Your company needs to borrow money so that it can invest in new projects. The pl

Question

Your company needs to borrow money so that it can invest in new projects. The plan is to get 30% of the money needed from selling bonds (interest rate: 4%), and to get 70% from borrowing from a bank (interest rate: 12%). So,

a) Which of the following projects are suitable for investment using the borrowed money?

b) Explain why some of the projects aren’t suitable for investment? (In other words, explain why is it that a certain project should be rejected, even if it has a positive rate of return.)

Projected Rate of Return Project Energy Conservation Employee Training Microchip enhancement Storage scaling Social networking Travel consolidation Pension reorganization Rebranding 30% 24% 17% 12% 9% 7% 4% 2%

Explanation / Answer

a) suppose we borrow in total a million. Then $300,000 will be borrowed from selling bonds at 4% so that amount to be returned after a year is $312,000. The amount to be repaid to bank is $700,000*(1 + 12%) = $784,000. In total we are paying $1.096 million, which implies a cumulative interest rate is 9.6%.

Since Energy conservation, employee training, microchip enhancement and storage scaling have a rate of return higher than 12%, we select them.

b) Now projects that have a rate of return less than 9.6% are not selected because they are unable to cover the interest payment and are therefore unacceptable, even if they have a positive rate of return.)

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