Investment Style & Equity Portfolio Management - Assignment Example

Section A B 2) C 3) B 4) B 5) B 6) B 7) E 8) A 9) B 10) A 11) C 12) A 13) D 14) E 15) A Section B Question Portfolio worth = $150,000,000 95% equity investment Beta = 0.95 Benchmark value = 1080.0 Value = $250 x 1080 = 270,000 (i) (150,000,000+15,000,000)/0.95/270,000 = Buy 644 futures (ii) (150,000,000+15,000,000)/1.05/270,000 = Buy 583 futures (iii) Infinite Question 2 Current Price $3.67 Ex Price $4.0 Call Price $0.20 (buy) Put Price $0.52 (sell) Risk free return 8% a) Costless Arbitrage Profit Costless arbitrage can be obtained by selling both call option and put option b) Amount of Arbitrage and Time Current Price $3.67 Ex Price $4.00 Call Price $0.20 Put Price $0.52 Selling Both Call & Put   Ex Call? Ex Put? Commission Inflow Transactional Cashflow If P>4 Yes No $0.72 loss of cost in excess of $4 If P4 Yes No $0.87 loss of cost in excess of $4 If P=0 and 0 otherwise Min would actually be the option price An example as an explanation: An investor buys a call on a stock with a strike price of 50 and an option expiration date of June 16, 2006 and pays a premium of 5 for this call option. The current price is 40. Assume that the share price (the spot price) rises, and is 60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for 60. The profit would be 10 minus the fee paid for the option, 5, for a net profit of 5. The investor has thus doubled his money, having paid 5 and ending up with 10. If however the share price never rises to 50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of 5. Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to 100). From the viewpoint of the seller, if the seller thinks the stock is a good one, (s)he is better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, 50) limits the sellers profit. In this case, the seller does realize the profit up to the strike price (that is, the 10 rise in price, from 40 to 50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option. Put Option Max [(K-S); 0] or formally (K-S)+ Where (x)+= x if x >=0 and 0 otherwise Min would be infinite loss An example as an explanation: I purchase a put contract to sell 100 shares of XYZ Corp. for 50. The current price is 55, and I pay a premium of 5. If the price of XYZ stock falls to 40 per share right before expiration, then I can exercise my put by buying 100 shares for 4,000, then selling it to a put writer for 5,000. My total profit would equal 500 (5,000 from put writer - 4,000 for buying the stock - 500 for buying the put contract of 100 shares at 5 per share, excluding commissions). If, however, the share price never drops below the strike price (in this case, 50), then I would not exercise the option. (Why sell a stock to someone at 50, the strike price, if it would cost me more than that to buy it?) My option would be worthless and I would have lost my whole investment, the fee (premium) for the option contract, 500 (5 per share, 100 shares per contract). My total loss is limited to the cost of the put premium plus the sales commission to buy it. Section D Question 1 Daughter Share: (480,000) Home = 480,000 Son Share: (480,000) Share Portfolio = 200,000 bought in 1998 for 60,000 Holiday home = 280,000 bought in 1991 for 75,000 There seems to be absolute equality in distribution of the inheritance in terms of current price monetary value, as both have been given $480,000 respectively. But there is a point that is left, which is indecisive on its position, whether to be placed in equity or equality. The share of the daughter cannot be realized by holding it and it is a single asset, which if sold would though realize that value but then there wont be any asset leftover. However, in case of the son, he has two assets, of which he can easily sell off one and have another remaining as may be his need be. Apart from this, the son may consider himself quite lucky to have gotten two things that would appreciate in value over time; while also considering the risk factor of holding share portfolio, and also the fact that he would be reaping benefits (dividends) out of the share portfolio and possible rent from the holiday home. On the contrary, the daughter just has a house to own, no source of income or benefit reaping. Therefore, the seemingly equal distribution stands otherwise. Question 2 There are three approaches that form the basis to valuing a financial planning practice—income, asset and market. There are multiple methods under each approach. As a prudent valuator, you should try to employ multiple methods and select the most appropriate ones to help in forming the final estimate of value. By using only one or two methods, particularly ones that are ultra-simplistic, homemade or unsubstantiated, you would be doing yourself a disservice. One method under the income approach, also referred to as the investment value approach, is the capitalization of earnings method. Others are the discounted cash flow or earnings methods. In the capitalization of earnings method, the FPP is viewed from the standpoint of its investment qualities. The approach assumes that an "equally desirable substitute" would be an FPP that has similar investment characteristics—one that enables you to earn money. Estimate the future income of the firm and convert the income stream into value. Simply put, your formula is value equals income divided by the expected rate of return: (V = I ÷ R). To continue along the line of adjusting the income statements, you must carefully scrutinize profits and (losses) and all compensations of your firm. You must analyze all fixed and variable expenses and investigate any unusual or nonrecurring ones. Carefully discern amounts allocated for travel and entertainment, continuing education, promotion, nonproductive family member or other salaries, vehicles and all benefits. Review depreciation, amortization and interest deductions and inquire into contributions to health care, retirement, profit sharing, insurance and other plans. The primary advantages of this method are that it (1) is based on earnings, (2) includes both tangibles and intangibles and (3) is replicable and effective. The most difficult part is the determination of the rate to convert the income stream into value, which is known as "capitalization." The rate is determined to a great extent by something with which you are very familiar—risk! As you know, risk is difficult to measure, especially in an FPP. In valuations, risk is calculated or built up based upon the risk-free rate of return on investments, risk premiums, risk tolerance, liquidity, management skills, perception, uncertainty and other indeterminate factors. There are multiple methods and variations to determine a capitalization rate. One of the ways to determine or build up a capitalization rate is in the following manner: Long-term U. S. Government bonds—risk-free current market rate 6.5% Market/investment risk 10 Liquidity risk 10 Management risk 3.5 30% To determine the value of your FPP by the capitalization-of-earnings method, conservatively project the probable gross revenues of the firm for the next year, deduct normal operating expenses, and ascertain and subtract the amount that you would have to compensate an employed planner or planners to produce the expected income stream. The result is the reasonable pre-tax profit of the FPP. Lastly, divide the profit by the calculated capitalization or investment risk rate. (a) Projected gross revenues $ 345,000 (b) Operating expenses @ 57% 196,650 (c) Professional compensation 75,000 (d) Profit 73,350 Capitalization Rate 30% (e) Profit ÷ Capitalization Rate = FMV $ 244,500 Question 3 Trustees and their responsibilities (1) Trustees have and must accept ultimate responsibility for directing the affairs of a charity, and ensuring that it is solvent, well-run, and delivering the charitable outcomes for the benefit of the public for which it has been set up. Compliance – Trustees must: (2) Ensure that the charity complies with charity law, and with the requirements of the Charity Commission as regulator; in particular ensure that the charity prepares reports on what it has achieved and annual returns and accounts as required by law. (3) Ensure that the charity does not breach any of the requirements or rules set out in its governing document and that it remains true to the charitable purpose and objects set out there. (4) Comply with the requirements of other legislation and other regulators (if any) which govern the activities of the charity. (5) Act with integrity, and avoid any personal conflicts of interest or misuse of charity funds or assets. Duty of prudence – Trustees must: (6) Ensure that the charity is and will remain solvent. (7) Use charitable funds and assets reasonably, and only in furtherance of the charity’s objects. (8) Avoid undertaking activities that might place the charity’s endowment, funds, assets or reputation at undue risk. (9) Take special care when investing the funds of the charity, or borrowing funds for the charity to use. Duty of care – Trustees must: (10) Use reasonable care and skill in their work as trustees, using their personal skills and experience as needed to ensure that the charity is well-run and efficient. (11) Consider getting external professional advice on all matters where there may be material risk to the charity, or where the trustees may be in breach of their duties. If things go wrong The Charity Commission offers information and advice to charities on both legal requirements and best practice to help them operate as effectively as possible and to prevent problems arising. In the few cases where serious problems have occurred we have wide powers to look into them and put things right. Trustees may also be personally liable for any debts or losses that the charity faces as a result. This will depend on the circumstances and the type of governing document for the charity. However, personal liability of this kind is rare, and trustees who have followed the requirements on this page will generally be protected. Question 4 Conditions Durable Power of Attorney Generally, a power of attorney ceases if the principal becomes incapacitated. But, through whats known as a durable power of attorney, a person can plan ahead to have the power of attorney survive any disability he or she could suffer. To provide a durable power of attorney, the person must include in his or her written document a statement of this intention. Springing Power of Attorney A springing durable power of attorney can be used when the principal does not want the agent to take any authority until the principal is determined to be incapacitated and unable to direct his or her own affairs. The durable power of attorney is said to spring into existence upon the disability of the person granting the power. The term "disability" should be defined in the document, such as the principal being in a coma or diagnosed with Alzheimers or another debilitating disease. Parties Involved South Dakota law defines a guardian as a person appointed by a court to be responsible for the personal affairs of a minor or protected person, but excludes one who is merely a guardian ad litem (a guardian appointed by the court to look out for the best interests of a child during the course of legal proceedings). A conservator is defined as one appointed by the court to be responsible for managing the estate and financial affairs of a minor or protected person. The person giving the power of attorney is called the principal. The person to whom the power is given is called attorney in fact or an agent. Obviously, the person selected to receive the power of attorney must be one who can be trusted and who is somewhat knowledgeable about finances because of the financial nature of his or her duties. Question 5 May 2006: Inheritance $150,000; Borrowing $200,000 Jan 2007: Growth 15% Purchase property within 2 years a) Return on Own Capital In May 2006 Total Investment = $350,000 In Jan 2007 Total Invest + Growth = 350,000 x 1.15 = $402,500 Ratio of investment (Inheritance To Borrow) = 3 : 4 Distribution of Jan 07 Capital = 172,500 + 230,000 Return on Own Cap = 172,500/402,500 = 42.85% b) Assessable Capital Gain on Encashment today Capital Gain = 402,500 – 350,000 = $52,500 c) Tax parable (30%) 402,500 x 0.30 = $120,750 (the whole of return and principle has been taken into account since after encashment, capital gains are liable to taxes) d) Strategy for entering the house market This is quite a tremendous thought, highly appreciable. Setting a long term target or goal is always helpful in determining the path or the journey. After identification of this goal, it would become much easier for Michael to actually achieve this and take suitable measures while trading to achieve the same. Question 6 Strategies to create and preserve wealth 1. Investment in stock exchange maintaining a stock portfolio Investment in stock exchange has got some tremendous advantages. It has always been recommended in the stocks market to invest for long term and generally, the fundamentally strong stocks arise over a period of time. A huge advantage of this is the fact of tax exemption on stocks as well as on the capital gains since they are not realized so exempted from the tax criterion. Dividend gains are another strong incremental income perspective of stock investment. 2. Investment in Insurance premiums 3. Investment in real estate 4. Investment in bonds 5. Investment in Unit Trust or any other funds The advantage of investment in funds or units has similar advantages of a stock investment, with the prime one being the fact that the capital gains are again tax exempted and the year end dividends are adjusted as increments in the number of units held. 6. Investment in fixed assets Question 7 Here are some of the traditional and distinguishing characteristics of UITs: UIT typically issues redeemable securities (or "units"), the UIT will buy back an investor’s "units," at the investor’s request, at their approximate net asset value (or NAV). A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust. Two advantages of UITs are broad diversification and steady cash flow. A specified rate of return is locked in for the duration of a UIT. Two disadvantages are high upfront costs (typically a 3% to 5% sales charge) and the potential for loss if units are sold prior to maturity. Question 8 Superannuation is essentially a savings account for your retirement and