Interest is a payment made by a borrower to the lender for the money borrowed and is expressed as a rate percent per year.
Types of Interest:
There are two types or kinds of Interest:
(a) Net Interest: The payment made exclusively for the use of capital is regarded as net Interest or pure Interest. According to Prof. Chapman—“Net Interest is the payment for the loan of capital when no risk, no inconveniences apart from that involved in saving and no work is entailed on the lender.”
Thus, Net Interest = Gross Interest – (payment for risk + payment for inconvenience + cost of administering credit)
i.e., Net Interest = Net Payment for the use of capital.
(b) Gross Interest:
Gross Interest according to Briggs and Jordan has said—“Gross Interest is the payment made by the borrowers to the lenders is called Gross Interest or Composite Interest.” It includes payments for the loan of capital payment to cover risks for loss which may be:
(i) A personal risks or
(ii) Business risks, payment for inconveniences of the investment and payment for the work and worry
involved in watching—investments, calling them in, and investing.
According to Prof. Marshall: Gross Interest is that “Interest of which we speak when we say that interest is the earning of capital simply or the reward of waiting simply, is net Interest but what commonly passes by the name of interest, includes other elements besides this and maybe called gross interest.”
Thus, Gross Interest = Net Interest + payment of risk + payment for inconvenience + cost of administrating credit
Profit or Economic Profit
An economic profit or loss is the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs, and as a result, a person can have a significant accounting profit with little to no economic profit.
Economic profit or loss is most useful when comparing multiple outcomes and making a decision between these outcomes. This is especially true for decisions with multiple variables that affect and do not affect accounting profit. For instance, one decision may result in a higher accounting profit, but after other variables are considered, the economic profit of another decision may be higher.
Economic profit is a measurement of opportunity cost. Opportunity cost is the value of the trade-of when a decision is made. For example, an individual may consider returning to school to get a degree but in doing so, needs to quit his current job. The individual should consider not only the cost of tuition and books but the income he forgoes by pursuing a degree. This lost opportunity to make money, or opportunity cost, is the underlying purpose of calculating economic profit.
Example of Economic Profit
An individual starts a business and incurs startup costs of $50,000. During the first year of operation, the business earns a profit of $75,000. If the individual had stayed at his previous job, he would have made $20,000. In this example, the accounting profit is $25,000, or $75,000 - $50,000. However, because the individual had the potential to earn income at another location while retaining the startup costs of the business, an economic profit of $5,000, or $30,000 - $25,000, is incurred.
