The savings and investments that an individual maintains should have some balance between equity (corporate stocks that

Question:

The savings and investments that an individual maintains should have some balance between equity (corporate stocks that rely on market growth and dividend income) and fixed-income investments (bonds that pay dividends to the purchaser and a guaranteed amount upon maturity). When inflation is moderately high, bonds offer a low return relative to stocks, because the potential for market growth is not present with bonds. Additionally, the forces of inflation make the dividends worth less in future years because there is no inflation adjustment made in the amount the dividend pays as time passes. However, bonds do offer a steady income that may be important to an individual, and they serve to preserve the principal invested in the bond, because the face value is returned at maturity.

The analysis that Earl has laid out has the following questions.

Can you answer them for him for both choices?

1. What is the overall rate of return after 12 years?

2. If he decided to sell the stock or bond immediately after the fifth annual dividend, what is his minimum selling price to realize a 7% real return? Include an adjustment of 4% per year for inflation.

3. If Earl needed some money in the future, say, immediately after the fifth dividend payment, what would be the minimum selling price in future dollars, if he were only interested in recovering an amount that maintained the purchasing power of the original price?

4. As a follow-on to question 3, what happens to the selling price (in future dollars) 5 years after purchase, if Earl is willing to remove (net out) the future purchasing power of each of the dividends in the computation to determine the required selling price 5 years hence?

5. Earl plans to keep the stocks or bonds for 12 years, that is, until the bond matures. However, he wants to make the 7% per year real return and make up for the expected 4% per year inflation. For what amount must he sell the stocks after 12 years, or buy the bonds now to ensure he realizes this return? Do these amounts seem reasonable to you, given your knowledge of the way that stocks and bonds are bought and sold?

Stocks
Stocks or shares are generally equity instruments that provide the largest source of raising funds in any public or private listed company's. The instruments are issued on a stock exchange from where a large number of general public who are willing... Dividend
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their... Face Value
Face value is a financial term used to describe the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate. For bonds, it is the amount paid to the...