Question

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

Only if the firm has no other choice that can give it with a better rate of return should it make the investment with a return of $6$percent.

Step-by-step solution

Step 1. Introduction

The net benefit and cost on an investment for a given period of time is referred to as the rate of return. It is calculated as a percentage (yearly). The net benefit is if the percentage is positive.

Step 2. Explanation

If the company invests, it will get a $6\%$rate of return, and if the company borrows, it will have to pay an interest rate of $8\%$on the loan. There is no need to borrow money because the company currently has it.

The firm should not participate in the investment in this scenario. The interest rate on the loan is $8\%$, and the firm's rate of return is $6\%$. As a result, the opportunity cost is greater than the investment returns. The company has a large quantity of cash on hand to begin an investment that will yield a $6\%$return, while the cost of borrowing will be $8\%$. As a result, the company would lose $2\%$of its value.

Another reason to avoid investing is that the loan rate is higher than the return on investment, implying a loss. If the company takes on the project with a return of $6\%$, it will be able to earn more money. By just lending out the money on the market, the company can make an extra $2$percent.

Only if the firm has no other choice that can give it with a better rate of return should it make the investment with a return of $6$percent.