The following investment opportunities are available to an investment center manager: $$\begin{array} { | c | c | c | }
\hline \text { Project } & \text { Initial Investment } & \text { Annual Earnings } \
\hline \text { A } & \$ 800,000 & \$ 90,000 \
\hline \text { B } & 100,000 & 20,000 \
\hline \text { C } & 300,000 & 25,000 \
\hline \text { D } & 400,000 & 60,000 \
\hline
\end{array}$$ Required:
a. If the investment manager is currently making a return on investment of 16 percent, which project(s) would the manager want to pursue?
b. If the cost of capital is 10 percent and the annual earnings approximate cash flows excluding finance charges, which project(s) should be chosen?
c. Suppose only one project can be chosen and the annual earnings approximate cash flows excluding finance charges. Which project should be chosen?

Question

The following investment opportunities are available to an investment center manager: $$\begin{array} { | c | c | c | } 
\hline \text { Project } & \text { Initial Investment } & \text { Annual Earnings } \
\hline \text { A } & \$ 800,000 & \$ 90,000 \
\hline \text { B } & 100,000 & 20,000 \
\hline \text { C } & 300,000 & 25,000 \
\hline \text { D } & 400,000 & 60,000 \
\hline
\end{array}$$ Required:
a. If the investment manager is currently making a return on investment of 16 percent, which project(s) would the manager want to pursue?
b. If the cost of capital is 10 percent and the annual earnings approximate cash flows excluding finance charges, which project(s) should be chosen?
c. Suppose only one project can be chosen and the annual earnings approximate cash flows excluding finance charges. Which project should be chosen?

Quizplus · Accepted Answer

The Answer is a. The ROI of the four projects are:

\begin{array} { | l | l r | } \hline \mathrm {A }: \$ 90,000 / \$ 800,000 & = & 11.25 \% \\hline \mathrm { B } : \$ 20,000 / \$ 100,000 & = & 20.00 \% \\hline \mathrm { C }: \$ 25,000 / \$ 300,000 & = & 8.33 \% \\hline \mathrm { D } : \$ 60,000 / \$ 400,000 & = & 15.00 \% \\hline\end{array}

The manager would only want to accept projects that would raise the existing ROI above 16 percent. Only project B would raise the existing ROI.
b. All projects with an ROI greater than the cost of capital of 10 percent should be chosen. Therefore, projects A, B, and D should be chosen.
c. The project with the highest residual income should be chosen. The residual incomes of the four projects are:

\begin{array} { | l | r | r | } \hline ext { A: } \$ 90,000 - ( 10 ) ( \$ 800,000 ) & = & \$ 10,000 \\hline ext { B: } \$ 20,000 - ( .10 ) ( \$ 100,000 ) & = & \$ 10,000 \\hline ext { C: } \$ 25,000 - ( .10 ) ( \$ 300,000 ) & = & ( \$ 5,000 ) \\hline ext { D: } \$ 60,000 - ( .10 ) ( \$ 400,000 ) & = & \$ 20,000 \\hline\end{array}

Project D has the highest residual income and should be chosen.

The Following Investment Opportunities Are Available to an Investment Center