7. Another example of opportunity cost is a company's cost of capital. Suppose a manufacturer wants to add

microwave ovens to its product line. To do this, it must invest $500,000 in new equipment.


Besides the original investment, the company estimates it would spend $200,000 per year on production

costs for labor and materials. It also estimates that it could sell about $225,000 worth of microwave ovens

each year. Would it benefit the company to manufacture the microwave ovens if it could earn 10 percent

interest by purchasing U.S. Treasury bonds with the $500,000? Explain your answer.

Answer:

You should invest in US bonds because you will be able to earn a higher return than if you build and sell microwaves.

Explanation:

alternative 1, build and sell microwave ovens:

initial outlay = $500,000

net cash flow per year = $225,000 - $200,000 = $25,000

alternative 2, invest in US securities:

investment = $500,000

net cash flow per year = $500,000 x 10% = $50,000

Opportunity costs are the benefits lost or extra costs resulting from choosing one activity or investment over another.

If you choose to build and sell microwaves, you will not be able to invest in bonds, and therefore, your net income will decrease by $25,000 - $50,000 = -$25,000.

Instead, if you invest in bonds and not microwaves, your net income will increase by $50,000 - $25,000 = $25,000.

You should invest in US bonds because you will be able to earn a higher return than if you build and sell microwaves.

alternative 1, build and sell microwave ovens:

initial outlay = $500,000

So,

net cash flow per year = $225,000 - $200,000 = $25,000

now

alternative 2, invest in US securities:

investment = $500,000

net cash flow per year = $500,000 x 10% = $50,000

In the case when  you choose to build and sell microwaves, you will not be able to invest in bonds, and therefore, your net income will decrease by $25,000 - $50,000

= -$25,000.

Now

Instead, if you invest in bonds and not microwaves, your net income will increase by $50,000 - $25,000

= $25,000.

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