Management Chapter 2 Most Experts Recommend That Individual Should Carry

Solutions for Chapter 2: Questions and Problems

CHAPTER 2

THE ASSET ALLOCATION DECISION

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 CPP, she may

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

investments in order to achieve above-average rates of return.

Solutions for Chapter 2: Questions and Problems

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

5. Student Exercise

6. 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

7. 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. Student Exercise

Solutions for Chapter 2: Questions and Problems

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CHAPTER 2

Answers to Problems

1. Most experts recommend that about 6 month’s 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

2. $20,000 taxable income:

Marginal tax rate = 15% + 6.05%

Taxes due = $20,000(21.05%)

= $4,210

Average tax rate = $4,210/$20,000 = 21.05%

3(a). $10,000 invested in 9% tax-exempt RSP (assuming annual compounding)

in 5 years: $10,000(FVIF @ 9%) = $10,000(1.5386) = $15,386

Solutions for Chapter 2: Questions and Problems

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

= 9% (1 – .29)

4(a). $10,000 invested in 10% tax-exempt RSP (assuming annual compounding)

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

= 10% (1 – .2105)

= 7.895%

5. 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

in 10 years: (1.03)5 = 1.3439

in 20 years: (1.03)5 = 1.8061

Solutions for Chapter 2: Questions and Problems

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5(a). Assuming $1,000 is deposited

In 2 years the term deposit will be worth: $1,000(FVIF @ $4%) = $1,081.60

allowable in the second year would be 2.5%.

5(b). This is a difficult question to answer directly. If the investor feels that inflation will remain