Question

Q5: Hali is thinking about quitting his current job, which pays a salary of $58,000 per year, to own and operate his own business. Investors are able to earn 13% from businesses that are equally risky as Hali’s intended business. If he started the business, he would spend $280,000 to purchase physical capital. This amount of money would come from two sources: $130,000 would be borrowed from a bank at an interest rate of 6% per year and $150,000 would come from Hali’s savings that are currently earning 0.8% in a risk-free savings account. The physical capital is expected to have useful life of 10 years and a scrap value of $24,000. Hali expects to spend $110,000 per year on assistants and will pay himself a salary of $26,000 per year while operating his business. His business is expected to earn total revenues of $270,000. After learning that Hali might quit, his employer offers him a salary of $66,000 per year to convince him to stay at his current job.

a) What is the annual accounting profit of Hali’s intended business? Show clearly how you arrived at your answer. If Fulton has to figure out how you arrived at your answer, marks will be deducted. 3 marks.

b) What is the annual economic profit of Hali’s intended business? Show clearly how you arrived at your answer. If Fulton has to figure out how you arrived at your answer, marks will be deducted.

Answer 1

Given :

Revenue = $270,000

(a) :- Explicit costs = depreciation of fixed assets + Interest paid on loan + Interest on savings account + salary of employees + Rick's salary

= [(280,000-24,000)/10] + [ 130,000 * 6% ] + [150,000 * 0.8% ] + 110,000 + 26,000

= 25,600+7,800+1,200+110,000+26,000

Thus, Explicit costs = $170,600

Annual accounting Profit = Revenue - Explicit costs

= 270,000 - 170,600

= $99,400

(b) :- Implicit costs is equals to the Salary of previous job= $66,000

Economic costs = Explicit costs + Implicit costs

= 170,600+66,000

= $236,600

Annual Economic profit = Revenue - Economic costs

= 270,000 - 236,600

= $33,400

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