NOTE ON ECONOMIC PROFIT 1

Transcription

1 Deparmen of Managerial Economics and Decision Sciences NOTE ON ECONOMIC PROFIT 1 In judging he success of a business enerprise, one almos always sars wih he quesion: How profiable is he business and is i likely o remain profiable over ime? The purpose of his noe is discuss he concep of economic profi and o illusrae how i relaes o and differs from more convenional noions of accouing profi. Because he concep of economic profi is grounded in he concep of opporuniy cos, we begin by discussing wha opporuniy cos is. We hen urn our aenion o economic profi. Finally, we show how economic profi is relaed o he concep of ne presen value ha you are learning (or have learned) in Finance. OPPORTUNITY COST Decision making in business is abou choosing among alernaive courses of acion. Consider a decision maker who has o choose from a se of muually exclusive alernaives, each of which enails a paricular moneary payoff. The opporuniy cos of a paricular alernaive is he payoff associaed wih he bes of he alernaives ha are no chosen. To undersand he concep of opporuniy cos more concreely, consider wo examples: You own and manage your own business. The business requires an average of 80 hours of your ime every week. Suppose insead of working in your own business, your bes alernaive is o work he same amoun of hours in a large corporaion for an income of $75,000 per year. The opporuniy cos of he ime you devoe o your business would herefore be $75,000. An auomobile firm has an invenory of shee seel ha i purchased for $1,000,000. I is planning o use he shee seel o manufacure 2,000 auomobiles. As an alernaive, i can resell he seel o oher firms. Suppose ha he price of shee seel has gone up since he firm made is 1 This noe was wrien by Professors David Besanko. Pars of his noe were adaped from Economics Primer, Besanko, D., D. Dranove, and M. Shanley, Economics of Sraegy (New York: John Wiley & Sons), 2000, while ohers were adaped from Noes on Cos, by Professor Nabil Al-Najjar. This noe is for he use exclusive us of sudens in MECN 430 a he Kellogg School of Managemen. Do no circulae or copy his noes for any oher use wihou explici permission. Version of November 10, 2003.

2 purchase, so if i resells is seel he firm would ge $1,200,000. The opporuniy cos of using he seel o produce he 2,000 auomobiles is hus $1,200,000, or $600 per auomobile. Noe he opporuniy cos differs from he original expense incurred by he firm. Afer reading his las example, sudens someimes ask, Why isn he opporuniy cos of he seel $200,000: he difference beween he marke value of he seel ($1,200,000) and is original cos ($1,000,000)? Afer all, he firm has already spen $1,000,000 o buy he seel. Why isn he opporuniy cos he amoun above and beyond ha original cos ($200,000 in his example)? The way o answer his quesion is o remember ha he noion of opporuniy cos is forward looking, no backward looking. Tha is, opporuniy cos measures wha he decision maker sacrifices a he ime he decision is made and beyond. When he auomobile company uses he seel o produce cars, i gives up more han jus $200,000. I forecloses he opporuniy o receive a paymen of $1,200,000 from reselling he seel. The opporuniy cos of $1,200,000 measures he full amoun he firm sacrifices a he momen i makes he decision o use he seel o produce cars raher han o resell i in he open marke. Opporuniy Coss Depend on he Decision Being Made The forward-looking naure of opporuniy coss implies ha opporuniy coss can change as ime passes and circumsances change. To illusrae his poin, le s reurn o our example of he auomobile firm ha purchased $1,000,000 worh of shee seel. When he firm firs confroned he decision o buy he seel or don buy he seel, he relevan opporuniy cos was he purchase price of $1,000,000. This is because he firm would save $1,000,000 if i did no buy he seel. Bu --- moving ahead in ime --- once he firm purchases he seel and he marke price of seel changes, he firm faces a differen decision: use he seel o produce cars or resell i in he open marke. The opporuniy cos of using he seel is he $1,200,000 paymen ha he firm sacrifices by no selling he seel in he open marke. Same seel, same firm, bu differen opporuniy cos! The opporuniy coss differ because here are differen opporuniy coss for differen decisions under differen circumsances. Opporuniy Coss and Marke Prices Noe ha he unifying feaure of his example is ha he relevan opporuniy cos was, in boh cases, he curren marke price of he shee seel. This is no coincidence. From he firm s perspecive, he opporuniy cos of using he producive services of an inpu is he curren marke price of he inpu. The opporuniy cos of using he services of an inpu is wha he firm s owners would save or gain by no using hose services. A firm can no use he services of an inpu in wo ways. I can refrain from buying hose services in he firs place, in which case he firm saves an amoun equal o he marke price of he inpu. Or i 2

