Question

You have extra $5,000 to invest. You do not need the money now but will need it after 3 years, so you plan to cash your investment at the end of 3 year. Usually your investments earn 7% annual interest compounded annually and you’d like to consider it as your minimum acceptable rate of return. You are considering several investment opportunities: Option 1. Depositing your money on the high interest savings account that earns 0.58% interest each month. Option 2. Buying and holding a stock that grows 10% per year. Option 3. Making a personal loan of $5000 to a friend and receiving $400 per year. Select the best option and explain why.

Answer 1

Value of $5000 @7% rate of return after 3 years,

FV = 5000*(1+0.07)3 = $6125.215

Option 1

Amount invested = $5000

Interest rate per month = 0.58% or 0.0058

Number of months in 3 years = 36 months

Value of $5000 invested after 3 years,

FV1 = 5000*(1+0.0058)36 = $6157.27755

Option 2

Amount invested = $5000

Growth rate of stock = 10%

Number of years = 3 years

Value of $5000 stock which grows at 10% annually after 3 years,

FV2 = 5000*(1+0.1)3 = $6655

Option 3

Amount invested = $5000

Amount recieved = $400 for 3 years

Value of $5000 at the end of 3 years when the loan is repaid,

FV3 = 400 + 400 + 400 + 5000 = $6200

Thus, with highest value of $5000 after 3 years, $6655, option 2 i.e. holding a stock for 3 years is tge best option paying 10% return which is more than minimum acceptable rate of return, 7%

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