1. Suppose Mr. Abdullah has $50,000 to invest in the financial market for one year. His choices have been narrowed to two options. Assume that any long-term capital gains will be taxed at 20%. Mr. Abdullah's minimum attractive rate of return (MARR) is known to be 5% after taxes. Determine the payoff amount at the tip of each branch. Option 1. Buy 1,000 shares of a technology stock at $50 per share that will be held for one year. Since this is a new initial public offering (IPO), there is not much research information available on the stock; hence, there will be a brokerage fee of $100 for this size of transaction (for either buying or selling stocks). Assume that the stock is expected to provide a return at any one of three different levels: a high level (A) with a 50% return ($25,000), a medium level (B) with a 9% return ($4,500), or a low level (C) with a 30% loss Assume also that the probabilities of these occurrences are assessed at 0.25, 0.40, and 0.35, respectively. No stock dividend is anticipated for such a growth-oriented company. Option 2. Purchase a $50,000 U.S. Treasury bond, which pays interest at an effective annual rate of 7.5% ($3,750). The interest earned from the Treasury bond is nontaxable income. However, there is a $150 transaction fee for either buying or selling the bond. Mr. Abdullah's dilemma is which alternative to choose to maximize his financial gain.
1. Suppose Mr. Abdullah has $50,000 to invest in the financial market for one year. His choices have been narrowed to two options. Assume that any long-term capital gains will be taxed at 20%. Mr. Abdullah's minimum attractive rate of return (MARR) is known to be 5% after taxes. Determine the payoff amount at the tip of each branch. Option 1. Buy 1,000 shares of a technology stock at $50 per share that will be held for one year. Since this is a new initial public offering (IPO), there is not much research information available on the stock; hence, there will be a brokerage fee of $100 for this size of transaction (for either buying or selling stocks). Assume that the stock is expected to provide a return at any one of three different levels: a high level (A) with a 50% return ($25,000), a medium level (B) with a 9% return ($4,500), or a low level (C) with a 30% loss Assume also that the probabilities of these occurrences are assessed at 0.25, 0.40, and 0.35, respectively. No stock dividend is anticipated for such a growth-oriented company. Option 2. Purchase a $50,000 U.S. Treasury bond, which pays interest at an effective annual rate of 7.5% ($3,750). The interest earned from the Treasury bond is nontaxable income. However, there is a $150 transaction fee for either buying or selling the bond. Mr. Abdullah's dilemma is which alternative to choose to maximize his financial gain.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Decision tree:
1. Suppose Mr. Abdullah has $50,000 to invest in the financial market for one year. His choices have
been narrowed to two options. Assume that any long-term capital gains will be taxed at 20%. Mr.
Abdullah's minimum attractive rate of return (MARR) is known to be 5% after taxes. Determine the
payoff amount at the tip of each branch.
Option 1. Buy 1,000 shares of a technology stock at $50 per share that will be held for one
year. Since this is a new initial public offering (IPO), there is not much research information
available on the stock; hence, there will be a brokerage fee of $100 for this size of
transaction (for either buying or selling stocks). Assume that the stock is expected to provide
a return at any one of three different levels: a high level (A) with a 50% return ($25,000), a
medium level (B) with a 9% return ($4,500), or a low level (C) with a 30% loss Assume also
that the probabilities of these occurrences are assessed at 0.25, 0.40, and 0.35, respectively.
No stock dividend is anticipated for such a growth-oriented company.
Option 2. Purchase a $50,000 U.S. Treasury bond, which pays interest at an effective annual
rate of 7.5% ($3,750). The interest earned from the Treasury bond is nontaxable income.
However, there is a $150 transaction fee for either buying or selling the bond. Mr.
Abdullah's dilemma is which alternative to choose to maximize his financial gain.
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