302898 Economic profits 1F Flashcards
Accounting profits are recognized when they are earned and include interest expense as a cost of borrowing money as well as taxes. Economic profits are:
earnings before tax.
earnings before interest and taxes.
a firm’s after-tax net income less the cost of invested capital.
the same as accounting profits.
Question #302898
a firm’s after-tax net income less the cost of invested capital.
- Economic profit = Net operating profit after tax - (Invested capital × Cost of capital)
The cost of the invested capital is not included in accounting profit; however, this cost is a real cost from the perspective of the firm’s stockholders. The cost of invested capital is, therefore, an expense in calculating economic profit.
Accounting Profit
Accounting profit is the difference between total revenues and measurable or estimable expenses paid to outsiders to acquire and use all necessary factors of production. Accounting profit does not include those implicit costs that are not measurable, such as opportunity costs and return to the owner for use of owner’s capital and entrepreneurial skills (the normal profit). It is the profit in excess of actual costs of production. The residual accrues to the owners.
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As a general rule, accounting profit is greater than normal profit, and normal profit is greater than economic profit because implicit costs are considered in the determination of normal and economic profits. (Income tax is basically applied to accounting profit that has been adjusted to taxable income per tax rules and regulations.)
Accounting profit is the basis for the financial statements of individual firms and is often extrapolated to the industry. It is not used when referring to the entire market.
Capital
Capital is a factor of production, one of the three essential elements of obtaining or producing wealth. Capital is man-made “investment” goods, e.g., tools, machinery, equipment, buildings, and storage, transportation, and distribution facilities. It is considered to be held (owned) primarily by households. Capital is a microeconomic concept.
Note: The economic resource known as capital or real capital refers only to man-made productive assets; money is not included in this definition. To an economist, money is financial capital or money capital.
Capital is the interest of owner(s) in the net assets (total assets minus total liabilities) of an entity. It is the measure of the resources provided to an entity that are considered permanent in nature—long-term debt and owner’s equity.
In an economic sense, capital also means assets that provide productive capacity—a factor of production.
(Compare to land and labor.)
Cost of Capital
The cost of capital is the weighted-average cost, in percentage form, that a firm will incur in raising new funds to finance future investment. The weighted-average cost of capital (WACC) is calculated using estimates of the future costs of different sources of funds that will be used to finance future investments in (usually) fixed assets or other long-term investments. The WACC is usually calculated on an after-tax basis, reflecting the tax benefits of using debt as part of the capital structure. It requires the use of current market-required rates of return for the types of securities the firm plans to issue, such as common stock, preferred stock, and long-term debt. When the firm has no plans to issue new stock but plans to use retained earnings, the cost of the retained earnings must be included in the calculations. Before the firm calculates its future cost of capital, it must determine a target capital structure; that is, the proportions of debt and equity that it plans to use over several future years in financing future investment.
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A firm should not make the mistake of calculating its cost of capital for a specific investment based on the source of financing available for that investment. Perhaps low-cost debt financing can be obtained in the next year that appears to make a low-return investment look profitable. If the firm intends to stay in business, however, it will have to use higher-cost equity financing the following year, since it cannot increase its debt indefinitely. When evaluating new investments, the firm should take a long-term view of its cost of capital based on its long-term planned capital structure.
Economic Profit
Economic profit is the difference between the total revenues and economic costs. It is the total revenues received from the sale of output less all costs (explicit and implicit, including opportunity costs and return to the owner for use of owner’s capital and entrepreneurial skills) of inputs used. Economic profit is the profit in excess of all costs of production, including normal profit and opportunity costs, which accrues to the entrepreneur/owner/investor. Economic profit is a profit not required for the firm to remain in business and retain all required factors of production including entrepreneurial, managerial, and leadership abilities. Its role in economic theory is to act as a signal to the owners of factors of production as to where their resources should be applied. Economic profit is a microeconomic concept.
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General rule: Economic Profit less than Normal Profit less than Accounting Profit. Income tax is basically applied to accounting profit (adjusted to taxable income per tax rules and regulations).
Economic profits (or losses) are a signal of disequilibrium in the market—their existence means that there are either too few or too many suppliers/producers in or resources devoted to the industry. At equilibrium, economic profits are zero:
If existing firms in the industry are making an economic profit (in the short run), these firms will want to continue in business; however, other firms will want to enter the industry to get some of these economic profits. (In this case, the industry supply curve will shift to the right, with a fixed demand curve and prices, and the economic profit will fall.)
Conversely, if existing firms are showing an economic loss, some of these firms will cease production and exit the industry and no new firms will enter. (The industry supply curve will shift to the left, price will increase, and the economic loss will disappear.)
Long-run equilibrium in a perfectly competitive market is the point at which existing firms show neither an economic profit nor loss—existing firms will stay in the industry and no new firms will enter the industry.
Net Income
Net income is operating income plus non-operating revenues minus non-operating expenses minus taxes.
2160.01
Sample data
Many different ratios are computed and used to analyze the operating characteristics of enterprises by investors and creditors, both present and potential, as well as management. Some of the frequently used ratios are described in following sections using hypothetical information for the Sample Company for the years 20X1 and 20X2.
2162.06
Economic value added (EVA)
Economic value added (EVA) is the economic profit as opposed to the GAAP profit. The focus of this ratio is on the earnings above the required cost of capital for shareholders. In other words, if the required rate of return is 12% and the company earns 16%, then value has been created for the shareholders; therefore, it could be said that the investors value the firm above the amount of capital that was originally invested.
Another way of looking at EVA is that a cost is assigned to the equity capital in addition to the cost of debt. On the traditional income statement, interest expense represents the cost of debt; however, there is nothing to denote the cost of equity. Since EVA focuses on economic profits, the opportunity cost of the equity capital must be taken into consideration. For example, if the shareholders could earn 12% on an investment of similar risk, then this opportunity cost of 12% must also be accounted for. The cost of all capital employed in the first would be considered to be the weighted-average cost of capital (WACC). NOPAT (net operating profit after taxes) is the after-tax profit of operating income and is equal to the operating profit times (1 – Tax rate).
EVA = NOPAT − (Cost of all capital × Total assets)
The EVA concept is often used by firms during the decision-making process when determining whether a large investment in plant and equipment would be in the best interest of the shareholders.
Calculation using the data from the Sample Company for the year ended December 31, 20X2 (section 2160.01), assuming that the WACC is 10%:
EVA = NOPAT – (Cost of all capital × Total assets)
= ($175,000 × (1 – 0.40)) – (10% × $1,000,000)
= $5,000
