Helen Chapman is 56 years old and intends to retire in four years. Most of her investment funds are tied up in her employer’s pension plan and in her personal registered retirement savings plan. In addition, she has managed to accumulate a personal investment fund of $100,000, which currently is invested in government treasury bills earning interest at 9%.
Immediately before retirement, Chapman intends to use her personal investments and her pension plans to acquire a life annuity that will provide her with a guaranteed monthly income. She is looking for an investment for the $100,000 currently invested in treasury bills that will maximize the value of the annuity. Her investment counsellor has proposed two secure investment options, as follows:
• Option 1 is a corporate bond yielding annual interest of 13%.The counsellor has advised that Chapman could fund a purchase of $200,000 of the bonds with $100,000 of cash (from the treasury bills) and $100,000 of borrowed funds. Because her house is debt-free, her bank has offered to provide her with a term loan secured by a mortgage on the house. The loan interest rate would be 10%, and no principal payments would be required until the end of the term of the loan.
• Option 2 is a real estate investment. A small, single-tenant commercial building is currently under construction and will be completed in six weeks. A prospective tenant has already agreed to a 12-year lease. The lease calls for rent payments of $40,000 annually for four years, at which time the annual rent will increase by 12% and then remain fixed for the remaining eight years of the lease. The tenant will be responsible for all costs associated with the property, including property taxes and insurance.