a. Explain the difference between business and economic profit?
b. How do implicit costs lead to a difference between accounting and economic profit?
c. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost?
d. The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work?
Introduction
1. The present value in economics refers to the present discounted value and it’s the value of the future amount of income that has been financially discounted to indicate or reflect the expect income’s current value just like the money was existed today. The present value of money is mostly less than the future value as money has interest making or earning capabilities known as time value of money which basically means that one dollar paid today is worth slightly much more than if it’s paid the day after today. (Ross, Westerfield and Bradford, 2010)
The PV =
| Interest | 15% |
| Current Profits | 150m |
| Growth rate | 7% |
| Total profits | 160.5 |
| PV | 184.575 |
Future values are discounted to indicate their present value and also to calculate their profitability. The discounted figures are compared to their current expenditures to analyze their income generation as matched to costs to weigh the viability of the project or venture. (Ross, Westerfield and Bradford, 2010)
1. b) Efficiency of producing a unit of a product is the maximum numbers that can be optimally produced in comparison to the observed standards of production. Technical efficiencies relates to the increase or decrease of an output as a result of another reduction or increment of a vector. Productive efficiency is literally the product of both technical and also allocative efficiency. Scale efficiency refers to the standard of measurement applied linear or non-linear programming framework. Allocative efficiency measures a company’s success in deciding the optimal set of standard outputs given a set of stated input prices. Structural efficiency measures the extent that an industry compares to others in the same industry at optimal level of production.
Efficiencies are used to compare and evaluate the performance of companies and their industry counterparts. They assist in analyzing the production and management standards of a company.
2a). Vertical integration refers to a company’s ownership of its own upstream suppliers and also its downstream buyers. Horizontal integration is basically a consolidation of several companies that handle similar or part of the company’s production process. Unlike vertical integration where a single company is engaged in production of different parts or sections of, for example transportation, marketing, farming and other retailing activities. In the oil industry companies like ExxonMobil or Royal Dutch Shell mostly adopt vertical integration which means owning the drilling companies together with the transportation networks and the refinery processes. Conglomerate mergers are not horizontal or vertical. The motive of these operations is to expand their operations and maximize their profits. These actions affect the productive and allocative efficiencies positively as more efficient firms are acquired to compete effectively in the market hence the efficiencies will increase in their effectiveness.
2b). Profit and shareholder maximization are two aspects that are very different. The managers of a company struggle for profits to be reinvested in business in order to generate more profits for the company while the shareholders struggle to obtain as much dividends as possible. Dividends payments means reduced investment opportunities for companies as the extra funds for investments have been paid out as dividends.
2c). Principal agency problem occurs when one person known as an agent has the ability to make lawful decisions on behalf of another person known as the principal. The problem occurs when the agent is motivated by factors that are of his own interest to act for his own benefit and not what he’s legally bound to do, that’s act for the best interest of his principal. Examples are the management of a company and the shareholders.
2d). Profit maximization does not represent the overall economic objective in the current world. Many issues have to be factored in the final economic benefits of the production processes. Companies have to consider other factors that affect the stakeholders such environmental factors such as global warming and other political, social and economic matters that affect a firm’s productivity.
The effects of global warming have affected most of the world’s climatical patterns that adequate measures have to be provided for in order for the earth’s environment to be sustainable.
5. A
| Revenue | 550,000 | ||
| Expenses | |||
| Bakery | 225,000 | ||
| Van | 45,000 | ||
| Rent | 60,000 | ||
| Assistant | 50,000 | ||
| Supplies | 90,000 | ||
| Loan interest | 15,000 | ||
| Total cost | 485,000 | ||
| Net Income | 65,000 | ||
| Accounting profit = | 65,000 | ||
| Economic profit = 65,000 – implicit cost | |||
| (opportunity Costs) | |||
| 65,000 – 100,000 = -35,000 | |||
| Economic Loss = | -35,000 |
Frank should purchase the bakery as it’s more profitable than his current job. The first year would be difficult but the subsequent years would generate more profit.
5. B. No. The initial expenses would be high but eventually the business would generate more income than his current salary.
5. C.
| year 1 | year 2 | ||
| Revenue | 450,000 | 450,000 | |
| Expenses | |||
| Bakery | 225,000 | ||
| Van | 45,000 | – | |
| Rent | 60,000 | 60,000 | |
| Assistant | 50,000 | 50,000 | |
| Supplies | 90,000 | 90,000 | |
| Loan interest | 15,000 | 15,000 | |
| Total cost | 485,000 | 215,000 | |
| Net Income | -35,000 | 235,000 | |
| Accounting profit = | -35,000 | ||
| Economic profit = 65,000 – implicit cost | |||
| (opportunity Costs) | |||
| -35,000 – 100,000 = -135,000 | |||
| Economic Loss = | -135,000 |
The advice to frank would be solicit for a bigger loan as the first year it would require an extra 35,000 just for the business to operate hence he would need $135,000 to also feed his family. He must have a minimum loan of 115,000 + 135,000 +13500 (interest) = 263,500. (Vance, 2003)
7. The present values of figures provided are;
| Years | Future Profits | Present value |
| $ M | $M | |
| 1 | 8 | 7.27 |
| 2 | 10 | 8.26 |
| 3 | 12 | 9.02 |
| 4 | 14 | 9.56 |
| 5 | 15 | 9.31 |
| 6 | 16 | 9.03 |
| 7 | 17 | 8.72 |
| 8 | 15 | 7.00 |
| 9 | 13 | 5.51 |
| 10 | 10 | 3.86 |
8. I really don’t agree with the statement as a company is also obligated to the surrounding community and all its stakeholders besides its shareholders. Corporate Social Responsibility is a form of self corporate regulation that a firm adheres to besides its primary objective of maximizing profits. The concepts of CSR ensures that a company observes and puts in place a self regulation mechanism that monitors the company’s business operations to ensure that they comply to the legal provisions and also with the industry’s ethical standards as well as adherence to the international norms. (Bhattacharya, Sanka and Korschun, 2011) Some companies go beyond the requirements by law and their ethical standards to further the cause of social good. Companies with good CSR policies are viewed positively and attract more brand loyalty than companies with weak or poor CSR relations. The basic strategies to maximize profits would also entail concepts of CSR activities. CSR serves as a marketing communication strategy that’s more effective and beneficial to all the stakeholders of the business. Good CSR policies may involve some extra expenditure by the company but may be beneficial in many other ways that all successful managers would embrace whole heartedly.
References
Bhattacharya, C.B., Sanka, S. and Korschun, D. (2011) Leveraging Corporate Social Responsibility: The Stakeholder Route to Business and Societal Value, Cambridge University Press, Cambridge: UK.
Ross, S., Westerfield, R.W. and Bradford D. J. (2010) Fundamentals of Corporate Finance (9 Ed.) New York: McGraw-Hill. pp. 145–287
Vance, D. (2003). Financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York: McGraw-Hill. p. 99