3 can resell unused services of he inpu in he open marke, in which case i gains an amoun equal o he marke price of he inpu. In boh cases, he opporuniy cos of he inpu services is he curren marke price of hose services. EXAMPLE: Asse Plays 2 Someimes here is a large discrepancy beween he accouning value and he economic value of a firm's asses. For example, an unsuccessful reailer migh have sores in downown Chicago wih land valued a hisorical cos from he ime he buildings were bough in he 1950s. As a akeover candidae, he company migh look unaracive in erms of is margins or he book value of is asses. Bu, he book value does no reflec he sores' higher real esae values; an invesor could buy he firm and sell off is asses a marke prices. Here, he correc ool for evaluaion is he opporuniy cos of he resources - no he book value of he company. Such opporuniies are called asse plays. The idea is o idenify companies whose book value does no reflec he rue economic value (opporuniy cos) of he underlying asses. Invesmen in such asse plays will be profiable when he marke has, for some reason, failed o accoun for he rue opporuniy value of he firm's asses employed in heir opimal use. Thus, even poorly managed companies should be priced a close o heir rue marke value. Oherwise, here exiss a profiable akeover candidae, eiher by realizing he liquidaion value or recognizing how exising asses can be beer managed so as o achieve heir rue opporuniy value. ECONOMIC COST AND ECONOMIC PROFIT The conceps of economic cos and economic profi are based on applying he concep of opporuniy cos o he firm as a whole. The economic cos incurred by a business firm over a given period (say, a year) is he sum oal of all of is coss, including any relevan opporuniy coss incurred over ha period of ime. 3 The firm s economic profi over a given period of ime (again, say, a year) is he difference beween he firm s oal revenue over ha period and is economic cos. To illusrae, consider a small sofware developmen firm ha is owner operaed. In 2004, he firm earned revenue of $1,000,000 and incurred expenses on supplies and hired labor of $850,000. The owner s bes ouside employmen opporuniy would be o earn a salary of $200,000 working for Microsof. The sofware firm s accouning cos is $850,000, and is accouning profi is hus $1,000,000 - $850,000 = $150,000. The sofware firm s economic cos is is accouning cos plus he opporuniy cos of he owner s labor services: $850,000 + $200,000 = $1,050,000. Is economic profi is hus: $1,000,000 - $850,000 - $200,000 = -$50,000. This negaive economic profi (or economic loss) 2 See Peer Lynch: One Up On Wall Sree, Penguin Books, 1989, for examples of asse plays ha helped him make a forune for Magellan Fund shareholders. 3 Thus, when we alk abou oal cos curves in microeconomics, we ypically mean oal economic cos. 3

