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Depreciation and opportunity cost of capital

How to account for things when you own the building instead of renting it. Created by Sal Khan.

Video transcript

Background voice: Let's think about how we would have accounted for things, if instead of renting our building for $200,000, instead we bought the building for $2,000,000, how would that showed up … how would that have shown up from an accounting profit point of view and an economic profit point of view? We're going to buy our building for $2,000,000. That is the market value of our building at the beginning of our period, at the beginning of year 1. Let's say, at the end of year 1, so this is year 1 right over here, that occurs. Maybe, to a large degree, this is because I used the building, there was a lot of traffic in there. Maybe it was a brand new building before and now it's essentially kind of ... the building itself has taken some wear and tear. Because of that, the market value of the building is now, 1.9 million dollars. Essentially, through this year, the building's value has depreciated by $100,000. We'll say the depreciation is $100,000. Notice, I didn't pay anyone that $100,000. It was not an explicit opportunity cost, but this really is an opportunity cost, because this $100,000 is the opportunity cost of not selling the building a year ago. Instead, using that building, I have essentially lost out on $100,000. That's not all that I have lost out on. I have also lost out on the ability to invest this $2,000,000 in other things. Maybe I could have invested the $2,000,000 at a 5% rate and gotten some interest on it. I also have the opportunity cost, opportunity cost of capital, of not investing that $2,000,000 some place else. The opportunity cost of capital, let's say I could have gotten 5% on my $2,000,000. 5% of 2,000,000 is $100,000. My opportunity cost of capital is $100,000. Another way to think about it is, let's just say that I buy the building and I sell it at the end of the year. Then, I would have literally lost $100,000 on that transaction and although I might have used it, so I got some value out of it, and I would have lost another $100,000 by not having that money invested in some other use during that period. These are the 2 non-explicit cost that will come into ... that would show up in our profit statements. Now, depreciation is something that is accounted for by accountants. When you look at a company's financials, you will see something called a depreciation. Which is a measure of, how are you ... You're kind of using up your capital goods, you are using up your building, you are using up your equipment, you are using up your vehicles, or whatever else you might have. Economist are very pure about depreciation. They say, what was the market value at the beginning of the period, what is the market value at the end, the difference is how much it has depreciated. This is kind of ... it's actually almost a more natural way. In accounting, and I won't go into the details, there are many ways to depreciate something. You might be able to say, "Well, if the thing is worth $2,000,000" "and if it's going to last me 10 years," "I can depreciate $100,000 a year," "or actually $200,000 a year." 2,000,000 divided by 10 years. There is different incentives based on if you are the owner of a firm, of how you depreciate. You might want to actually want to have a lot of depreciation for tax purposes, so that you can somehow hide a profit or whatever. For the sake of this video, we're going to assume that both the accountants and the economist will mark off $100,000 of depreciation, if we were to buy the building. Let's redo our 2 financial statements, the accounting version and the economic version. In the accounting version ... Let me copy and paste all of this. Copy and let me go down here and paste it. Let me paste it. Now, we don't have any rent expense. Instead of renting the building, we've gone off and we've bought the building. Let me get rid of that. Our rent expense is now going to be 0, is now going to be 0. We do have a depreciation expense. I'll write that in another color. We do have a depreciation expense of $100,000. We don't think about the opportunity cost of capital. What we could have done ... This is opportunity cost of capital. What we could have done with that $2,000,000 that we used to buy the building. Our pretax profit, our pretax accounting profit, pretax profit from an accounting point of view, is going to be … Let's see, 50 minus 200 is 300, minus another ... Let me make sure that I get this right. I have … Actually, it's gotten better, because my rent was 200 and now I only have a depreciation of 100. It's 50 minus 350 gives me a pretax profit of $150,000. That was because I was renting it for more and now my depreciation, based on how ... what happened with the market rate, actually changed less than what my rent would have been. The economic profit, at least based on the way we've done the numbers here it will actually come out neutral. Which it should, because really economic profit, we're just trying to decide, does it make sense for us to run this business in this way. When we look at the economic profit ... Let's copy and paste this again. Let me copy just this part. Copy and paste. Maybe if things actually did improve, when we actually changed whether we owned or rent, then that would say that's the more economic way to do it. Let's say that it's year 2 or this is year 1 again. Now we're doing, this is economic profit, year 1. Our food is the same. Our labor is the same. Our rent disappears. Let me get rid of that. Let me get rid of the rent. The rent is now going to be 0. We now own our building. Rent is 0. These are all our explicit cost. These are direct payments of money to someone else. Now, let's think about our implicit cost. Implicit cost. We still have the same implicit cost that we had up here. We have the wages foregone. We talked about maybe I was a doctor and I'm not working as a doctor to run this restaurant, so my wages foregone are $150,000. Wages foregone are $150,000. Actually, I think ... Wages lost are $150,000. Now, we have the depreciation on top of that. I'll do this in magenta to show what is new. We have the depreciation of $100,000. On top of that, we have the opportunity cost of capital. The return we could have gotten on that $2,000,000, that instead we used to buy the building. I'll call it OCC, opportunity cost of capital, in this situation was the 5% of $2,000,000, another $100,000. The way that I've worked out the numbers here, we didn't have to spend 200,000 on rent, but we increased our implicit cost by owning the building, by 200,000, so it all comes out the same. We still get what we got in the previous one, of an economic profit of negative $100,000. Negative 100,000 of economic profit. Economic profit. This of course was accounting profit. I wanted to really just highlight in this, is that you don't get kind of a freebie on the economic profit when you decide to buy instead of rent, or rent verses buy. There are still ways of accounting for, essentially, the opportunity cost of doing any of these actions.