If there were no scarcities, there would be no need to make choices. If there are no alternatives available, then the freedom to choose has very little meaning. Choosing a particular alternative means comparing the benefits and costs of that alternative.
Opportunity cost
Let B(Z) be the benefits from choosing alternative Z, and C(Z) be the costs of choosing Z. Then Z should b chosen if B(Z) > C(Z), not h h ld be h ( ) ( ) otherwise. B(Z): maximum rupee amount you would be willing to pay to do or choose Z. C(Z): rupee value of the resources you must give up in order to do Z.
As the definition of C shows, the cost must be calculated with reference to the other alternatives that were forgone. Definition: The opportunity cost of an action refers to the rupee value of the next best alternative forgone.
Even though opportunity costs include lots of non-monetary costs, we often monetize opportunity costs, translating the costs into rupee terms for comparison purposes. Monetizing opportunity costs is clearly valuable, because it gives a means of comparison
EXAMPLE Arun works as a waiter during weekends and earns Rs.100. A couple of his friends are trying to persuade him to go holidaying with them next weekend. They will bear the cost of transportation. However, Arun will have to pay his share of lodging which will be Rs.50 and also pay Rs.40 as meal charges. Arun calculates that the opportunity cost of holidaying is (a) Rs.100. (c) Rs.90. (b) Rs.190. (d) Rs.150.
Accounting costs are derived from financial reports that mainly categorize explicit rupee payments. As a result, accounting costs can miss out on some implicit or hidden costs. The major deficiency of the conventional economic statement is that it does not provide revenues and costs of alternative actions.
EXAMPLE Suppose that you invest Rs.1000 in some shares. You get a return of 20 per cent (Rs.200) annually. One day, you decide to start a small business of your own and sell off your shares and invest your money in your own business. At the end of the year, you find that you have made a profit of Rs.100 - 10 per cent return on your investment.
However, the economic view of the business will be that Rs.100 is being lost annually.
Two representations
Shares Own Business Income 200 100 _____________________________________ Own Business Profit 100 Opportunity Cost of Funds 200 Profit/Loss (-) 100
Why? Because the opportunity cost of the funds is Rs. 200, and this must be subtracted from the profit to give you a correct picture of the viability of your business.
Sunk Costs: costs that should not be included but often are
From a firm's point of view, sunk costs arise when an investment in an asset cannot be recovered by subsequent resale. Once incurred, sunk costs are not part , p of the firm's alternatives because they cannot be put to alternative use. Therefore, an investment is a sunk cost when its opportunity cost is zero.
The sunk cost fallacy Once one has made a significant nonrecoverable investment, there is a psychological tendency to invest more even when the return on the subsequent investment isnt worthwhile. France and Britain continued to invest in the Concorde (a supersonic aircraft no longer in production) long after it became clear that the project would generate little return. Watching a movie to the end, after you are convinced that it stinks, would be another example.
The popular phrase associated with the sunk cost fallacy is throwing good money after bad. The fallacy of sunk costs arises because of a psychological tendency to try to make an investment pay off when something happens to render it obsolete. The fallacy of sunk costs is often thought to be an advantage of casinos. People who lose a bit of money gambling hope to recover their losses by gambling more, with the sunk investment in gambling inducing an attempt to make the investment pay off.
ECONOMIC PROFIT
Sunk costs
Sunk costs should be avoided while calculating costs But the nature of cost whether it is sunk or avoidable is important From a prospective viewpoint managers should be very careful before committing to costs that will become sunk, since such commitments cannot be reversed
(Added) value from the point of view of the firm: The concept of economic profit
Accounting profit is equal to total revenue minus i explicit costs Economic profit is equal to total revenue minus i all opportunity costs. The opportunity costs consist of both explicit costs and all implicit costs
Profit and Loss Account for ABC Company for the year ending March 31, 2008
Therefore, in economics, if we say that a firm is earning zero or negative profits, this does not mean that its accounting profit is zero or negative.
Even a positive accounting profit may hide the true cost of resources being used by the firm.
If economic profit = 0, then firm is said to earn normal profit: If a firm is to continue operations in an industry, economic rationale demands that it earn revenue at least sufficient to cover the returns from alternative uses of its resources. If economic profit > 0, then the firm is making 0 supernormal profits, and resources are attracted into the industry. If economic profit < 0, the firm can earn more elsewhere, and it would want to exit from the industry.
WACC is the risk-adjusted cost of both the debt and equity capital and is designed to show the opportunity cost to all the capital suppliers to the firm.
Suppose there are three types of capital used by a firm K 1, K 2, K 3, and their associated implicit returns are r1, r2 and r3. Then the total cost of capital will be r1K1 + r2K2 + r3K3. This can be written as rK,
EVA
Then r is weighted average return on all the capital employed by the firm that could have been earned elsewhere (in the best possible alternate usages). The total cost of capital, rK, is then called the weighted average cost of capital because of the way we define r.
1
Company 2002 NOPAT (Rs. Cr.) 2002 WACC (%) 2002 Capital Employed (Rs. Cr.) 2002 EVA (Rs. Cr.) 2001 EVA (Rs. Cr.) Delta EVA (Rs. Cr.)
HLL
1535
13.7
3868
1003
765
239
Production Possibilities Frontiers and Realworld Trade-offs Production possibilities frontier A curve g showing the maximum attainable combinations of two products that may be produced with available resources.
Infosys
816
23.1
2483
242
224
17
Wipro
854
23.1
2680
235
111
124
Reliance
5115
11.4
47536
-318
328
-646
ITC
1304
13.7
5213
591
420
171
ONGC
6817
12.3
55198
17
-580
596
More funds for tsunami relief meant less funds for other charities.
Economic Growth The ability of the economy to produce increasing quantities of goods and services.