Question

Rates of Return The minimum acceptable rate of return (MARR) for any investment is nearly always greater than the bank interest rate, because of risk and other factors. List at least four such factors you might encounter to justify that higher rate for the money you invest.

(b) Cash Flow Diagrams You need to decide whether to buy or lease a car. All the following values are in present $ so you do not need to adjust for the time value of money. If you buy the car for $65,000 it will have a resale value of $15,000 after four years. Alternatively, you could lease the car at $11,000 per year. Either option will also cost you $5,000 per year for petrol, maintenance and registration. Construct a cash flow diagram for each scenario. Which option makes the best financial sense?

(c) Time Value of Money i. You will need $10,000 in four years time. How much money do you need to deposit in the bank now if it pays an interest rate of 10%? ii. What is the “tyranny of discounting” and why does it have an effect on environmental decisions involving money?

(d) Breaking even You manufacture storage battery packs for photovoltaic units, selling for $5,000 each. Your variable costs are $3,200 per unit and you have fixed overheads of $2,500,000. How many battery packs do you have to sell to: i Break even? ii Make a profit of $10 million?

Answer 1

The four reasons for higher MARR than bank interest rate are as follows

1 The return on a bank is fixed so whether the earning is more or less than the interest rate we have to pay the fixed rate. Whereas the return on equity is uncertain. It is residual cash flow. Thus, due to the uncertainty return, the MARRis higher than the interest rate of the bank.

2 Debt holders don't take the risk if companies perform poorly or make a loss. However, equity holders do bear this risk so they demand a higher return.

3 Debt is generally secured against an asset while equity does not

4 In case a company files for bankruptcy the debtholders has first claim to the value and whatever is left given to equity holders. Thus, due to priority in claims, the debtholders demand lower return.

b)

The cash flow diagram shows inflow of cash on the upper side of the line and outflow below the line. On the line, there are different periods of time starting from time 0 till the time N which is time to maturity in the given question it is time 4

Since the cost of petrol and maintenance is a cost incurred in both options so we are not considering it in our cash flow diagrams.

The cash flow diagram for the option to buy a car is given below

The cash flow diagram for the option to lease a car is given below

Here we have assumed that the rent or lease will be paid at the end of each year

If we have the discount rate we would be able to find the net present value of both the options and the higher NPV option will be the option we chose.

c) Given,

Future value of money required = 10000

Time period = 4 years

Discount rate = 10%

Hence, if we want 10000 after for year then we will require X amount of money to invest today in a bank which will give an annual return of 10%

=>

=>

=> X = 6830.13

d) The breakeven quantity is calculated by dividing (Profit + Fixed cost) by the contribution margin

Here, Price = $5000

Variable cost = $3200

Thus, contribution = 5000-3200 = $1800

Hence, Breakeven =

  = 6944.44 Units

Hence, by selling 6944.44 units the firm will get profit of $10 million