Critical Thinking
Global Economic Environment – BUSI 620
Q
From the end-of-chapter discussion questions (DQ) and problems (P)
Salvatore Chapter 1:
a.Discussion Questions: 9
How is the concept of a normal return on investment related to the distinction between
business and economic profit.
A business must be able to understand how business profit and economic profit relates to
the normal return on investment. The two have a different meaning and purpose that
provides vital information to businesses to help them make the right decision whether to
choose or drop certain expenses to maximize its profit.
Profit or business profit is the revenue of the firm minus the explicit cost which is the
actual out-of-pocket expenses to buy or hire the inputs it requires for production.
Example of expenses are the wages to hire labor, interest on borrowed capital, rent on
land and buildings, and raw materials. The economic profit equals the revenue of the
firm minus its explicit and implicit cost. Implicit cost are the value of inputs owned and
used by the firm in its own production processes. An example of implicit cost is the
salary that a manager could earn somewhere else in similar capacity and the return the the
firm can earn from investing its capital and renting its land and other inputs to other firms
[ CITATION Sal15 \l 1033 ].
References
Salvatore, D. (2015). Managerial Economics in a Global Economy (Eight ed.). New York:
Oxford University Press.
b.Problems: 6 – Determine which of the two investment projects of Problem 5 the manager
should choose if the discounts rate of the firm is 20 percent.
Determine which of two investment projects a manager should choose if the discount rate of the
firm is 20 percent. The first project promises a profit of $100k in each of the next four years,
while the second project promises a profit of 75k in each of the next 6 years.
C T 1
UESTIONS FOR RITICAL HINKING
Base on the calculation of the present value of the two investment projects, the manager should
choose Project 1 since it will bring more profit to the company.
Project 1
PV = $100,000/1+.2 + 100,000/1+.22 +100,000/1+.23 +100,000/1+.24
$100,000/1.2 + 100,000+1.44+ 100,000+1.728 + 100,000+2.0736
83,333 + 69,444 + 57,870 + 48,225
PV = $258, 872
Project 2
PV = $75k/1+.2 + 75k/1+.22 +75k/1+.23 +75k/1+.24+75k/1+.25+75k/1+.26
$75k/1.2 + 75k/1.44 +75k/1.7 28+75k/2.0736+75k/2.48832+75k/2.985984
62,500 + 52,083 + 43,403 + 36,169 + 30,141 + 25,117
PV = $249,413
15. Integrating Problem
Samantha Roberts has a job as a pharmacist earning $30.000 per year, and she is deciding
whether to take another job as the manager of another pharmacy for $40.000 per year or to
purchase a pharmacy that generates a revenue of $200.000 per year. To purchase the pharmacy
Samantha would have to use her $20.000 savings and borrow another $80.000 at an interest rate
of 10 percent per year. The pharmacy that Samantha is contemplating purchasing has additional
expenses of $80.000 for supplies, $40.000 for hired help, $10.000 for rent, and $5.000 for
utilities. Assume that income and business taxes are zero and that the repayment of the principal
of the loan does not start before three years
a) What would be the business and economic profit if Samantha purchase the pharmacy? Should
Samantha purchase the pharmacy?
Business Profit is $57,000.00 and Economic Profit is $15,000.00
Yes, Samantha should purchase the pharmacy because it is profitable.
b) Suppose that Samantha expects that another pharmacy will open nearby at the end of three
years and that this will drive the economic profit of the pharmacy to zero. What would the
revenue of the pharmacy be in three years?
200,000 revenue minus $15,000 (economic revenue) = $185,000 revenue in 3 years
c) What theory of profit would account for profits being earned by the pharmacy during the first
three years of operation?
It would be the managerial efficiency theory of profit.
Cash Flows
Sale of
Business
Year 1Year 2
15,00015, 000
15,000 15,000
div.1.15 1.15x1.1
5
13,043 11,342
Year 3
15,000
-
50,000
-
35,000
1.15x1.15x1.15
- 1,372
23,013 net present value
d) Suppose that Samantha expects to sell the pharmacy at the end of three years for $50.000
more than the price the paid for it and that she requires a 15 percent return on her investment.
Should she still purchase the pharmacy?
Note:
1.P15(d): Compare the present value of economic profit in each of the next three years and
the loss of $50,000 in the third year using 15% as the discount rate.
Yes, her net present value is still in the positive - $1372.56
Revenue
Expenses
Supplies
Hired Help
Rent
Utilities
Net Expense
Operating Income
Interest 10% on 80,000 loan
Net income (Business Profit)
Operating Cost
Salary (opportunity cost)
Savings Return (10% on her 20,000)
Operating Cost Net
Economic Profit (Net - Total Operating cost)
200,000
80,000
40,000
10,000
5,000
135,000
65,000
8,000
57,000
40,000
2,000
42,000
15,000
