Questions for Critical Thinking 1
Questions for Critical Thinking 1
Liberty University
Business 620/ Global Economic Environment
Salvatore’s Chapter 1:
Discussion Question
9. How is the concept of a normal return on investment related to the distinction between business and economic profit?
There is no normal return on investment. To be considered a return on investment, the internal rate of return should exceed the cost of capital. A low risk, ongoing enterprise might be satisfied with an IRR= 7-10%, while a more risky venture might require 15-25% IRR. The normal return on investment is considered part of the profit by business managers, accountants, and economists. To the general public and the business community, profit or Business profit refers to the revenue of the firm minus the explicit or accounting costs of the firm (p. 16). To the economist, economic profit (or above-normal profit) equals the revenue of the firm minus its explicit costs and implicit costs (p. 16). Economic profit is considered in allocating society’s resources among competing uses which is cost estimation. Normal profit is required in business profit really to succeed in business. Economic profit is not factored in this equation. According to Salvatore, “the concept of business profit may be useful for accounting and tax purposes, it is the concept of economic profit that must be used in order to reach correct investment decisions” (p. 16-17).
Problems
6. Determine which of the two investment projects of Problem 5 the manager should choose if the discount rate of the firm is 20 percent.
Formula for Net Present Value is: PV=R1/(1+K)1 + R2/ (1+K)2 +R3/ (1+K)3 + R4/ (1+K)4, . . .
Investment Project 1:
$100,000/ (1.20)1 + $100,000/ (1.20)2 + $100,000/ (1.20)3 + $100,000/ (1.20)4
= 100,000/ 1.20 + 100,000/ 1.44 + 100,000/ 1.728 + 100,000/2.0736
= 83,333.33 + 69,444.44 + 57,870.37 + 48,225.31 = 258,873.45
Investment Project 2:
$75,000/ (1.20)1 + $75,000/(1.20)2 + $75,000/(1.20)3 + $75,000/(1.20)4
Liberty University
Business 620/ Global Economic Environment
Salvatore’s Chapter 1:
Discussion Question
9. How is the concept of a normal return on investment related to the distinction between business and economic profit?
There is no normal return on investment. To be considered a return on investment, the internal rate of return should exceed the cost of capital. A low risk, ongoing enterprise might be satisfied with an IRR= 7-10%, while a more risky venture might require 15-25% IRR. The normal return on investment is considered part of the profit by business managers, accountants, and economists. To the general public and the business community, profit or Business profit refers to the revenue of the firm minus the explicit or accounting costs of the firm (p. 16). To the economist, economic profit (or above-normal profit) equals the revenue of the firm minus its explicit costs and implicit costs (p. 16). Economic profit is considered in allocating society’s resources among competing uses which is cost estimation. Normal profit is required in business profit really to succeed in business. Economic profit is not factored in this equation. According to Salvatore, “the concept of business profit may be useful for accounting and tax purposes, it is the concept of economic profit that must be used in order to reach correct investment decisions” (p. 16-17).
Problems
6. Determine which of the two investment projects of Problem 5 the manager should choose if the discount rate of the firm is 20 percent.
Formula for Net Present Value is: PV=R1/(1+K)1 + R2/ (1+K)2 +R3/ (1+K)3 + R4/ (1+K)4, . . .
Investment Project 1:
$100,000/ (1.20)1 + $100,000/ (1.20)2 + $100,000/ (1.20)3 + $100,000/ (1.20)4
= 100,000/ 1.20 + 100,000/ 1.44 + 100,000/ 1.728 + 100,000/2.0736
= 83,333.33 + 69,444.44 + 57,870.37 + 48,225.31 = 258,873.45
Investment Project 2:
$75,000/ (1.20)1 + $75,000/(1.20)2 + $75,000/(1.20)3 + $75,000/(1.20)4