Question

An owner can lease her building for $120,000 per year for three years. The explicit cost of maintaining the building is $40,000, and the implicit cost is $55,000. All revenues are received, and costs borne, at the end of each year. If the interest rate is 5 percent, determine the present value of the stream of: A. Accounting Profits B. Economic Profits

Answer 1

• The present value of the accounting profit is $217,859.

• The present value of the economic profit is $68,000.

Further Explanation:

Accounting profit:

The accounting profit is the surplus of the revenue over expenses. The expenses only include an explicit cost. The explicit costs are the normal business cost that occurs and can be measured in terms of money. These expenses are necessary for the smooth flow of operational activities and earning revenue.

Economic profit:

The economic profit is calculated by subtracting the implicit cost from the accounting profit. The implicit cost includes all the non-financial costs and opportunities forgone for earning the revenue.

Calculate the present value of the accounting profit:

First, calculate the accounting profit by subtracting the explicit cost from the lease value.

\begin{aligned}\text{Accounting profit}&=\text{Lease value}-\text{Explicit cost}\\&=\$120,000-\$40,000\\&=80,000 \end{aligned}

Calculate the present value:

\begin{aligned}\text{Present value of Accounting profit}&=\text{Accounting profit}\times{FVA_{5\%,3 years}}}\\&=\$80,000\times{2.72}\\&=217,859\end{aligned}

Thus, the present value of the accounting profit is $217,859.

Calculate the present value of the economic profit:

First, calculate the economic profit by subtracting the implicit cost from the accounting profit.  

\begin{aligned}\text{Economic profit}&=\text{Accounting profit}-\text{Implicit cost}\\&=\$80,000-\$55,000\\&=\$25,000\end{aligned}

Calculate the future value:

\begin{aligned}\text{Present value of Economic profit}&=\text{ Economic profit}\times{FVA_{5\%,3 years}}}\\&=\$25,000\times{2.72}\\&=\$68,000\end{aligned}

Thus, the present value of the economic profit is $68,000.

Learn More:

1. Learn more about the competitive market

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2. Learn more about the interest rate

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3. Learn more about the investment  

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Answer Details:

Grade: Middle school

Chapter: Economic profit

Subject: Economics

Keywords: lease, building, three, years, explicit, cost, maintaining, building, implicit cost, revenues, costs, borne, interest, rate, determine, present, value, stream, accounting profits, economic profits

Answer 2

A) Accounting profits dont take implicit costs into account, only "real" or quantifiable costs. Thus the present value of a 120,000 lease at 5% for three years with explicit costs of $40,000 maintenance is: 

PV = [ FV/(1+r)^n ] - (Explicit Cost) 

PV = 120000/(1.05^3) - (40000*3) B) same thing but add implicit costs ... 

PV = 120000/(1.05^3) - (40000*3) - (55000*3)