Importance of Political Economy than NeoClassical Economics

Logical flaws in NeoClassical Economics

Issues of general equilibrium and disequilibrium

The neoclassical economics is basically based on methodological individualism. This school of thought of Economics has assumption that consumers are utility maximise under perfect information. In addition, they derive individual demand curves and add individual demand curves to get market demand curves. The same applies to the supply curves of firms in a competitive market. Then the demand and supply find prices and they allocate resources between different markets and arrive at equilibrium in goods, labor and money market simultaneously. In this school of economic thought,  if markets  to work without any hinderance they produce greatest efficiency and equity based on the assumptions of consumer behaviour and behaviour of firms at micro level achieves Pareto optimality in welfare and greatest efficiency at macro level.
That is  the marginalist and Neoclassical economics apparently give a coherent picture of the market economy which is the best of all worlds. However, they ignore many complex issues and aggregation issues at macro level to do get the outcome as explained above in theory. This neoclassical economics has many logical flaws and they ignore many factors which are important practical consideration in a real world economy which have diverse tastes, commodities,  social interaction, conflict, institutional issues,  gender issues as well class formatiion,

Classical Economics
Foundations of Economics or more appropriately the foundation of political economy were laid by "classical economists" in the wake of Industrial capitalism in Britain in the period of 17th and 18 century.  Adam Smith's " Enquiry into Wealth of Nations" in 1776, si the first most comprehensive treatise on this subject. He considered that the key to wealth of nations is the broadening of market. He identified the basic force of the market economy is the self-interest of producers and consumers which also in the same time with the "invisible hand" increased public good.  He also emphasized  division of labour and specialization to increase the efficiency of the market system.  He identified demand and supply as the basic market forces. He also developed to some extent the labor theory of value which is further developed by has successor Ricardo, in his book  Principles of Political Economy and Taxation, 1817. Ricardo also formulated the law of comparative advantage and the market forces to international trade, which holds ground even today. He also formulated law of diminishing returns especially in relation to land.  J.S. Mill formulated, who is the last among the last in classical economists,  between production and distribution, where production must be guided by free market forces and distribution can have scope  for intervention by non-market forces, in his " Principles of Political Economy, 1848".
As well, Thomas Malthus in his "Principles of Populations, 1798" identified the long-term race between agriculture and population growth. He observed, that the former grows by arithmetic proportion the latter grows by geometric proportions, which leads to an imbalance, which can only be resolved by pestilence, disease and famine. This theory is till relevent to some countries even today.
As well, they all believed that the economy will be always at equilibrium at very close to full-employment if government intervention is small but necessary for the efficient functioning of markets by laws and some essential services such as postal and security services and protection of basic freedoms. In addition, they developed the quantity theory of Money.They also identified classes and class formation.
However, Karl Marx in "Das Capital" was not confident of the free market system and he has predicted the collapse of the system. He identified, contradiction inherent to the free market system when it develops  due to of exploitation and wages less than the value created by social labor and under consumption and the rate of profit falling down, creating crisis of the system . In his view, the labor theory of value is the regulator of the system and its dynamics and the demand and supply is the executor of the system.
Marginalism and Neo-Classical Economics
In 1870, and in later years the Neo-Classical economics emerged and neo-Classical economists developed precise economic laws of optimizing consumer at the margin given their preferences by maximizing the utility or calculating the cost and benefit of consumption at he margin of consuming goods and services spend by the last unit of money. In the same time, the firms produce, where small productivity is equal to wages, rate of interest is equal to the small efficiency of capital and rent is equal to small efficiency of land except for more productive land where there may  super profit as identified by Ricardo.  This law, optimizes the use of the factors of production. The level of production, is determined where marginal cost equals marginal revenue where profit is maximized. As well, demand and supply is always equal as there is tendency of equilibrium through the price mechanism. In addition, Pareto equilibrium states, that the free market produce best results. In effect, according to Neo-Classical economic point of view, competitive market equilibrium theory implies,  that the role of government must be as small as possible.  These  laws, were further developed and refined by Alfred  Marshall, of england, J.B. Say of France, Kunt Wicksell of  Sweden, Irving Fisher and J.B Clark of USA.
As, well, in neoclassical economics, Mathematics is important to neo-classical Economists. For example, the economist  William Stanley Jevons and Leon walrus used mathematical analysis as economics used quantitative measurements. In this way, Walrus pioneered " General Equilibrium Theory" using equations of all transactions in an economy.  Mathematical approach to economics was given shape by P.A. Samuelson in his book of " Foundation of Economics, (1947). In addition, recently mathematic approach to economics in neo-Classical economics came into being by " Game Theory". It was first pioneered by John Van Newman, Oskar Margenstern and by John Nash in " The Theory of Games and economic behavior" in 1944. In 2005, it was further popularized, by a Nobel prize-winning  economist Thomas Shelling. In the same time, technique of complex theory had an impact on economics using mathematical techniques.
However, one of the founder of Neo-Classical economics Alfred Marshall has been critical about mathematical techniques as a major way to ask the economic phenomenon. For example, he has observed in his principles, that 'Use of Mathematics as a short-term language and not an engine of inquiry". As well, John Maynard Keynes, trained as a Mathematician, has commented that purely mathematical approach to economic study is not right or not fruitful.

