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# Chap003 - Fundamental Interpretations Made from Financial...

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Unformatted text preview: Fundamental Interpretations Made from Financial Statement Data SOLUTIONS: E3-1. a. Amount of return \$50 \$53 ROI = Amount invested Julie: \$560 = 8.93% Sam: \$620 = 8.55% Julie's investment is preferred because it has the higher ROI. b. Risk is a principal factor to be considered. E3-2. a. Interest earned on the savings account: \$1,200 * 5.5% * 6/12 = \$33. b. Interest earned on loan to Judy: (\$1,240 amount repaid - \$1,200 amount loaned) = \$40. Rate of return for 6 months is \$40 / \$1,200 = 3.3% Rate of return on an annual basis is 6.6% c. The loan to Judy promises a higher return than the rate earned on the savings account (6.6% versus 5.5%), but this may not be enough to compensate your friend for the risks and inconveniences involved with an unsecured personal loan. Query: Does Judy have a good credit history? Will she repay the \$1,240 as promised? Will her repayment be on time? Will your friend incur any collection expenses? Is your friend willing to “tie up” her money for six months and lose the convenience of her demand deposit account? E3-3. Solution approach: Calculate the amount of return from each alternative, then calculate the ROI of the additional return from the higher paying investment relative to the \$200 that must be invested to get the higher return. ROI * amount invested = amount of return. Alternative # 1 10% * \$500 = \$50 return. Alternative # 2 11% * \$700 = \$77 return. The extra amount of return of \$27 on an additional investment of \$200 is an ROI of 13.5%. (\$27 / \$200 = 13.5%) . Therefore, do not pay an interest rate of more than 13.5% to borrow the additional \$200 needed for the higher yield investment. E3-4. a. \$800 * 6% = \$48 return. b. Return on \$1,000 at 8% = \$80 Cost of \$200 at 15% = \$30 Net return = \$80 - \$30 = \$50 E3-4. (continued) c. Net return / Investment = ROI Chapter 3 \$50 / \$800 = 6.25% Solution Approach: A “prudent investor” would be wise to take the following factors into consideration before choosing between alternative investment opportunities: 1. How long is the investing horizon of each investment? In this case, both investments were for one year. If this were not the case, the rate of return calculation would have to be "annualized" before a valid comparison could be made between the alternative investments. Rate of Return = Principal x Interest x Time. 2. How flexible is the investment? In this case, the savings account would be more flexible than the certificate of deposit because money can be withdrawn (or deposited) on a day to day basis in a savings account without penalty. 3. What is the relative risk of each investment? In this case, both investments would be considered "risk free" (i.e., certain) because bank savings accounts and certificates of deposit are both backed by the FDIC. If one of the investments were riskier than the other (i.e., an investment in a start-up corporation's common stock), then a prudent investor would demand a higher rate of return on the riskier investment as compensation for the additional risk inherent in the investment. compensation for the additional risk inherent in the investment....
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Chap003 - Fundamental Interpretations Made from Financial...

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