Finance Chapter 2 For Tax Reasons Franklin May Wish Consider Putting Some Debt This Asset

CHAPTER 2

ASSET ALLOCAITON AND SECURITY SELECTION

Answers to Questions

1. In answering this question, one assumes that the young person has a steady job, adequate

insurance coverage, and sufficient cash reserves. The young individual is in the

2. In answering this question, one assumes that the 63-year-old individual has adequate

insurance coverage and a cash reserve. Depending on her income from social security,

3. Typically investment strategies change during an individual’s lifetime. In the

accumulating phase, the individual is accumulating net worth to satisfy short-term needs

(e.g., house and car purchases) and long-term goals (e.g., retirement and children’s

college needs). In this phase, the individual is willing to invest in moderately high-risk

4. A policy statement is important for both the investor and the investment advisor. A policy

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or in part.

statement assists the investor in establishing realistic investment goals, as well as

providing a benchmark by which a portfolio manager’s performance may be measured.

5. The 45-year old uncle and 35-year old sister differ in terms of time horizon. However,

each has some time before retirement (20 versus 30 years). Each should have a

6. Before constructing an investment policy statement, the financial planner needs to clarify

the client’s investment objectives (e.g., capital preservation, capital appreciation, current

8(a). At this point we know (or can reasonably infer) that Mr. Franklin is:

• unmarried (a recent widower)

• childless

• 70 years of age

Taking this knowledge into account, his Investment Policy Statement will reflect these

specifics:

Objectives:

Return Requirements: The incidental throw–off of income from Mr. Franklin’s large asset

pool should provide a more than sufficient flow of net spendable income. If not, such a

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or in part.

need can easily be met by minor portfolio adjustments. Thus, an inflation-adjusted

enhancement of the capital base for the benefit of the foundation will be the primary

return goal (i.e., real growth of capital). Tax minimization will be a continuing collateral

goal.

Risk Tolerance: Account circumstances and the long-term return goal suggest that the

portfolio can take somewhat above-average risk. Mr. Franklin is acquainted with the

nature of investment risk from his prior ownership of stocks and bonds, he has a still long

actuarial life expectancy and is in good current health, and his heir—the foundation,

thanks to his generosity—is already possessed of a large asset base.

Constraints:

Time Horizon: Even disregarding Mr. Franklin’s still-long actuarial life expectancy, the

horizon is long-term because the remainder of his estate, the foundation, has a virtually

perpetual life span.

Liquidity Requirement: Given what we know and the expectation of an ongoing income

and the great freedom of action enjoyed in this situation (i.e., freedom from confining

considerations) are important in this situation, if not necessarily unique.

8(b). Given that stocks have provided (and are expected to continue to provide) higher risk–

adjusted returns than either bonds or cash, and considering that the return goal is for long-

term, inflation-protected growth of the capital base, stocks will be allotted the majority

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or in part.

real estate assets already owned by Mr. Franklin, no further allocation to this asset class

is made. It should be noted that the warehouse is a source of cash flow, a diversifying

asset and, probably, a modest inflation hedge. For tax reasons, Mr. Franklin may wish to

consider putting some debt on this asset, freeing additional cash for alternative

investment use.

Given the long-term orientation and the above-average risk tolerance in this

situation, about 70 percent of total assets can be allocated to equities (including real

estate) and about 30 percent to fixed income assets. International securities will be

Current

Range (%) Target (%)

Cash/Money Market 0 – 5 0

U.S. Fixed Income 10 – 20 15

Non-U.S. Fixed Income 5 – 15 10

U.S. Stocks (Large Cap) 30 – 45 30

(Small Cap) 15 – 25 15

9. The major advantage of investing in common stocks is that generally an investor would

earn a higher rate of return than on corporate bonds. Also, while the return on bonds is

pre-specified and fixed, the return on common stocks can be substantially higher if the

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or in part.

company and could well be negative. A line graph of returns over time should indicate a

lower average level of return and lower variability of returns over time for bonds than for

common stock.

10. The three factors are:

(1) Limiting oneself to the U.S. securities market would imply effectively ignoring more

11. International diversification reduces portfolio risk because of the low correlation of

12. There are different correlations of returns between securities from the U.S. and alternate

13. The correlations between U.S. stocks and stocks for different countries should change

over time because each country has a fairly independent set of economic policies.

Factors influencing the correlations include international trade, economic growth, fiscal

14. The major risks that an investor must consider when investing in any bond issue are

business risk, financial risk, and liquidity risk. Additional risk associated with foreign

15. The additional risks that some investors believe international investing introduces include

foreign exchange risk and country risk. For example, according to Exhibit 2.9, in 2010

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or in part.

the U.S. return of 15.30 was higher than that of Germany (7.10 percent) and Japan (13.80

percent), while in 2007 the U.S. return was only 3.80 percent, while the German market

rose to 30.50 percent and the Japanese market fell to 6 percent. The returns for these two

countries include the domestic return in the issuing country and an adjustment for any

exchange rate movement between their currencies and the dollar.