4 means ha he owner made $50,000 less in income by operaing his business han she could have made in her bes ouside alernaive. The sofware business desroyed $50,000 of he owner s wealh in ha, by operaing he sofware business, she earned $50,000 less income han she migh have oherwise. Economic Profi in Firms Wih Long-Lived Asses Economic profi becomes a more suble when dealing wih firms ha have long-lived asses, such as plan, equipmen, and land (which, of course, is mos business firms!). Neverheless, he concep is sill firmly rooed in he noion of opporuniy cos. To illusrae, consider he following sequence of examples: Example #1: You are considering saring a ho dog sand. The ho dog sand will generae a revenue of $100,000 a year. Your ou-of-pocke expenses (wages, supplies, maerials, insurance, ec.) will be $50,000 a year. You are leasing he ho dog sand from a leasing firm, and for his you pay $20,000 a year. Finally, by running he ho dog sand, you forego $25,000 in annual salary. Wha is your annual economic profi (EP)? From our discussion above, you know he answer: economic profi is he your revenue, minus your cash expenses, minus he opporuniy cos of your ime: EP = $100,000 - $50,000 - $20,000 - $25,000 = $5,000 per year. Example #2: You are considering saring a ho dog sand. The ho dog sand will generae a revenue of $100,000 a year. Your ou-of-pocke expenses (wages, supplies, maerials, insurance, ec.) will be $50,000 a year. You purchased your ho dog sand by obaining a morgage loan from he bank, and for his you have an annual morgage paymen of $20,000. Finally, by running he ho dog sand, you forego $25,000 in annual salary. Wha is your annual economic profi (EP)? This is essenially idenical o he example above: EP = $100,000 - $50,000 - $20,000 - $25,000 = $5,000 per year. Example #3: You are considering saring a ho dog sand. The ho dog sand will generae a revenue of $100,000 a year. Your ou-of-pocke expenses (wages, supplies, maerials, insurance, ec.) will be $50,000 a year. By running he ho dog sand, you forego $25,000 in annual salary. You will finance he purchase of he ho dog sand using your own savings. Wha is your annual economic profi (EP)? Is i: EP = $100,000 - $50,000 - $25,000 = $25,000 per year? The answer is no. You can begin o see his by noing ha he proposed EP of $25,000 seems inconsisen wih he answers o he firs wo examples. In hose examples, you had o pay for use of he criical asse in he business, he ho dog sand. In he firs case, you paid a lessor; in he second case, you paid a lender. In boh cases, he use of he asse 4

5 was no free. Bu is he use of he asse free if you purchase i wih your own funds? Almos cerainly no. By purchasing he ho dog sand, your wealh is lower han i would be oherwise, which means ha you forego he opporuniy o inves ha wealh in oher asses ha could have generaed an annual reurn. For his example, suppose ha by invesing your funds o buy he ho sand, you forego he opporuniy o earn an annual reurn of $20,000 on your money. Given ha, your annual economic profi is: EP = $100,000 - $50,000 - $20,000 - $25,000 = $5,000 per year. This series of examples illusraes ha in firms wih long-lived asses ha are purchased wih funds provided by he owner(s) of he business (eiher an owner-manager or shareholders), here is ypically an opporuniy cos associaed wih he use of he financial capial ha is needed o acquire he asses. Tha opporuniy cos is he reurn ha he owners could have received from invesing in aciviies of comparable risk. As a furher illusraion, consider a firm ha has raised $100 million from invesors in order o acquire he land and physical asses ha i needs in order o do business. Le s suppose ha by providing funds o he firm, hese invesors lose he opporuniy o inves heir funds in aciviies ha provide an 8 percen annual reurn. This opporuniy reurn is known as he firm s cos of capial. 4 In order o deliver a reurn o invesors ha is commensurae wih he reurns hey give up by providing heir funds o he firm, he firm mus generae an annual profi flow of a leas 0.08 $100 million = $8 million per year over he life of he asses. This cos, ofen referred o as he firm s capial charge or is annual capial cos is an economic cos, even hough i would no appear in he firm s income saemen. As Peer Drucker has wrien, Unil a business reurns a profi ha is greaer han is cos of capial, i operaes a a loss I does no cover is full cos unless repored profi exceeds he cos of capial. Unil hen, i does no creae wealh, i desroys i. 5 Wha Drucker is saying is ha a firm mus cover all of is coss, including is capial charge, in order o be ruly profiable. For invesor-owned firms, economic profi is ypically measured by aking he difference beween he firm s ne operaing profi afer axes (NOPAT) and is capial charge: 6,7 4 Deermining he cos of capial for a firm is a subjec ha you cover in your Finance course and hus will no be discussed here. Suffice i o say ha he convenional approaches used o deermine a firm s cos of capial is deeply grounded in he concep of opporuniy cos. 5 Peer Drucker, The Informaion Execuives Truly Need, Harvard Business Review, January-February Recall from your accouning classes ha NOPAT is equal o revenue minus cos of goods sold minus selling and general adminisraive expenses minus ineres expenses minus axes. 7 Advanced poin: Under his definiion of economic profi, he cos of capial i is he weighed average cos of capial (i.e., including boh he cos of equiy and he cos of deb), and K is he firm s oal invesed capial (including ha financed by boh equiy and deb). As a firs approximaion K is he sum of working capial and fixed asses in year, alhough in pracice value-based managemen consuling firms such as Sern Sewar ha calculae EP for cliens make many accouning adjusmens in order o arrive a esimaes of K. There is an alernaive definiion of EP (economically and algebraically equivalen o he 5

