You have the chance to expand your business by making an investment (Initial Investment) that requires ‘n’ years to finish (Completion date after start ), after which a fixed rate of return (Rate of return after completion) of ‘X %/yr’ will be returned (simple interest) on your initial investment. You have the initial investment available to pay for this expansion project now (liquid assets), but your advisor urges you to consider the following options before making a decision. Assume all debt payments are ‘Y %/yr’ APR.
Consider the analysis period to be the life of the loan (5 years)
1) Do nothing (invest the initial investment in risk-free CD’s @ 6% simple annual interest). Interest paid to you (not reinvested)
2) Pay cash for the expansion and have no debt.
3) Finance the expansion over 5 years with the possibility to:
a. Pay the loan back using simple amortization.
b. Pay interest only on the loan, with the initial principal due at the end of the term.
c. Pay 10% down, and make no other payments until the loan term ends at which time the compounded interest and remaining principal will be due.
Discussion questions:
- Which, if any, of the choices “1 to 3” above do you make and why? Perform your calculations via (assume MAARR as discount rate, as needed):
- NPW
- EUACB
- Incremental IRR
- Discuss opportunity costs of your decision relative to the “do nothing” option
Part 1B: Description: (Ref: Capstone_Exercise_1_Solution_Sum14.xlsx)
You have the chance to expand your business by making an investment (Initial Investment) that requires ‘n’ years to finish (Completion date after start ), after which a fixed rate of return (Rate of return after completion) of ‘X %/yr’ will be returned (simple interest) on your initial investment. You have the initial investment available to pay for this expansion project now (liquid assets), but your advisor urges you to consider the following options before making a decision. Assume all debt payments are ‘Y %/yr’ APR.
Consider the analysis period to be the life of the plant (20 years)
4) Do nothing (invest the initial investment in risk-free CD’s @ 6% simple annual interest). Interest paid to you (not reinvested)
5) Pay cash for the expansion and have no debt.
6) Finance the expansion over 5 years with the possibility to:
a. Pay the loan back using simple amortization.
b. Pay interest only on the loan, with the initial principal due at the end of the term.
c. Pay 10% down, and make no other payments until the loan term ends at which time the compounded interest and remaining principal will be due.
Discussion questions:
- Which, if any, of the choices “1 to 3” above do you make and why? Perform your calculations via Incremental IRR ONLY
- Discuss opportunity costs of your decision relative to the “do nothing” option
Assume that your business model is to invest only in opportunities with a MAARR (Minimum Attractive/Acceptable Rate of Return of 10%/annum)
