1. Consider two investments that you can make. You can either buy a share of sto
ID: 2382947 • Letter: 1
Question
1. Consider two investments that you can make. You can either buy a share of stock in a company that will pay a dividend of $ 15 every year into the foreseeable future, or a buy a special type of bond that will start paying the same $ 15 in one year, and thereafter that payment will increase at the rate of 1 %, for a total of 3 payments. If the interest rate is 4 % (in both cases), which investment is better?
To answer this question, calculate the difference between the present values of each investment. That is, obtain the value that results for the present value of buying the stock minus the present value of buying the bond (that way, if the difference is positive then the stock is better, and viceversa). Enter your answer rounded to one decimal.
2. Congratulations! You just won a very special kind of lottery. Instead of receiving a large lump sum now, for tax reasons this lottery makes equal yearly payments of $ 5,760 for the rest of your life! The only catch is that you have to wait 2 years for the first payment. What is the present value of this lottery prize? The annual rate of interest is 8 %. Round your answer to one decimal.
Please show the steps on using the financial calculator. Thanks!
Explanation / Answer
1. Consider two investments that you can make. You can either buy a share of stock in a company that will pay a dividend of $ 15 every year into the foreseeable future, or a buy a special type of bond that will start paying the same $ 15 in one year, and thereafter that payment will increase at the rate of 1 %, for a total of 3 payments. If the interest rate is 4 % (in both cases), which investment is better?
To answer this question, calculate the difference between the present values of each investment. That is, obtain the value that results for the present value of buying the stock minus the present value of buying the bond (that way, if the difference is positive then the stock is better, and viceversa). Enter your answer rounded to one decimal.
Answer
Present Value of buying the stock = Annual Dividend/Required Rate
Present Value of buying the stock = 15/4%
Present Value of buying the stock = $ 375
Present value of buying the bond = 15/1.04 + 15*1.01/1.04^2 + 15*1.01^2/1.04^3
Present value of buying the bond = 42.03
Difference between the present values of each investment = 375 - 42.03
Difference between the present values of each investment = $ 332.97
Decision : stock is better
2. Congratulations! You just won a very special kind of lottery. Instead of receiving a large lump sum now, for tax reasons this lottery makes equal yearly payments of $ 5,760 for the rest of your life! The only catch is that you have to wait 2 years for the first payment. What is the present value of this lottery prize? The annual rate of interest is 8 %. Round your answer to one decimal.
Present value of this lottery prize = (equal yearly payments/annual rate of interest)/(1+annual rate of interest)^1
Present value of this lottery prize = (5760/8%)/1.08
Present value of this lottery prize = $ 66,666.67
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