A Flashcards
Calculate, interpret and compare accounting profit, economy profit, normal profit, and economic rent **The ultimate goal of analyzing the different types of profit is to determine how their relationships to one another influence the firm’s market value of equity**
Calculate Accounting Profit = Economic + Normal
Sum of Normal and Economic Prof
Rev - All accounting or explicit costs
Acc. Prof, bottom line = T rev - T acct. costs
Accounting or Explicit costs: Payments to non-owner parties for services or resources that they supply to the firm.
*Interest expense IS an explicit cost, because it represents the return required by suppliers of debt capital
Interpret Accounting Profit (basic profit) (Bottom Line)
SR, LR - Variable
Define as, NI reported on the IS aka net income, net profit, net earnings
Calculate Economic Profit (abnormal prof)(super normal prof)
Define as Acct profit less implicit opp. costs not included in total accting costs
Economic costs: The sum of total accting costs and implicit opp. costs
Econ prof = Total rev. - total econ costs
The largest implicit cost omitted in calculating total accounting cost: The cost of equity capital!
Econ Prof = Acct prof - req. return on equity capital
Interpret Economic Profit (Not necessary to stay in business)(Econ prof = 0 = normal prof) (in SR may occur due to +NPV, so long as competition isn’t fierce)(LR econ prof. exists in less than perfect markets)
SR, LR - Variable
*“For the publicly traded corporation, we consider the cost of equity capital as the only implicit opportunity cost identifiable. “
Cost of Equity capital is Req. ROR(equity investment)
Calculate Normal Profit
Just covers the implicit opp costs (equity investment [ R.ROR])
Interpret Normal Profit (necessary to stay in business)(basic profit)
SR - Relatively stable
LR - Variable; The normal profit rate can change according to investment returns across firms in the industry
“normal profit is the level of accounting profit needed to just cover the implicit opportunity costs ignored in accounting costs”
Calculate Economic Rent
(P2-P1) x Q1
Interpret Economic Rent
Results when a particular resource or good is in fixed supply (A vertical supply curve) [land, special commodities - have inelastic supply in SR and LR] and the market price is higher than what is required to bring the resource or good onto the market and sustain its use.
Demand (high demand, price increases, supply does not change due to fixed nature - non-renewable resources, and government policy constraints) determines the price level and magnitude of economic rent.
“The firm has not done anything internally to merit this special reward: It benefits from an increase in demand in conjunction with a supply curve that does not fully adjust with an increase in quantity when price rises.”
“Any commodity, resource, or good that is fixed or nearly fixed in supply has the potential to yield economic rent. and attracts capital funds and may reward equity investors.”
Analysis tip: “When one is analyzing fixed or nearly fixed supply markets (e.g., gold), a fundamental comprehension of demand determinants is necessary to make rational financial decisions based on potential economic rent.”
Compare Accounting, Economic, Normal Profit, and Economic Rent
Accounting Profit > Normal Profit? Then Econ prof > 0 and firm is able to protect econ profit over long run and firms market value of equity is positive
Accounting Profit = Normal Profit? Then Econ profit = 0 which has no effect on Firms Market Value of Equity
Accounting Profit < Normal PRofit? Then Econ profit < 0 which implies economic loss and results in a negative effect on firms market value ofequity
Not Req but interesting ORIGINS OF ECON PROF
“■ competitive advantage;
■ exceptional managerial efficiency or skill;
■ difficult to copy technology or innovation (e.g., patents, trademarks, and copyrights);
■ exclusive access to less-expensive inputs; ■ fixed supply of an output, commodity, or resource; ■ preferential treatment under governmental policy; ■ large increases in demand where supply is unable to respond fully over time; ■ exertion of monopoly power (price control) in the market; and ■ market barriers to entry that limit competition.”
