Question

Suppose a business is considering borrowing money for two purchases. The first is a new machine costing $2,000. The owner of the business is told that the additional revenue resulting from using the first machine will be $2,080. The other purchase is a second machine (to be used in another building) costing $1,000. The owner is told that the additional revenue from the second machine will be $1,060. What is the expected rate of return for each of these purchases? Suppose that the interest rate is 7%. Assuming that the firm is a profit-seeking firm, would the firm choose to undertake the first project, the second project, both, or neither? Why? (If you have trouble doing the actual calculations, just show how you would compute it.).

Answer 1

Case of first machine

Cost of machine 1=C=$2000

Additional Revenue due to machine 1=R=$2080

Expected rate of return in case of machine 1=(R-C)/C=(2080-2000)/2000=4%

Case of second machine

Cost of machine 2=C=$1000

Additional Revenue due to machine 2=R=$1060

Expected rate of return in case of machine 2=(R-C)/C=(1060-1000)/1000=6%

In this case expected rate of return is less than prevailing rate of interest 7%. So, firm should not buy any of the machine as he can get higher rate of return by investing at current rate of 7%. So,

Firm should purchase neither of the machines