Question
In: Finance
As a shareholder of a firm that is contemplating a new project, would you be more...
As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, the cash brake-even point (the point at which operating cash flow is zero), or the financial break-even point? why?
Solutions
Expert Solution
The shareholders always focus on the actual cash generated by the company and not the accounting profit or financial break-even point. The accounting profit is based on an accrual basis and the company may be profitable but may not have received cash.
The accounting profit does not account for the cost of capital of the shareholders. Consider this example. If a company has generated 8% accounting profit for the year but the cost of capital is 9%, then the shareholders have actually lost value even though the accounting profit is positive.
Value-added = Accounting profit - cost of capital * investment
If the investment is $1 million. Then accounting profit = 8% of 1 million = 80,000. If the cost of capital is 9%, then the dollar required return = 9% of 1 million = $90,000. So, the shareholders have actually lost $10,000. And hence accounting-breakeven or the financial break-even is not a good measure of shareholders value.
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