Solutions Chap 8 Suggested Exercises

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Solutions Chap 8 Suggested Exercises

2. Howard Bowen’s cotton farm analysis appears below.
a. Accounting profits:
Revenues$5,000,000
Less: Variable operating costs4,500,000
Less: Depreciation40,000
Less: Wages50,000
Equals: Operating Income$410,000
Less: Interest expense400,000
Accounting income before tax+$10,000

b. Economic profits:
Revenues$5,000,000
Less: Variable operating costs4,500,000
Less: Opportunity value of Bowen's income potential30,000
Less: Economic depreciation60,000
Equals: Economic profit before financial costs$410,000
Less: Interest expense400,000
Less: Opportunity cost of net $1 million equity @10%100,000
Equals: Economic profit, or (loss)($90,000)

If these calculations are representative of Bowen's regular performance, he would be better off financially by selling the farm and working for someone else. This analysis ignores many intangible factors that may affect Bowen's decision.

3. Mary Graham’s work at Piedmont Properties.

a. Pro forma Accounting pre-tax profits for the first year:

Revenues $2,000,000
Less: Salaries 1,500,000
Operating expenses 250,000
Depreciation 5,000
Total 1,775,000
Operating income 245,000
Less: Interest expense 75,000
Accounting profit before tax $170,000

b. Pro forma Economic pre-tax profits for the first year:

Revenues $2,000,000
Less:...
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