## Question

###### IB- Kathy Myers frequently purchases stocks and bonds, but she is uncertain how to determine the...

## Answers

Answer: The following are the details given.

a) Three years ago Kathy Myers has paid $13,000 for 200 shares of Malti Company's common stock.

b) She received $420 cash dividend on the stock at the end of each year for three years.

c) At the end of three years, she sold the stock for $16,000.

d) Kathy would like to earn a return of at least 14% on all of her investments.

Net Present Value (NPV)

A discounted cash flow measure to evaluate the viability of an investment proposal. It serves to determine whether the present value of estimated cash flow exceeds the investment on a project. The Net Present Value is the difference of the sum of discounted cash flows and the outlay.

NPV of cash flow = Present value of all future cash in flows over the life of the project (-) Present value of cash out flow

NPV = [CF1/(1+r)^1+CF2/(1+r)^2+CF3/(1+r)^3+-----------CFn/(1+r)^n] (-) CFo

Where CF1, CF2------Future cash inflows occurring at the end of first year, second year-------etc.

n = life of the project in years.

r = discount rate (cost of capital)

CFo = Present cash out flow

So in this case

CFo = $13,000,

Cash inflows occurring at the end of first year = $420 (Cash dividend), second year = $420 (Cash dividend) and third year = $420 (Cash dividend) and also she sold the stock for $16,000.

Cost of Capital = 14%

Hence, present value of cash inflows = ($420)/(1+0.14)^1+($420)/(1+0.14)^2+($420)/(1+0.14)^3+($16,000)/(1+0.14)^3 =$11,775

Hence, NPV = $11,775 (-) $13,000 = (-) $1,225

From the above it is clear that the net present value is negative. Hence, the Malti Company stock does not provide a 14% return.