Question

Linda Clark received $236,000 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 $100,000. The stock paid no dividends, but it was sold for $171,000 at the end of three years.

b. Preferred stock was purchased at its par value of $55,000. The stock paid a 7% dividend (based on par value) each year for three years. At the end of three years, the stock was sold for $40,000.

c. Bonds were purchased at a cost of $81,000. The bonds paid annual interest of $4,500. After three years, the bonds were sold for $89,000.

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 12% return, and he gave Linda the following computations to support his statement:

   

Common stock:
Gain on sale ($171,000 – $100,000)	$	71,000
Preferred stock:
Dividends paid (7% × $55,000 × 3 years)		11,550
Loss on sale ($40,000 – $55,000)		(15,000	)
Bonds:
Interest paid ($4,500 × 3 years)		13,500
Gain on sale ($89,000 – $81,000)		8,000
Net gain on all investments	$	89,050

$89,050 ÷ 3 years	= 12.60 %
$236,000

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 12% discount rate, compute the net present value of each of the three investments.

1-b. On which investment(s) did Linda earn a 12% rate of return?

2. Considering all three investments together, did Linda earn a 12% rate of return?

3. Linda wants to use the $300,000 proceeds ($171,000 + $40,000 + $89,000 = $300,000) from sale of the securities to open a retail store under a 12-year franchise contract. What minimum annual net cash inflow must the store generate for Linda to earn a 11% return over the 12-year period?

Answer 1