Planning Personal Finance - Assignment Example

Planning Personal Finance – Case Study The base option for Kyle and Helen is the offer of £ 263,200 where the sale of their old house is simultaneous with the move to their new house. For the offer of £ 264,000 with a moving date of 3 months, Cash inflow from higher offer is (264,000 – 263,200) = £ 800 Cash outflow towards mortgage and insurance for the 2 additional months is (400+50) x 2 = £ 900 This offer is effectively lower than the base option by £ 100 For the offer of £ 265,500 with a moving date of 4 months, Cash inflow from higher offer is (265,500 – 263,200) = £ 2,300 Cash outflow towards mortgage and insurance for the 3 additional months is (400+50) x 3 = £ 1,350. This offer is higher than the base option by £ 950 Kyle and Helen should therefore accept the offer of £ 265,500 with a moving date of 4 months. 2. From the data presented in the case study, Kyle is not a stock market investor and holding the shares for sentimental reasons runs the risk of the value of those shares continuing to lose value. Kyle received the shares at no cost and any price that he gets is to be regarded as a profit. The recent fall in price of the stock is only a notional or paper loss. If Kyle can do an analysis of the distillery industry and the position of the local distillery company, he may be able to draw some conclusions on whether the dip in price is temporary or part of a long term trend. He can also get advice from a stock broker. His target should, however, be to sell the shares immediately or as soon as possible. Kyle may be liable to pay capital gains tax on the sale value if the price at which he sells is higher than the market price of the shares on the date he inherited them. If the total gain is less than £ 10,000, no tax is payable and of course, sale at a lower price also does not attract tax (HMRC, 2012). 3. Critical Illness Cover pays out a lump sum amount when a specified illness occurs, which for Kyle’s mother was a minor stroke. Once the claim amount is paid, the coverage ceases and she is not entitled to any other payments from the insurance company. A Permanent Health Insurance (PHI) policy would have paid her up to 65% of her pre-tax earnings until her normal date of retirement which is 65 years of age (Conner, 2013). When Kyle’s mother first considered insurance, the PHI policy would have been a better choice as it would have covered any medical condition that prevented her from working whereas the Critical Illness Policy would have covered only a specified list of ailments. Since a medical condition that prevents work could occur at any age, the PHI policy would have paid her money each year until her scheduled retirement age (Bevis, 2009). For Kyle’s mother, the question now is whether the £ 68,000 lump sum she received from her Critical Illness policy at the age 59 is better than 65% of her earnings for 6 years that she would have received with the PHI policy. This question can be resolved by finding out the yearly payments a PHI policy would need to make for 6 years that would equal the present value of the lump sum she received. The interest rate is assumed as 5%. The calculation is made in the table below and shows that an annual payment of £ 13,397.19 for 6 years from the PHI policy would have the present value that equals the lump sum of £ 68,000. To get these annual payments, the mother’s annual salary when she had the stroke should have been £ 20,611.06. The yearly payments for 6 years that would equal the present value   of £ 68,000 at 5% is given by the Excel formula (tvmcalcs.com)       =pmt(rate, nper, pv)           (in £ )   where,               rate is the annual interest rate of 5%     0.05   nper is the number of periods which is 6 years   6   pv is the present value which is £ 68,000     68000   The yearly payments that would equal the present value is (13,397.19)   Since the PHI payment is a maximum of 65% of present salary,     the mothers annual salary should have been a minimum of (20,611.06)   Kyle’s mother would have been better off with a PHI policy if her salary was at least £ 20,611.06, the year she had to stop working. 4. Kyle and Helen need to make a personal financial plan to meet both planned and unplanned possible events in their lives. This starts with making a simple yearly cash flow diagram which would start with their present incomes and expenditure and the expected future needs such as the secondary school and university education for their children. Kyle is 40 years old and Helen is 38 and both are employed. They could both remain employed until they reach 65. Their incomes should rise over the next 25 years of their career and the cash flow projection could factor this growth in income. Their living expenses would increase both due to inflation and any life style changes they plan such as a larger house or annual holidays. The cash flow projections also need to build in the financial costs for secondary school and college education for their two children. The current estimates of the cost of secondary education in a private school are about £ 4,000 per term and for university education about £ 10,000 per term and these would rise over time with inflation (McCormack, 2011). The boy Ross is 8 years old and the girl Shona is 4 years old. Secondary schooling for the older child Ross will start in 4 years and continue for the next 6 years until he reached 18. University education would be for the