The flaws in the Foundation of Neo-Classical Economics
In Neo-Classical economics, is based on a concept called 'homo-economics'. That is, the person as an economic agent, whether the person is a consumer or a producer making choices is a faulty one.  That is, people do not make choices independently  their own choices, and their choices are influences by interpersonal relations, community values, media impacts as well by community and group values. In reality, people act in a social context,  be seen in that way and not isolated people abstracted from the social world .   Nobel prize economist Trygve Haavelelmo in his lecture " economics and Welfare 1989" has observed an individual embedded in a social world.
Another serious flaw in Neo-classical economics 'rational' choices made by a person in a self-interested way to maximize utility is extremely illogical. This is because, in reality people make spontaneous decisions, like impulse buying, thrill seeking, want to know the unknown, making decisions according to some religious or moral values especially in food consumptions and other consumptions, even though they need not be rational. In other words, in reality people make decisions, which are not motivated by self-interest alone and other influences which motivate them in consumption behaviour. They can also be motivated by ethical and moral values. In this sense, rational consumer behaviour as assumed by the Neo-Classical economics is extremely dubious and not based on empirical evidence or observation in day-to-day economic activity of any person.
In neo-classical economics, they base their ideal model to judge other market models. However, they rarely exist in any market economy. Most markets are far removed from the perfectly competitive markets. Some modern corporations are very huge and they exert power due to their money power as well their ability to manipulate consumers by the aid of advertisement, particularly in a reality where the information is asymmetrical and uncertainty is the norm and not exception. Corporations manipulate demand and not supply.  A renowned economist J.K. Galbraith has observed this fact. In other words, even if consumers maximize utility, the utility is not controlled by the person but manipulated by the modern  corporations in reality, perfect market conditions is a mere abstraction than concrete assumption based on empirical facts.
In marginalist economic analysis firms take decisions where marginal cost equals marginal revenue to optimize profit . However, in actual practice, the firms do not make decisions as marginalist suggest. They often make these decisions not based on marginalist economic analysis, but in response to technological breakthroughs as well as by compulsions of machinery. and capital equipment. As well, , there exist no constant coefficient of production and there is no perfect divisibility of goods or factors of production. If this  is the case, even if markets are perfect, the economic efficiency and profit maximization is not the main goal of firms, or they cannot practice profit maximization based on marginalist analysis, they need not optimise the efficiency of the use of scarce resources.
In the text books, the market characterization is simple and they do not adequately cover brand and goodwill. They are important for any marketing people and marketing departments of any modern-day corporations. brands and goodwill are important considerations for modern business organizations than competitive markets alone as they do not compete with other firms solely o the basis of price alone. That is, some markets are not perfect markets and they are monopolistic markets and brand and goodwill are crucial factors competition than price.
In Neo-Classical general equilibrium model is static . They do not adequately consider uncertainty and dynamic processes in an economy.   Input-output relationships is linear in their model. However, in reality they are normally non linear and they are chaotic . As well, they tend are a rule and not an exception.
In addition, the neo-Classical economic models overlook institutional set-up like legal system, educational set-up and cultural institutions, which are very difficult  included due to the fact that these models are mathematically oriented and these are very difficult  concepts to be incorporated.
In the neo-classical model, economic activity in non-market sectors like family, educational area, health area and government are heavily overlooked, even they are crucial in a given market economy or even any modern market economy. For example it has been estimated that the family economic activity accounts for at least 40% of GNP in Western economics.
Micro economics of the Neo-classical model to predict macro level economic forecasting is not impressive.
Conclusions
As discussed above, even neo-classical economics is the dominant school of thought in economics, by many economists for their narrow definition and there claim that their economics is scientific. it is obvious from the above discussion, it is clear it has many logical flaws as well it overlooks many issues of the real market system and how it works and its role in the issues of efficiency and fairness as well how it develops over time. If these issue are not addressed and broader definition of economics like political economy with other social sciences is not undertaken in future.  Economics will be a dismal science and its usefulness to solve real world economic problems is questionable.

