Question

Tillie’sTrilbies estimates that revenues and expenditures for the next fiscal year are:

Total Revenue $6,800,000

Cost of Materials 5,000,000

Cost of Labor 1,000,000

Advertising 100,000

Insurance 50,000

Rent 350,000

Miscellaneous Expenses 100,000

a. Calculate Tilly’s accounting profit.

b. Suppose that in order to open her trilby business Tilly gave up a $250,000 per year job as a buyer at a high-end department store. Calculate Tilly’s economic profit.

c. Tilly is considering purchasing a building across the street and moving her company into that new location. The cost of the building is $5,000,000, which will be fully financed at a simple interest rate of 5 percent per year. Interest payments are paid annually on the last day of Tilly’s fiscal year. The first interest payment will be due next year. Principal will be repaid in 10 equal installments beginning at the end of the fifth year. Calculate Tilly’s accounting profit and economic profit for the next fiscal year.

d. Based upon your answer to part c, should Tilly buy the new building? Explain.

Answer 1

(a)

Calculate the Tilly's accounting profit -

Accounting profit = Total revenue - Cost of materials - Cost of labor - Advertising - Insurance - Rent - Miscellaneous Expenses

Accounting profit = $6,800,000 - $5,000,000 - $1,000,000 - $100,000 - $50,000 - $350,000 - $100,000

Accounting profit = $200,000

The Tilly's accounting profit is $200,000.

(b)

Tilly has given up her job with salary of $250,000 to start her own business.

Foregone salary = $250,000

Calculate the Tilly's economic profit -

Economic profit = Accounting profit - Foregone salary

Economic profit = $200,000 - $250,000 = $-50,000

The Tilly's economic profit is $-50,000.

(c)

Cost of building = $5,000,000

Interest rate = 5% per year

Interest payment = $5,000,000 * 0.05 = $250,000

If Tilly purchases the building then she does not have to pay the rent.

So,

Accounting profit = Total revenue - Cost of materials - Cost of labor - Advertising - Insurance - Interest payment - Miscellaneous Expenses

Accounting profit =

$6,800,000 - $5,000,000 - $1,000,000 - $100,000 - $50,000 - $250,000 - $100,000

Accounting profit = $300,000

The Tilly's accounting profit next fiscal year would be $300,000.

Calculate the economic profit -

Economic profit = Accounting profit - Foregone salary

Economic profit = $300,000 - $250,000

Economic profit = $50,000

The Tilly's economic profit next fiscal year would be $50,000.

(d)

Purchase of building enable the Tilly to save $100,000 and this enable Tilly to earn positive economic profit which indicates the viability of business in the long run.

So,

Tilly should buy the new building.