Reference no: EM131910305
Case Study
INFLATION CONSIDERATIONS FOR STOCK AND BOND INVESTMENTS
Background
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 for most bonds 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.
Information
Earl is an engineer who wants a predictable flow of money for travel and vacations. He has a collection of stocks in his retirement portfolio, but no bonds. He has accumulated a total of $50,000 of his own funds in low-yielding savings accounts and wants to improve his long-term return from this nonretirement program “nest egg.” He can choose additional stocks or bonds, but has decided to not split the $50,000 between the two forms of investments. There are two choices he has outlined, with the best estimates he can make at this time. He assumes the effects of federal and state income taxes will be the same for both forms of investment.
Stock purchase: Stocks purchased through a mutual fund would pay an estimated 2% per year dividend and appreciate in value at 5% per year.
Bond purchase: If he purchased a bond, he would have a predictable income of 5% per year and the $50,000 face value after the 12-year maturity period.
1-Case Study Questions
The analysis that Earl has laid out has the following questions. Can you answer them for him for both choices?
a-What is the overall rate of return after 12 years?
b-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.
c-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?
d-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?
e-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?