Question

Ms. Walters runs a small business. The total value of the firm’s capital stock is $500,000. Revenue this year is expected to be $400,000 and the cost of operating is $170,000. Government bond are currently paying a rate of return of 25% per annum. Calculate her economic profit. Select one: a. $230,000 b. $470,000 c. $400,000 d. $170,000 e. $270,000 f. $500,000 g. $570,000 h. $105,000

Answer 1

Economic Profit = $105,000

Option h is the right option.

Explanation:

Economic profit represents the profit of the business after taking into account the economic costs. It considers the opportunity cost of funds besides accounting profit.

In this scenario,

the Operating profit = Revenues- costs

= 400000-170000 = $230,000

Opportunity cost is the cost of the next best alternative. In this case if the capital was not used in the business it would have earned interest.

So, the opportunity cost = Interest rate* Capital

= 25%*500,000

=125,000

Economic Profit = Accounting profit-opportunity cost

= 230,000-125,000

=$ 105,000