Question

Janet is running a painting business. She receives $200,000 payment from buyers at the end of year, at which time she also pays $20,000 fixed cost and 30% of the revenues as a variable cost.

1.An opportunity for new business opens for Janet from which she will make $100,000 accounting profits at the end of year.   If she takes this new business, then she has to reduce her work for painting business, so the revenue from painting business will drop by 30%. What will be the size of annual economic profit from the new business?

2.If the new business will last only for the next five years, so she can take the profits from the new business for five times starting from one year from now, what is the size of the value of the new business for Janet?   Assume that the annual interest rate is 5%.   

Answer 1

	Ans 1
	Particulars	Amt $	Remarks
1	Janet's Net Annual Income from New Business	$       100,000
	Income from Painting when new business is taken up
	Revenue	$       140,000	30% drop
	Less Variable cost @30% of revenue	$          42,000
	Less Fixed cost	$          20,000
2	Net Income	$          78,000
	Income from Painting without new business
	Revenue	$       200,000
	Less Variable cost @30% of revenue	$          60,000
	Less Fixed cost	$          20,000
3	Net Income	$       120,000
4	Opprtunity cost of New Business =Loss of
	net Income =(3-1)=120000-78000=	$          42,000
	Annual Economic Profit of New Business=Net Income from New Business-Opportunity cost=$100,000-42000=	$         58,000	Ans 1

Ans 2
Size of value of bew business will be the PV of the net income from the new business in 5 Years
Annual interest rate is 5%, so the future earnings to be discounted by 5% rate.
Year	Accounting Profit	PV Factor at 55=1/1.05^n	PV of Accounting Profit
1	$       100,000	0.952	$     95,200
2	$       100,000	0.907	$     90,700
3	$       100,000	0.864	$     86,400
4	$       100,000	0.823	$     82,300
5	$       100,000	0.784	$     78,400
		Total	$ 433,000
So the size of the value of the new Business for Janet is $433,000