BEC B5 Opportunity cost question

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  • #160972 Reply
    Anonymous
    Inactive

    Hi,

    I don't understand why we have to divided by 2 (time). The question didn't mention much about timing. Anyone can help? Thank you very much!

    American Coat company estimates that 60,000 special zipper will be used in the manufacture of men's jackets during the next year. Reese Zipper company has quoted a price of $0.6 per zipper. American would prefer to purchase 5,000 units per month, but Reese is unable to guarantee this delivery schedule. In order to ensure availability of these zippers, American is considering the purchase of all 60,000 units at the beginning of the year. Assuming American can invest cash at eight percent, the company's opportunity cost of purchasing the 60,000 units at the beginning of the year is?

    a. 1320

    b. 1440

    c. 1500

    d. 2640

    Choice “a” is correct.

    Cost to purchase 60,000 zippers:

    60,000 x 0.6 = 36,000

    The opportunity cost is the forgone interest on the 33,000 cash payment (the first 3000 would have had to be paid in either case).

    The 33,000 cash payment made evenly throughout the period is the same as making the total payment in the middle of the period. The solution is:

    Principle Rate Time Interest

    33,000 x 0.08 x 1/2 = 1320

    #290635 Reply
    fdt
    Participant

    It's because the principle balance on which you would earn the interest would be decreasing incrementally with each monthly purchase. Since the monthly purchases are made in equal installments over the year, the interest earned would be the average principle balance during the year ($33,000 / 2 = $16,500) times the 8% annual interest rate. This comes to the $1320. The below schedule should help to illustrate it:

    _	Principle	Interest Rate	Interest
    Month Balance (8% / 12) Earned

    Jan 33,000 0.006666667 $220
    Feb 30,000 0.006666667 200
    Mar 27,000 0.006666667 180
    Apr 24,000 0.006666667 160
    May 21,000 0.006666667 140
    Jun 18,000 0.006666667 120
    Jul 15,000 0.006666667 100
    Aug 12,000 0.006666667 80
    Sep 9,000 0.006666667 60
    Oct 6,000 0.006666667 40
    Nov 3,000 0.006666667 20
    Dec 0 0.006666667 0
    TOTAL: 1,320

    #290636 Reply
    Anonymous
    Inactive

    Hi fdt,

    Thanks for the explanation. What kind of situation that we don't need to divided by 2? I would like to make a comparison. Thank you!

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