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SUSAN JONES

a). What would be the business and economic profit if Susan purchases the pharmacy?
Economic profit/loss is the difference between sale of a product and the opportunity cost of items used. Opportunity costs in Susan’s case are the alternative returns foregone in making her choice. Susan Jones has three options; to continue with the job as a pharmacist, take a new job as a pharmacist manager or purchase a pharmacy. Susan should go ahead and take the managerial job. Her annual accounting profits from the new pharmacy will be as follows:

SUSAN JONES PROFIT AND LOSS FOR THE YEAR ENDED 2011

TOTAL REVENUES
(4%INCREASE)

$208,000

TOTAL EXPENSES
(2%INCREASE)

Prescription and non prescription fee

$102,000.00

Wages to workers

$45,900

Rent

$8,160

Electricity

$2,040

Natural gas

,       $1530

Telecommunication

$1,530

Depreciation and amortization fee

$3,060

Interest expense

$8,160

($172,380)

EARNINGS BEFORE INTREST AND TAX

$35,620.00

Tax (35%)

$12,467.00

NET PROFIT AFTER TAX

$23,153.00

 
In the first year, Susan Jones will make an after tax profit of $23,153. In the second year of the business, the total revenue and expenses will still increase by 4% and 2% respectively. The projected profit and loss account for the following period is illustrated below

 
SUSAN JONES PROFIT AND LOSS FOR THE YEAR ENDED 2012

TOTAL REVENUES
(4%INCREASE)

$216,320.00

TOTAL EXPENSES
(2%INCREASE)

Prescription and non prescription fee

$104,040.00

Wages to workers

$46,818

Rent

$8,323

Electricity

$2,081

Natural gas

         $1,561

Telecommunication

$1,561

Depreciation and amortization fee

$3,121

Interest expense

$8,323

($175,827.60)

EARNINGS BEFORE INTREST AND TAX

$40,492.40

Tax (35%)

$14,172.34

NET PROFIT AFTER TAX

$26,320.06

Susan Jones pharmacy profit will also increase during the second year. The projected profit and loss account for the following period is illustrated below:

SUSAN JONES PROFIT AND LOSS FOR THE YEAR ENDED 2013

TOTAL REVENUES
(4%INCREASE)

$224,972.80

TOTAL EXPENSES
(2% INCREASE)

Prescription and non prescription fee

$106,120.80

Wages to workers

$47,754

Rent

     $8,489

Electricity

$2,123

Natural gas

$1,59

Telecommunication

$1,592

Depreciation and amortization fee

$3,183

Interest expense

$8,489

     ($179,344.56)

EARNINGS BEFORE INTREST AND TAX

$45,628.24

Tax (35%)

$15,969.88

NET PROFIT AFTER TAX

$29,658.36

From the above estimated income statement for 2011, 2012, and 2013, we can deduce Susan Jones business profits from the pharmacy project. The sum of the projected profits throughout the years is taken and it will constitute discounting the profits then summing them up for the three year period. This is arrived at as follows:
 

YEAR

PROJECTED AFTER TAX PROFIT

2011
1.12^1
$23,153
$25,931.36

2012
1.12^2
$26,320.06
$33,015.88

2013
1.12^3
$26,568.36
$37,326.63

TOTAL BUSINESS PROFITS
$96,273.88

 

When calculating the economic profit if Susan buys the pharmacy, the Economic Value Added or EVA of the project is considered.
The profits calculated above will be used as net operating profits after taxes in this case. The capital charge is also defined as the interest rates on the capital that Susan borrows to finance her project.
Thus, EVA for 2011 = $25,350 – (10% of $80,000*0.65) = $ 17,953
           EVA for 2012 = $30,550 – (10% of $80,000*0.65) = $ 21,120.06
           EVA for 2013 = $35,958 – (10% of $80,000*0.65) = $ 21,368.36
The table below shows the total economic profits from Susan’s project:

Year

Projected after tax economic profits

2011

$17,953.00

2012

$21,120.06

2012

$21,368.36

Total after tax economic profits
$60,441.42

b). Suppose that Susan expects to sell the pharmacy at the end of three years for $50,000 more than the price she paid for it and that she requires a 12 percent return on his investment. Should she still purchase the pharmacy?
When one is faced with investment decisions, it is prudent to calculate the net present value of the project in question. Net Present value calculations are used to create a way in which different cash flows resulting from a project being undertaken by an investor can be compared. Therefore, before advising Susan on whether to abandon or go ahead and invest into the project, we need to determine the present value of investment into the project.
The formula for calculating the present value of a project is as follows:
[Cash flow*   (1+R)-T]
Where:
R = rate of return on capital
T = time taken
When using this formula to determine the investment decision, the investor should consider the following;
When the net present value resulting from the calculation is greater than zero, then the project is feasible. This is because a positive net present value adds value to an investment and in the end, it is profitable. A negative present value is disastrous to any business entity and thus, an investor is advised to abandon projects with a negative present value. When the present value is exactly zero, the investor is indifferent to either invest in the project or drop it depending on the opportunity costs.
The table below analyses Susan’s situation and provides her with a prudent solution on her investment decision dilemma.
The discounted net present value of cash flows arising from the project is as follows:

YEAR

CASHFLOW
PRESENT VALUE

2011
(1.12^-1)
$17,953.00
$16,029.46

2012
(1.12^-2)
$21,120.06
$16,836.78

2013
(1.12^-3)
$21,368.36
$15,209.58

Salvage value
           $50,000
$35,589.01

TOTAL P.V

$83,664.84

NPV=initial cost-PVIF*cashflow

initial cost =$100000

present value of cash flows=$83664.84

             NPV=
$16,335.16

 
N.B: the project was financed from Susan’s savings and a loan. $20000- savings, $80000 -loan at a 10% interest rate.
From the above, it’s clear that if Susan purchases the pharmacy, she stands chance to break even. This is confirmed by appraising the project using net present value to discount the value thus factoring in time value for money. The project’s npv is above zero and this shows that the project is economically viable. The steady growth of profits from the pharmacy over the years is also a clear indication that the venture is profitable.
Comparing the profits arising from a new venture i.e. purchasing a pharmacist, with getting a new job as a manager where she will be paid $50,000 per year, it is only rational that Susan takes the managerial job. As an entrepreneur, her business is subject to growth and risk as well. This thus implies that Susan should perform the business risk analysis. This involves, evaluating any factor that can jeopardize the well being of her project. Risk analysis will also enhance her decision making as she will weigh between risk and return and decide the option that best fits her risk return preference. In her current situation, revenue increases annually at 4%, while her expense also increase at 2%. After 3 years, her business will have a $50000 as salvage value and the loan principal of $80000 will be due. When making her decision, Susan could consider many factors including competition, job freedom and monetary rewards.
However, incase Susan decides to purchases the company and stiff competition arises in the third year, Susan should dispose the pharmacy.

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