Chris Stanley is considering buying an original Picasso for $400,000 today with

Question

Chris Stanley is considering buying an original Picasso for $400,000 today with the intention of selling it at the end of one year. Chris expects that the painting will be worth $480,000 in one year. However, his forecast is uncertain: the painting might sell for more or sell for less than this amount in one year. Currently, the bank offers an interest rate of 10%, compounded annually, on Federally insured deposit accounts up to a balance of $500,000. Joan Miro, a local banker, tells Chris that he considers the purchase of this painting to be risky; therefore, his bank would charge an interest rate of 25%, compounded annually, on a one-year loan of $400,000 to Chris for his investment in this Picasso. Chris happens to have $400,000 currently in his bank account. Should Chris invest in the Picasso? Why or why not? Hint: this problem is implicitly a one-period NPV problem. Invest in the Picasso, because its present value is $436,364, which is greater than the cost. Invest in the Picasso, because it could be worth much more than $480,000 in one year. Do not invest in this painting, because its present value is $384,000, which is less than the cost. Do not invest in the Picasso, because it is more risky than saving in the bank account.

Explanation / Answer

Ans is C Do not invest in this painting, because its present value is $384,000, which is less than the cost.

Explanation: Since banker considers this type of investment much risky and offers a loan at 25% for $400,000 i.e. the appropriate discount rate for this should be 25%

Present value at 25% = $480000/1.25 = $384,000, so Picasso is currently overpriced at $400,000 and should not invest.

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