Capital economic profit

What Is Capital Economic Profit?

Capital economic profit, often simply referred to as economic profit, is a fundamental concept in Corporate Finance that measures the true profitability of a business or project by considering both explicit and implicit costs. Unlike traditional accounting profit, which only subtracts direct, out-of-pocket expenses from revenue, capital economic profit also accounts for the Opportunity Cost of the capital and resources employed. This metric helps determine whether a venture is generating returns above the minimum required to compensate for all resources committed, including those not involving direct cash outlays. A positive capital economic profit indicates that the business is creating value beyond what could have been earned by investing its resources in the next best alternative⁵¹.

History and Origin

The concept of economic profit has roots deeply embedded in economic theory, predating modern financial accounting practices. Early economists sought to understand the true surplus generated by economic activity beyond the mere monetary expenses. Classical economists like Alfred Marshall contributed significantly to the understanding of profit within the broader context of Market Equilibrium and resource allocation. Marshall, a dominant figure in British economics from the late 19th century, emphasized the interplay of supply and demand and introduced concepts like consumer and producer surplus, which underpin the idea of value creation beyond direct costs.⁵⁰,

Historically, the definition of profit has evolved. Before the late nineteenth century, profit was often simply viewed as the excess of income over outgo. However, with the rise of corporate enterprises, more sophisticated calculations became necessary⁴⁹. The modern understanding of capital economic profit distinguishes itself by explicitly incorporating implicit costs, particularly the cost of capital, providing a more comprehensive view of value creation. This distinction became crucial for internal strategic Investment Decisions, rather than just for external financial reporting. The concept of Economic Value Added (EVA), a specific variant of economic profit, was developed by Stern Stewart & Company in 1983, aiming to quantify the true cost of investing capital and assess if it generates enough cash to be considered a good investment,⁴⁸.

Key Takeaways

• Capital economic profit considers both Explicit Costs (direct monetary expenses) and Implicit Costs (opportunity costs of resources used).
• A positive capital economic profit signifies that a business is creating value beyond the next best alternative use of its capital, contributing to Shareholder Value.
• It serves as a crucial internal metric for strategic decision-making, Capital Allocation, and evaluating project viability.
• Unlike accounting profit, capital economic profit is not typically reported on Financial Statements and can be more subjective due to the estimation of implicit costs.
• A business can have a positive accounting profit but a negative capital economic profit if its chosen venture does not outperform alternative opportunities.

Formula and Calculation

Capital economic profit is calculated by subtracting both explicit and implicit costs from total revenue. Alternatively, in corporate finance, it can be expressed in terms of return on invested capital and the cost of capital.

The general formula is:

\text{Capital Economic Profit (or EVA)} = \text{NOPAT} - (\text{Invested Capital} \times \text{WACC})