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$350,000 is Lark's net accounting profit (net income) for the year. The purpose of calculating economic profit is to determine if the company should actually continue to operate in the business that it is operating in, or if its owners could make more money by doing something else (such as participating in the next best alternative). If the amount of profit that the company is making is less than what the owners could make elsewhere, the company will have negative economic profit. The cost of equity is the investors' required rate of return, i.e. the amount that the investors could earn elsewhere. Therefore, in this problem, the cost of equity is the difference between the company’s accounting profit (or net income) and its economic profit.
The purpose of calculating economic profit is to determine if the company should actually continue to operate in the business that it is operating in, or if its owners could make more money by doing something else (such as participating in the next best alternative). If the amount of profit that the company is making is less than what the owners could make elsewhere, the company will have negative economic profit. The cost of equity is the investors’ required rate of return, i.e. the amount that the investors could earn elsewhere. Therefore, in this problem, the cost of equity is the difference between the company's accounting profit (or net income) and its economic profit. Common equity is $2,500,000, and the opportunity cost of equity is 15%. Thus, the cost of equity is $2,500,000 × .15, or $375,000. Net income is $350,000. Net income minus the cost of equity equals the company’s economic profit. $350,000 ? $375,000 = $(25,000). Note that the cost of debt is not an adjustment to accounting profit in calculating economic profit. This is because the 10% interest on the long-term debt has already been accounted for in the calculation of net income. On the income statement, we see “Interest $100,000.” That is the 10% interest on the $1,000,000 long-term debt. So net income has already been reduced by the interest on the debt. If we were to subtract it a second time, we would be subtracting it twice.
The purpose of calculating economic profit is to determine if the company should actually continue to operate in the business that it is operating in, or if its owners could make more money by doing something else (such as participating in the next best alternative). If the amount of profit that the company is making is less than what the owners could make elsewhere, the company will have negative economic profit. The cost of equity is the investors' required rate of return, i.e. the amount that the investors could earn elsewhere. Therefore, in this problem, the cost of equity is the difference between the company's accounting profit (or net income) and its economic profit. We have been unable to determine how to calculate this incorrect answer choice. If you have calculated it, please let us know how you did it so we can create a full explanation of why this answer choice is incorrect. Please send us an email at support@hockinternational.com. Include the full Question ID number and the actual incorrect answer choice -- not its letter, because that can change with every study session created. The Question ID number appears in the upper right corner of the ExamSuccess screen. Thank you in advance for helping us to make your HOCK study materials better.
The purpose of calculating economic profit is to determine if the company should actually continue to operate in the business that it is operating in, or if its owners could make more money by doing something else (such as participating in the next best alternative). If the amount of profit that the company is making is less than what the owners could make elsewhere, the company will have negative economic profit. The cost of equity is the investors' required rate of return, i.e. the amount that the investors could earn elsewhere. Therefore, in this problem, the cost of equity is the difference between the company's accounting profit (or net income) and its economic profit. This answer results from subtracting both the cost of equity and the cost of debt from the company's net income. However, the cost of debt is not an adjustment to accounting profit in calculating economic profit. This is because the 10% interest on the long-term debt has already been accounted for in the calculation of net income. On the income statement, we see "Interest $100,000." That is the 10% interest on the $1,000,000 long-term debt. So net income has already been reduced by the interest on the debt. If we subtract it a second time, we are subtracting it twice.