Investment Decision Rule: Project Return vs. Opportunity Cost
The decision to accept a corporate investment project is based on a strict criterion derived from comparing it to its opportunity cost. A project should be undertaken if, and only if, its expected future return is greater than the return achievable from the next best alternative, which is investing the initial funds in the financial market. This means the project is recommended only when its payoff exceeds what would be earned by investing the initial cost, , at the guaranteed real interest rate, .
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Investment Decision Rule: Project Return vs. Opportunity Cost
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Corporate Investment Decision
A manufacturing company is evaluating a one-year project with an initial cost of $10 million. The project is expected to generate a total return of $11.5 million at the end of the year. To make a sound investment decision based on the concept of opportunity cost, which of the following comparisons is the most essential for the company to make?
Critiquing an Investment Rationale
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A company has determined that the next best alternative to funding its own projects is to invest in financial markets, which offers a guaranteed 7% annual return. For each potential one-year project listed below, match it with the correct investment decision and rationale.
A firm is evaluating a project that requires an initial outlay of $500,000 and is expected to generate a total return of $520,000 one year later. The firm has identified that the best alternative use of these funds is an investment that would yield a 5% return over the same year. Based on this information, the firm should proceed with the project.
A technology firm is evaluating a one-year research and development project that requires an initial investment of $500,000. The firm has determined that the next best use of these funds would be to place them in a financial instrument yielding a 6% annual return. For the research project to be financially justifiable, its expected total return after one year must be greater than $____.
A financial analyst is tasked with determining whether a company should proceed with a major one-year investment project. Arrange the following steps in the logical order the analyst should follow to make a recommendation.
A company is considering a one-year project that costs $20 million and is expected to generate a total return of $22 million. The company's next best alternative is to invest the $20 million in financial assets that offer a guaranteed 5% annual return. Four managers offer their opinions on the decision. Which manager provides the most economically sound reasoning for their conclusion?
Project Choice and Opportunity Cost
Learn After
Future Opportunity Cost of an Investment
Project Viability Analysis
A company is evaluating a one-year project that requires an initial investment of $50,000. The project is expected to yield a total payoff of $52,000 at the end of the year. The company could alternatively invest the $50,000 in the financial market and earn a guaranteed real interest rate of 5%. Based on a direct comparison of the project's return to its next best alternative, what is the correct decision and justification?
A company should always undertake a project if its expected future payoff is greater than its initial investment cost.
Determining the Break-Even Interest Rate
A firm is evaluating several independent one-year projects, each requiring an initial investment of $200,000. The firm can alternatively invest its funds in the financial market to earn a guaranteed real interest rate of 4%. For each potential project payoff listed below, match it to the correct investment decision.
Critique of an Investment Decision Framework
A company is considering a project with an initial cost of $100,000. The next best alternative is to invest this amount in the financial market for one year at a guaranteed real interest rate of 6%. To justify undertaking the project, its expected payoff must be greater than the value of this alternative. The value of this alternative, which represents the amount the company would have after one year from the financial market investment, is $____.
A manager is deciding whether to approve a new one-year corporate project. Arrange the following steps into the correct logical sequence for making this decision based on a comparison to the next best alternative.
A manufacturing firm has determined that a specific one-year project, requiring an initial outlay of $1,000,000 and expecting a payoff of $1,050,000, is a worthwhile investment. This decision was based on a comparison to the alternative of investing in the financial market. Subsequently, before the final decision is made, the guaranteed real interest rate available in the financial market increases. How does this change in the interest rate affect the original assessment of the project?
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