NewEnvironments: Suppose you have four indivisible investments

Suppose you have four indivisible investments that each have an initial cost of $2 and internal rates of return of 5%, 10%, 12% and 15%.

If you have $3 in retained earnings at 8% and access to lending at 17%, how many assets do you purchase?

Question options:

  • 1
  • 2
  • 3
  • 4

Answer: (1)

Solution:

You can build a bar chart for visual aid, but it is not necessary.

1. use up the $3 in retained earnings first:
The 15% investment gets looked at first since it has the highest IRR. It's a $2 investment, so we can cover it with the $3 from Retained Earnings, since the IRR is greater than MARR on the retained earnings, 8%, with $1 left over.

2. Next we look at the 12% investment:
We only have $1 left in retained earnings. Since the investment is $2, we will need to combine the $1 in retained earnings, at 8%, with $1 from the loan at 17%. Then, check to see if the combined MARR is less than or equal to the 12% IRR using the following equation:
(1/2)*.08+(1/2)*.17=.125

-Since a MARR of 12.5% is greater than 12%, we reject this investment.

3. All other investments:
We have expired our Retained Earnings, and the loan rate of 17% is higher than all other investments.

The 15% investment is the only one we accept.

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