An investment fund is considering two long term investments. Which investment of

Question

An investment fund is considering two long term investments. Which investment offers the best rate of return assuming equal risks and a 10 year investment?

Bond: Coupon bond with a face value of $100,000 that can be purchased today for $70,000 that matures in 10 years. Its annual coupon rate is 8% paid semi-annually.

Stock: A stock whose shares can be purchased for $84 per share today and its price is forecast to grow 12% annually for the next 10 years. It will pay dividends of $1.50 semi-annually. Note that the future price of the stock can be calculated using the annual growth rate and the FV function.

Briefly discuss your recommendation. Submit using a spreadsheet.

Explanation / Answer

The bond calculation will be fairly simple. We will discount the cash flow for each year: IRR 13.7% BOND 0 1 2 3 4 5 6 7 8 9 10 -70,000 8000 8000 8000 8000 8000 8000 8000 8000 8000 108000 -1.28719 -70000 7037.298 6190.445 5445.5 4790.201 4213.76 3706.684 3260.63 2868.253 2523.094 29962.85 (Since the text does not paste nicely, try pasting it into word and sorting out the columns. It is evident that the IRR (rounded to one decimal point) that brings our PV closest to 0 is 13.7%. The stock is a little bit more difficult. Here we receive "semiannual" payments. So to be as thorough as possible, I calculated the cash flows according to these dividends. This gave us 20 periods and caused an annual IRR of 13.9% IRR 6.9% ANNUAL: 13.9% STOCK 0 1 2 3 4 5 6 7 8 9 10 -84 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 0.01937868 -84 1.402537658 1.311407922 1.22619933 1.146527158 1.072031677 1.002376532 0.937247222 0.876349683 0.819408954 0.766167944 11 12 13 14 15 16 17 18 19 20 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 262.3912495 0.716386263 0.669839141 0.626316413 0.58562157 0.54757087 0.511992511 0.478725851 0.44762069 0.418536583 68.45651471 We are always going to want to choose the investment with the highest IRR, so the stock appears to be our best choice.

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