Money Management: a Life Insurance Investment and a Personally Managed Fund - Essay Example

October 22, Money Management Introduction Retirement years are filled with uncertainties especially if the retiree has a medical condition that needs frequent doctor. It therefore makes planning for retirement much more difficult. If I receive KD 500,000 when I retire then I have to invest it in some way in order to withstand the effects of inflation. There are many options available but some are very risky and at this time of my life I have to think about the certainty of my income. I have therefore decided to consider one of two options – a life insurance investment and a personally managed fund. Option 1 – Life Insurance Fund If I invest the KD 500,000 with a life insurance company then I may be able to earn a stable income each year with adjustments for inflation. Based on discussions with my insurance company the following table reflects the amount that I would receive if I invest in an insurance policy that makes adjustments for inflation and pays my estate the balance of my policy at death. Table 1 in Appendix 1 provides the necessary information. The table shows an initial investment of KD 500,000 and indicates that over a 20 year period and assuming a 3.5% rate of interest and an inflation rate of 3%, I would be able to have an inflation adjusted income of KD 15,000 in year 1 continuing to $26,302 payment in year 20. The table only shows 20 years because I assume that the number of years that I will live after retirement is approximately 20. This policy however, continues as long as I am alive. The balance on the account at year 20 suggests that there will be sufficient funds for me to earn an income many years after year 20. In fact, my principal amount only starts declining in year 12 suggesting that I will be paid out of interest earned on the investment only up to year 11. After year 11 the payments will start affecting my principal. My total receipt up to year 20 would be KD 403045.62 with a balance on the account of KD 443,861.55. This indicates a net return of KD 346,907.17 ((KD 403,045.62 + KD 443,861.55) – KD 500,000). Option 2 – Personally Managed Funds In the event that I choose to manage the funds personally then I would be able to make earnings at rates between 3 to 7 per cent. This fund would consist of a mixture of bonds and stocks with at least 60% of the funds in stocks. I would use the income generated from the fund n the first year – year 1 as a basis to determine my future income if I am to maintain the same standard of living. I therefore allow for an inflation rate of 3% as with the life insurance option. Table 2 in Appendix 1 provides information on this fund. An average rate of return of 5% annually is assumed. This is based on the fact that a smaller portion would be invested in risk free investments (government bonds) while the larger portion would be invested in the more risky investments (stocks). The information indicates that after the first payment of KD17,500 subsequent payments will require selling investments and therefore reducing the principal initially invested. Comparison of both options In comparing both options the life insurance fund has a lot to recommend it. It is secure, simple, provides high returns, safe, and has no sales or administrative charges (immediateannuities.com). i. The life insurance offer provides a stable income for the rest of the pensioner’s life and in some cases beneficiaries can receive the balance after death. The income streams from the personally managed fund are not likely to be as stable, even though this is assumed in the table above. Additionally, the personally managed fund is more risky. ii. The pensioner does not have to watch the market and report on interest and dividends as in the case of the personally managed funds. iii. Returns on life insurance funds are normally higher than those on government bonds. The reason is that a portion of the principal is normally paid with the interest earned. However, the personally managed find s a mixture of bonds and stocks. iv. The