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Questions and Answers
What does accounting profit primarily represent?
What does accounting profit primarily represent?
Which of the following statements correctly describes a limitation of accounting profit?
Which of the following statements correctly describes a limitation of accounting profit?
How is economic profit defined in relation to a firm's market value?
How is economic profit defined in relation to a firm's market value?
What is one advantage of using economic profit over accounting profit?
What is one advantage of using economic profit over accounting profit?
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What does the return on equity (ROE) measure?
What does the return on equity (ROE) measure?
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What is a feature of bounded rationality in relation to profit maximization?
What is a feature of bounded rationality in relation to profit maximization?
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Which financial indicator is commonly used to assess profitability in comparison to accounting profit?
Which financial indicator is commonly used to assess profitability in comparison to accounting profit?
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Which of the following is NOT a characteristic of economic profit?
Which of the following is NOT a characteristic of economic profit?
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Study Notes
Accounting Profit
- Definition: Accounting profit is the difference between a firm's revenue and its costs. Calculated over a specific period (usually a year), it considers employee salaries, machinery payments, and material expenses.
- Profitability: Profitability is evaluated by comparing accounting profit to other factors like capital invested (e.g., return on equity). Return on equity measures the profit owners receive for every euro invested.
- Shortcomings: Accounting profit is imprecise, dependent on accounting choices (e.g., depreciation), and overlooks valuable but non-quantifiable assets (e.g., reputation). It primarily reflects past performance, making future prediction difficult. Real-world firms often aim for satisfactory rather than maximum profit, and the concept neglects risk.
Economic Profit
- Definition: Economic profit is the difference between the firm's equity market value at the end of a period and its value at the start, plus any dividends issued during the period.
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Formula: EPt = (EMVt - EMVt-1) + DIVt
- EPt: Economic profit for period t
- EMVt: Equity market value at the end of period t
- EMVt-1: Equity market value at the start of period t
- DIVt: Dividends issued during period t.
- Advantages: Calculated externally by the market, unlike accounting profit. It considers risk and assesses the ability to generate future profit from the firm's equity market value.
Shareholder Profitability/Return
- Definition: Shareholder profitability or return is calculated by dividing economic profit by the investor's initial investment (equity market value).
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Formula: SRt = [(EMVt - EMVt-1) + DIVt] / EMVt-1
- SRt: Shareholder return for period t
- EMVt: Equity market value at the end of period t
- EMVt-1: Equity market value at the start of period t
- DIVt: Dividends issued during period t
- Comparison: Shareholder return is usually compared between similar companies.
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Description
This quiz explores the differences between accounting profit and economic profit, including their definitions, profitability assessments, and inherent shortcomings. Understand how these concepts impact a firm's financial health and decision-making processes.
