Question

Question 2

You have just purchased a new VCR to show videos to your customers. The VCR cost $500 in real dollars, and you depreciate the machine at a rate of 25% each year. You can borrow money from the bank at a nominal interest rate of 10%, or receive a 6% nominal interest rate for depositing money at the bank. The expected inflation rate in the coming year is 5%.You used the company's own funds to purchase the VCR. The firm's user cost of capital for the rest year is

a) 130
b) 150
c) 155
d) 175

I know the answer is a) 130 but I'm not sure why, please explain.

Answer 1

User cost is the aggregate of depreciation expense and opportunity cost.

Depreciation expense = Cost of product × 25%

                                    = $500 × 25%

                                    = $125

If the material is not purchased, it could have been kept as bank deposit. Opportunity cost is the real interest of depositing money.

Opportunity cost = Cost of product × Real rate of interest for depositing

                             = $500 × (Nominal rate of interest for depositing money – Rate of inflation)

                             = $500 × (6% - 5%)

                             = $500 × 1%

                             = $5

User cost = Depreciation expense + Opportunity cost

                = $125 + $5

                = $130 (Answer)

Note: Nominal rate of interest for borrowing money is not relevant here, since own fund is used for purchasing.