Question

Assume the role of an investor;

Choose one (or more) investments that investor would likely make from the following choices: common stock, preferred stock, and/or bonds; and

Answer the follow-on questions.

First, choose one of the following profiles:

Investor A

25-year-old, first-time investor with $5,000 to invest. Long term investment goals.

Investor B

50-year-old with $200,000 in savings. Looking to diversify investment portfolio and reduce risk as retirement approaches.

Investor C

Retired 65-year-old with $1.2M in savings. Looking for steady, fixed income investments.

Then, answer these follow-on questions based on your choices:

Describe one valuation method for each investment choice you made

Describe the impact that interest rates have on your investment choices

Answer 1

Investor A :

Since, the investor is young and has funds to invest, he should invests in equities. As investments in equities, is risky and in this age bracket the investor is capable of taking risks and has a higher risk appetite. Due to the investor having long term investment goals, equities can help in wealth creation.

Investor B:

Investor B can invest in preferred stocks and bonds. As preferred stocks are less risky than the common stocks and investing in them can provide diversification benefits. Preferred stocks provide stable dividends and have a superior claim over equity in times of liquidation of the company and payment of dividends.

Investor C:

Investor C, should invest in bonds, as bond investments provide steady and stable returns. Keeping in mind, the age of the individual, investments in bond is the appropriate choice. Bonds are less risky and suit the investors has he has a low risk appetite due to his age which is 65 years.

One valuation method :

Equity :

Dividend Discount Model:

Po = D1/ Re - g

where,

D1 = dividend paid next year

Re = required return on equity

G = growth rate

Valuation model for preferred stocks:

Dividend discount model:

Po = dividend/ Rp

Rp = required return on preferred stocks

Valuation model for bonds:

Present value of bonds = present value of all coupon payments + Fv of bonds

= PMT1/ ( 1+ RE)^1 + PMT2/(1 + Re )^2 + ............. [PMn + FV/(1 + Re)^n]

The impact of interest rates:

Both the bonds and preferred stocks value rise, as the interest rates fall and fall when the interest rates rise and the future cash flows are discounted at a higher rate. As bonds and preferred stocks pay fixed payments, their value fall with a rise in the interest rates.

When interest rates fall, the consumers will increase their spending power which will push up the stock prices. Due to decrease in interest rates, investors will quickly move money form bonds and put it into stocks, thus making their prices rise. As interest rates move up, the stock prices falls as the cost of borrowing becomes more expensive,