Question

Assume that your firm has a potential investment project which generates a return of 15% and has a cost of $200,000. Assume further that your firm has $200,000 of retained earnings and that the market interest rate is 10%. In this case, your firm should:

Answer 1

Invest in the new project that generate a 15% rate of return

Step-by-step explanation:

Our firm can decide to either:

• Alternative A: invest the $200,000 in bonds or other stock that generates the market interest rate of 10% = $20,000 earnings per year.
• Alternative B: invest the $200,000 in the new project and receive a 15% rate of return = $30,000 earnings per year.

If the company decides to invest the $200,000 in the new project its earnings will increase by $30,000 per year, which is $10,000 more than other investments that can generate market interest rate.