A software company decided to build a larger factory at a cost of $50 million that would be...

Question

A software company decided to build a larger factory at a cost of $50 million that would be operational for 5 years. At the end of five years the factory would become obsolete and could not be sold used. The company would borrow the money from the loanable funds market at 7% interest. Assume the decisions by the company were made rationally in the interest of the firm.Which of the following statements are true or false. Why?

Employing the new factory would ultimately reduce average total cost.
The present value of the gain from employing the new factory must be less or equal to $50 million.
The rate of return from the new factory must be greater than 7%.

Part II

Several years after the factory was in place, more production workers were hired to help fulfill an unusually larger than expected demand for its software. They would hire labor from the region at $10 per hour. Which of the following statements are true or false. Why?

The marginal physical product from the new hires is more than that at the margin from the labor already working at the firm.
Total production will increase at a diminishing rate.
The cost of labor at $10 per hour is related to the demand for that labor by other uses.

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David · Accepted Answer

Part I
A software company decided to build a larger factory at a cost of $50 million that would be operational 
for 5 years. At the end of five years the factory would become obsolete and could not be sold used. The 
company would borrow the money from the loanable funds market at 7% interest. Assume the decisions 
by the company were made rationally in the interest of the firm. Which of the following statements are 
true or false? Why?
1. Employing the new factory would ultimately reduce average total cost. 
2. The present value of the gain from employing the new factory must be less or equal to $50 
million. 
3. The rate of return from the new factory must be greater than 7%.
Solution:
Before answering the question it is imperative to state that there is no data available on the existing 
production & costs of the company. Hence we shall use the statement given in the problem that “the 
company made the decisions rationally.
1. True: Any company undertakes setting up of new capacity only & when the new capacity 
enables a reduction in the average total cost. Assuming the firm to be rational decision maker, 
as mentioned above,

A software company decided to build a larger factory at a cost of $50 million that would be operational for 5 years. At the end of five years the factory would become obsolete and could not be sold...

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