Linda Clark received $100,000 from her mother\'s estate. She placed the funds in

Question

Linda Clark received $100,000 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 $70,000. The stock paid no dividends, but it was sold for $100,000 at the end of three years. b. Preferred stock was purchased at its par value of $35,000. The stock paid a 9% dividend (based on par value) each year for three years. At the end of three years, the stock was sold for $21,000 c. Bonds were purchased at a cost of $63,000. The bonds paid annual interest of $3,000. After three years, the bonds were sold for $65,500. 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 10% return. and he gave Linda the following computations to support his statement: Common stock: Gain on sale ($100,000 $70,000) S 30,000 Preferred stock: Dividends paid (9% x $35,000 x 3 years) Loss on sale ($21,000 $35,000) 9.450 (14,000) Bonds: Interest paid (S3,000 x 3 years) Gain on sale ($65,500 $63,000) 9,000 2,500 S 36,950 Net gain on all investments S36,950 3 years $100,000 12.3% Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factorsg tables.

Explanation / Answer

Solution 1a:

Solution 1b:

NPV of only common stock investment is positive. Therefore Linda earned 10% rate of return on common stock investment.

Solution 2:

Overall NPV of three investment = $5,100 -$11398.10 - $6,351.50 = -$12649.60

As combined NPV is negative therefore Linda did not earn 10% rate of return on all investment together.

Solution 3:

Required annal cash inflows to earn 9% return = Investment required / cumualtive PV Factor for 11 year at 9%

= $186,500 / 6.805 = $27,406.32

Computation of NPV for each of three investment Item Now 1 2 3 Common Stock: Purchase of the stock -$70,000.00 $0.00 $0.00 $0.00 Sale of the stock $0.00 $0.00 $0.00 $100,000.00 Total Cash Flows -$70,000.00 $0.00 $0.00 $100,000.00 Discount factor 1 0.909 0.826 0.751 Present Value -$70,000.00 $0.00 $0.00 $75,100.00 Net Present Value $5,100.00 Preferred Stock: Purchase of the stock -$35,000.00 $0.00 $0.00 $0.00 Annual Cash Dividend $0.00 $3,150.00 $3,150.00 $3,150.00 Sale of the stock $0.00 $0.00 $0.00 $21,000.00 Total Cash Flows -$35,000.00 $3,150.00 $3,150.00 $24,150.00 Discount factor 1 0.909 0.826 0.751 Present Value -$35,000.00 $2,863.35 $2,601.90 $18,136.65 Net Present Value -$11,398.10 Bonds: Purchase of the Bond -$63,000.00 $0.00 $0.00 $0.00 Annual Interest Income $0.00 $3,000.00 $3,000.00 $3,000.00 Sale of the bonds $0.00 $0.00 $0.00 $65,500.00 Total Cash Flows -$63,000.00 $3,000.00 $3,000.00 $68,500.00 Discount factor 1 0.909 0.826 0.751 Present Value -$63,000.00 $2,727.00 $2,478.00 $51,443.50 Net Present Value -$6,351.50

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