Big Mac Case

Opportunity Costs:

Walter is faced with an enviable but tough choice. On one hand he has an offer from a leading investment bank starting at $250,000 a year with a signing bonus of $50,000 and an expected first year bonus of $50,000. This offer will be open to him for a year although the first year bonus is not guaranteed. On the other hand he has an offer from a friend to be partner in a real estate project. The project will require an initial investment of $800,000 from each partner. The friend says that the resale value of the project is expected to be $2.4 million after one year.

Walter has $400,000 saved. He has talked to his bank and he will be able to borrow $400,000, guaranteed by the property, for 7% per annum.

a) Should Walter take his friend up on his offer and defer joining the investment bank till next year? Explain all the costs involved and justify your answer.

b) Walter 's living expenses are $1500 a month on rent and $1000 on food and entertainment. Does this information change your answer?

Solution:

a) Sample Calculations (will vary based on assumptions):

Gross Payoff for each of the 2 partners from Real Estate Project: $ 400,000

Interest Cost of Loan ($28,000)

Opportunity Cost of Salary ($250,000)

Opportunity Cost of 1st year Bonus ($50,000)

Opportunity Cost of Own Savings @5% ($20,000)

Economic Profit of Project for Walter $52,000

Note: Think through all the assumptions that can vary and therefore change the result.

b) If Walter maintains the same lifestyle regardless of his job, these costs are not marginal to his decision and do not affect the answer. The only difference will be that he will have to finance his living expenses from other sources since he does not get the proceeds from the real estate project till the end of the year. You can of course include an additional interest component in the cost calculation in part (a).