You have just purchased a new VCR to show videos to your customers.The VCR cost $500,and you depreciate the machine at a rate of 25% each year.You can borrow money from the bank at 10%,or receive 6% for depositing money at the bank.The expected inflation rate in the coming year is 5%.You borrowed money from the bank to purchase the VCR.The firm's user cost of capital for the first year is
A)$130.
B)$150.
C)$155.
D)$175.

Question

Quizplus · Accepted Answer

The user cost of capital is the sum of economic depreciation, interest expenses, and opportunity cost.

Economic depreciation = $500 x 0.25 = $125

Interest expenses = $500 x 0.10 = $50

Opportunity cost = $500 x 0.06 = $30

So the total user cost of capital for the first year is $125 + $50 + $30 = $205.

However, we need to factor in the expected inflation rate of 5% to adjust for the decrease in the value of money.

Adjusted user cost of capital = $205 + ($205 x 0.05) = $215.25

Since we borrowed money from the bank at 10%, we need to pay back $550 ($500 + $50) at the end of the year.

Therefore, our best choice would be to deposit money in the bank at 6%, which would give us $30 ($500 x 0.06) in interest at the end of the year.

So our net user cost of capital for the first year would be $215.25 - $30 = $185.25.

The closest answer choice is B) $150. However, this option does not factor in the inflation rate, so it is not the correct answer.

You Have Just Purchased a New VCR to Show Videos