Pepperdine University

FINC 655

Chapter 5

Multiple Choice Solutions

1)Which of the following will increase the break-even quantity?

1. 1. A decrease in overall fixed costs [Breakeven is calculated as Q=F/(P-MC), Therefore a decrease in overall fixed costs would decrease the numerator and hence the Breakeven Quantity]
   2. A decrease in the marginal costs [Breakeven is calculated as Q = F/(P-MC). Therefore a decrease in the marginal costs will increase the denominator, and subsequently decreases the Breakeven Quantity]
   3. A decrease in the price level [Breakeven is calculated as Q= F/(P-MC). Therefore, a decrease in the price level will decrease the denominator, which will increase the Breakeven quantity]
   4. An increase in price level [Breakeven is calculated as Q= F/(P-MC). Therefore, an increase in the price level will increase the denominator, which will decrease the Breakeven Quantity.

2. The higher the interest rates
   1. the more value individuals place on future dollars [a higher interest rate means future dollars are worth less relative to current dollars (present value of future dollars is lower)]
   2. the more value individuals place on current dollars [a higher interest rate means dollars today will have more value in the future because of the compounding effect of interest. In other words, the future value of the current dollars is higher]
   3. less investments will take place [the higher interest rate means the future value of current dollars is higher, which may lead to an increase in investment]
   4. does not affect the investment strategy [interest rates are an important consideration of any investment strategy in terms of its impact on both the investing and borrowing rates]

3. Assume a firm has the following cost and revenue characteristics at its current level of output: price=$10.00, average variable cost=$8.00 and average fixed cost =$4.00. This firm is

1. 1. incurring a loss of $2.00 per unit and should shut down. [In the short run, only variable costs are avoidable and should be considered in a shut down decision]
   2. realizing only a normal profit. [In this case, the firm is not making a profit]
   3. realizing an economic profit of $2.00 per unit. [In this case, the firm is not making a profit]
   4. incurring a loss per unit of $2.00, but should continue to operate in the short run. [In the short run, only variable costs are avoidable and should be considered in a shutdown decision. As the current price ($10) is still higher than the variable costs ($8), the company should continue to operate in the short run until the fixed costs become avoidable]

4. Sarah’s Machinery Company is deciding to dump their current technology A for a new technology B with small fixed costs but big marginal costs. The current technology has fixed costs of $500 and marginal costs of $50 whereas the new technology has fixed costs of $250 and marginal costs of $100. At what quantity is Sarah Machinery indifferent between two technologies?
   1. 5 [Total costs can be calculated as C=FC+VC(Q). Technology A has total costs of C=500+50(Q), while Technology B has C=250+100(Q). Sarah is indifferent at the quantity at

which these two costs are the same. Therefore, setting these equations equal to each other gives us 500+50(Q) = 250

+100(Q), which allows us to solve for Q = 5]

1. 2. 6 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same]
   3. 7 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same]
   4. 8 [Total costs can be calculated as C=FC+VC(Q). Sarah will be indifferent between the two technologies at the quantity where these two costs are the same]

5. What is the net present value of a project that requires a $100 investment today and returns $50 at the end of the first year and $80 at the end of the second year? Assume a discount rate of 10%.
   1. $10.52 [To find Net Present Value, discount the future cash flows by the discount rate raised to the period in which it was received (for example, year one means k=1, etc) and then subtract the initial investment from the sum of those cash flows]
   2. $11.57 [Net present value is calculated by discounting the future cash flows from the period they were received and subtracting the initial investment from the sum of those cash flows. In this case, (50/1.1)+(80/1.12)=111.57. $111.57-$100 initial investment gives a NPV of $11.57]
   3. $18.18 [Remember that the cash inflows need to be discounted back to present value from the time period in which they occur (50 at the end of year 1, 80 at the end of year 2)]
   4. $30.00 [Don’t forget about the time value of money. To determine the net present value, the future cash flows will need to be discounted and the initial investment will be subtracted from the sum of those values]

6. You expect to sell 500 cell phones a month, which have a marginal cost of $50. If your fixed costs are $5,000 per month, what is the break-even price?
   1. $10 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC]
   2. $50 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC]
   3. $60 [Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC. This gives us P= (5000/500)+50 = 10+50 = $60]
   4. $100[Breakeven Q= FC/(P-MC). This means (P-MC)Q=FC, so P-MC= (FC/Q) and finally P= (FC/Q) – MC]

7. You are considering opening a new business to sell dartboards. You estimate that your manufacturing equipment will cost $100,000, facility updates will cost $250,000, and on average it will cost you $80 (in labor and material) to produce a board. If you can sell dart boards for $100 each, what is your breakeven quantity?
   1. 1,000 [Breakeven Q=FC/(P-MC). In this case, the Fixed costs include both the equipment and the updates, the price is given at $100, and the MC equals the average cost per board]
   2. 3,500 [Breakeven Q= FC/(P-MC). Don’t forget to consider the marginal costs!]
   3. 4,375 [Breakeven Q= FC/(P-MC). Don’t forget to consider the price!]
   4. 17,500 [Breakeven Q = FC/(P-MC). In this case, fixed costs are $350,000 ($100,000 equipment +

$250,000 updates), the Price is given as $100 and the Marginal cost is the $80 cost per additional board. Putting these in the formula, we see that 350,000/(100-80) = 17,500]