Question

Irving owns a chain of movie theaters. He is considering whether he should build a new theater downtown. The expected rate of return is 15 percent per year. He can borrow money at a 12 percent interest rate to finance the project. Should Irving proceed with this project? LO30.3 a. Yes. b. No.

Short answer

Yes, because the return is higher than the interest rate.

Step-by-step solution

Understand the Problem

Irving is considering building a new theater with an expected rate of return of 15% per year. The cost to borrow the money for this project is 12% per year. To determine if he should proceed with the project, compare the expected return with the borrowing costs.

Compare Returns and Interest Rate

The core question is whether the return (15%) is greater than the borrowing interest rate (12%). Calculate the difference: 15% - 12% = 3%. This positive difference means that the return is greater than the cost.

Decision Making

Since the expected rate of return (15%) is greater than the interest rate on the loan (12%), the project will yield a net positive return. This means that Irving will earn more than he pays for the loan, making it a profitable venture.

Key concepts

Rate of Return

When evaluating investment opportunities like Irving's decision to build a new theater, understanding the rate of return is crucial. This concept measures the gain or loss of an investment over a particular period, expressed as a percentage of the investment's cost. Essentially, it tells us how much profit or loss we can expect compared to the initial amount invested. A 15% rate of return indicates that for every dollar Irving invests in the theater, he anticipates earning an additional 15 cents each year.

Factors influencing the rate of return include market conditions, the business's operational efficiency, and external economic policies. Investors often aim for a high rate of return, hoping it outweighs any associated costs, such as borrowing expenses. Here in this scenario, Irving's projected 15% rate suggests a lucrative venture if it surpasses related costs.

To better grasp the potential of investments, consider using the rate of return to compare them. Ensure the returns sufficiently cover all expenses while leaving room for profit.

Interest Rate Comparison

Interest rate comparison plays a vital role when deciding to invest or take on debt. In our scenario, it's about comparing the projected profit percentage (rate of return) against the percentage cost of borrowing money (interest rate).

In Irving's case, his project expects a 15% return, while borrowing costs him 12%.

• When the rate of return exceeds the interest rate, the investment can be considered profitable.
• If the rates were reversed, caution would be advised since Irving would spend more on borrowing than he earns.

Interest rate comparison is crucial as it helps forecast profit margins. Investors assess whether an expected margin (like Irving's 3% gap collected from 15% minus 12%) justifies the risks involved. Keep this method in your toolbox for any investment contemplation, as it ensures a clear understanding of potential gains versus costs.

Profitability Analysis

The final step in investment decision-making is profitability analysis, which determines if an endeavor will truly be fruitful. Essentially, it corroborates the previous calculations to ensure financial gain.

For Irving, the analysis revolves around estimating potential earnings from the theater against the borrowing costs, and any additional expenses. Here's a simplified approach to a basic profitability analysis:

• Calculate Expected Returns: With a 15% rate of return, project revenue streams and total gains.
• Subtract Total Costs: From borrowing expenses at 12% interest to operational and maintenance expenses.
• Net Profit Assessment: Determine whether expected returns surpass costs, resulting in net profit.

Profitability analysis acts as a safeguard. It ensures that the investment decision isn't just intuitively sound but proves financially dependable. For Irving, the analysis confirmed that the predicted 3% profit margin makes it a valid choice, offering more rewards than risks. This helps secure foresight and confidence in the undertaking. Always incorporate it in decisions to maximize investment success. By evaluating potential profits against costs, you'd gain solid ground for your projects, just as Irving planned with his theater.