Emily has $100,000 that she wishes to invest and is consideringthe following two

Question

Emily has $100,000 that she wishes to invest and is consideringthe following two options:

·      Option A: Investment inRedbird Mutual Fund, which is expected to produce interest incomeof $8,000 per year.

·      Option B: Investment inCardinal Limited Partnership (buys, sells, and operates winevineyards). Emily’s share of the partnership’s ordinaryincome and loss over the next three years would be:

         YEAR                                            INCOME(LOSS)

1                                                                       ($ 8,000)

2                                                                        (2000)

3                                                                        34,000

Emily is interested in the after-tax effects of thesealternatives over a three-year horizon. Assume that Emily’sinvestment portfolio produces ample passive income to offset anypassive losses that may be generated. Her cost of capital is 8%(the present value factors are 0.92593, 0.85734, and 0.79383), andshe is in the 28% tax bracket. The two investment alternativespossess equal growth potential and comparable financial risk. Basedon these facts, compute the present value of these two investmentalternatives and determine which option Emily should choose.

Explanation / Answer

PV of Option A: (1-0.28)[8000/(1+0.08) + 8000/(1+0.08)^2 + 8000/(1+0.08)^3] =14844 PV of Option B: The tax rate is also applied to the losses because they're entirelyoffset by her other investments. (1-0.28)[(-8000)/(1+0.08) + (-2000)/(1+0.08)^2 + 34000/(1+0.08)^3]= 12865 She should choose Option B given the higher PV, since everythingelse is comparable.

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