The Importance of Cost of Capital in Financial Management

The Importance of cost of capital in Financial Management
The concept of cost of capital is crucial in financial management. Like any other source of finance has a cost and cannot, therefore, be used in the most effective manner unless that cost can be accurately determined and taken into account.
There are many misconceptions about the cost of capital which must be carefully avoided. If, for example, a business has large amount of cash which it proposes to invest in a project, it might appear that the finance in this case is free of charge because no payment has to be made for its use to outside suppliers. It should be remembered, however, it does have an opportunity cost, ie the cost of foregoing which the cash might have earned in some other use even if this only be the placing of it on deposit at a bank.
Another cause of difficulty is the notion of the weighted average cost of capital. The fact that debenture is issued in order to raise the cash for a project does not mean that the cost of that debenture is the cost of capital for that project. Finance is not normally project-specific and must be regarded as being drawn from a common pool containing all sources in a desired mix. Many questions will require the calculation of weighted average cost of capital.
In this paper, I will try to illustrate the main variations on the theme of the cost of capital which are likely to be encountered and the main difficulties associated with these. They are:
The cost of individual components of capital, that is equity and debt.
The calculation of the weighted average cost of capital
The concept of marginal cost of capital
The implications of expected growth to the cost of equity.
It should be notices that other topics can creep unto question on the cost of capital. Examples are the calculation of the market prices of securities, ratios and investment appraisal.
Cost of individual components of cost of capital
To illustrate the implications of calculating individual components of cost of capital, I will use an example to explore the issues related to evaluate how debt affects the cost of capital and the concept of marginal cost of capital, to decide what form of finance best suite for a project.
Example:
Company X has the following balance sheet as follows:
000's
Share capital (1.00 per share) 5000
Reserves 2000
Trade creditors 3000
overdraft 1000
Total 11000
000's
Fixed assets 6000
Stock 3000
Debtors 2000
Total 11000
It intends to invest in a major project, which will increase earnings by 30%. The project will require the purchase of fixed assets totaling 2 million and stocks, debtors and creditors will increase by 25%.
At present the annual profits of the company are 2 million and dividends of 1.5 million are paid. Assume these figures are expected to to persist indefinitely ignoring the new project. The ordinary shares have a stock exchange value of 2.00 each.
The directors are considering alternative methods of raising the 2.5 million required for the project and have identified the following alternatives:
An issue of 2.5 million 15% debentures. This would have the effect of increasing to 25% the earnings yield required by the stock market on the ordinary shares of the company.
A rights issue on the basis of one new shares at par for each two shares already owned.
Say the directors want to calculate the cost of capital of the proposed debenture issue. As well, they want to calculate the value of the ordinary shares after making the proposed rights issue. Above all, they want to evaluate the relative merits of the proposed financing methods and any other alternatives to the proposed financing methods applicable for this project.
In order to address all issues relevant to this problem the directors must have a step by step method to address all the issues. My guide to this problem is as follows:
Step 1: calculate the marginal cost of capital in respect of the debenture issue.
In this example, this is complicated by the fact that the change in the capital structure has an effect on the cost of equity and that the calculation of the marginal cost of debenture issue must take into account.
Total cost of debenture issue:
Interest at 15% of 2.5 million 375000
Required increase in earnings
of equity 500000*
Total cost of Debenture issue 875000
*Current yield is earnings/ Value of equity = 2/10=20%
This has increased to 25%. That is it has to increase by 5% of 10 million. This is 500000.
There fore the actual marginal cost of debenture = 875000/2500000= 35%
Step 2: Calculate the probable value of the ordinary shares if the proposed rights issue is made.
In this instant, it can be presumed that the value or market value of the shares after rights issue is equal to the current market value of the existing shares plus the cash raised by the rights issue.
Value now is 5000000*2 10000000
Cash raised by rights issue 2500000
Value after rights issue 12500000
Number of shares after rights issue is 7500000
Value of each share = 12500000/7500000= 1.67
Step 3: Determine the rate of return offered by the major project under consideration.
Increase in earnings is 30% of 2 million. That is the expected earnings of the project is 600000.
Investment required
Fixed assets 2000000
stock 3000000
Debtors 2000000
Total 5000000
less creditors 3000000
Working capital 2000000
25% increase 500000
Total Investment 2500000
Yield = 600000/2500000=24% per year.
Step 4: Based on the above calculations, evaluate the merits of the proposed financing methods.
Step 1 shows that the marginal cost of debenture issue is 35% per year. If this form of finance is to be used the project is not worthwhile as it yields only 24%. This proposal therefore should be rejected.
The current cost of equity is 20%. It may be assumed that an increased yield is required only if gearing is introduced and that therefore the marginal cost of the rights issue is 20% per year. This same for the existing equity. This would make the proposal acceptable and this is the form of finance which should be used.
Step 5: Draw attention to alternative sources of finance.
The alternatives are:
Leasing of fixed assets. This is what is known as off balance sheet financing and means that the initial investment by the company is reduced to that required by the increase in working capital.
Consider Bank overdraft. The cash flow from the proposed project of 600000 would make it possible to pay back the initial investment of 2500000 in a little over four years. The bank may be willing to increase the overdraft facility for such a short time.
Retained profits. If dividends were curtailed and the project postponed for a period sufficient funds could be raised to finance the new project within a year or two.
The models used to calculate the expected return on equity and their advantages and disadvantages
The dividend growth model approach
The easiest way to estimate the expected cost of equity is to use the dividend growth model. Under this model it is assumed that the dividends will grow at a constant growth rate.
If the constant growth rate= g
The price per share = P0 then
P0 = D0* (1+g)/(Re -g) where D0 is the dividend paid now and Re is the rate of return on equity. That is Re = D1/P0 + g.
In this model to estimate Re one must know D0, P0 and g. For publicly traded shares D0 and P0 are readily observable. However g has to be estimated from past dividend data. The growth rate can be calculated on the basis of historical data or use the forecasts from different sources and average them because all the forecasts will vary considerably. It is obvious from this model that the accuracy of the Re depends on the accuracy of the dividend growth rate “g”. If the growth rate is not accurate then the expected return on equity also will be inaccurate more than the growth rate changes.
For example, suppose a company paid a dividend of 20 cents per share last year. The share is currently sell for 2.60. If one estimates dividend will grow steadily at 4 per cent per year into the indefinite period in the future. What is the expected return on equity?
In this example D0 = 0.2 there fore d1 = 0.20*(1+0.04) = 0.208
Using the dividend growth model Re = D1/P0 + g, Re = 0.206/2.60 + 0.04 = 0.12 or 12%.
That is, the expected return on equity or cost of equity is 12%.
In the above example, if say the growth rate is 2% instead of 4% what will be the effect on the expected rate of return? Applying the the model using 2% as growth rate the expected rate of return on equity is 0.0985 or 9.85%. That is the expected rate of return has changed by 2.15% if the the growth rate has changed by 2%. That is the expected rate of return on equity in the dividend growth model is very sensitive to the changes in the growth rate other things are being equal.
Advantages and disadvantages of the dividend growth model
The main advantage is the simplicity of the model. That is, it is easy to understand and easy to use. However, it has a number of practical problems in application and disadvantages.
First if companies do not pay dividends then the model is not applicable. Even they pay dividends this model assumes the dividends will grow at a constant rate. This is not the case for most of the companies. There fore, it is only applicable to companies where there is reasonable grounds to assume the dividends will grow steadily.
Secondly as demonstrated above the model is sensitive to changes to the growth in dividends. That is, if there is an error in the estimate of dividend growth rate the the expected return on equity will change more than the error in the estimate of dividend growth rate. As well, the dividends are estimated from past dividend records. The future dividends may considerably change because of future conditions may be quite different to the past.
Finally, the dividend growth model does not take in to account explicitly the riskiness of the investment like the Security Market Line approach. That is it does not take in to account the certainty or uncertainty of dividend growth rate. As a result, it is difficult to say the return on equity is commensurate with the level of risk. However, there is an implicit adjustment for risk using the current market price of shares. All other things being equal, the higher the risk lower the share price. Further, lower the risk higher the share price. However it has to assume all the other information is the same. This is not the case in reality.
The Security Market Line approach
According to Security Market approach expected return on a risky asset such as equity depends on three things. They are as follows:

1. The risk free rate “ r f “
   
2. The market risk premium, “E(rm)- r f”.
   
3. The systematic risk of the asset relative to average, which is the beta co-efficient, “b”.
   

That is applying the SML model Re = Rf + b:* (Rm – Rf).
Implementing the SML approach
To use one must estimate Rf the risk-free rate, market risk premium (Rm -Rf) and the beta co-efficient.
In a study it has been found the behavior of returns for shares and government bonds from 1882 to 1989 the risk premium over the period was 7.94%. Over the same period the risk free rate was found to be 5.21%. Studies in US, UK and Canada revealed the long-term premium to be around 7%. For large company shares from 1923 to 2003 it has been found that the risk premium in USA to be 8.6%, while for the 1901 to 2006 in Australia the risk premium was 7.6%. That is one can use 8% as risk premium and 5% as risk free rate in the SML model as an estimate. However, one must beware the SML model uses future reurns not past returns. The past returns can be used as future return assuming the economic conditions are not very different. If say for a company the beta of the shares is 0.875 then applying the risk-free rate of return and market premium rate the return on equity can be cal calculated as below:
Re = Rf + b*(Rm – Rf)
Re = 5% + 0.675*8% = 12%.
Advantages and disadvantages of SML approach in estimating the return on equity
The SML approach has two primary advantages. First, it explicitly adjust for risk. Second, it is applicable to companies other than with steady dividend growth. Thus it may be useful in a wide variety of circumstances.
There are disadvantages in SML approach. This approach is based on estimating the risk-free rate and the market risk premium and beta co-efficient. To the extent the estimates are poor, the resulting cost of equity will be inaccurate. For example using different time periods may estimate quite different risk premium and risk free rate. Finally, like the dividend growth model SML approach also uses historical data to estimate the inputs of the model even though the figures are for the future. That is the future is estimated on the past.
The future mat be quite different to the past and the estimation based on the past may not be relevant and it may be quite inaccurate. However, in a perfect world, the dividend and SML approach are both applicable and both result in similar answers. If this happens, one can have confidence in the estimation of the inputs in to these models. It advisable to compare the results of the calculation with other similar companies as a reality check.
The expected return on debt and preference shares
The expected return on debt
The cost of debt can be calculated using the coupon rate of say a debenture and using an approximate equation as follows:
Say the Interest = I, par value of debenture = PV, Net proceeds of issue = market price -cost = NP, number of years to maturity = n then expected return on debt “Rd' can be approximately expressed in the variables as mentioned above. The equation for the Rd is as follows:
Rd = [I + (PV – NP)/n] / (PV + NP)/2
If the rate of corporate tax is say = t%
Then the after tax expected return or the cost of debt = Rd* (1-t)
Say a company issued an eight year debenture at 7% interest on par vale of 100. Say it has been issued 2years ago.. The debenture is currently selling at 95.38. The expected after tax return calculation is as follows:
Rd = [7 + (100 – 95.38)/6] / (100 + 95.38)/2 = 7.95%
This rate of return for debentures is before tax. As tax is deductible for a company the interest cost the after tax return on debentures must be less by the tax percentage.
There fore, the Rd after tax = 7.95%* (1-0.30) = 5.565% approximately.
Expected return on preference shares
As preference shares have a fixed dividend rate, the value of preference shares is the perpetuity of the dividend amount discounted by the rate of dividend. That is, if the preference shares market price is “ P0” and the dividend amount is “D” then the the expected rate of return on preference shares “R p” can be expressed as follows:
R p = D/P0.
Say a company is trading preference shares in the stock exchange. Its current price is 2.11 and the par value of preference shares is 2. Its expected rate is 0.14/2.11. That is, the expected rate of return on preference shares is 6.64%.
The weighted average cost of capital(WACC)
Say the market value of debt = D
Market value of stock or shares = E
Then the total value V = D + E. therre fore the weights of equity is E/V and the weight of debt is D/V.
There fore like the portfolio average return, the weighted average cost of capital is as follows:
WACC(unadjusted) = E/V* Re + D/V*Rd.
If taxes are incorporated then the WACC equation will be as follows:
WACC = E/V*Re + D/V* Rd* (1- t), where t is the rate corporate tax.
Approximate and explicit after-tax expected return on debt
The equation above for the expected return on debt is an approximate equation, for the after tax expected return. The other concept is the approximate after-tax cost of debt and actual or explicit after-tax cost of debt or expected after-tax return on debt. In approximate after tax cost of debt one calculates the yield and then adjust for the tax on interest. However, in the explicit cost of debt calculation the tax is discounted and included in the original equation in one step.
If the current yield = Rd
Debt nominal interest rate = C
Par value = F
period to maturity = t
Current market price = P then
P = C* [1- 1/(1+ Rd)t ] /Rd + F/(1+Rd)t
Approximate after-tax cost of debt = Rd* ( 1- T) where T = corporate tax rate
If one wants to calculate the explicit cost of debt incorporating the tax effect in one step then the equation for explicit cost of debt is as follows:
Say the explicit after-tax cost of debt = R d(t)
Then market value P = C*(1-T)* [1 – 1/(1+R d(t))t ]/ R d(t) + F/(1+R d(t))t
say P = 94.75, C = 5, t= 3, F =100, T = 30%, then applying the approximate equation Rd or yield is as follows:

1.  
   1. = 5*[ 1- 1(1+ Rd)3] /Rd + 100/ (1+Rd)3
      

By trial and error the yield is 7%. Then applying the corporate tax equation the approximate cost of debt = 7%* (1-0.30) = 4.9%
If one calculates the explicit cost incorporating the corporate tax in one step, then Explicit after-tax cost of debt for the above inputs is as follows:

1.  
   1. = 5*(1-0.30)*[1 -1/ (1+ R d(t)3] / R d(t) + 100/ (1+ R d(t) )3
      

By trial and error the after tax explicit cost of debt = 5.443%. One can see the approximate after-tax cost of debt varies from explicit after-tax cost of debt. However, the approximate equation is a good estimate for the explicit after-tax cost of debt. There fore one can use the approximate equation as a proxy for the explicit after tax cost of debt.
Example - Calculation of WACC
Company A has 1.4 million shares outstanding. The share price of the company is currently is 20.00. The publicly quoted price of debt currently is 93 cents of par value. It has total book value of 5 million. The current yield is 11%. The risk-free rate is *5, and the market risk premium is 7%. The beta estimated for company A is 0.74. The corporate tax is 30%. Calculate the WACC of company A?
Solution
From using the SML model approach, cost of equity = 8% + 0.74* 7% = 13.18%. Total value of equity is equal to 1.4 million* 20 = 28 million. The pre- tax cost of debt is 11% as given. The market value of debt = 0.93* 5 million = 4.65 million. The total value = 2* + 4.65 = 32.65. The percentage of equity to total value = 28/32.65.= 0.8576. There fore debt to total value = 1-0.8576 = 0.142. There fore, the WACC for company A is as follows:
WACC = 0.8576* 13.18% + 0.1424*11% 8 (1-0.30) = 12.4%.
Divisional and project cost of capital
In a company the overall company risk may vary from that of divisional risks depending on the different risk profile of project they undertake compared to the overall risks of the company as whole. If projects are evaluated on the basis of the cost of capital compared with rate of return of individual projects of divisional performances, then based on the SML Line analysis, company may accept high risk projects, which tends to have higher returns as opposed to lower risk projects. This may lead to inaccurate project evaluation process and may cost the company and may loose shareholders wealth by investing in high risk projects.
That is, if projects are perceived to have high risk profile compared to ovral company activities then they must calculate divisional cost of capital compared with similar companies rather than using cost of capital for a company to evaluate the projects or divisional performances. In effect they must adjust the companies weighted average cost of capital so that it reflects the risk profile of those projects. In addition, if there exists financing cost to issue additional capital for a specific project, then this fact must be taken in to account in the weighted avarage cost of capital when evaluating competing projects before accepting or rejecting such projects.
Conclusion
As mentioned above the concept of cost of capital is an important concept in financial management as this can be used as a tool to compare different projects and to enable to use appropriate long -term finances and investing in projects which earns more than the risks involved in those projects. That is cost of capital acts as a bench mark if it is estimated properly and used wisely as discussed above. It is also essential to know the limitations of the models to estimate equity rate of return in particular and use appropriate models depending on the nature of their dividends, whether they are private or public companies and whether their operations differ substantially between different divisions. In addition, the cost of capital also is an important concept to be used in the proper capital structure of a company, particularly in real world cost of capital vary with different gearing ratios because of tax, cost of finances, risk of insolvency using debt and cost of bankruptcy.

