Taxation And Finance

Posts Tagged ‘Cash’

The fields of economics and accounting serve very different purposes. Microeconomic and financial theories seek to explain the allocation of resources in an economy through firm, consumer and investor behavior and market mechanisms.Economic profits drive firm behavior and lead to the maximization of shareholders’ wealth (and, thereby, their lifetime consumption).

The calculation of such profits reflects the actual timing of investments (rather than smoothing out periodic capital expenditures via depreciation) and incorporates all costs, including the cost of equity capital (and, potentially, other opportunity costs). The economic profit rate is defined as that rate which equates (a) the discounted present value of forecasted after-tax free cash flows generated by a given investment project with (b) the initial outlays required.1 It is extremely difficult, if not impossible, to quantify a firm-wide economic profit rate as a practical matter.

Under conditions of free entry and exit, and absent financing constraints, firms will continue to enter a given market until the net present value of market participation (that is, the present value of projected after-tax free cash flows, discounted at the opportunity cost of capital and reduced by the initial investment required) is driven to zero. Until this point is reached, incumbent firms will earn positive economic profits (i.e., profits in excess of a “normal” return), and shareholders’ wealth will be increased thereby. Through the process of market entry, additional resources are dedicated to the manufacture of those products that consumers value more highly than the resources necessary to produce them.