You are the manager of a Fortune 500 hotel chain and must decide where to locate

Question

You are the manager of a Fortune 500 hotel chain and must decide where to locate a new hotel. Based on tax considerations, your accounting department suggests that Atlantic City is the best choice, followed closely by Las Vegas. In particular, your current year tax savings from locating in Atlantic City are $4 million but only $3 million in Las Vegas. Your marketing department, on the other hand, has provided you with sales estimates that suggest that the present value of the gross (of taxes) operating profits from locating in Atlantic City are only $10 million but are $14 million for Las Vegas. It will cost $14 million to build the hotel in either location. Ignoring all other considerations, where should you build the hotel? What are your firms economic profits if you locate the hotel in Atlantic City?

Explanation / Answer

Ignoring other considerations, if you build the hotel in Atlantic City your accounting profits
are zero (computed as $4 million in tax savings, plus $10 million in operating profits, minus
$14 in building costs). In contrast, if you build in Las Vegas your accounting profits are $3
million (computed as $3 million in tax savings, plus $14 million in operating profits, minus
$14 million in building costs). Your best alternative is thus to build in Las Vegas to earn $3
million in accounting (and economic) profits. If you build the hotel in Atlantic City, your
accounting profits are zero, but your implicit cost is the $3 million you give up by not
building in Las Vegas - your best alternative. Thus, your economic profits of building in
Atlantic City are -$3 million.

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