16. There are four alternatives to direct investment in foreign stocks available to investors:

17. Unlike corporate bonds, interest on municipal bonds is exempt from taxation by the

federal government and by the state that issued the bond, provided the investor is a

18. The convertible bond of the growth company would have the lower yield. This is

intuitive because there is a greater potential for the price of the growth company stock to

19. Liquidity is the ability to buy or sell an asset quickly at a price similar to the prior price

assuming no new information has entered the market. Common stocks have the

advantage of liquidity because it is very easy to buy or sell a small position (there being a

large number of potential buyers) at a price not substantially different from the current

20. Art and antiques are considered illiquid investments because in most cases they are sold

at auctions. The implication of being traded at auctions rather than on a developed

exchange is that there is tremendous uncertainty regarding the price to be received and it

takes a long time to contact a buyer who offers the “right” price. Besides, many buyers of

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or in part.

Coins and stamps are more liquid than art and antiques because an investor can determine

the “correct” market price from several weekly or monthly publications. There is no such

publication of current market prices of the numerous unique pieces of art and antiques

and owners are forced to rely on dealer estimates. Further, while a coin or stamp can be

readily disposed of to a dealer at a commission of about 10–15 percent, the commissions

on paintings range from 30–50 percent.

To sell a portfolio of stocks that are listed on the New York Stock Exchange, an investor

simply contacts his/her broker to sell the shares. The cost of trading stocks varies

depending on whether the trade is handled by a full service broker or a discount broker.

21. The results of Exhibit 2.16 would tend to support adding some stocks from emerging

markets to your portfolio. The table indicates a low positive correlation with U.S. stocks

22. International stocks versus U.S. stocks – Problems:

1. Information about foreign firms is often difficult to obtain on a timely basis and once

2. Financial statements are not comparable from country to country. Different countries

3. Stock valuation techniques useful in the United States may be less useful in other

countries. Stock markets in different countries value different attributes.

5. Increased costs: custody, management fees, and transactions expenses are usually

higher outside the United States.

23. Arguments in favor of adding international securities include:

1. Benefits gained from broader diversification, including economic, political, and/or

geographic sources.

3. Advantages accruing from improved correlation and covariance relationships across

the portfolio’s exposures.

5. Wider range of industry and company choices for portfolio construction purposes.

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or in part.

liabilities.

At the same time, there are a number of potential problems associated with moving away

from a domestic-securities-only orientation:

1. Possible higher costs, including those for custody, transactions, and management fees.

CHAPTER 2

Answers to Problems

1. Most experts recommend that about six months’ worth of living expenses be held in cash

reserves. Although these funds are identified as “cash,” it is recommended that they be

invested in instruments that can easily be converted to cash with little chance of loss in value

2(a). $10,000 invested in 9 percent tax-exempt IRA (assuming annual compounding)

2(b). After-tax yield = Before-tax yield (1 – Tax rate)

3(a). $10,000 invested in 10 percent tax-exempt IRA (assuming annual compounding)

3(b). After-tax yield = Before-tax yield (1 – Tax rate)

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or in part.

in 5 years: $10,000(FVIF @ 8.50%) = $15,037

in 10 years: $10,000(FVIF @ 8.50%) = $22,610

in 20 years: $10,000(FVIF @ 8.50%) = $51,120

4. With inflation growing at 3% annually, the above figures need to be deflated by the

following factors:

in 5 years: (1.03)5 = 1.1593

5. Student Exercise

7. Student Exercise

8.

8(a). The arithmetic average assumes the presence of simple interest, while the geometric average

assumes compounding or interest-on-interest. The geometric mean internal rate of return is a

8(b). Ranking is best accomplished by using the coefficient of variation (standard deviation/

arithmetic mean, multiplied by 100):

1 – Real Estate 36.88

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or in part.

4 – Common Stocks 164.40

5 – Long Corp. Bond 166.96

8(c) Expected mean plus or minus two standard deviations:

9. If inflation is 3%,

real rate of return = (1 + return)/ (1+ inflation rate) -1

T-bills: real return = 1.035/1.03 -1 = 0.0048

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APPENDIX 2

Answers to Problems

1. Lauren’s average return Kayleigh’s average return

______________ _______________

5 – 5.6 = -0.6 5 – 4.4 = 0.6

12 – 5.6 = 6.4 15 – 4.4 = 10.6

2. Calculation of Correlation Coefficient

Observation

1

-0.6

.36

0.6

.36

2

6.4

40.96

10.6

112.36

3

-16.6

275.56

2.6

6.76

4

4.4

19.36

0.6

0.36

5

6.4

40.96

-14.4

207.36

377.20

327.20

4.4 22/5 5.6 28/5

5

)1075155(

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5

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=

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=

K –K L – L

L–L

2

)L–(L

)K–(K

2

)K–(K

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or in part.

While there is a slight negative correlation, the two securities are essentially uncorrelated.

Thus, even though the two companies produce similar products, their historical returns

suggest that holding both of these securities would help reduce risk through

diversification.

066.

)09.8)(69.8(

64.4

COV

r

09.844.65 69.844.75

44.65

5

2.327

44.75

5

2.377

K:L

LK

K

2

K

2

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