Question

Problem 9 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) b) Which of the following projects are suitable for investment using the borrowed money? 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.) Proiected 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%

Answer 1

Weight of money borrowed by selling bonds=w1=30%=0.30

Rate of interest for bond option=r1=4%

Weight of money borrowed from bank=w2=70%=0.70

Rate of interest for bond option=r2=12%

Weighted cost of capital=r=0.3*4%+0.70*12%=9.6%

1. If projected rate of return of a project is higher than weighted cost of capital, project is suitable for investment otherwise not.Based on the above, we can choose following project/s

Energy Conservation

Employee Training

Microchip enhancement

Storage scaling

2. In such cases, projected rate of return is less than weighted cost of capital. It means that net profits will be negative in such cases. These projects are likely to make net loss.