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Qb Candidates were asked to estimate and advise upon the maximum interest rate the company should be prepared to pay to finance investment in all of the remaining projects available to it.
The answer provided calculated the profitability index of the remaining projects and added it as a percentage to the cost of capital of the company 10+7.652= 17.652%
I do not understand the logic.
Prof, kindly help with an explanation.
In order to be able to do the rejected projects, they will need to borrow more money and will have to pay higher interest on it than the current 10%.
The profitability index of the rejected projects is 7.652% but this was calculated using the NPVs discounted at 10%. So if they could borrow more money at 10% they would certainly invest in the rejected projects (because the index is +’ve), but for every extra 1% the have to pay, the benefit from the rejected projects would be 1% less (so at 11% interest, they would only gain 6.652% and so on). They will be prepared to pay more interest provided the PI% does not fall below zero, and so the most they will pay is 17.652%
You are welcome (but in future please ask in the Ask the Tutor Forum if you want me to answer) 🙂
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