Ted Baxter runs a small, very stable newspaper company in southern Oregon. The p

Question

Ted Baxter runs a small, very stable newspaper company in southern Oregon. The paper has been in business for 25 years. The total value of the firms capital stock is $1 million, which Ted owns outright. This year, the firm earned a total of $250,000 after out of pocket expenses. Without taking the opportunity cost of of capital into account, this means that Ted is earning a 25% return on his capital. Suppose that risk free bonds are currently paying a rate of 10% to those who buy them. a. What is meant by the "opportunity cost of capital"? b. Explain why opportunity costs are real costs even though they do not necessarily involve out of pocket expenses. c. What is the opportunity cost of Ted's capital? d. How much excess profit is Ted earning?

Explanation / Answer

a. Opportunity cost of capital is the cost of foregoing the next best option for investing the capital elsewhere instead of investing in the business.

b. Opportunity costs are real costs because Ted could have earned 10% risk free income if he had decided to just invest in the bonds instead of running a risky business.

c. Opportunity cost per year of Ted's capital is = 10% * 1 million = $100,000

d. Excess Returns over opportunity costs = 250,000 - 100,000 = $150,000

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