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Case Problem 4.1 Coates’s Decision
On January 1, 2017, Dave Coates, a 23-year-old mathematics teacher at
Xavier High School, received a tax refund of $1,100. Because Dave
didn’t need this money for his current living expenses, he decided to
make a long-term investment. After surveying a number of alternative
investments costing no more than $1,100, Dave isolated two that seemed
most suitable to his needs.
Each of the investments cost $1,050 and was expected to provide
income over a 10-year period. Investment A provided a relatively certain
stream of income. Dave was a little less certain of the income provided
by investment B. From his search for suitable alternatives, Dave found
that the appropriate discount rate for a relatively certain investment was
4%. Because he felt a bit uncomfortable with an investment like B, he
estimated that such an investment would have to provide a return at least
4% higher than investment A. Although Dave planned to reinvest funds
returned from the investments in other vehicles providing similar returns,
he wished to keep the extra $50 ($1,100 − $1,050) invested for the full
10 years in a savings account paying 3% interest compounded annually.
As he makes his investment decision, Dave has asked for your help in
answering the questions that follow the expected return data for these
investments.
Questions
a. Assuming that investments A and B are equally risky and using the
4% discount rate, apply the present value technique to assess the
acceptability of each investment and to determine the preferred
investment. Explain your findings.