principal is normally safe in the case of the life insurance fund. However, in the case of the personally managed funds it will be affected by fluctuations in the stock market. v. Investments in stocks are subject to administrative and other charges. This is likely to have a negative impact on the returns on personally managed funds. However, such charges will not affect the life insurance fund as these would have already been taken into consideration in calculating the return. The only advantage with the managed fund is that I can change my portfolio as much as I want. Once the insurance contract is signed I cannot change it. I will have to stick with it even if my circumstances change. Personally managing a fund is a very complex process and at this stage in life I would prefer to relax while I receive my income. Managing a fund can be very time consuming. These and other factors make the life insurance fund the better option. Although, the return appears to be better on the personally managed funds the fact is that the rates used is not certain. Certainty in relation to the amount to be received is always better than an uncertainty and at this stage of my life the life insurance fund satisfies this criterion. 2.0 Share Analysis When investing funds in stock market it is important that an analysis is carried out to determine the profitability and financial health of the company in which the investment is being made. The table below provides financial information on two companies – Alico, Inc and ALCO Stores, Inc. Both companies are listed on the New York Stock Exchange and so their shares are traded publicly. Therefore, there are no restrictions on who can purchase them. Appendix 2 provides information that can help investors determine the better option. The market valuation ratios provide an indication of how investors view a company’s past performance (Brigham and Ehrhardt 2005). Investment ratios provide information that can be used to determine whether an investment in a particular company will provide the level of returns that is being sought. Financial health ratios indicate the liquidity status (as represented by its current and quick ratios) of a company – that is whether it is able to pay its debts as they fall due (BPP 2009) and its financial leverage – the extent to which it uses debt financing (Brigham and Ehrhardt 2005) while the profitability ratios indicate the effectiveness of a company’s operations (Brigham and Ehrhardt 2005). Acceptable current and quick ratios are 1.5 and 0.8 respectively (BPP 2009). While the current ratios of both companies appear acceptable the quick ratios are very low and indicate that current assets have a very high proportion of inventory which is cannot be turned into cash easily. Of the market valuation ratios the price/earnings (P/E) ratio is widely used. It provides information on how much investors are willing to pay for every dollar of profits reported (Brigham and Ehrhardt 2005). The P/E ratio is calculated by dividing the companies share price by the earnings per share EPS. The information in the table suggests that they are willing to pay more for ALCO Store’s stocks than for that of Alico – 15.56 and 13.2 times respectively. However, these companies operate in different industries and this may be the key factor here. The Price/Book ratio which is the same as the Market/Book ratio also provides an indication of how a company is viewed by investors (Brigham and Ehrhardt 2005). It takes the market price of the stock and divides it by the value of equity on the books (in the balance sheet). A company with a better return on equity than another normally sells at a higher multiple. This fact is reflected in Appendix 2. Alico, Inc has an ROE of 6.57 while ALCO Stores ROE is 1.59. The companies Price/Book ratios are 1.8 and 0.3 respectively which indicates that the price at which the stocks trade are 180% (1.8 times) of the book value in the case of Alico and 30% (0.3 times) in the case of ALCO Stores. The Price/Cash Flow ratio is also used because of the importance of cash flow to a business. Alico has a much better Price/Cash Flow ratio than ALCO Stores – 6.5 and 1.7 respectively. Brigham and Ehrhardt (2005) indicate that this can be misleading since it does not represent a forecast of future cash flows. The financial leverage for both companies suggests high levels of gearing. However, BPP (2009) suggests that high levels of financial leverage may be as a result of undervalued assets. The debt/ equity ratio suggests that Alico’s debt is within the range that analyst finds acceptable (that is 50%) while ALCO stores debt may be a little too high at 55% of equity. Appendix 1 Year Initial Investment KD Interest rate Inflation rate Capital Growth KD Withdrawal KD Balance KD 0 500,000.00 0.035 0.03 0.00 0.00 500,000.00 1 500,000.00 0.035 0.03 517500.00 15000.00 502500.00 2 502,500.00 0.035 0.03 520087.50 15450.00 504637.50 3 504,637.50 0.035 0.03 522299.81 15913.50 506386.31 4 506,386.31 0.035 0.03 524109.83 16390.91 507718.93 5 507,718.93 0.035 0.03 525489.09 16882.63 508606.46 6 508,606.46 0.035 0.03 526407.68 17389.11 509018.57 7 509,018.57 0.035 0.03 526834.22 17910.78 508923.44 8 508,923.44 0.035 0.03 526735.76 18448.11 508287.65 9 508,287.65 0.035 0.03 526077.72 19001.55 507076.17 10 507,076.17 0.035 0.03 524823.83 19571.60 505252.24 11 505,252.24 0.035 0.03 522936.06 20158.75 502777.32 12 502,777.32 0.035 0.03 520374.53 20763.51 499611.02 13 499,611.02 0.035 0.03 517097.40 21386.41 495710.99 14 495,710.99 0.035 0.03 513060.87 22028.01 491032.87 15 491,032.87 0.035 0.03 508219.02 22688.85 485530.17 16 485,530.17 0.035 0.03 502523.73 23369.51 479154.22 17 479,154.22 0.035 0.03 495924.62 24070.60 471854.02 18 471,854.02 0.035 0.03 488368.91 24792.71 463576.19 19 463,576.19 0.035 0.03 479801.36 25536.50 454264.87 20 454,264.87 0.035 0.03 470164.14 26302.59 443861.55 Table 1 – Life Insurance Offer Year Initial Investment Interest rate Inflation rate Capital Growth KD Withdrawal KD Balance KD 0 500,000.00 0.05 0.03 0.00 0.00 500,000.00 1 500,000.00 0.05 0.03 517500.00 17500.00 500000.00 2 500,000.00 0.05 0.03 517500.00 18025.00 499475.00 3 499,475.00 0.05 0.03 516956.63 18565.75 498390.88 4 498,390.88 0.05 0.03 515834.56 19122.72 496711.83 5 496,711.83 0.05 0.03 514096.75 19696.40 494400.34 6 494,400.34 0.05 0.03 511704.36 20287.30 491417.06 7 491,417.06 0.05 0.03 508616.66 20895.92 487720.74 8 487,720.74 0.05 0.03 504790.97 21522.79 483268.17 9 483,268.17 0.05 0.03 500182.56 22168.48 478014.08 10 478,014.08 0.05 0.03 494744.58 22833.53 471911.05 11 471,911.05 0.05 0.03 488427.93 23518.54 464909.40 12 464,909.40 0.05 0.03 481181.22 24224.09 456957.13 13 456,957.13 0.05 0.03 472950.63 24950.82 447999.82 14 447,999.82 0.05 0.03 463679.81 25699.34 437980.47 15 437,980.47 0.05 0.03 453309.79 26470.32 426839.47 16 426,839.47 0.05 0.03 441778.85 27264.43 414514.42 17 414,514.42 0.05 0.03 429022.42 28082.36 400940.06 18 400,940.06 0.05 0.03 414972.96 28924.83 386048.13 19 386,048.13 0.05 0.03 399559.81 29792.58 369767.23 20 369,767.23 0.05 0.03 382709.09 30686.36 352022.73 Total         470231.55   Table 2 – Personally Managed Funds Appendix 2 Company Analysis   Alico, Inc ALCO Stores, Inc Key Valuation Ratios     Price/Earnings 13.2 15.6 Price/Book 1.8 0.3 Price/Sales 1.8 0.1 Price/Cash Flow 6.5 1.7 Dividend Yield  0.5 n/a   Financial Health     Current ratio 2.47 4.02 Quick ratio 0.5 0.29 Financial leverage 1.63 2.11 Debt/Equity 0.49 0.55       Profitability     EBITDA  15.45  1.42 ROE  6.57  1.59 Source: Morningstar Database References BPP Learning Media Ltd. (2009) ACCA Paper F7-Financial Reporting. London, UK: BPP Learning Media Ltd. Brigham, E.F and Ehrhardt, M.H. (2005). Financial Management: Theory and Practice. 11th ed. USA: Thomson South Western Immediate Annuities (n.d.). A Lesson in Immediate Annuities. [Online] Retrieved from http://www.immediateannuities.com/information/rates.html?rates=a25c2a67b04c675a278fc965e73bbf8a [Accessed 21 October 2012] Morningstar (2012) Alico, Inc. [Online] Retrieved from http://library.morningstar.com/Stock/price-ratio?t=ALCO®ion=USA&culture=en-US [Accessed 22 October 2012] Read More