Strategies of survival for an individual and small business in a recession

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Survival methods for an individual and small business organization

Jobs and investment opportunities

In a recession, other people lose their jobs than you. However, in a depression, you and others lose jobs. if a recession is anticipated, average consumer worries about how it negatively affect them and how they can cope with these negative effects. The following are some of the effects of recession and how to cope with them.
Negative impact of recession on borrowing and credit availability and how to cope with it.
In a recession banks will be less reluctant to grant loans to people and businesses. This is now a problem due to the credit crisis as it affects  availability of loans itself. To manage debts in these circumstances, one must not borrow excessively and must combine their existing debts in to lower interest rate bearing accounts.
Recession and its impact on interest rate and reduced mortgage repayments
In recession, the interest rate is most likely  lower. This enables people and businesses to save on mortgage repayments. This gives some savings in a crucial time to cope against job losses, if that occurs.
Recession and its impact on unemployment and how to cope with unemployment

Recession is an economic condition, where the rate of unemployment increases to a high level compared to the  level of unemployment at normal economic activity for a country.  As the output is decreased, the demand for labor is also reduced and this created unemployment is some sectors worse than others. In other words, the  impact of recession on employment is  not the same for all sectors of an economy and unemployment is concentrated in some sectors.  For example, the recession may affect finance and housing market than agriculture or manufacturing sector.
To cope with possible unemployment if you work in a sector where it affects your possibility of losing your job, think of alternatives, such as online work or online business opportunities. As well,  if you think you may lose your job plan to take unemployment insurance,  if you don't have it at the present moment in time.  The future unemployment may occur or not occur, so don't worry too much about it.  The best possible solution is, to look for other work opportunities and learn new skills, where there is a high demand for labor. For example,  you may learn information technology skills or electronics where there is high demand for this type of labor in most industries.
Recession and its impact on falling profitability of business and how a small business can cope with it
If one is operating a small business recession may affect your business adversely because of falling rate of profit. It may also affect the survival of business if it is operating in a sector which is severely affected by it.  To cope with such a situation, a small business can look for cutting costs which do not compromising the business. There is always waste in any business and this gives an opportunity to cut cost and improve efficiency. Some economists think that recession are good as it gives a business to increase the efficiency of business and benefits the economy as well as it can improve productivity of the economy.  The small business also can consider whether it has possibilities to diversify if recession is affecting its rate of profit.  For example, it can add some new lines of business which attracts frugal customers as recession affects consumers buying behaviour.  In addition, the fall in profit is cyclical. As this is the case, plan to borrow at lower cost  for the difficult years.
Recession and its impact on Stock Market and how to secure profitable investment in a recession
In a recession, normally there is a chance the stock market may cut in value due to falling profits and low dividends. If this is the case, look for diversifying the portfolio or invest in commodities like gold or other commodities which may do well even in a recession.  In recession, the stock market reduces in value.  It anticipates a recession and it may not fall in value during recession.
Recession and its impact on consumer confidence and how to cope with it
The worst impact of recession is its negative impact on consumer confidence as consumers become more uncertain about the future. However, do not depend on media to judge consumer confidence as they mostly exaggerate the situation by sensational news.  To cope with this situation, be calm about it and make the best out of the situation. If you panic, you may end up worse than keeping a calm mind about consumer confidence.
Conclusion
As discussed above, if a person or small business can adopt these strategies they can cope with the negative consequences of recession and take advantage of the positive consequences of recession and can survive and cope well in recession as well they may become more competitive and can grow after the recession is over.

Accounting Theory and Accounting Practice

All fields of knowledge have theories to base its practices. That is, theories play a crucial role in formulating postulates, principles so that it can develop objectives, rules, procedures and methods to continue to revise the methods based on the development of theories. In this essay, I will discuss what are theory, accounting theory, nature and role of accounting, descriptive, normative and positive theories in accounting and the present normative accounting theory of conceptual framework. As well, I will discuss accounting postulates, concepts and principles, which are based on accounting theories.

The Definition of Theory

In my view the theory means a set of coherent principles, concepts, symbols and hypothetical principles which is a reference point in field of knowledge. The theories in general are composed of words and symbols and do not have a physical form.

The Purpose of Theory

The purpose of theory plays an important part in any field. This applies to accounting also. The most important utility of theories in any field of inquiry is that it is a source of new knowledge as they change with new insights by continuous research in any particular field by the researchers who are acknowledged by the profession because of their expertise, integrity, experience and knowledge in that field. In this context, accounting needs theories so that it can develop new knowledge continually as in other fields such as science, social science, psychology etc.

Nature of Accounting

The nature of accounting is primarily a statement which has some basic principles and concepts. That is the nature of accounting is defined by an accounting theory. In essence the nature of accounting can be defined as follows:
“The nature of accounting is a process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of information”.

The Measurement-Communication System

In the measurement communication system the accountant is the transmitter of accounting information. He sends the message in a financial report form to the users or receivers of this crucial information. The accountant is influential in identifying economic information, objectives and in the same time he is also affected by the firm’s environment. The receivers of accounting information in the communication system interpret the information about the firm and then make economic decisions. In this communication system one can see the communication system is basically based on human behavior. As well, the accounting practitioners are governed by conventions and authority. That is their accounting procedures and accounting policies are largely determined by conventions and authority. In addition, the accounting researchers like in any other field develop accounting theories by systematic study in the accounting field.

