Question

Poseidon company has an opportunity to invest in three different projects; Apple, Beta and Delta. Each project would have an initial cost of $10 million. Alpha has an expected rate of return of 16%, Beta has an expected return rate of 8%, and Delta has an expected return of 12%. The company’s cost of capital is 6% if they borrow $10 million, 10% if they borrow $20 million, and jumps to 15% if they borrow $30 million. Based on this information, which projects should Poseidon invest in?

a. Only Alpha, as it has the highest rate of return.
b. None of the projects.
c. All three projects.
d. Only Alpha and delta.

Answer 1

Poseidon company should invest only in project Alpha since it has the highest rate of return that exceeds the increasing cost of capital at different borrowing levels. Investing in Beta and Delta would lead to lower or negative net returns because of the higher cost of capital. The correct option is a. Only Alpha, as it has the highest rate of return.

Step-by-step explanation:

The decision on which projects Poseidon company should invest in involves comparing the expected rates of return on the projects against the company's cost of capital at different levels of borrowing.

The company has to consider that the cost of capital increases with the amount it borrows, which means the overall profitability of an investment is influenced by this incremental cost increase.

To determine the right projects to invest in, we need to compare the expected rate of return of each project with the corresponding cost of capital based on the total amount borrowed:

Investing $10 million in Alpha (16% expected return) means the cost of capital is 6%, leaving a net return of 10%.

Investing $20 million to include Beta (8% expected return) would raise the cost of capital to 10%, making Beta's investment unattractive. However, Alpha's net return would still be 6% over the cost of capital.

Investing $30 million to include Delta (12% expected return) will raise the cost of capital to 15%, which means Delta's investment is not feasible, as it does not exceed the cost of capital. Alpha's net return would drop to 1%, which is still positive but significantly reduced.

Based on this analysis, Poseidon company should invest in project Alpha only because it has the highest rate of return that exceeds the incremental cost of capital even when borrowing $20 million.