Question

An investor considers investing 100 000 TL for the next year. This investor has 3 options. The first option is to buy a government bond that sells 100 TL. The par value of this government bond is also 100 TL and the remaining maturity is 1 year. This government bond pays %20 annual coupon interest. The second option is to buy a commercial paper which sells 2200 TL discount. The par value is 10 000 TL and the maturity is 1 year. The other alternative is to invest in a common stock for a year. The current market price of the common stock is 6 TL per share and 1-year target price estimation of the market analysts is 7.90 TL on average for this share. Which option would you invest in and why? Show your answer mathematically.

Answer 1

Let’s evaluate all three options available.

Option1) Investor investing in government bond will provide coupon rate as 20% and as bond is trading at par hence there is capital gain hence annual return will be 20%

Option2) Investor investing which is selling at 2200TL discount with the par value of 10000 TL is trading at 7800TL, however there is no interest rate provided on commercial paper hence capital gain is what investor will receive.

Here, 2200 TL discount which investor is receiving is the capital gain.

total return = 2200/7800= 28.2%

Option 3) Investor investing in common stock which is trading at 6TL and it is estimated that stock will achieve target price of 7.9 TL in one year time horizon and there is no dividend on stock.

hence, total return = 1.9/6=31.67%

From above options one can clearly observe that option 3 is giving the highest return hence one should opt for it however it is also given in the option that target price of the is the estimation, which may or may not be achieved as equity investing is subject to market risk.

In the option 2, investor is surely receiving the 28.2% return which makes it safe investment with almost similar return and less risky than what one will receive in equity hence investor should opt for option 2.