Question

Suppose a handbill publisher can buy a new duplicating machine for $500 and the duplicator has a 1-year life. The machine is expected to contribute $550 to the year’s net revenue.
What is the expected rate of return?

If the real interest rate at which funds can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the machine?

Will it invest in the machine if the real interest rate is 9 percent? If it is 11 percent?

Answer 1

Answer & Explanation:

Step 1

The expected rate of return r is calculated as follows:

r = (expected revenue - cost / cost) * 100%

= (550 - 500 / 500) * 100%

=10%

Step 2

The publisher will choose to invest the machine when the real interest rate is 10% and 9%. When the expected rate of return is higher than the cost of borrowing, that is, the real interest rate, the investment is profitable and should be undertaken.

In this question, the expected rate of return is 10%, higher than the borrowing cost of 8% and 9%; thus, the investment of the new machine should be undertaken.

When the cost of borrowing is 11%, which is higher than the rate of return of 10%, the investment should not be undertaken.