2015 April - Q1

Discussion in 'CB2' started by ominming, Mar 30, 2021.

  1. ominming

    ominming Member

    1. A company makes economic profits of 10%. The risk premium for the company’s line of business is 5%. If the banks offer a rate of interest on savings accounts of 3%, the opportunity cost to the owners of the company is:
      A 5%.
      B 7%.
      C 8%.
      D 10%.​
    I thought the opportunity cost is the best alternative forgone, so either 5% or 3%?
    May I know how to get the answer C and the calculation if it is used?​
     
  2. Dave Johnson

    Dave Johnson ActEd Tutor Staff Member

    Hi

    This was covered explicitly in CT7 but not in CB2.

    The opportunity cost of capital investment is the alternative best investment possibility of the firm. However we cannot simply compare the expected return on alternative investments without allowing for the relative riskiness of those investments (e.g. buying government bonds vs. digging for oil have different levels of risk and reward).

    The opportunity cost we use is the risk-free rate of interest (in this case 3%) plus a risk premium specific to the industry that the company is in, to reflect an alternative of equal riskiness to the company's line of business. That gives us 3% + 5% = 8%, so option C.

    Dave
     

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