Question

What makes for a good investment? Use the approximate yield formula or a financial calculator to rank the following investments according to their expected returns. Round the answers to two decimal places. Do not round intermediate calculations.

1. Buy a stock for $45 a share, hold it for 2 years, then sell it for $80 a share (the stock pays annual dividends of $3 a share).
     %
   
2. Buy a security for $25, hold it for 2 years, then sell it for $65 (current income on this security is zero). Do not round intermediate calculations.
     %
   
3. Buy a 1-year, 10 percent note for $960 (assume that the note has a $1,000 par value and that it will be held to maturity). Do not round intermediate calculations.

Answer 1

We will evaluate each of the options individually

a. Purchase price of stock = $45, Annual dividends = $3 and Selling price = $80, No of years = 2

We will find the annual return by finding out rate or I/Y in financial calculator

In financial calculator, enter

PV = - 45 , PMT = 3 , FV = 80 and N=2

then compute rate or I/Y , using financial calculator we get rate or I/Y = 39.1845% = 39.18%

b. Price of security = $25 Selling price = $65 and No of years = 2, Annual income from security = 0

We will find annual return by finding out rate or I/Y in financial calculator

In financial calculator enter

PV= -25, PMT = 0 , FV = 65, N=2

then compute rate or I/Y, using financial calculator we get rate or I/Y = 61.2451% = 61.25%

c. Price of Note = 960 , Par value of note = 1000, Coupon rate = 10%, No of years = 1

Coupon = Coupon rate x par value = 10% x 1000 = 100

We will find the annual return by finding out rate or I/Y in financial calculator

In financial calculator we enter

PV = -960 , PMT = 100 , FV =1000, N=1

then compute rate or I/Y, using financial calculator we get rate or I/Y = 14.5833% = 14.58%

On basis annual return option b makes a good investment as it offers highest annual return

Ranking of investments on basis return

Return of option b > Return of option a > Return of option c