next 5 years. For Shona, secondary schooling will start in 8 years and the expenses will overlap the expenses for Ross’s education for 7 years. Educational loans are available for university education but not for secondary school education. Besides meeting the education requirements of the two children, Kyle and Helen also need to provide for their living expenses beyond retirement for at least 20 years till they reach the age 85. I addition to living expenses, they need to provide for possible medical care needs. The plan so far is based on both Kyle and Helen remaining active and working until their retirement. The plan now needs to provide for contingencies for one of both of them having to stop working due to a medical condition or the death of one of them. Such events would cause major disruptions to the projected cash flows and may require contingency plans for handling the consequences. Based on the analysis in question 3 above, Kyle and Helen should consider individual Permanent Health Insurance policies to provide for an earnings stream if either of them having to stop working due to a medical condition. An example of such a plan, worked out for a hypothetical young couple is available at http://www.providentsolutions.co.uk and can be used as a template to make their own plan by Kyle and Helen (Provident, 2011). 5. Kyle’s company pension scheme is a defined benefit plan which is good for employees as there is no market risk to the assured benefits. Most companies have now shifted their pension plans to a defined contribution plan where the employee carries the market risk. Kyle would receive a lump sum amount and a yearly pension on retirement. The values of these are shown in the table below. Kyle present salary         (in £ ) 58,000 If Kyle were to retire immediately (with 12 years of employment)   His yearly pension would be 12/80 x present salary   8,700 The lump sum he would get is 12 x (3/80) x present salary 26,100               Kyles retirement salary after 25 years at 5% a year increase 196,409 Kyle would have at that age worked a total of 12+ 25years 37 His yearly pension would be 37/80 x final year salary   90,839 The lump sum he gets on retirement is 37x (3/80) x final year salary 272,517 If Kyle were to retire immediately, he would get a lump sum of £ 26,100 and a yearly pension of £ 8,700. If he works to the age of 65, on the assumption that his salary would rise 5% a year, he would get a lump sum of £ 272,517 and a yearly pension of £ 90,839. Helen has made no pension arrangements and she needs to make one immediately. In addition to the above pension, Kyle and Helen will each receive a state pension of which is a maximum of £ 110.15 a week (the present rate) in return for their National Insurance contributions (Gov.UK, 2013). Kyle and Helen each needs to buy a Permanent Health Insurance policy to provide a source of income if they need to stop working due to a medical condition or disability. The insurance premium paid for this policy would be tax deductible. For Kyle, he is at a marginal tax rate of 40% and therefore if he pays £ 100 as premium, his post tax salary would reduce only by £ 60. Helen is at a marginal tax rate of 20% and for her a premium of £ 100 would reduce her post tax salary by £ 60 (HMRC1, 2012) In addition, Helen needs to buy a defined contribution pension plan to provide a pension for her after retirement. Payments into this plan will be tax deductible in the same manner as explained for the PHI policy. Kyle can modify his pension option to pay an inflation indexed pension after retirement. This will mean lower pensions at the start that rises later. Since pension payments are taxable, these could help Kyle reduce taxes. Both Kyle and Helen need to start separate Individual Savings Accounts (ISA) in each of their own names and in the names of the two children. Payments into the ISA are tax exempt up to a limit of £ 11,520 a year, half of which can be in cash. This would be a good tax saving measure. For the children the limits are lower. The payments into the children’s account will provide a corpus for their education costs once they reach the age of 16. 6. Kyle and Helen’s tax liability for 2012 -13 is shown in the table below. Kyle’s tax liability works out to £ 10, 430 and Helen’s tax liability works out to £ 5, 200. Kyle Tax calculation for 2012-13 (HMRC1, 2012)     (in £) Kyle salary for 2012-13       58,000 Deduction for personal allowance     8,105 Deduction for 7% contribution to pension fund   4,060 Deduction for charity to Clyde Foundation     500 Deduction for payment to young cousin for education (treated as a gift)   2,400 Taxable income         42,935 Income tax @ 20% for income up to £ 34,370   6,874 Income tax @ 40% for income over £ 34,371-£ 150,000 3,426 Tax on £ 400 dividend from Dunoon Marine shares @ 32.5% 130 Tax on sale of 2500 shares of Dunoon Marine at profit of - 100 pence per share is £ 2,500 which is below exemption   limit of £ 10,600 for 2012-13.         Total tax payable by Kyle       10,430 Helen Tax calculation for 2012-13       Helen salary for 2012-13       26,000 Deduction for personal allowance     8,105 Deduction for contribution to pension fund     - Taxable income         26,000 Income tax @ 20% for income up to £ 34,370   5,200 Total tax payable on Helens income     5,200 7. The decision whether to sell or hold the treasury stock is based on the present value of future cash flows from holding the treasury stock. The present value of the future cash flows from the treasury stock is calculated using the Excel formula (tvmcalcs.com)         =pv(rate,nper,pmt, fv)         where,             rate is the rate of discount for future cash flows taken as 5% 5% nper is the number of years       9 pmt is the yearly interest receivable (4.75% x £ 8,000)   380 fv is the future value of the stock       8000 The present value of the stock is     (7,857.84) In this calculation, the discount rate for future cash flows is assumed as 5%. At this discount rate, the present value of the treasury stock Helen owns is £ 7,857.84. If she sells the stock, she will get 120% x £ 8,000 which is £ 9,600. Helen should therefore sell the treasury stock. She would not have to pay any capital gains tax on the profit since the gain is £ 1,600 which is below the exemption limit of £ 10,600 for the year 2012-13 (HMRC2, 2012). 8. In an endowment mortgage, the borrower pays only the interest charges during the tenure of the mortgage and pays the principal at the end of the term. To fund the repayment of the principal, the borrower takes a term insurance policy that is for the same term as the house mortgage. These are two separate contracts and the borrower remains liable to pay the principal value of the house. In a repayment mortgage, the equated monthly payments are worked out to repay both the principal and the interest so that there is no repayment liability for the borrower at the end of the mortgage term (BBC News, 2007). The endowment mortgage is advantageous for young people who can buy a house at an early stage of their life when the earnings would be low. The life insurance premium would also be lower for a younger person. The insurance policy also covers the repayment of principal if the borrower dies. For older people, the life insurance premium goes up sharply and the repayment mortgage is better. 9. Investing a lump sum in an OEIC company exposes the amount to immediate risk. If the timing of the investment is right in terms of the markets being at a low or the sector for investment has a major upswing in stock prices. This is difficult for most investors and it is safer to make monthly investments. The OEIC would be shifting its investments to different companies and to different industries or types of assets based on the market movements and this would help provide a larger degree of safety. Monthly investments also allow you the option of choosing another OEIC company if you find the first company not performing as you expected (Which, 2013) 10. The monthly payments due on the car bought for £ 18,000 on hire purchase credit at 7.9% per annum interest is shown below. The monthly payments on the hire purchase of car is calculated using the Excel formula (tvmcalcs.com)           =pmt(rate,nper,pv)           where,             rate is the monthly interest rate which is 7.9% /12   0.006583333 nper is the number of months of payment     60 pv is the present value of the loan     18,000 The monthly payment due on the loan is     (364.11) Kyle and Helen need to make a payment of £ 364.11 each month for 5 years to repay the loan. Since there is no information of the upfront processing or other fees for the loan, the APR is the same as the nominal interest rate which is 7.9 %. 11. The calculations for the two bank accounts of Kyle’s mother are shown below. a) The deposit of £ 8,500 for 4 years at 3.85% interest will have the maturity value of £ 9,886.55 and the compound interest earned is £ 1,386.55 Present value of deposit (PV)     8500 Interest rate ( r )       0.0385 Period of deposit (n)       4 Maturity value of deposit = PV x (1+r)^ n   9,886.55 Compound interest on deposit     1,386.55 b) The balance of £ 16,721.11 was invested 5 years ago at 3.25% interest. The original sum deposited is £ 14,250 and the compound interest that has been earned over the 5 years is £ 2,471.11. Maturity value of deposit (FV)     16721.11 Interest rate ( r )       0.0325 Period of deposit (n)       5 Present value of deposit = FV/ (1+r)^ n   14,250.00 Compound interest on deposit     2,471.11 * * * * References: 1) BBC News, (2007). “Understanding different mortgage types”, BBC News, 24 April 2007. (Accessed on 15 April 2013 at www.bbc.co.uk) 2) Bevis, G., (2009). “Permanent Health Insurance”, This is Money, 3 April 2009. (Accessed on 14 April 2013 at www.thisismoney.co.uk) 3) Conner, T. (2013). “Income Protection or Critical illness Insurance?” Drewberry Insurance, 2013. (Accessed on 14 April 2013 at www.drewberryincomeprotection .co.uk) 4) Gov.UK. (2013). “The basic state pension”, Gov.UK, 6 April 2013. (Accessed on 15 April 2013 at www.gov.uk). 5) HMRC 1, (2012). “Income Tax rates and allowances”, HM Revenue & Customs. (Accessed on 14 April 2013 at www.hmrc.gov.uk). 6) HMRC 2, (2012). “Introduction to Capital Gains Tax”, HM Revenue & Customs. (Accessed on 14 April 2013 at www.hmrc.gov.uk). 7) McCormack, S., (2011). “Why a private education may be more affordable than you think”, The Independent, 22 Sept 2011. (Accessed on 14 April 2013 at www.independent.co.uk) 8) Provident, (2011). “Personal Financial Plan”, Provident Solutions, 1 March 2011. (Accessed on 15 April 2013 at www.providentsolutions.co.uk). 9) TVMCalcs. com. “Microsoft Excel as a financial Calculator”. (Accessed on 14 April 2013 at www.tvmcalcs.com) 10) Which, (2013). “Lump sum or regular savings”, Which? 2013. (Accessed on 15 April 2013 at www.which.co.uk) Read More