6 where: EP = economic profi in year. EP = NOPAT ik, NOPAT = ne operaing profi afer axes in year. i = firm s cos of capial. K = capial invesed in he business a he beginning of year. Table 1 shows economic profis for some U.S. food and beverage chains beween 1992 and TABLE 1 ECONOMIC PROFIT FOR SELECTED U.S. FOOD AND BEVERAGE CHAINS, ($ MILLION) Company McDonald's Sarbucks Ouback Seakhouse Brinker Inernaional Wendy's Inernaional Advanica Resauran Jack In The Box CKE Resaurans Source: Sern Sewar Performance 1000 Daabase Table 1 illusraes ha a firm can have posiive accouning earnings bu a negaive economic profi. For example, in 1999 Sarbucks had posiive NOPAT of more han $100 million (no shown in he able), bu i had a negaive economic profi of $83. 8 Wha does his negaive $83 million mean? Essenially i means ha Sarbucks asses, if liquidaed and deployed elsewhere, would have earned $83 million more in income for is owners han Sarbucks earned in In his sense, in 1999 Sarbucks desroyed $83 million of is owners wealh because is owners could have earned $83 million more ha year by deploying he funds hey had invesed in Sarbucks in heir bes alernaive use. No all firms, of course, make a negaive economic profi. In 1999, McDonald s earned an accouning profi of slighly over $2.4 billion (again, no shown) and a posiive economic one shown above) in which he capial charge is based solely on he cos of equiy. The consuling firm Marakon ypically defines EP in his equiy-based fashion. 8 The measure of economic profi shown in Table 1 is called Economic Value Added or EVA, a erm developed and rademarked by he financial consuling firm Sern Sewar & Company. See Sewar, G. Benne, The Ques for Value: A Guide for Senior Managers, New York: Harper Business, 1991 for an exensive discussion of how EVA is calculaed. 6

