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.

A) 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).
__________%

B) 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.
____________ %

C) 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

Answer A):

Buying price of share= $25, Selling price after holding it for 2 years = $80. The stock pays annual dividend of $3 per share

Using the approximate yield formula,

Expected Return = Average annual return / Average Investment = {$3 + ($80 - $25) / 2} / {($25 + $80)/2}

=58.10%

Answer B):

Buying price = $25, Selling price after holding it for 2 years = $65

Current income on this security is zero

Using the approximate yield formula,

Expected return = {$0 + ($65- $25) / 2} / {($25 + $65) / 2}

= 44.44%

Answer C):

Buying price of a 1-year, 10 percent note = $960, Maturity Value after one year = Face value = $1,000

Annual interest = Face Value * Rate of interest = $1,000 * 10% = $100

Using the approximate yield formula,

Expected Return = {$100 + ($1,000 - $960)} / {($960 + $1,000)/2}

=14.29%