Increasing Cost Of Funds Exclusive Choice

Question

A B C D E F
1st yr Cost 2 5 15 20 22 30
Life 6 2 4 3 6 4
PW(10%) -1 10 22 17 19 18
IRR 6% 30% 14% 11% 15% 12%
  1. Which asset should you get with no restrictions on retained earnings? MARR=10%
  2. Which assets should you get with no restrictions on retained earnings? MARR=10%
  3. If you had $15 of retained earnings (@10% MARR) and access to a 13% loan, which assets would you get if they're indivisible?
  4. If you had $25 in Retained Earnings as capital budget, which assets would you get?

Answer:

  1. C, this asset has the highest PW. B/c there are no restrictions, we are open to whichever asset we choose.
  2. B,C,D,E and F. A has a negative PW, so we simply threw that asset out.
  3. Order the assets from highest IRR to lowest IRR, i.e., B, E, C, F, D, A. Asset B may be purchased with just retained earnings and since B's IRR is 30% and the MARR on retained earnings is 10% you buy it leaving you with $10 in retained earnings. The next asset, E, costs $22 and can be purchased with the remaining $10 in retained earnings and $12 from a loan. The blended MARR on the funding is 10/22 (10%) + 12/22 (13%)=11.6% which is less than the IRR of asset E (15%) and therefore purchased. Since there are no remaining retained earnings, the next asset, C, has its IRR, 14% compared to the loan rate, 13%. Since the IRR is higher, you buy that asset too. The remaining assets have IRR that are less than the loan rate and therefore not purchased.
  4. B and C: Excluding A because its PW is negative, and excluding F because its cost exceeds the budget, we are left with B, C, D, and E. The combinations with costs below the budget are: B, C, D, E, (B+C) and (B+D) with PWs of $10, $22, $17, $19, $32 and $27 respectively. We choose the (B+C) combination because it has the highest present worth. (Capital budgeting is explained in the next section of the course outline.)

A Good Sample Question

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