Question

Transcendental Advisors is advising one of their corporate clients on potential investment opportunities. The advisors are presented with two business strategies (a and b below). The company expects the profit to be $2,000,000 a year with no growth. The company also operates tax-exempt and is subject to 8.6% p.a. cost of capital compounded annually. The company long-term borrowing rate is 5.9% p.a. compounded annually.

a) Spend $5,000,000 to expand existing operations, boosting current expected annual profit from $2,000,000 to $3,000,000.

b) Spend $10,000,000 on lobbying and sign an exclusive contract with the government, who guarantees to purchase all of the company’s products for $2,500,000 a year but prohibits the company from selling anything to the existing customer base. Which investment opportunity is better? Show your work. (assume the client company operates perpetually)

Answer 1