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Profit Details

Profit Details. Debt and Equity. To start a firm requires $ for plant, equipment, product development, etc Those $ will be part (or all) of fixed costs Can raise the $ two ways: Borrow at fixed rate of interest– Debt Sell shares in the firm - Equity. Opportunity Cost.

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Profit Details

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  1. Profit Details

  2. Debt and Equity • To start a firm requires $ for plant, equipment, product development, etc • Those $ will be part (or all) of fixed costs • Can raise the $ two ways: • Borrow at fixed rate of interest– Debt • Sell shares in the firm - Equity

  3. Opportunity Cost • The value of the item in the best use (other than this one.) • Value of my grandma’s building if not used for my Dad’s company • Value of my Dad’s time if not used for his company • Value of the money invested in the business if it were used in another business instead.

  4. Profit and Earnings • Economic profit: Revenue – All costs • Cost Includes: • all of the money that went in to the firm, whether debt or equity • Opportunity cost of entrepreneurs’ labor, real estate etc. • Earnings: Revenue – VC – debt service • Doesn’t acct for • Opportunity cost • Value of invested capital (what people paid for shares.)

  5. Businessman and Economist • Business: I got earnings of $100K on my $1M investment. I earned 10 percent! • Economist: He earned the same 10 percent on his money that he would have earned if he just invested in the stock market. • So: Earnings – Opportunity Cost of Capital = ZERO • His profits were ZERO. • (Just terminology, but important.)

  6. Bankruptcy • Earnings < 0 • Lets assume no self supplied labor, buildings,etc • Same as Revenues – VC – debt service < 0 • Same as R – VC – debt – opp. Cost capital < - opp. Cost of capital • Same as Profit < Opp. Cost of Capital • Can’t pay bank loans and VC of production.

  7. Point of Bankruptcy • Legal mechanism • Allows firm to negotiate with suppliers and pay back less than all its debt so that it can survive. • Makes sense when can pay back some, but not all of debt. • Makes sense when firm will make more money alive than dead

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