Problem 1 (3 pts) - Concepts a) Explain the concepts of fixed cost versus variab

Question

Problem 1 (3 pts) - Concepts
a) Explain the concepts of fixed cost versus variable cost. Also contrast the concept of fixed cost to sunk cost.
b) Explain what “interest” is (in the financial sense). Briefly discuss the main reasons for interest being widely accepted and used in the modern economy.
c) Explain the concept of “capitalized worth”, relating it to the economic concept of “rent”.
d) Explain the “internal rate of return” by relating it to the PW of a project and the MARR. Also discuss its advantages as a decision metric and its shortcomings.

Explanation / Answer

a.

Variable cost is the company’s cost associated with the quantity of goods or services it produces. Variable cost may increase or decrease with the production volume. For example if a company manufactured glass for cost of $2. If the company produces 600 units its variable cost will be $1200. However if the company does not manufactured any units then its variable cost will be zero that means it will not have any variable cost for producing glass.

On the other hand fixed cost does not alter with the amount of goods or services a firm produces. It does not vary with production volume; it remains same even if no goods or services are produced. Using the same example above, if the company has a fixed cost of $12,000 per month for the machine it uses to produce glass. If company does not manufacture any glass for the month, it would still have to pay $12,000 for the cost of renting the machine.

Sunk cost is that spending cost which once the company spent. Sunk cost could not be refunded. For example depreciation is a sunk cost.

b.

Interest is a fee which is paid by the borrower for the use of another party’s money. The borrower who takes loan for purchasing home, car or for any other big item, in return they have to pay interest for lending money on the principal amount. Interest is widely accepted and used in modern economy because majority of the money used in the current economy is created by loans given by banks. This money is created by the monetary policy used by the central banks which includes setting of the interest rates.

c.

Capitalized worth is a method which is used to determine the present value of all revenues and expenses for an infinite period of time.

d.

The internal rate of return (IRR) is the break-even interest rate which equals the net present value of a project cash flow in and out.

PW (IRR) = PW (cash in) – PW (cash out)

                = 0

Advantages of IRR:

Disadvantages of IRR:

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