NewEnvironments:Suppose you have $2 retained earnings remaining

Suppose you have $2 retained earnings remaining at 5% and access to lending at 10%. You are faced with an indivisible asset with an IRR of 7% and an initial cost of $5. Do you invest?

Question options:

  • Kind of, we would only get 2/5 of the asset.
  • No, the blended cost of funds is 8%, more than the IRR.
  • No, since the IRR is less than the loan rate.
  • Yes, since we can replace an asset already funded by retained earnings with this one.

SOLUTION:

1) Given: We have $2 in retained earnings at 5% and access to a 10% loan.
The asset is INDIVISIBLE with an IRR of 7% and costs $5.

2)Since the asset is indivisible, we could buy it with the remaining $2 in retained earnings and $3 from a loan.

3)The blended MARR on the funding is
[ (fraction of asset bought with retained earnings)*(MARR of retained earnings) + (fraction of asset bought with loan)*(Loan Rate) ]
[ (2/5)(5%) + (3/5)(10%) = 8% ] which is greater than the IRR of the asset (7%).

4) Since, the incremental cost of funds (8%) is greater than our incremental benefit (7%), we DON'T buy the asset.

ANSWER:

  • No, the blended cost of funds is 8%, more than the IRR.
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