Question

Linda Clark received $210,000 from her mother’s estate. She placed the funds into the hands of a broker, who purchased the following securities on Linda’s behalf:

a. Common stock was purchased at a cost of $91,000. The stock paid no dividends, but it was sold for $160,000 at the end of three years.

b. Preferred stock was purchased at its par value of $46,000. The stock paid a 4% dividend (based on par value) each year for three years. At the end of three years, the stock was sold for $32,000.

c. Bonds were purchased at a cost of $73,000. The bonds paid annual interest of $3,500. After three years, the bonds were sold for $75,000.

The securities were all sold at the end of three years so that Linda would have funds available to open a new business venture. The broker stated that the investments had earned more than a 11% return, and he gave Linda the following computations to support his statement:

   

Common stock:
Gain on sale ($160,000 – $91,000)	$	69,000
Preferred stock:
Dividends paid (4% × $46,000 × 3 years)		5,520
Loss on sale ($32,000 – $46,000)		(14,000	)
Bonds:
Interest paid ($3,500 × 3 years)		10,500
Gain on sale ($75,000 – $73,000)		2,000
Net gain on all investments	$	73,020

$73,020 ÷ 3 years	= 11.60 %
$210,000

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

Required:

1-a. Using a 11% discount rate, compute the net present value of each of the three investments.

1-b. On which investment(s) did Linda earn a 11% rate of return?

2. Considering all three investments together, did Linda earn a 11% rate of return?

3. Linda wants to use the $267,000 proceeds ($160,000 + $32,000 + $75,000 = $267,000) from sale of the securities to open a retail store under a 10-year franchise contract. What minimum annual net cash inflow must the store generate for Linda to earn a 8% return over the 10-year period?

Answer 1

Ans 1) a)

Ans 1) b)

Since NPV of only common stock is positive, therefore Linda earned 11% rate of return on common stock.

Ans 2)

Overall NPV = $25,992 - $18,105.19 - $9,607.05

= $1,720.24

As combined NPV is negative, Linda did not earn 11% rate of return on all investment together.

Ans 3)

Required annual cash inflows = Initial Investment / PVAF (8%, 10 years)

= $267,000 / 7.139

= $37,400