TUTORIAL 1 (11 15 AUGUST)

SOLUTION GUIDE FOR SUBMISSION QUESTION

SAVING AND INVESTMENT: (TEXTBOOK REFERENCE: CHAPTER 2)
Question 7*
This question re-examines Patricks decision (Example 2.5, Chapter 2, BOF) to purchase a ride-on
lawn mower. Patrick wants to calculate the annual cost to himself of owning the ride-on lawn
mower (this is called the user-cost or user-cost of capital).
He has the following information:
Initial purchase price of lawn mower = $5,000
Nominal interest rate = 6% per annum (Patrick has to borrow the $5,000)
Physical rate of depreciation on a lawn mower = 10% per annum
Expected sale price of lawn mower at end-of-year = $4,800
(i) Calculate in $s the cost to Patrick of owning the lawn mower for a year. (Hint: You will get a
slightly different answer depending on how you treat depreciation. Either way is acceptable)
One issue with this question is how to interpret the expected sale price at the end of the year. (I
will make sure to be clearer in the future).
One way is to assume that it is the market price of the depreciated lawn mower at the end of the
year. In this case $4,800 will reflect two things:
- The effect of physical depreciation and
- Any change in the market price of new lawn mowers (a pure capital gain or loss)
Under this assumption
User-cost = initial purchase price + interest cost on borrowing expected sale price
User-cost ($) = 5000 + 0.06(5000) 4800
User-cost ($) = $500
An alternative approach (and the one we will use) is to measure physical depreciation and the
capital gain (loss) separately. In this case we have:
User cost = initial purchase price + interest cost on borrowing [(depreciated lawn mower)end of
year price of new lawn mower)]
User-cost ($) = 5000 + 0.06(5000) (1-0.10)(4800)
User-cost ($) = $980
In the above calculation the price of new lawn mowers has fallen from 5000 to 4800 over the year
(a capital loss). Due to physical depreciation of 10%, Patrick only has 0.9 units of a lawn mower to
sell at the end of the year.
One final point. If you use the first approach to calculate user-cost, since the physical depreciation
rate is 0.10, we can work out what the end of year price must have been for a new lawn mower:
4800 = (1 0.10)(end of year price of a new lawn mower)
so
end of year price of a new mower = 4800/0.90 = 5333.3 (a capital gain of 333.3)

(ii) Divide the $ value from (i) by the initial purchase price to get the user-cost as a decimal (or you
can multiply by 100 to get a percentage if you wish).
Depending on how you did the calculation you get:
uc = 500/5000 = 0.10 (10%) or
uc = 980/5000 = 0.196 (19.6%)
(iii) Suppose that Patricks father had given him the $5,000 for his birthday, is the nominal interest
rate now irrelevant to the user cost calculation? Explain.
No, the interest cost is still relevant. It now reflects Patricks opportunity cost of using the $5000
to buy a lawn mower, rather than using it to purchase a financial asset that pays 6% interest.
Suppose we use the following symbols:
Initial purchase price of lawn mower =
Nominal interest rate =
Physical rate of depreciation on a lawn mower =
Expected sale price of lawn mower at end-of-year =
(iv) Write out a general formula for the user-cost of capital.
We will separate-out physical depreciation and (pure) capital gains/losses.
User-cost = initial price
+ interest cost (
- (Depreciated capital)(end-year price)
User-cost =
(v) Identify the factors that can affect a firms cost of capital.
From the formula there are three factors:
- Nominal interest rate
- Rate of physical depreciation
- Change in price of new capital goods
(vi) At the aggregate level, what factor is likely to be the most significant cause of variation in the
cost of capital? Explain your reasoning.
At the aggregate or macro-economic level changes in the interest rate seem likely to be the main
source of variation in the user-cost of capital. Interest rate changes have economy-wide effects
and are likely to affect all firms at the same time. Changes in depreciation rates and capital good
prices will often be specific to individual firms, rather than affecting all firms in the economy at the
same time (and in the same way).