Functions of Theories

Basically theories have three functions. The first function of theory or theories is to explain. For example why an accountant do not do a particular accounting method because of ethical codes  and accounting standards require him to use such methods and he uses these accounting methods to protect him from sanctions imposed by accounting
 bodies and for his own self interest of not being able to practice and earn an income if he does not obey to authority and sanctions. The second function of theory is to predict. For example in accounting a theory may predict cosmetic accounting changes may not affect share price if the capital market is efficient and share price is not based only on accounting information but other information as well and there fore accounting methods changes may not affect  share prices. The third function of a theory is to prescribe or recommend. For example in accounting the accounting theory may recommend current cost accounting because of its utility or should be used to provide as it may provide useful information to users. However, all theories do not have all these functions. Some theories explain, some explain and predict, some predict only and some only recommend.

History of Accounting Theory

The history of accounting can be categorized in to descriptive theory period before 1955, normative theory period between 1956 and 1974 and positive accounting theory period after 1976.
However, currently mostly many advanced countries at least one can say the accounting theories are based on conceptual frame work based on primarily by normative accounting theories as well as in some accounting issues positive accounting theories are used to explain behavior of managers and the impact of accounting on capital market performance in general.
The examples of descriptive accounting theories used before 1955 are based on observations and what is used in accounting a particular economic event mostly is adopted as a method for that transaction in a particular field. For example if depreciation is used in practice applying a certain method then that is accepted as a method of accounting if it is widely used. That is, descriptive accounting theories guide accounting methods, principles and conventions.
After 1956, the normative accounting theories governed to prescribe what should be done. For example, after 1956 norms of best practice was developed by the incorporation of usefulness of accounting information. This not necessarily based on observation. Due to Normative accounting theories decision usefulness theories were developed and also measurement issues and income concepts became important. As well, the normative accounting theories gave birth to conceptual frame works projects.
After 1975 on wards because of dissatisfaction with normative theories positive accounting theories became important. For example these theories enable the accounting profession to explain and predict that what should be done based not necessarily based on observation. That is the positive accounting theories are basically a specific scientific method of inquiry in to specific accounting issues. The in accounting the important positive accounting theories are capital market based research, contracting theory, behavioral research.

The hierarchical position of financial accounting objectives, postulates and theoretical concepts, principles of accounting and accounting techniques

In accounting, the financial accounting objectives determine the postulates and theoretical accounting concepts. The theoretical concepts and postulates determine accounting principles. The accounting principles determine accounting techniques.
That is, the hierarchical positions of these related concepts are as follows:

• Financial accounting objectives
• Accounting postulates and Theoretical accounting concepts
• Accounting principles
• Accounting techniques, method, rules and procedures

Accounting Postulates, concepts and principles

The basic accounting postulates are accounting entity postulate, Going concern postulate, unit of measure postulate and accounting period postulate. Theoretical accounting concepts are propriety theory, fund theory, entity theory. The accounting principles are revenue recognition, cost and matching, uniformity and comparability, consistency and full disclosure, materiality and conservatism. Most of the postulates, theoretical accounting concepts and principles are derived from descriptive accounting theories.

Critique of the development of accounting rules

The critique of the development of accounting rules mostly come from the insistence on descriptive accounting theories historically. The development applying this accounting theory gave birth to Generally Accepted Accounting Practice. They are piecemeal in nature and they produced inconsistencies as well they were incapable to handle unusual economic events. They also gave birth to creative accounting. These developments of accounting rules were due to problems of lack of general theory, permissiveness of accounting practice, inconsistency of practices, and defense against political interference.
To address these deficiencies conceptual framework was proposed. This is a normative method of theory development. It is premised on the user needs driving the formulation of rules and other operational procedures for use in practice.

The definition of Conceptual framework

The conceptual frame work is a system of fundamentals and interrelated objectives which is expected to lead to consistent standards that prescribes the nature, function and limits of financial accounting and reporting.

Conclusion

As discussed above, it is obvious to see the accounting theory and its role in developing accounting postulates, theoretical concepts, accounting principles and accounting techniques. In addition to define the objectives of financial accounting and reporting. The different accounting theory methods have impacted on the development of accounting rules, operational practices and their evolution on a historical basis. In effect, it is obvious that the development of sound practices in the future depends on the accounting theory used and its effectiveness in terms of robust evaluation of theoretical methods based on sound criteria and apply appropriate theories to develop accounting practice in the future domestically and i

