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Assume that your firm has a potential investment project which generates a return of 15% and has a cost of $200,000. Assume further that your firm has $200,000 of retained earnings and that the market interest rate is 10%. In this case, your firm should:

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Answer:

Invest in the new project that generate a 15% rate of return

Explanation:

Our firm can decide to either:

  • Alternative A: invest the $200,000 in bonds or other stock that generates the market interest rate of 10% = $20,000 earnings per year.
  • Alternative B: invest the $200,000 in the new project and receive a 15% rate of return = $30,000 earnings per year.

If the company decides to invest the $200,000 in the new project its earnings will increase by $30,000 per year, which is $10,000 more than other investments that can generate market interest rate.

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