Question

2. Assuming that the average annual return of the three-month T-bills is 3% and the average annual return for the SP500 is 9%. If you have the following investment transactions: (-10000, 11000) (-1000, 1200) a. Which project would you execute if the future cash flow is a sure thing? b. Discuss and present a possible solution: If the future cash flows are simply expected ones and you consider that the risk of these investments can be comparable to an investment in stock markets, would your decision of part a. change? Why?

Answer 1

a. second project would be executed as it has higher rate of return.

rate of return project 1 = [(11000/10000) - 1]*100 = (1.1 - 1)*100 = 0.1*100 = 10%

rate of return project 2 = [(1200/1000) - 1]*100 = (1.2 - 1)*100 = 0.2*100 = 20%

The negative value is initial investment and positive value is return of initial investment plus return earned on initial investment.

b. Your decision of part of a. will not change because with same risk of investment in stock market, project 2 is giving higher return of 20% compared to 9% of stock market return.

If both projects can be executed at the same time then they should be executed because both projects will give higher rate of return than stock market with same level of risk as investment in stock market.