Evaluating Investment Decision Criteria
An investment advisor suggests two methods for deciding whether to fund a one-year project:
Method A: The project is profitable if its future payoff is greater than the initial investment amount.
Method B: The project is profitable if its future payoff is greater than the amount the initial investment would have grown to if placed in an alternative investment earning the market rate of interest.
Evaluate these two methods. Which method provides a more accurate assessment of a project's profitability, and why? In your explanation, describe the key economic principle that the superior method incorporates.
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A firm is considering a one-year project that requires an initial investment of $50,000. The project is expected to yield a total payoff of $53,000 at the end of the year. The current annual market interest rate available for a similar-risk investment is 7%. Using the future value formulation for investment profitability, should the firm undertake this project, and why?
Project Profitability Analysis
Investment Decision Analysis
A company invests $10,000 in a project that will return $10,500 in one year. Given a market interest rate of 6%, the project is considered profitable because the future payoff is greater than the initial investment.
Evaluating Investment Decision Criteria
Match each component of the future value investment profitability criterion,
X > I(1+r), with its correct economic interpretation.A company is considering a project with an initial investment of $20,000. The current annual market interest rate is 5%. To be considered profitable based on the future value criterion, the project's payoff in one year must be greater than $____.
A project manager approves a one-year project requiring a $50,000 initial investment with an expected payoff of $53,500. The manager's justification is that the project yields a 7% return. However, the prevailing market interest rate for investments of similar risk is 8%. Based on the principle of comparing a project's future payoff to the future opportunity cost of the investment, why is the manager's conclusion to approve the project flawed?
A company has sufficient capital to undertake only one of two mutually exclusive one-year projects. The current annual market interest rate is 5%.
- Project Alpha: Requires an $80,000 initial investment and has an expected future payoff of $85,000.
- Project Beta: Requires a $100,000 initial investment and has an expected future payoff of $104,500.
Based on the criterion that a project's future payoff must exceed the future opportunity cost of the investment, which action should the company take?
Implied Interest Rate for a Profitable Project