Assume that a machine, which has a useful life of only one year, costs $2,000.Also, assume that the difference between the estimated operating costs, which includes power and taxes, and the additional revenue from the output of this machine is expected to be $2,300.If the firm finds that it can borrow funds at an interest rate of 10 percent per annum, the firm should:
A)not purchase the machine because the expected rate of return exceeds the cost of borrowing.
B)purchase the machine because the expected rate of return exceeds the cost of borrowing.
C)not purchase the machine because the cost of borrowing exceeds the expected rate of return.
D)purchase the machine because the cost of borrowing exceeds the expected rate of return.

Question

Quizplus · Accepted Answer

The expected rate of return on the machine is calculated as follows:
Expected revenue from output - Estimated operating costs = $2,300
Therefore, expected revenue from output = $2,300 + Estimated operating costs
Assuming estimated operating costs are $500, expected revenue from output is $2,800.
Expected rate of return = (Expected revenue from output - Cost of machine)/Cost of machine
Expected rate of return = ($2,800 - $2,000)/$2,000 = 0.4 or 40%
The interest rate on borrowing funds is 10% per annum.
The expected rate of return (40%) is greater than the cost of borrowing (10%), so the firm should purchase the machine.

Assume That a Machine, Which Has a Useful Life of Only