Final answer:
The real interest rate is 5 percent (11% nominal interest rate minus 6% inflation rate). Since the considered investment offers a 6 percent rate of return, which is higher than the real interest rate, it would be financially prudent for the firm to make the investment with their available cash.
Step-by-step explanation:
When assessing the level of investment for the given conditions, it is important to understand the distinction between nominal and real interest rates. The real interest rate is calculated by subtracting the expected inflation rate from the nominal interest rate. In this case, with a nominal interest rate of 11 percent and an expected inflation rate of 6 percent, the real interest rate for investment borrowing is determined.
The firm in question is contemplating an investment that promises a 6 percent rate of return. If the firm had to borrow money for the investment, the interest on the loan would be 8 percent. However, since the firm has the necessary cash on hand, and thus does not need to borrow, the cost of the investment is simply the opportunity cost of not investing that cash elsewhere, rather than the cost of the loan.
Therefore, if the firm's goal is to maximize returns and the return on the investment is greater than the real interest rate that they would earn on an alternative investment or pay on a loan, then the firm should make the investment. In this scenario, as the firm has available cash and does not need to consider borrowing costs, it should compare the 6 percent rate of return of the investment to the real interest rate in the market.
Given the nominal interest rate of 11 percent, and the expected inflation rate of 6 percent, the real interest rate would be 5 percent (11% - 6%). Since the investment's return is 6 percent, this is higher than the real interest rate, making it financially sensible for the firm to invest the cash it has on hand, as long as the investment risk is acceptable and there are no better alternatives.