Final answer:
Avoidable interest refers to the interest cost that would not have been incurred if expenditures for asset construction had not been made. It is based on weighted average accumulated expenditures and the appropriate interest rates applied. The determination of the interest rate includes the opportunity cost for investing financial capital and any risk premiums.
Step-by-step explanation:
The concept of "avoidable interest" refers to that portion of total interest cost which would not have been incurred if expenditures for asset construction had not been made. When a company constructs an asset and incurs expenditures, such as for building construction or production equipment, these expenses often necessitate a certain amount of borrowing. As such, interest costs can accrue due to the borrowed capital.
Avoidable interest can be calculated by considering the weighted average accumulated expenditures on the project and applying an interest rate. The interest rate used is either the rate on borrowing that actually occurred and can be directly attributed to the construction of the asset, or, if the company had no specific borrowing, a weighted average of the rates on all outstanding non-specific borrowings for the period.
However, not all interest costs are capitalized. Only interest cost incurred during the asset construction period related to expenditures made is considered avoidable, and therefore, capitalizable. This is because such interest cost represents additional funds that would not have been expended had the asset not been constructed. In your provided scenario, if the cost of financial capital is 9% but the firm can capture a 5% return to society, it adjusts its effective rate to 4% and thus its investment strategy changes accordingly to $183 million. This reflects the firm's management of its avoidable interest by considering both the opportunity cost of investing financial capital and potentially a risk premium to ascertain the actual financial cost of their investment decisions.
Interest rates influence investment levels significantly, and lower interest rates generally encourage increased investment spending. The financial investor in the example is considering investment opportunities by taking into account the opportunity cost of financial capital, and perhaps a risk premium, which would lead to a selection of a 15% interest rate.