Question

As the Fund Manager for Bank of Trinidad and Tobago Limited, you are to advise the following two (2) clients based on their respective financial situations.

a. Your best friend has asked to assist him in making the best investment out of the following options. Which would you advise him to choose and why, considering the risks are the same for all the options. Show all workings to support your answer.

Option 1: $12,000 in 5 years at 6 percent interest.

Option 2: $15,000 in 2 years at 9 percent interest.

Option 3: $15,000 today. No strings attached. Option4: $5,000 each year for 2 years at 7 percent interest compounded semiannually.

2 b. Betty Kay has a contract under which she will receive the following payment for the next 5 years: $1,000, $2,000, $3,000, $4,000 and $5,000. She will then receive an annuity of $8,500 a year for the end of the 6th through the end of the 15th year. She is offered $30,000 to cancel the contract. If the payments are discounted at 14 percent should she cancel the contract? Show all workings.

Answer 1

a.

Present Value of Option 1 = Amount / (1 + Interest)^Years = 12000 / 1.06^5 = $8967.10

Present Value of Option 2 = Amount / (1 + Interest)^Years = 15000 / 1.09^2 = $12625.20

Present Value of Option 3 = $15000

Present Value of Option 4 = Amount in year 1/ (1 + Interest/2)^(Years*2) + Amount in Year 2 / (1 + Interest/2)^(Years * 2)

Present Value of Option 4 = 5000/ (1 + 0.035)^2 + 5000 / (1 + 0.035)^4

Present Value of Option 4 = $9024.77

Option 3 is recommended as it gives highest present value

b.

If the payments are discounted at 14 percent should she cancel the contract?

No the cancellation of contract is not recommended because the PV of cash inflows is higher than the offer price.

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