4. In each of the following scenarios, which security should an investor buy? As

Question

4. In each of the following scenarios, which security should an investor buy? Assume that the securities are identical in all ways except as described below. Explain your answer. a. Security A has an expected return of 12 percent, whereas security B has an expected return of 10 percent. b. Interest on security C is 10 percent and is taxable, whereas interest on security D is 7 percent and is not taxable, and the investors tax rate is 40 percent. c. Security E has a 20 percent chance of default, whereas security F has a 15 percent chance of default. d. Security G and security H are both debt securities that cost $1,000 and mature in one year. An investor incurs a transactions cost of $50 to purchase security G, which has an expected return of 8 percent. An investor incurs no transactions cost to purchase security H, which has an expected return of 5 percent.

Explanation / Answer

a) A - If the only info you have is expected return, go for the higher one. b) D - The after tax yields are 10(1 - .4) = 6% vs 7% c) F - Lower default rate is better d) H - Total return is 5% vs 3% ((1000 * .08 ) - 50 ) / 1000

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