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

Quizplus · Accepted Answer

MD Groceries depletes its cash balance every 4 days, which means it replenishes its cash account 91 times a year (365 days/4). The cost of replenishing the cash account each time is $2.50, which means the total annual cost of replenishing the cash account is $2.50 x 91 = $227.50.

To determine the opportunity cost, we need to calculate how much the $5,000 cash balance would earn if it were invested instead of being held as cash. The annual opportunity cost can be calculated as:

Opportunity cost = Cash balance x Market rate of return
Opportunity cost = $5,000 x 0.045
Opportunity cost = $225.00 per year

Therefore, the annual opportunity cost of holding onto the $5,000 cash balance is $225.00. Since the cost of replenishing the cash account ($227.50) is greater than the opportunity cost ($225.00), it would be more beneficial for MD Groceries to lower its cash balance and reduce the number of times it replenishes its cash account. If the firm reduces its cash balance to $2,500, it will replenish its cash account only 46 times a year, which means the annual cost of replenishing the cash account will be $115.00 ($2.50 x 46). In this case, the opportunity cost of holding onto the $2,500 cash balance would be $112.50 ($2,500 x 0.045). Therefore, the best choice would be to lower the cash balance to $2,500.

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