I’m having difficulty understanding the concept of normal profit when it comes to calculating economic profits. It is the only opportunity cost that I cannot quite put my finger on. Is it just what you would have expected to earn given the riskiness of the type of business?
Which brings me to my next question… when discounting future cash flows, we are trying to determine economic profit right? That is, profit in excess of the discount rate (normal profit)? I know every thing I read says you have to discount a project’s future cash flows by WACC…but I cannot find an explanation as to WHY. Let’s say the cash flow the first year is 100 and the WACC is 10%. This gets discounted to time 0 to $90.91. Does this mean that $90.91 is the profit in excess (economic profit) of the normal profit (WACC of 10%)?
This has been on my mind and I just cannot find an answer anywhere.作者: genuinecfa 时间: 2013-4-17 17:13
Normal profit is the opportunity cost of entrepreneurship. Entrepereneurs have skills in creating businesses, by working solely for one company, they forgo the oppornutiy of creating others business. the profit from the business they could have created, represent what is called normal profit.
90,91 represent what the 100 in the future is worth today(at the time that you are considering investing in the projet). Now if the project requires that you invest $92 initially, you can easily say is not worth it, because if you put you money in financial market where you earn 10.
putting 92 in the project you earn 100
putting 92 in the financial your 101.20
Now you see that by discounting you where able to make comparions and decide whether or not to invest in the project base on future expected cash flows.
The general principle is that you can not compare to cash flow if they do not occure at the the same time. And the magic of discounting allow you to see what a future sum is the worth any time before the payout date.
to respond to your last question 90.91 is not the normal profit, it is the amount at which you should indiferrent on whether on invest in the project or invest in the financial market. is it also the maiximum at which you should consider investing in the project knowing that it pays$100 and the WACC is 10%.
