BUS101: Introduction to Business

Profit is equal to a firm's revenue minus its expenses, while value is the present value of the firm's current and future profits.

Learning Objective

• Differentiate between profit and value

Key Points

• Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an investor, whereas economic profit is the difference between a firm's total revenue and all costs (including normal profit).
• Given that profit is defined as the difference in total revenue and total cost, a firm achieves a maximum profit by operating at the point where the difference between the two is at its greatest.
• The value of a firm is linked to profit maximization. A firm looking to maximize its profits is actually concerned with maximizing its value.

Term

• game theory

  A branch of applied mathematics that studies strategic situations in which individuals or organisations choose various actions in an attempt to maximize their returns.

Examples

• Which of the following statements is true regarding a firm's value? A) The value of a firm is the sum of its expected profits; B) The value of a firm is the sum of the PV of its current and future profits; or C) The value of a firm is its current profit. The answer is B. The present value of a firm is determined by considering both the current and expected profits of a firm.
• 1) If a firm's current profits are $10,000 and the firm is expected to earn $10,500 in profits in each of the next 3 years, What is the value of the firm in present term. The interest rate is 8%. A) 41,500 B) 39,170 C) 37,060 D) 40,000 The answer is C. The following equation is used to determine the firm's value: PV(firm)=p(0) + [p(1)/(1+i)]+ [p(2)/(1+i)^2]+ [p(3)/(1+i)^3], where p=10,00 p(1), p(2) and p(3)=10,500, and i=.08. PV(firm)=10,000+[10,500/(1+.08)]+ [10,500/(1+.08)^2]+ [10,500/(1+.08)^3] PV(firm)=10,000+9722+9002+8335 PV(firm)=37,060

Profit

In accounting, profit refers to the difference between the purchase and the component costs of delivered goods and/or services, and any operating or other expenses. In neoclassical microeconomic theory, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an investor, whereas economic profit is the difference between a firm's total revenue and all costs (including normal profit). In both classical economics and Marxian economics, profit refers to the return of capital stock (means of production or land) to an owner in any productive pursuit involving labor, or a return on bonds and money invested in capital markets. By extension, in Marxian economic theory, the maximization of profit corresponds to the accumulation of capital, which is the driving force behind economic activity within capitalist economic systems. Some common-use definitions of profit include the following:

• Gross profit equals sales revenue minus cost of goods sold (COGS), thus removing only the part of expenses that can be traced directly to the production or purchase of the goods.
• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) equals sales revenue minus cost of goods sold and all expenses, except for interest, amortization, depreciation and taxes.
• Earnings Before Interest and Taxes (EBIT), or operating profit, equals sales revenue minus cost of goods sold and all expenses except for interest and taxes. This is the surplus generated by operations.
• Earnings Before Tax (EBT), or net profit before tax, equals sales revenue minus cost of goods sold and all expenses except for taxes. It is also known as pre-tax book income (PTBI), net operating income before taxes, or simply pre-tax income.
• Earnings After Tax, or net profit after tax, equals sales revenue after deducting all expenses, including taxes (unless some distinction about the treatment of extraordinary expenses is made). In the U.S., the term net income is commonly used.

Profit Maximization

It is a standard economic assumption (though not necessarily a perfect one in the real world) that other things being equal, a firm will attempt to maximize its profits. Given that profit is defined as the difference in total revenue and total cost, a firm achieves a maximum by operating at the point where the difference between the two is at its greatest. In markets that do not show interdependence, this point can either be found by looking at graphical representations of revenue and cost directly, or by finding and selecting the best of the points where the gradients of the two curves (marginal revenue and marginal cost respectively) are equal. In interdependent markets, game theory must be used to derive a profit maximizing solution.

Value

Economic value is a measure of the benefit that an economic actor can gain from either a good or service. It is generally measured relative to units of currency. The interpretation, therefore, is "what is the maximum amount of money a specific actor is willing and able to pay for the good or service?" Note that economic value is not the same as market price. If a consumer is willing to buy a good, this willingness implies that the customer places a higher value on the good than the market price. The difference between the value to the consumer and the market price is called "consumer surplus". It is easy to see situations where the actual value is considerably larger than the market price; the purchase of drinking water is one example. Value is linked to price through the mechanism of exchange. When an economist observes an exchange, two important value functions are revealed: those of the buyer and those of the seller. Just as the buyer reveals what he is willing to pay for a certain amount of a good, so, too, does the seller reveal what it costs him to give up the good. Said another way, value is how much a desired object or condition is worth relative to other objects or conditions.

In terms of a business, value is the present value of the firm's current and future profits. The value of a firm is linked to profit maximization. A firm looking to maximize its profits is actually concerned with maximizing its value. As such, it is important for a firm to be able to accurately determine its present value.