Nutrient Cycling in Maintaining Ecosystem Functioning

Nutrients are central to the function and growth of organisms. In an ecosystem decomposer organisms are essential in breaking down biomass matter and cycling nutrients. Animal waste and dead organic matter are broken down by bacteria and fungi into their constituent elements. Some nutrients are released into the soil and become available for uptake by the roots of the plants for production of new plant matter. Elements such as oxygen, hydrogen and carbon are transmitted by air and water to the living components of ecosystems. Decomposition of dead and waste organic material returns hydrogen and carbon to the atmosphere. Carbon is released as carbon dioxide from the decay of carbohydrates. Hydrogen and nitrogen are released from the decaying protein as ammonia.
Weathering also assists in releasing nutrients into the soil. However nutrients are also lost in the soil.  litter stays in an ecosystem through run-off. Acid rain is an example of nutrient pollution in ecosystems.
We will now observe a particular ecosystem to further illustrate the importance of nutrient cycling in ecosystems. In the Amazon basin nutrient inputs occur through precipitation, wind borne dust, ash, through nitrogen fixation by organisms, weathering of sediments and aerosols.
Essentially producer organisms are responsible for the intake of mineral nutrients into the ecosystem. Thus they construct the very substance of life. Consumer organisms break down organic tissue and return the material in an form to be used again by plants.
Geographers have recorded the flows of nutrients from place to place and reached the conclusion that nitrogen fixation is of the utmost importance. Plants gain their nitrogen as nitrates. Bacteria produce nitrates from soil, air and ammonia, a product of the decay of proteins in dead tissue and waste.
As per information above, the success of ecosystems depends on how well they can produce, use and primarily recycle nutrients. Without nitrogen cycling organisms will not grow, therefore they would lose the ability to function and their roles would not be carried out resulting in the collapse of whole ecosystems.
Since the nineteenth century, humanity has become a global force altering more than half of the surface of the planet through urban-industrial growth, farming and forestry. The composition of the atmosphere has been altered, waterways enriched with nutrients. This choked  the rivers with pollution. As well, soils have been degraded and eroded, and natural ecosystems broken up and their biodiversity diminished.
Human actions have impacted nutrient cycle in numerous ways. Fertilizers, pesticides and other agricultural chemicals are washed into the rivers and oceans.  It  is augmented by increased run off resulting in a loss of nutrients from the soil and litter level of ecosystems. In turn, this removes nutrients plants and animal's need to consume for food and to aid their growth.
In addition, sewage and effluents from aquaculture enterprises and other human developments introduce excess materials and nutrients into the marine environment, creating instability and stressing out specific components of an ecosystem. Combined further with problems of over-fishing, and other disturbances, the changes humans are bringing to the nutrient cycle in eco-sytem can be extensive
Energy flows in ecosystems are also cause for concern due to increased human impacts. Energy flow can be described as energy being used up by the organism (to move its muscles, digest food, excrete wastes, think, etc.) and/or lost as heat as it moves through ecosystems, and new energy is continually added to the earth in the form of solar radiation. An important fact is that energy does not recycle.
Human impacts on energy flows in various ecosystems are caused by land use, water and electricity/appliance household use, combustion of fossil fuels and nutrient flows. The HANPP Approach found that humans already appropriate one-quarter of global terrestrial NPP(net primary production), thus reshaping most of the earth's land - with potentially dramatic effects on biodiversity energy flows and the stability and resilience of ecosystems.
With so many ways in which humans can impact the energy flow and nutrient cycle of ecosystems, we must combat our disastrous effects by beginning to undo the damage we have caused. Starting with using less energy, preserving our natural resources (water) and using/taking only what we need, not what is luxurious and comfortable. If we pull together, educating each other on environmentally friendly habits then I believe we can reduce our footprint on ecosystems and admire there beauty once again.

Causes of unemployment

In this essay I will discuss how unemployment is an individual and a social problem and how Max Weber distinguished power, authority and coercion and how the functionalist, conflict theorist and symbolic interaction theory view the economy and by the mid century how they have evolved and the role of these theories to explain social and economic phenomenon.

How unemployment is individual and social problem

Unemployment is caused by many factors in a modern market economy. It can be caused by rapid technological change, business cycle or recessions, seasonal factors in some industries particularly such as changes in tastes and climatic conditions which affects demand for certain products and services, individual perceptions and willingness to work and search for jobs, their values and attitudes towards some jobs and about employers, accessibility for retraining and acquisition of work skills, willingness and perception of unemployed of the benefits of training and the possibility for them to get a job after the training even though they have a chance to get a job, discrimination in the workplace based on race, color. religion, ethnicity, age and class.
It can be seen from the above causes unemployment in a particular period can be a combination of caused by social factors and how the economy as a whole works and also due to the subjective individual factors. In a sociological point of view according to functionalist and conflict theorists the unemployment is caused primarily by the social factors than by the individual factors. However according to Max Weber and symbolic interaction theories individuals construct their own social constructs and perception and they can be subjective in their behavior and there fore can become unemployed even though the actual condition they can get a job in the job market.
In summary applying the sociological and the primary causes of unemployment unemployment is individual as well as a social problem in a market economy. As discussed above it is caused by the society as well as by individuals. Even the economy or societal factors are not present unemployment can be caused by individual perception and their own subjective behavior.

Max Weber's distinction among power, authority and coercion

Power can be defined as one person's ability to influence others does what ever they want even though they don't like to do what is demanded and they resist doing what is demanded. For example a professor can influence the students to assign work and demand them to do to satisfy some criteria. As well a dictator like Hitler can control all aspects of life because of this ability to impose his will on majority of people. In other words a person or group on other person or other groups can use power legitimately or illegitimately. That is power need not come from proper authority or legitimate authority. That is power and authority can be different in this respect.
According to Max Weber authority can arise from tradition, charisma of certain powerful people or from legal-rational. That is authority need not come from any logical reason but likely to come from respect for the past. For example a monarchy in Western Europe can get authority because they ruled the populace over a long period of time. Even the traditional authority can exist in modern democracies because the people respect the monarchy or authority of monarchy at least in a limited symbolic head of states in Western Europe.
Authority also can arise from charisma of some powerful people. They have authority because of their charisma. This arises because they have the ability to lead a vast number of people for a particular cause using their powerful charm and influence over ordinary people. For example Martin Luther King, Gandhi. Nelson Mandela is the modern examples of charismatic authority they had because of their ability to charm and influence a vast majority of people for a particular cause.
Authority also can arise from legal-rational. That is in society authority is given to individuals and organization based on rationally enacted laws and regulations. This authority is impersonal and differs from charismatic authority because the legal-rational authority is impersonal and the charismatic authority is personal and admired by the people who accept that authority. In modern societies the authority is derived from the legal-rational compared to charismatic and traditional in varying degrees in industrialized societies in particular.
Coercion is the extreme manifestation of power in a way threatens the person to complete obedience because it threatens the person coerced physically, financially and socially. This results in persons following the authority of another because of fear rather than will. Coercion is mostly linked with abuse and conflict. Coercion exists in many dictatorships in the past as well as in the present world in many parts of the world where citizens are forced to follow the regime of dictatorship.
The view of the economy in the perspectives of functionalist, conflict theorists and symbolic interaction theory

Functionalist perspective of the economy

In the perspective of functionalist sociological theorist social systems including economy works like a biological organism where every part of the system work in a united manner so that smooth functioning is maintained and so that society builds consensus between different parts of the system.. In this change is evolutionary and the changes take place to minimize dysfunction and to enhance the stability and its survival in the future. In this respect Capitalism will not collapse and will endure in the future as the functions of the system will adjust and evolve so that it maintains the social order and stability without any radical overhaul of the economic system. In addition the social, legal, political, religious systems will not be in conflict with the economic system and work in unison with the economic system so the whole social organism survive and social order is maintained and their functions and their purpose even though different work as a unified system. As discussed above this is the functionalist view of the economy.

