Linda Clark received $210,000 from her mother’s estate. She placed the funds int

Question

Linda Clark received $210,000 from her mother’s estate. She placed the funds into the hands of a broker, who purchased the following securities on Linda’s behalf:

a. Common stock was purchased at a cost of $91,000. The stock paid no dividends, but it was sold for $160,000 at the end of three years.

b. Preferred stock was purchased at its par value of $46,000. The stock paid a 4% dividend (based on par value) each year for three years. At the end of three years, the stock was sold for $32,000.

c. Bonds were purchased at a cost of $73,000. The bonds paid annual interest of $3,500. After three years, the bonds were sold for $75,000.

The securities were all sold at the end of three years so that Linda would have funds available to open a new business venture. The broker stated that the investments had earned more than a 11% return, and he gave Linda the following computations to support his statement:

1-a. Using a 11% discount rate, compute the net present value of each of the three investments.

1-b. On which investment(s) did Linda earn a 11% rate of return?

2. Considering all three investments together, did Linda earn a 11% rate of return?

3. Linda wants to use the $267,000 proceeds ($160,000 + $32,000 + $75,000 = $267,000) from sale of the securities to open a retail store under a 10-year franchise contract. What minimum annual net cash inflow must the store generate for Linda to earn a 8% return over the 10-year period?

Common stock: Gain on sale ($160,000 - $91,000) $ 69,000 Preferred stock: Dividends paid (4% x $46,000 x 3 years) Loss on sale ($32,000- 46,000) 5,520 (14,000) Bonds: Interest paid ($3,500 x 3 years) Gain on sale ($75,000 73,000) 10,500 2,000 $ 73,020 Net gain on all investments

Explanation / Answer

Computation of NPV for each of three investment Item Now 1 2 3 Common Stock: Purchase of the stock -91000 Sale of the stock 160000 Total Cash Flows -91000 160000 Discount factor 1 0.9009 0.8116 0.7312 Present Value -91000 0 0 116992 Net Present Value 25992 Preferred Stock: Purchase of the stock -46000 Annual Cash Dividend 1840 1840 1840 Sale of the stock 32000 Total Cash Flows -46000 1840 1840 33840 Discount factor 1 0.9009 0.8116 0.7312 Present Value -46000 1657.656 1493.344 24743.808 Net Present Value -18105.192 Bonds: Purchase of the Bond -73000 Annual Interest Income 3500 3500 3500 Sale of the bonds 75000 Total Cash Flows -73000 3500 3500 78500 Discount factor 1 0.9009 0.8116 0.7312 Present Value -73000 3153.15 2840.6 57399.2 Net Present Value -9607.05 Solution 1b: NPV of only common stock investment is positive. Therefore Linda earned 11% rate of return on common stock investment. Solution 2: Overall NPV of three investment = $25992-$18105.192 - $9607.05 = -$1720.24 As combined NPV is negative therefore Linda did not earn 11% rate of return on all investment together. Solution 3: Required annal cash inflows to earn 8% return = Investment required / cumualtive PV Factor for 10 year at 8% "=267000/7.1389 = $37400.72

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