Pepperdine University

FINC 655

Chapter 3

Multiple Choice Solutions:

1)A business owner makes 1000 items a day. Each day he or she contributes 8 hours to produce those items. If hired, elsewhere he/she could have earned $250 an hour. The item sells for $15 each. Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the firm’s accounting profit for the month equals:

1. 1. $300,000 [Revenue equals 1000 items per day * $15/item*30days = $450,000. Explicit costs are given as

$150,000. Therefore, accounting profit = $450,000-$150,000 = $300,000]

1. 2. $60,000 [This number represents the opportunity cost of his labor; $250/hr*8hrs/day*30 days = $60,000]
   3. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days = $450,000.]
   4. $240,000 [For accounting profit, opportunity costs are not considered]

2. A business owner makes 1000 items a day. Each day he/she contributes 8 hours to produce those items. If hired, elsewhere he/she could have earned $250 an hour. The item sells for $15 each. Production does not stop during weekends. If the explicit costs total $150,000 for 30 days, the economic profit for the month equals:
   1. $300,000 [This number represents the accounting profit. Revenue equals 1000 items per day * $15/item*30days =

$450,000. Explicit costs are given as $150,000. Therefore, accounting profit = $450,000-$150,000 = $300,000]

1. 2. $60,000 [This number represents the opportunity cost of his labor; $250/hr*8hrs/day*30 days = $60,000]
   3. $450,000 [This number represents the total revenue; 1000 items per day * $15/item*30days = $450,000.]
   4. $240,000 [When calculating economic profit, opportunity costs are considered. Total Revenue is

$450,000 (1000 item/day*$15/item*30days), Explicit costs are given at $150,000 and the opportunity cost of labor is $60,000 ($250.hr*8hrs/day*30days). Therefore, economic profit is $450,000-$150,000-$60,000 = $240,000]

3. If a firm is earning negative economic profits, it implies
   1. That the firm’s accounting profits are zero. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved].
   2. That the firm’s accounting profits are positive. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved].

1. 3. That the firm’s accounting profits are negative. [Not necessarily, it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved].
   4. More information is needed to conclude about accounting profits [it is impossible to determine the relationship between economic and accounting profit without information on the economic costs involved]

4. Opportunity costs arise due to
   1. Resource scarcity [without scarce resources (time, labor, money, etc), the pursuit of another alternative does not require one to give up anything in return.
   2. Interest rates [interest is an economic cost that reflects what creditors charge for use of their capital]
   3. Limited wants [Limited wants would not generate opportunity costs]
   4. Unlimited scarcity [Unlimited scarcity does not generate opportunity costs]

5. After graduating from college, Jim had three choices, listed in order of preference: (1) Move to Florida from Philadelphia, (2) work in a car dealership in Philadelphia, or (3) play soccer for a minor league in Philadelphia. His opportunity cost of moving to Florida includes
   1. The benefits he could have received from playing soccer [Opportunity cost represents the value of only the best foregone alternative]
   2. The income he could have earned at the car dealership [opportunity cost reflects the value of the best foregone alternative, in this case the car dealership salary]
   3. Both a and b [Opportunity costs represent the value of only the best foregone alternative]
   4. Cannot be determined from the given information [Opportunity costs reflect the value of the best foregone alternative, what is that for Jim in this case?]

6. Economic Value Added helps firms to avoid the hidden-cost fallacy
   1. by ignoring the opportunity costs of using capital [On the contrary, EVA makes the hidden cost of equity visible to the firm]
   2. by differentiating between sunk and fixed costs [EVA may help managers distinguish between the two, but it does so by looking at the cost of capital associated with each]
   3. by taking all capital costs into account including the cost of equity [By taking all of the capital costs into account such as the cost of equity, firms can better gauge their economic profit and the opportunity costs associated with some of their current assets]
   4. none of the above [It is one of the above]

7. The fixed-cost fallacy occurs when
   1. A firm considers irrelevant costs [The sunk or fixed cost fallacy occurs when you make decisions using irrelevant costs or benefits. In other words, you consider costs and benefits that do not vary with the consequences of your decision]
   2. A firm ignores relevant costs [This is the definition of the hidden cost fallacy]
   3. A firm considers overhead or depreciation costs to make short-run decisions [Overhead and depreciation are example of irrelevant or suck costs that are not impacted by the outcome of a short term decision]
   4. Both a and c [The sunk or fixed cost fallacy occurs when costs (such as depreciation and overhead) are considered even when they do not vary with the consequences of the decision.

8. Mr. D's Barbeque of Pickwick, TN produces 10,000 dry-rubbed rib slabs per year. Annually Mr. D's fixed costs are

$50,000. The average variable cost per slab is a constant $2. The average total cost per slab then is