Question: You own a small business that sells freshly baked goods. You are considering buying a new $10,000 oven. Like most small business owners, you tend to finance your investment either from your savings (when you have some!) or with your credit card. Suppose you are currently earning 2 percent on your savings, and you have a credit card that charges 11.9 percent annual interest.
A. You expect a nominal rate of return on the oven of about 10 percent. Should you buy the oven if you are able to finance its purchase internally? Should you buy it if you are financing externally? Explain. (Professor's common: Ask yourself: what comparisons do business people make? do they compare nominal returns and real interest rates? Or nominal returns and nominal rates? Now look at the problem again and go through it slowly . . . do you have nominal or real rates of return? Nominal or real rates of interest?)
Internal finance: Buy/Don't Buy/Indifferent. (circle one)
External finance: Buy/Don't Buy/Indifferent.(circle one)
Explain:
B. Suppose instead that you expect your costs and your prices to increase by 3 percent. But the price of the oven is still $10,000. Do you change your decision about whether to purchase the oven with internal financing? Do you change your decision about whether to purchase the oven with external financing? Explain.
Internal finance: Buy/Don't Buy/Indifferent. (circle one)
External finance: Buy/Don't Buy/Indifferent.(circle one)
Explain: