Important Details
Debt and Equity
• To start a firm requires $ for plant, equipment,
product development, etc
• Those $ will be part (or all) of fixed costs
• Can raise the $ two ways:
– Borrow at fixed rate of interest– Debt
– Sell shares in the firm - Equity
Opportunity Cost
• The value of the item in the best use (other
than this one.)
– Value of my grandma’s building if not used for my
Dad’s company
– Value of my Dad’s time if not used for his company
– Value of the money invested in the business if it
were used in another business instead.
Profit and Earnings
• Economic profit: Revenue – All costs
– Cost Includes:
• all of the money that went in to the firm, whether debt
or equity
• Opportunity cost of entrepreneurs’ labor, real estate
etc.
• Earnings: Revenue – VC – debt service
– Doesn’t acct for
• Opportunity cost
• Value of invested capital (what people paid for shares.)
Businessman and Economist
• Business: I got earnings of $100K on my $1M
investment. I earned 10 percent!
• Economist: He earned the same 10 percent
on his money that he would have earned if he
just invested in the stock market.
– So: Earnings – Opportunity Cost of Capital = ZERO
– His profits were ZERO.
• (Just terminology, but important.)
Bankruptcy
• Earnings < 0
• Lets assume no self supplied labor,
buildings,etc
• Same as Revenues – VC – debt service < 0
• Same as R – VC – debt – opp. Cost capital < opp. Cost of capital
• Same as Profit < Opp. Cost of Capital
• Can’t pay bank loans and VC of production.
Point of Bankruptcy
• Legal mechanism
• Allows firm to negotiate with suppliers and
pay back less than all its debt so that it can
survive.
• Makes sense when can pay back some, but
not all of debt.
• Makes sense when firm will make more
money alive than dead