Increasing Cost of Funds

Increasing Cost of Funds

Class Notes

For volume of investments at time period zero;
Retained earnings are typically considered to have a 'high certainty'.
Commercial loans are considered to have some uncertainty.
Capitol market, stocks, and bonds are highly uncertain.

Note: Like returns that are 'certain' even if not so large.

Indivisible Assets Divisible Asset
Find Blended incremental cost of funds Take part that has IRR>=MARR

Note: If blended MARR>=IRR, then buy it.

Classroom Notes:

Ex1:

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MARR: 10%

5 Choices:

A (irr=25%, scale of investment=$5)

B (irr=20%, scale of investment=$15)

C (irr=15%, scale of investment=$10)

D (irr=12%, scale of investment=$5)

E (irr=8%, scale of investment=$10)

- Choose: A, B, C, D because irr > MARR. Dont Choose: E because irr < MARR (8% < 10%)

Ex2:

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MARR=10%

Same 5 choices as Ex1

This time retained earnings gives you only $30 for scale of investment purchases. You purchase A, B, C and now have to decide…do you take a loan at 17% and purchase D and E?

  • D only gets you a irr = 12% which is not greater than the 17% of loan so no to D
  • E only gets you a irr = 8% which is not greater than the 17% of loan so no to E as well.

Ex3:

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MARR=10%

Same 5 choices as Ex1

This time retained earnings gives you only $25 for scale of investment purchases. You purchase A and B and you have 2 ways you can look at purchasing C:

  • Divisible Asset: Divide C in half and get C1 and C2. C1 can be payed for with retained earnings ($5 you have left over) and C2 can be payed with a loan. Buy C1, but do not buy C2 because the irr for C = 15% and the loan is 17%.
  • Indivisible Asset (asset you cant divide. ie…truck, car, etc.): 5/10*10%(retained earnings)+5/10*17%(loan) = 13.5% which is more than the MARR (10%) so buy.

Ex 4:
$6 available to invest at MARR = 10% Loan Rate = 12%
Which assets do you buy?

A B C D
Year 3 5 2 10
IRR % 15 17 12 8

To solve this example, order the IRR from highest to lowest and buy the highest IRR.

B A C D
Year 5 3 2 10
IRR % 17 15 12 8
Remainder 6 1 0

$1 will remain when asset B is purchased. Take a $4 loan to purchase assets A and C. Only purchase assets B, A and C.

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