Question

# Jessica Nekton received \$170,000 from her mother’s estate. She placed the funds into the hands of...

 Jessica Nekton received \$170,000 from her mother’s estate. She placed the funds into the hands of a broker, who purchased the following securities on Ms. Nekton’s behalf:

 a. Common stock was purchased at a cost of \$85,000. The stock paid no dividends, but it was sold for \$190,000 at the end of seven years. b. Preferred stock was purchased at its par value of \$46,000. The stock paid a 7% dividend (based on par value) each year for seven years. At the end of seven years, the stock was sold for \$32,000. c. Bonds were purchased at a cost of \$50,000. The bonds paid \$2,500 in interest every six months. After seven years, the bonds were sold for \$53,000. (Note: In discounting a cash flow that occurs semiannually, the procedure is to halve the discount rate and double the number of periods. Use the same procedure in discounting the proceeds from the sale.) (Ignore income taxes.)

 The securities were all sold at the end of seven years so that Ms. Nekton would have funds available to start a new business venture. The broker stated that the investments had earned more than a 11% return, and he gave Ms. Nekton the following computation to support his statement:

 Common stock: Gain on sale (\$190,000 – \$85,000) \$ 105,000 Preferred stock: Dividends paid (7% × \$46,000 × 7 years) 22,540 Loss on sale (\$32,000 – \$46,000) (14,000) Bonds: Interest paid (\$2,500 × 14 periods) 35,000 Gain on sale (\$53,000 – \$50,000) 3,000 Net gain on all investments \$ 151,540

 \$151,540 ÷ 7 years = 12.7% \$170,000

 Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

 Required: 1a. Using a 11% discount rate, compute the net present value of each of the three investments. (Use the appropriate table to determine the discount factor(s) and round final answers to the nearest dollar amount.)

1b. On which investment(s) did Ms. Nekton earn a 11% rate of return?
 Common stock Preferred stock Bonds None

2. Considering all three investments together, did Ms. Nekton earn a 11% rate of return?
 No Yes

 Year Equity Preferred Bond 0 -85,000 -46,000 -50,000 1 0 3,220 5,000 2 0 3,220 5,000 3 0 3,220 5,000 4 0 3,220 5,000 5 0 3,220 5,000 6 0 3,220 5,000 7 190,000 35,220 58,000 NPV \$6,515.10 -\$15,413.66 -\$979.70

NPV for stock and preferred can be calculated using NPV function in excel or calculator given the above cash flows and discount rate of 11%

For Bond, PV of cash flows need to be calculated using PV function

N = 7 x 2 = 14, I/Y = 5.5%/2 = 2.75%, PMT = 2,500, FV = 53,000

=> Compute PV = \$49,020.30

NPV = 49,020.30 - 50,000 = - 979.70

1b) Only stocks earned 11% returns.

2) No, because the sum of all three NPVs < 0.

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