Question

You have two investment options:

Option A

You can purchase $2,000 of stock in a company. You estimate that this company will earn a total of $10,000 during its life. You expect the company to pay all of these earnings to you as a dividend 10 years from today. Currently, the risk-free rate is 1% but this investment is really risky and you feel that a 14% discount rate is appropriate.

Option B

You can purchase $2,000 worth of bonds. The bond will pay you $250 at the end of each year for three years. At the end of the third year, the bond will also pay you back its $2,000 face value. You feel that this is a very safe investment and a 2% discount rate is appropriate.

Which investment has the highest present value?

Answer 1

Option A.

Assumption : The dividend earn every year is equal i.e 10,000/10 = $1000

Where A = Annuity, r = discount rate, n = time period.

Hence, the present value of option A is $5,220.

Option B.

Present Value of bond = Present Value of annuity cash flows + Present Value of Redemption Price

Hence present value of option B is $ 2,605.62.

Clearly, present value of Option A is greater than Option B.

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