Kathy Myers frequently purchases stocks and bonds, but she is uncertain how to determine the rate of return that she is earning. For example, three years ago she paid $13,000 for 200 shares of Malti Company’s common stock. She received a $420 cash dividend on the stock at the end of each year for three years. At the end of three years, she sold the stock for $16,000. Kathy would like to earn a return of at least 14% on all of her investments. She is not sure whether the Malti Company stock provide a 14% return and would like some help with the necessary computations.

(A) The net present value is -$1,225. (B) Kathy Myers did not earn 14% return on investment.

Explanation:

Solution

(A) Calculate the net present value as shown below:

                                           Now              1              2               3

Purchase of stock  =        ($13,000)

Annual Cash Divided                            $420      $420        $420

the Sale of Stock                                                                   $16,000

Total cash Flow                ($13,000)     $420      $420        $420

Discount Factor at 14%     1.000           0.877     0.769        0.675

The present value            ($13,000)     $368       $323        $11,083

Net present value

($368 +$323  +  $11,083- 13,000 = ($1,225)

The net present value is -$1,225.

(b) The NPV is negative. It shows that the rate of return on income is lower than the minimum required rate of return. so, KM did not earn 14% return.

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