Final answer:
The accounting model of firm valuation focuses on explicit costs and reports accounting profit, suitable for taxation and financial reports, while the economic model includes both explicit and implicit costs to determine economic profit, which reflects the long-term economic success and holistic value creation by the firm, indicating the necessity of considering broader implications of investments.
Step-by-step explanation:
The accounting model and the economic model of firm valuation have distinct methodologies and implications for evaluating a firm's performance, especially concerning research and development (R&D) investments and capital budgeting projects that impact earnings per share (EPS). The accounting model focuses on accounting profit, which includes only explicit costs – direct, out-of-pocket expenses. It's a cash concept that indicates the firm's profitability based on the difference between revenues received and the explicit costs paid out. This is the profit that is reported for tax and financial reporting purposes.
On the other hand, the economic model is broader, and it accounts for economic profit, which includes both explicit and implicit costs – the opportunity costs of utilizing resources that could have been used elsewhere. When considering R&D or capital budgeting decisions, this model takes into account not just the immediate financial impact on EPS but also the longer-term potential, such as increased market share, technological leadership, or efficiencies that result from the investment. Firms might appear less profitable in the short term under the accounting model when they invest heavily in R&D or engage in projects with an immediate dilutive effect on EPS.
However, if these investments lead to significant innovations, there can be a positive spillover for society, leading to broader economic gains represented by the Dsocial curve, which includes these benefits and lies above the Dprivate curve that indicates only the firm's gains. Empirical evidence suggests that while accounting profits are relevant for taxation and financial statements, firms need to consider economic profit to ensure long-term economic success and value creation. Therefore, firms focusing only on accounting profits may underinvest in R&D, potentially affecting their competitiveness and long-term viability.