure of return on investment is that it ties in directly with the accounting process. A second and even more important reason is that it is the only approach available for measuring the on-going return on investment for a collection of assets which together comprise a division or a company. In spite of the almost universal use of book yield, we know very little about the accuracy of the measure itself. Does it correctly measure the actual yield on investment? Is it a consistent general yardstick in the sense that it provides comparable measures as between divisions, companies, and industries? These questions have hardly been asked, let alone answered. For at least one class of purposes for which return on investment is used, the book yield measure has been questioned and found wanting. I refer to single investment projects or acquisitions. In this situation the size and timing of all investment outlays and all net cash receipts flowing from these outlays are available, or can be estimated-either retrospectively or prospectively.