Ted Baxter runs a small, very stable newspaper company in southernOregon. The pa

Question

Ted Baxter runs a small, very stable newspaper company in southernOregon. The
paper has been in business for 25 years. The total value of thefirm's capital stock is
$1 million, which Ted owns outright. This year the firm earned atotal of $250,000
after out-of-pocket expenses. Without taking the opportunity costof capital into
account, this means that Ted is earning a 25% return on hiscapital. Suppose that
risk-free bonds are currently paying a rate of 10% to those who buythem.
(a) What is meant by the "opportunity cost of capital"?
(b) Explain why opportunity costs are "real" costs even though theydo 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

The opportunity cost is only 15%, because that is the rate ofreturn of your capital investments, minus the yield of thebonds. Opportunity costs are real only because doing nothing would resultin a loss, instead of any gain at all. The only way not investingwould not be an opportunity cost would be if the expected yield ona return is 0%. Opportunity cost = $250,000 - $100,000, or $15,000. To be honest, I'm not sure what the term "excess profit" means, andwould hate to give you a wrong answer, but I hope the resthelps.

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