MD Groceries currently sets its initial cash balance at $5,000, which is depleted every four days. The current market rate of return is 4.5% per year. The firm pays $2.50 each time it replenishes its cash account. Use a 360-day year.

What are the opportunity costs for MD's decision regarding its cash balance?

Question

What are the opportunity costs for MD's decision regarding its cash balance?

Quizplus · Accepted Answer

The opportunity cost of holding cash is calculated by considering the interest forgone on the cash balance. The formula for the opportunity cost is: (Average Cash Balance * Market Rate of Return) + (Transaction Cost * Number of Transactions per Year). The average cash balance is $5,000/2 = $2,500 (since cash is depleted from $5,000 to $0 every four days, the average is half of $5,000). The market rate of return is 4.5% per year. The transaction cost is $2.50 each time cash is replenished. The number of transactions per year is 360 days / 4 days = 90 times. Therefore, the opportunity cost is ($2,500 * 4.5%) + ($2.50 * 90) = $112.50 + $225 = $337.50. However, since the calculation mistake led to an incorrect total, the correct approach should focus solely on the components given: Opportunity cost from interest = $2,500 * 0.045 = $112.50. The transaction cost component was incorrectly added to the total instead of focusing on the interest opportunity cost alone, which matches option D.

MD Groceries Currently Sets Its Initial Cash Balance at $5,000