Question

5. Consider a person who is currently evaluating whether to invest his resources into a one-year project or not. This person has estimated that the total revenues from this project will be 22000 euros, whereas this sum will be received exactly in one year. This project, however:

1) requires currently a total investment of 20000 euros, which must be made at once;

2) requires a contribution of 500 working hours by the person mentioned. It is known that there are currently also other investment opportunities for 20000 euros (aside the project) available, of which investment alternative A will offer an annual interest rate of 5% (paid at the end of investment period), and investment alternative B will offer an annual interest rate of 10% (paid at the end of investment period). Both these alternative investments have the same risk as the project, which is evaluated by the person mentioned. It is also known that the person mentioned could earn maximum 8000 euros if he worked 500 hours elsewhere (outside of the project mentioned). For simplicity, let’s assume that these 8000 euros (as a net salary for these 500 hours of work outside of a project) would have been received exactly in a year from now. Find the economic profit and formulate the recommendation (regarding the use of resources) for this person.

Answer 1

Solutions:

Accounting profit=Total Revenue- Investment

Economic Profit= Total Revenue- Opportunity Cost

Here,

Opportunity Cost= 8000 Euros (that would have been earned if he worked outside of the project) + the money which has been invested in the project.

Accounting Profit= 22000 Euros-20000 Euros= 2000 Euros

Economic Profit= 22000 Euros - (20,000 Euros + 8000 Euros)

                           = - 6000 Euros

Here, Economic Loss is 6000 Euros or Economic Profit is -6000 Euros.

Investment Scenario-I

Investment Alternative- A

Accounting Profit= Revenue- investment

                                = 5% of 2000 Euros +20000 Euros - 20000 Euros

                                 = 21000-20000=1000 Euros

Investment Alternative-B

Accounting Profit= Revenue- investment

                                =10% of 2000 Euros +20000 Euros - 20000 Euros

                                 = 22000-20000= Euros 2000

Therefore, it would be ideal for the person to invest in Project-B rather than investing in other above-mentioned project. If he invest first project then he would face the loss of economic profit though he would be earning accounting profit of 2000 Euros. Hence, the person should go for the investment in Project-B.