Analysis of investment choices
Order Instructions:
Table 2 below shows five alternative ways to invest a £100,000 lump sum. Explain how each of the investments might be exposed to the three high-level risks: capital risk, income risk and liquidity risk. Discuss how your assessment of each investment might change if the expected inflation rate fell from 4% to 2% a year.
Table 2: Alternative ways of investing a £100,000 lump sum
_________________________________________________________________________
Investment Key facts
Cashstream+ account
Instant savings account with NewBank, a former UK building society turned into a commercial bank.
Nominal interest rate: 2% a year, variable.
From the bank’s income statement: proportion of total bank income from net interest = 23%.
_____________________________________________________________________
Gold Star Saver account
Fixed-term savings account with Queen’s Bank, one of the oldest high-street banks in the country.
Interest rate: 1.25% a year, guaranteed for four years.
From the bank’s income statement: proportion of total bank income from net interest = 65%.
________________________________________________________________________
Gilt: 3% Treasury 2020
Government bonds with a redemption date of 2020.
Interest rate: 3% a year, guaranteed until redemption of bond in 2020.
_________________________________________________________________________
eSuits shares
Shares in rapidly growing company eSuits, a new e-commerce outfit selling bespoke gentlemen’s suits online, also listed on the London Stock Exchange.
__________________________________________________________________________
No dividend yet. Annual profits predicted to grow by 8% pa (might pay dividend later). Standard deviation of annualised return: 30%.
___________________________________________________________________________
Farmhouse in France Second home and holiday-let proposition, purchase price £300,000; mortgage obtained for £250,000 over 20 years at 6% variable interest; return expected to average 25% a year.
SAMPLE ANSWER
Analysis of Investment Choices
Investments are bound to be affected by various types of high-level risks in the market. The following discussion shows how various investments would be affected by capital risk, income risk and liquidity risk.
Cashstream + account
A savings account is unlikely to be affected by capital risk. This is because the initial amount of investment or deposit made remains intact. While the interest rates may vary, the capital investment remains unaltered and this option is therefore considered safe for risk-averse investors. Given that the interest payable is variable, the income risk is relatively high. This is because income stream paid for the investment is expected to decrease with decrease in interest rates. Liquidity risk for this type of investment is low as the investor may choose to withdraw their cash any time they wish to without restrictions as in a fixed account.
If inflation was to fall from 4% to 2% a year, there would be an increased rate of return as interest rates rise in response to the favorable inflation rates. Since real interest rate is equal to nominal rate minus inflation, the new real interest rate would shift from -2% to 0% for this investment.
Gold Star Saver account
This investment has a low capital risk the principle amount invested in a fixed account remains unchanged throughout the investment period. Income risk is also low because the interest on the account is guaranteed till maturity and is not dependent on changes in interest rates. Fixed-term savings accounts have a high liquidity risk and therefore are not suitable for investors who may need to retrieve their funds with urgency. If inflation was to reduce to 2%, the returns from the investment would remain unchanged. This is because the fixed account guarantees an interest rate of 1.25% per year. The returns are therefore fixed despite changes in the market and this may be a good investment.
Gilt: 3% Treasury 2020
Bonds have a relatively low capital risk as compared to other investments such as shares. In terms of income risk, the bond is worth investing in because the income risk is low. The bond is guaranteed to earn 3% per year until redemption. Liquidity risk is however very high. The investor will have to wait until the bond matures in 2020 in order to redeem the invested amount. This means that there is little ease in converting the bond into cash within a short period of time. A reduced rate of inflation would not affect the bond because it offers a fixed and guaranteed rate of return.
eSuits shares
This investment carries high capital risk, high income risk but has a low liquidity risk. Given that this is a business investment, the investor may have little influence on the profits or losses that the business incurs; yet their income depends on the profit made. Losses signify high chances of losing invested capital especially if the business does not work out eventually; hence high capital risk. Income depends on demand and other market factors and the income risk is high because it is difficult to predict demand. The liquidity risk is however low because the investor can easily retrieve cash upon the sale of the suits online. A reduction in inflation from 4% to 2% would mean that buyers have a higher purchasing power and demand is therefore likely to increase. Accordingly, returns for the investor would go up significantly.
Farmhouse in France
Capital risk is high for this investment; given that the prices in housing keep fluctuating and the value of the house may depreciate with time. Income risk may be high as well because income streams will depend on the availability of clients to let the farmhouse. In regards to liquidity risk, this is relatively high as disposal of the farmhouse to obtain liquid cash may take a signfificant amount of time before a potential buyer can be identified. Reduced inflation would affect this investment in a positive manner as the level of spending would go up; hence greater demand for letting the farmhouse.
Reference
Broadbent, M. & Cullen, J. (2012). Managing Financial Resources. London: Routledge
We can write this or a similar paper for you! Simply fill the order form!
