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Question:


Imagine that you are trying to evaluate the economics of purchasing an automobile. You expect the car to provide annual cash benefits of $1,200 at the end of each year, and assume that you can sell the car for proceeds of $5,000 at the end of the planned 5-year ownership period. All funds which are you use has 6% discount rate. What should be the required return applicable to valuing the car.
 


Answer:


Step 1

The minimum return expected by the investor from the project is known as the required rate of return. It should be greater than the cost of capital to earn the profit.

Step 2

In the provided scenario, the cost of capital is 6%.
The required return to value the car should be 6% because the cost of capital is 6%. Thus, if the investor gains a return of 6% from the car then the investor will be capable of paying its cost of capital. The investor will incur losses in case the return will be lower than the cost of capital that is 6%.
 
On the whole, it can be concluded here that, the investor must value the car at the rate equal to the cost of capital in order to earn the profits.

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