Q. Envision that you have served as business manager of Media World for over 2 years. You have noticed that for the last 12 months the business has regularly had cash assets of $20,000 or more at the end of each month. You have found a 6-month certificate of deposit that pays 6% compounded monthly. To obtain this rate of interest, you must invest a minimum of $2,000. You have also found a high interest savings account that pays 3% compounded daily. Based on the cash position of the business at this time, assume that you decide to invest $4,000.
1. Assume that you will invest the full amount in a certificate of deposit.
a. What would be the future value of the CD at the end of the investment term? (14 points)
b. How much interest would the investment earn for the period? (14 points)
c. What would be the effective rate of the investment?(14 points)
2. Assume that you decide to invest the $4,000 in the high-interest savings account.
a. What future value would you expect to receive at the end of 6 months? (14 points)
b. How much interest would the investment earn for the period? (14 points)
c. What would be the effective rate of the investment? (14 points)
3. Write a recommendation to the partners justifying a short-term investment of business funds at this time, recommending one of these investments. Include your analysis from questions 1 and 2 in your recommendation. (16 points)
Option-1: 6 month CD that pays 6% compounded monthly. Invest minimum $2,000
Option-2: Saving account. Pays 3% compounded daily.
Investment amount = $4,000
1)Assume that you will invest the full amount in a certificate of deposit.
- What would be the future value of the CD at the end of the investment term?
Interest rate = r= 6% annual = 6/12 = 0.5% monthly
N = no. of periods = 6 (investment period = 6 months)
P = Principal = $4,000
FV = P(1+r)^n = 4,000 * 1.005^6 = $4,121.51
- How much interest would the investment earn for the period?
Interest Earned = FV – P = $4121.51 - $4000 = $121.51
- What would be the effective rate of the investment?
A = $4,121.51 , P = $4,000 , r = ?, n = 6 months = 0.5 year
Thus interest I = A – P = $121.51
Effective rate r = I*100 / P*n = (121.51*100)/(4000*0.5) = 6.0755%
2. Assume that you decide to invest the $4,000 in the high-interest savings account.
a. What future value would you expect to receive at the end of 6 months?
Interest is compounding daily. Annual interest rate = 3%
Thus, daily interest rate = r = 3/365 %
P = $4,000 , n = 6 months = 365/2 days = 182 days (considering interest is paid for keeping money for full day)
FV = ?
FV = P(1+r)^n = 4000*(1+3/365%)^182 = $4,060.28
b. How much interest would the investment earn for the period?
Interest Earned = FV – P = $4,060.28 - $4000 = $60.28
- What would be the effective rate of the investment?
A = $4,060.28 , P = $4,000 , r = ?, n = 6 months = 0.5 year
Thus interest I = A – P = $60.28
Effective rate r = I*100 / P*n = (60.28*100)/(4000*0.5) = 3.014%
3. Write a recommendation to the partners justifying a short-term investment of business funds at this time, recommending one of these investments. Include your analysis from questions 1 and 2 in your recommendation.
Presently we have cash of $20,000 or more at the end of the month every month which is not earning any interest. We should invest this cash somewhere where we can earn some interest as well as liquidity is maintained. There are two options available for investment:
- 6-month certificate of deposit that pays 6% compounded monthly. Minimum investment required is $2,000
- high interest savings account that pays 3% compounded daily
Compounding daily sounds attractive. But when we analyzed the two options we found that option -1 (i.e. CD) is actually giving effective interest of 6.07% while second option (Saving account) gives effective rate of interest of only 3.014%
Based on this effective interest rate, it is recommended to put money in CD. Minimum investment requirement is $2,000 in CD but we have more than $20,000 cash every month. So meeting this minimum requirement of investment should not affect us.
Recommendation: Invest cash in 6-month certificate of deposit