7 profi of $329 million (see Table 1). This posiive economic profi means ha McDonald s creaed $329 million more in income for is owners han is sources would have creaed for hemselves if hey liquidaed McDonald s asses and invesed hem in heir bes alernaive use. In his sense, in 1999 McDonald s creaed an addiional $329 million in wealh for is owners ha hey could no have goen elsewhere. ECONOMIC PROFIT AND NET PRESENT VALUE Economic profi is closely relaed o he concep of ne presen value from finance. We will use an example o illusrae ne presen value and he relaionship beween i and economic profi. Consider a firm ha conemplaes consrucing of a plan wih a capaciy o produce 100,000 unis per year. Suppose ha he firm can sell hese unis a a price of $25 per uni, and his price is expeced o remain seady for he foreseeable fuure.the firm s expenses when i produces a capaciy are $5 per uni of oupu. The cos of building he plan is $15 million. To make he example as simple as possible, assume ha he plan has an infiniely long life, (i.e., i does no depreciae). Suppose, finally, ha he firm s cos of capial is 10 percen. This rae reflecs wha he firm s invesors could make from alernaive invesmens and hus reflecs he appropriae opporuniy cos for evaluaing he invesmen in he plan. Should he firm build he plan? We can look a his decision in wo seemingly differen, bu (as i urns ou) equivalen, ways. Firs, we could calculae an annual economic profi in he way we jus discussed. Toal revenues would be $2.5 million per year ($25 100,000 unis per year = $2.5 million per year). Toal coss ha would show up on he firm s accouning saemens would be $500,000 per year. The annualized opporuniy cos of he plan would be he 10 percen cos of capial imes he invesmen of $15 million, or $1.5 million per year. Thus, $1.5 million represens he annual capial cos associaed wih he plan. Thus, we have: EP = $2,500,000 - $500,000 - $1,500,000 = $500,000 per year. Since he invesmen in he plan is expeced o yield a posiive economic profi year afer year, he firm should build i. Pu anoher way, by invesing in he plan, he firm delivers o is owners $500,000 per year above and beyond wha hey could earn from heir bes alernaive invesmen. The second way o analyze his decision is o use ne presen value analysis. To explain his approach, we mus firs inroduce he concep of presen value. The presen value of a cash flow C received in years a an ineres rae i is equal o he amoun of money ha mus be invesed oday a he ineres rae i, so ha in years he principal plus ineres equals C. 9 Mahemaically, presen value would be given by: 9 For a good inroducion o he basic conceps of presen value, see Brealey, R. A. and S. C. Myers, Principles of Corporae Finance. 7

8 PV = C ( 1+ i). The presen value of a sream of cash flows received over a period of years is he sum of he presen values of he individual sums. Thus, he presen value of cash flows C 1, C 2,... C T received one year from now, wo years from now,..., T years from now, is C1 C2 CT PV = + + L + 2 (1 + i) (1 + i) (1 + i) T, which can be wrien more compacly as C T = 1 (1 + i). The ne presen value (NPV) of an invesmen is simply he presen value of he cash flows he invesmen generaes minus he cos of he invesmen. Given he assumpions ha he invesmen has an infinie life and ha he price and revenues are expeced o remain he same over he foreseeable fuure, he NPV of he invesmen in he plan is given by 2,000,000 NPV = 15,000,000. (1.10) = 1 This looks inimidaing, bu forunaely he erm in he summaion is he presen value of a perpeuiy. A perpeuiy is a level cash flow C received each year forever. The presen value of a perpeuiy has a convenien formula: I is equal o he cash flow divided by he ineres rae, C/i. Wih his formula, we can rewrie NPV as 2,000,000 NPV = 15,000,000 = $5,000, Since he ne presen value is posiive, he firm should underake he invesmen. You migh have noices ha he calculaions of NPV and economic profi are similar. Indeed, NPV is equal o he presen value of economic profi generaed by he invesmen over is (infinie) lifeime: EP NPV =, i or, in our example, where EP = $500,000 per year, i = 0.10, we have: 500,000 NPV = = $5,000, When cash flows are no consan and/or when he invesmen has a finie life, hese relaionships beween NPV and economic profi are more complicaed o illusrae, bu hey sill hold. In paricular, i can be shown ha he collecive NPV of he firm s 8

9 invesmens is equal o he presen value of he economic profi hose invesmens generae over heir useful lives. Given his, economic profi can be hough of as an annualized NPV calculaion. This, in urn, provides an inerpreaion for zero economic profi. Zero economic profi does no mean ha he firm s ne cash flows are zero. Insead i means ha he presen value of hese cash flows jus covers he cos of he firm s invesmens, or equivalenly he ne presen value of he firm s invesmens are zero. 9