Choosing an investment
SAMPLE ANSWER
Investment
An investor may be interested in the net present value because of the following reasons:
Present value enables the investor to quantify expected benefits from an investment. A positive net present value is an indication that the investment is profitable while a negative value indicates that the project is not viable.
Secondly, present value determines the value of future cash-flows in ‘today’s value’ and this helps the investor to better understand the expected returns over the period of investment. According to Broadbent and Cullen (2012), it informs the investor of how much a future project would be worth if it existed today.
Choosing an investment
Present Value: Product 1
PV = C x [(1+r)n – 1 /r]
Coupon payment per year = (7% x 100) = £7
PV = 7 x (1.074 – 1/0.07)
£31.07
Present Value: Product 2
PV = FV/(1+r)n
FV = (25p x 4)6 + 5 = £11
= 11/(1+0.125)6
= £5.43
Present value: Product 3
PV = C x [(1+r)n – 1 /r]
Coupon payment per year = (11% x 100) = £11
Paid half yearly = 5.5
PV = 5.5 x (8.06-1)/0.11)
= 353.11
Based on the present values calculated above, I would consider investing in product 3. This is because the present value for the product is significantly high compared to the current value of the bond. It is therefore expected to generate more returns for the investor.
My choice would remain unchanged if the bond was to be sold at £140 because the interest rates remain unchanged. The present value of the bond is still low compared to the alternative investments.
Risks associated with holding government bonds
Governments bonds like any other investment come with various risks. Two of these risks are explained as follows:
Interest rate risk: Interest rates and bond prices are inversely related such that the prices of bonds rise when interest rates fall and go down when interest rates are high. When interest rates decline, investors in a bid to hold on to higher interest rates as long as they can will tend to buy bonds which pay a higher interest rate than the market rate. The high demand for bonds raises the prices of bonds. The opposite is true when interest rates go up; leading to low bond prices (Broadbent and Cullen, 2012).
Inflation risk: When there is a dramatic increase in inflation, investors may experience a negative rate of return as their purchasing power declines. This happens where the inflation increases at a faster rate than the investment (Broadbent and Cullen, 2012).
Reference
Broadbent, M. & Cullen, J. (2012). Managing Financial Resources. London: Routledge
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