5.

London Hilton (Paris’s other sister) left her job as a model, where she was earning $100,000
per year, to set up a business venture which markets high fashion shoes under her own brand.
She has just finished her first year and her accountant has just given her the income statement.
London is delighted with the profit her business has earned. Luckily for her, her parents let her
set up shop in a hotel which was empty because they were about to renovate it. Although the
hotel site could probably have been sold for about $2 million when she began her business a year
ago, London was able to convince her accountant to record the asset at the price of $1 million,
which her parents had paid for it a few years earlier. With a forty year depreciable life, London
says that the lower book value “has really helped to keep my costs down.” London also said,
“Anyway, that old hotel was in a part of town where property values dropped about 10% this
past year—although it looks like values will be stable in the future.” London out-sources shoe
production, so she has no assets other than the former hotel site.

Assume that London could make an 8% per annum return on any money invested outside the
shoe business.

Accountant’s report on first year profitability

Revenues $750,000

Cost of goods sold 220,000

Depreciation 25,000
Advertising 75,000
Maintenance 30,000
Net income $400,000

a) London may be happy about her accountant’s report, but did she make an economic profit in
her new business? Show your calculations.

- Economic Profit = Total Revenue - (Explicit Cost + Implicit Cost)

= Net Income + Depreciation – Implicit opportunity costs
= 400,000 +25,000 – (100,000 + 2,000,000 * 10% + 2,000,000 * 8%)
= -35,000

She did not make an economic profit in her new business.

b) By the end of her first year, London’s reputation as a model has dissipated greatly and she
would be lucky to get a job as a fashion show assistant, which only pays $50,000. If the
revenues and the costs on the accountant’s income statement are unchanged from the first
year to the second, is it worthwhile for her stay in the shoe business a second year (i.e., what
is her expected economic profit for the second year)? Explain any assumptions behind your
calculations.
 - Economic Profit = Total Revenue - (Explicit Cost + Implicit Cost)
= Net Income + Depreciation – Implicit opportunity costs
= 400,000 + 25,000 - 50,000 – 2,000,000 * (1-10%) * 8%
= 231,000

She should stay in her business in the second year.

Assumptions behind the calculations:

 Property value remains 1,800,000 in the second year
 Straight linear depreciation method with no revaluation
 If London exits her shoe business, she will sell the property in the beginning of the
year and earn 8% interest
 Pay as a fashion show assistant is received at the end of the year

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