Financial Risk and Return Considerations

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1.[Financial Risk and Return Considerations] Explain how you would choose between the following situations. Develop your answers from the perspective of the principles of entrepreneurial finance presented earlier in the chapter. You may arrive at your answers with or without making actual calculations.

A. You have $1,000 to invest for one year (this would be a luxury for most entrepreneurs). You can earn a 4% interest rate for one year at the Third First bank or a 5% interest rate at the First Fourth bank. Which savings account investment would you choose and why?

Third First bank: $1,000 x 1.04 = $1,040
First Fourth bank: $1,000 x 1.05 = $1,050

The First Fourth bank loan would be preferred because you would receive $10 more ($1,050 versus $1,040) at the end of one year. This example illustrates the principle: “real, human, and financial capital must be rented from owners.” The time value of money is an important component of the rent one pays for using someone else’s financial capital.

B.A “friend” of yours will lend you $10,000 for one year if you agree to repay him $1,000 interest plus returning the $10,000 investment. A second “friend,” has only $5,000 to lend to you but wants total funds of $5,400 in repayment at the end of one year. Which loan would you choose and why?

First friend: $1,000/$10,000 = 10% interest rate
Second friend: $400/$5,000 = 8% interest rate

The second friend is offering you a lower interest rate (8% versus 10%) which would be preferred, other things being equal. This example illustrates the principle: “real, human, and financial capital must be rented from owners.” The time value of money is an important component of the rent one pays for using someone else’s financial capital.

However, the dollar amount of financial that is needed also must be considered. For example, if you “need” $10,000 then the lower interest rate $5,000 loan is not a viable option. The only viable...
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