Chapter Exercises

1.15One solution to the principal–agent problem in restaurants is the system in which waiters and waitresses in restaurants work for tips as well as for a small boss salary.Discuss a potential problem for management with this type of revenue-based incentive scheme. 1.16Employese of fast-food restaurants who work directly with customers do not earn tips like waiters and waitresses.Discuss possible solutions to the manager–worker/principal–agent problem in fast-food restaurants. 1.17Explain why frequent spot checks by managers to encourage workers to put forth their best effort may not always be in the best interest of the firm’s owners. 1.18Under what condition is the assumption of profit maximization equivalent to shareholder wealth maximization? 1.19In practice,what is a good approximation of the risk-free rate of return on an investment? 1.20As a practical matter,how would you estimate the risk premium on an investment? 1.21Discuss several reasons why a firm in a competitive industry might earn above-normal profits in the short run.Will these above-normal profits persist in the long run? Explain. 1.22Firms that earn zero economic profit should close their doors and seek alternative investment opportunities.Do you agree? Explain. 1.23What is likely to happen to the price,quantity,and quality of products produced by firms in competitive industries earning above normal profits? Explain.Cite an example.

CHAPTER EXERCISES

1.1Tilly’s Trilbies has estimated the following revenues and expenditures for the next fiscal year: Revenues $6,800,000 Cost of goods sold 5,000,000 Cost of labor 1,000,000 Advertising 100,000 Insurance 50,000 Rent 350,000 Miscellaneous expenses 100,000 a.Calculate Tilly’s accounting profit. b.Suppose that to open her trilby business,Tilly gave up a $250,000 per year job as a buyer at the exclusive Hammocker Shlumper department store.Calculate Tilly’s economic profit.

c. Tilly is considering purchasing a building across the street and moving her company into that new location.The cost of the building is $5,000,000,which will be fully financed at a simple interest rate of 5% per year.Interest payments are due annually on the last day of Tilly’s fiscal year.The first interest payment will be due next year.Principal will be repaid in 10 equal installments beginning at the end of the fifth year.Calculate Tilly’s accounting profit and economic profit for the next fiscal year. d.Based upon your answer to part c,should Tilly buy the new building? Explain.(Hint:In your answer,ignore the economic impact of principal repayments.) 1.2Last year Chloe quit her $60,000 per year job as a web-page designer for a leading computer software company to buy a small hotel on Saranac Lake.The purchase price of the hotel was $300,000,which she financed by selling a tax-free municipal bond that earned 5.5% per year. Chloe’s total operating expenses and revenues were $100,000 and $200,000, respectively. a.Calculate Chloe’s accounting profit. b.Calculate Chloe’s economic profit. 1.3In the last fiscal year Neptune Hydroponics generated $150,000 in operating profits.Neptune’s total revenues and total economic costs were $200,000 and $75,000,respectively.Calculate Neptune’s normal rate of return. 1.4Andrew Oxnard,chief financial officer,has been asked by Harry Pendel,chief executive officer and cofounder of Pendel & Braithwaite,Ltd. (P&B),to analyze two capital investment projects (projects A and B),which are expected to generate the following profit (p) streams:

Profit Streams for Projects A and B ($ thousands)

Period, t pA

pB

1 $100 $350 2 200 300 3 250 200 4 300 100 5 325 100 $1,175 $1,050

Profits are realized at the end of each period.Assuming that P&B is a profit maximizer,if the discount rate for both projects is 12%,which of the two projects should be adopted?