may suit people who: are looking to invest for retirement dont need access to their funds until they have retired How does it all work? Superannuation and Rollover Funds are tax-effective, long term investments that provide a benefit upon retirement, usually in the form of a lump sum. A Rollover Fund is simply a Superannuation Fund, which allows investors to roll-in benefits from previous Superannuation investments. Combining all of your Superannuation into one fund allows you greater control and may reduce fees. Investors are able to choose between a variety of investment portfolios with different asset ties and risk/return profiles. Question 9 a) Paul’s will stand valid at this point in time because he hasn’t revoked it as yet. b) Advise If Paul Dies Paul’s all property would go to Violent most probably because he prepared his will prior to marrying Carol. However, the $500,000 insurance might go to Carol as a beneficiary. What may just go to Violent, assuming that it is mentioned in the will prepared earlier, would include the rental property, superannuation, cars, etc. If Carol Dies In such a scenario, all the property would go to Paul, and nothing for the young kids. c) Estate assets would include only the family home and contents. Primarily because it is joint owned. d) Carol should put an obligation in her will with regards to the shares investment that they cannot be sold for a certain period of time. Since capital gains are tax free, they would be having lesser tax burden. Also investment in unit trust funds would be assistive. e) There is extreme need of POA for either particularly for Carol who should think about the kids’ future. The POA should be set to assume only if and when either of them lose capacity to make reasoned decisions. f) A binding nomination beneficiary clause in the superannuation form actually indicates that the estate distribution would be restricted to and through this person only. No other person, by any means would be getting anything from this fund except the person mentioned here. Section E Question 1a Interest compounded monthly Cost 48,000 Down Payment 8,000 Bank A: 5 years, 889.78/month 48,000 – 8,000 = 889.78 / (1+i)60 (1+i )60 = 0.0222445 1+i = 0.93 i = 6.14% Bank B: 10 years, 506.70/month 48,000 – 8,000 = 506.70 / (1+i)120 (1+i)120 = 0.0126675 1+i = 0.96 i = 3.57% Bank B (Answer) Question 1b Invest. 400,000 @ 6% compounded monthly Withdrawal 6078.84/month 400,000 = 6078.84 / (1+0.06)t (1.06)t = 0.0151971 t = 80 (Answer) Question 1c Down Pay $1,000 PMT 1,000/month for 60 months (61 pay in total) i = 9% p.a. compunded annually Value of lease? 1,000 x [1,000/(1.09)60] = 20891.5717 (Answer) Question 2 Instructions for graph: I couldn’t plot them as I didn’t had the facilitation to do so and scan and send. But it is really simple. The y-axis (Risk) is nothing but just the standard deviation, while return (x-axis) is the expected return, and they are to be plotted as the given percentage. Exp Ret St Dev PE Risk/Return PE/Return A 0.10 0.10 14 1.0 140 B 0.15 0.10 15 0.7 100 C 0.15 0.20 18 1.3 120 D 0.10 0.15 17 1.5 170 E 0.10 0.20 15 2.0 150 Most Attractive for Risk Averse Investor: B Least Attractive for Risk Averse Investor: C Highest risk/return ratio: E Highest PE Return: D Question 3 Machinery $1,000,000 Required RR 10% p.a. Tax Rate = 30%   Paper Rooftimber Initial Invest in Mach. 6,250,000 10,000,000 WC 250,000 500,000 Fact Life 10 10 RV 1,000,000 1,000,000 Depreciation p.a. 525,000 900,000 Annual Profits 1,500,000 2,000,000 Paper Rooftimber Profit 1,500,000 2,000,000 Dep 525,000 900,000 Op Exp 975,000 1,100,000 Tax 292,500 330,000 Net Cash Flow 682,500 770,000 PV of CF 4,193,689.50 4,731,342.00 PV of SV + WC 3,242,542.15 3,891,050.58 Less: Cost 6,250,000 10,000,000 NPV 1,186,231.65 (1,377,607.42) Paper project should be accepted. (Answer) Question 4 IRR Value = Cost / Net Cash flow   Cost CF Term IRR Value PVIFA Value Payback   A 233,324 61,552 5 years 3.7907 10% 3.79 years B 240,000 60,108 5 years 3.9928 8% 3.99 years Question 5a t = 5 years Coupon = 10% Par Value = $1,000 Issued in 2005 V = (Interest x PVIFA 3 years 10%) + (M x PVIF 3 years 10%) = (100 x 2.4869) + (1,000 x 0.7513) = 999.99 It is certainly worth holding today (Answer) Question 5b g = ? P = 6 d = 0.24 R = 11% P = D / (K - g) 6 = 0.24 / (0.11 – g) 0.11 – g = 0.04 or g = 0.07 = 7% (Answer) Question 6 1. C 2. A 3. C 4. B 5. B 6. Solution Orders in multiples of 10,000 Annual usage 500,000 units Utilization over 50 weeks CH = 10% of the purchase price of goods CP = $10/unit CO = $100/order Delivery time = 1 week Safety stock = 0 EOQ = [2 x 500,000 x 100 / 1] sq root = (10,000) sq root = 10,000 units 7. Solution Annual Inventory Cost: Ordering Cost + Carrying Cost = (100 x 500,000/10,000) + [(500,000/2) x 10 x 0.10] = 5,000 + 250,000 = $255,000/- Read More