An economic spread is the difference between the weighted average cost of capital and the real rate of return on investments. It determines whether a company or economy is making money from its capital assets, such as machinery and property. In more simplistic terms, an economic spread can be thought of as the difference between the cost of doing business and the business's gross profit. Some economists refer to it as the economic value or market value added, since the spread reveals the financial worth of a company's operations.
Financially solid companies and economies are able to make money from their investments. When an economic spread is high, it can signal the occurrence of growth and expansion. The concept is similar to an individual being able to invest money in a savings account or stock and earn a return on that money over time. The idea of a spread focuses on the real rate of return or the actual return adjusted for inflation.
The weighted average cost of capital helps determine the amount of economic spread. It takes into account the market value of equity and debt, along with its cost and the percentage of the firm that is financed by each source of capital. This is a major source of income for a company and also one of its greatest liabilities. In order to pay back investors for the cash they infuse into its operations, a company must produce a return.
The return is the amount of money that a company is able to generate from invested capital. It is the second component of the economic spread, and usually predicts a firm's solvency. For example, a company's stock may generate a 20 percent return over five years. This means that the firm's operations were able to generate an additional 20 percent worth of income from the cash received by stock investors.
When adjusted for inflation, the actual rate of return may be lower than what the quoted rate indicates. For instance, if the annual inflation rate is 5 percent and the quoted return rate is 15 percent, the real rate of return is 10 percent. Inflation decreases the value of money since it costs more to perform the same type of operations or purchase the same goods.
When a company's cost of capital is higher than its return, the economic spread is negative. A positive spread can be interpreted as the company's ability to make money from its assets, while a negative spread indicates that the firm is overextended. There may be some cases where the spread equals zero, which reveals that the firm is breaking even.
