Chapter 7: Problem 39

A firm is considering an investment that will earn a 6\(\%\) rate of return. If it were to borrow the money, it would have to pay 8\(\%\) interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment? Show your work.

Short Answer

Expert verified

In short, the firm should make the investment as it will earn a 6% rate of return, which is greater than the 0% return from not investing. The cost of borrowing is irrelevant since the firm is not borrowing any money for the investment.

Step by step solution

Calculate the rate of return from the investment

If the firm chooses to make the investment, they would earn a 6% rate of return. We can represent this as a percentage: Rate of return from investment = \(6\%\)

Calculate the cost of borrowing the money

However, since the firm is not borrowing any money for the investment, this part is irrelevant for the decision-making process.

Compare the rate of return from investment to the cost of borrowing

As established before, since the firm is not borrowing any money, the rate of return from not investing would be 0%. Thus, we need to compare the 6% return from the investment to a 0% return from not investing.

Make a decision based on the comparison

Since a 6% rate of return from investment is greater than the 0% return from not investing, it would be in the firm's best interest to make the investment.

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