Question

What are the advantages and disadvantages of economic income?

Answer 1

Economic income is the unrealized gain coming out of the increasing value of asset in the market.

Example: Suppose the current value of an asset is $50,000 and it is expected that the value to be increased in the next year by 10%. Then the value would be [$50,000 × (1 + 0.10) = 50,000 × 1.10 =] $55,000. Therefore, the unrealized gain in the next year would be $5,000 if the asset is not sold.

Advantages:

No.1) it gives idea to the firm what would be the value of asset going to be in the market in near future. If the estimation is correct the result would be then almost correct.

No.2) it assists firms for finding exact time for selling assets. The period of highest return could be chosen for selling, considering the replacement factor and inflation rate.

Disadvantages:

No.1) this is not useful if interest rate in the market fluctuates heavily, because in that case the correct discount factor can’t be implemented which is required for present value calculation of future cash flows.

No.2) believing on economic income is very hard, since it is not based on historical data and cost approach – it may be found that while selling asset in the market the expected market price drops suddenly.