Jon Mitchell runs a small, very stable newspaper company in northern Georgia. Th
ID: 1249912 • Letter: J
Question
Jon Mitchell runs a small, very stable newspaper company in northern Georgia.The paper has been in business for 23 years. The total value of the firm’s stock is
$2 million, which Jon owns outright. This year the firm earned a total of $500,000
after out-of pocket expenses. Without taking the opportunity cost of capital into
account, this means that Jon is earning 25 percent return on his capital. Suppose
that risk-free bonds are currently paying a rate of 10 percent to those who buy
is them.
a. What meant by the “opportunity cost of capital”?
b. Explain why opportunity costs are “real” even though they do not necessarily
involve out-of-pocket expenses.
c. What is the opportunity cost of Jon’s capital?
d. How much excess profit is Jon earning?
Explanation / Answer
a) Opportunity cost of capital is the best return you could have achieved on your money had you chosen to invest it in something other than what you actually did. b) Opportunity costs are real in that they represent foregone chances to earn a return on your money. c) The opportunity cost of Jon's capital is 10% *2,000,000 or 200,000, assuming this is his best alternative to investing his money the way he has. d) Jon's economic or "excess" profit is $500,000- 200,000 or $300,000.
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