Conflict theorist view of the economy

In contrast conflict theorist believe society do not work as a unified system. Conflict and struggle take place as different groups work to maximize their benefit in the same time other groups loose. Functionalist view conflict in a negative manner. However the conflict theorist see the conflict to some extent is beneficial as it forces the parties to come to a common ground and make the economic system or the social system to change for the better and minimize the losers and maximizing the benefits for a greater number of groups as well make the power system in check so that abuse of power is minimized.
In this context the economic system and social order changes continually and changes take place and shaped by different interest groups in varying degrees in a market economy. However Marxism as a conflict theory predicts radical change to the economic system to move towards a socialist system it has not eventuated. However Max Weber as a conflict theory predicts the viability of the market economy with some reform to minimize the negative aspects of capitalism like alienation and the negative impact of bureaucracy in capitalist economies and more democracy in society and continuous reform of the economic system to make it work efficiently but also effectively by legal, social and political reform appropriate to a countries historical, cultural, political and social context.

Symbolic interaction theory perspective of economy

Symbolic interaction theory is a micro-sociological theory as opposed to the functionalist and conflict theory. That is symbolic interaction theory analyze how individuals and groups interact with each other and how they adept to change and shape change and build economic and social relations and political structures and institutions rather than viewing the economic system as whole. In their perspective communication and negotiation between individuals and groups and build symbolic meaning imposing this meaning in society and economic system and its parts work on these symbolic meaning of the societies relationship with the economic affairs of society and its priorities and what changes are beneficial to society in economic terms in these symbolic meanings determine how the economic system work and all the issues involved in the economy and how it must be resolved and the process of reform and changes to the economic system.

End of mid-century and the evolution of new sociological theories

In the present global economic environment and deregulation of the market economy and also after the fall of Berlin Wall and the collapse of Soviet Union the power of Marxism has dramatically reduced. This created new sociological theories such as post-modernism, relativism and neo-liberal theories of economics and society in general. However the functionalist and conflict theories have some resonance to some groups in society particularly to trade union movement in some parts of the world. This may be due to the negative consequences at least perceived by some groups in society and particularly in the developing world.
In era of rapid technological changes, social changes as well as political instability in some parts of the world and unpredictability of economic and social outcomes may revive some of the earlier theories particularly the conflict theories may become credible at least in some parts of the world. The social stability and order is not a phenomenon in this century in some parts of the world and there are rapid changes in countries and some countries face severe instability even after reform particularly in some parts of Asia and Africa as well as in Middle East.
In addition after the mid century the environmental issue became prominent. Some economist and sociologists view this as a market failure. As suggested by functionalist and symbolic interaction theories the environmental issue must not arise. However it is a reality and most political scientists, economists now agree environmental problem is a serious issue for the whole world. This may be due to the negative consequence of the market economic system and the externalities it produces. However as economic systems become more dynamic and adaptable to change there is hope the present system will survive with evolving reforms within the system rather than radical over hall of the present economic and social system. However the political instability and economic instability in some parts of the developing world and the crucial environmental issues must be adequately addressed. The way the present economic system address successfully these complex issues will determine the survival of the present economic and social order and the relevance of functionalist, conflict theory of Max Weber or the symbolic interaction theory or post modernism than the radical conflict theory of Karl Marx.

Conclusion

As discussed above unemployment can be an individual issue as well as a social problem. This is an individual issue because the individual can perceive subjectively and behave in a subjective manner. However the social or economy as whole also can affect his employment prospects particularly if the economy goes through boom and bust cycles. I addition it may be also due to technological innovation and rational economic decision Contribute to structural unemployment. There fore unemployment can be an individual issue as well as a social problem.
In the perspective of Max Weber power, authority and coercion are distinguishable because power can be exercised by any strong personality without legitimate authority or even if a person has legitimate authority that person can abuse the power given by that legitimate authority. In addition authority can come from tradition, charisma or from legal-rational authority given to a person or group by rational and logical reason. As well according to Max Weber coercion is the abuse of power in extreme as a threat. It can be a physical, financial or social threat. The person who abuses power to compel the other person or group for complete obedience can use coercion. In this sense according to Max Weber power, authority and coercion are distinct and distinguishable.
In summary the functionalist's view of economy is that the economy works as a unified system like a biological organism. The functions of the separate parts can be different but the functions are defined so that the economy works to maintain order particularly social order and changes only happens to reduce dysfunctions. Consensus is the norm and conflict is an exception and it is temporary as all participants in the economic system voluntarily make consensus so that the system works to maintain order.
However the conflict theory is opposite of functionalist theory and suggests in an economic system conflict and struggle is norm because the participants maximize their benefit in the expense of others because conflicting interests. For them conflict is necessary for change and to refine the economic system where the economic participants come to common grounds so that the economic system evolves and adepts dynamically. for conflict theorist the economy changes all the time and social order is disturbs and it evolves in to a new economic relationship and new economic system. However according to Max Weber the Capitalist system will adept and change and evolve but not radically change by revolution in to a socialist economic system as predicted by Karl Marx.
The symbolic interaction theory is a micro sociological theory which emphasizes the importance of symbolic meaning which arises from interaction of different groups and individuals in society and which is imposed on society which determines how the economic participants behave and what changes are necessary within the symbolic meaning and what institutions are necessary to meet the outcomes which is symbolically important at a particular time. In this perspectives the changes are made by groups and individuals interacting and communicating and create meaning or constructing meaning is the driving force for change and adapt for changes in the external environment.
By the mid century many new sociological theories have risen. However the old theories are not disbanded by at least some groups in society and in different parts of the world. In the current global environment and deregulation of economies neo-liberal theories are dominating at least in the economic field. As well post-modernism have risen after the collapse of the Soviet Union and the collapse of Communism in the Eastern European countries. However the functionalist and conflict theories play a part in some western countries in different degrees and in some developing world. As discussed above even though interaction theory and other new theories become prominent due to negative consequences of global economy and liberalization process some groups and in some parts of the world conflict theory is used in practice in explaining how the economic system works and the positive and negative consequences due to the externalities of the capitalist economic system. The relevance of theories to explain economic system depends in the future how environmental issues; social and political instability in some parts of the world is resolved by the current economic and social order.