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Case Problem 4.1 Coates's Decision On January 1, 2017, Dave
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I need assistance with all problems attached except 4.1 Can you assist?

Case Problem 4.1 Coates?s Decision

On January 1, 2017, Dave Coates, a 23-year-old mathematics teacher at Xavier High School, received a tax refund

of \$1,100. Because Dave didn?t need this money for his current living expenses, he decided to make a long-term

investment. After surveying a number of alternative investments costing no more than \$1,100, Dave isolated two

that seemed most suitable to his needs.

Each of the investments cost \$1,050 and was expected to provide income over a 10-year period. Investment A

provided a relatively certain stream of income. Dave was a little less certain of the income provided by investment

B. From his search for suitable alternatives, Dave found that the appropriate discount rate for a relatively certain

investment was 4%. Because he felt a bit uncomfortable with an investment like B, he estimated that such an

investment would have to provide a return at least 4% higher than investment A. Although Dave planned to reinvest

funds returned from the investments in other vehicles providing similar returns, he wished to keep the extra \$50

(\$1,100 ? \$1,050) invested for the full 10 years in a savings account paying 3% interest compounded annually.

As he makes his investment decision, Dave has asked for your help in answering the questions that follow the

expected return data for these investments.

Expected Returns

End of Year

A

B

2017

\$?? 50

\$??0

2018

\$?? 50

\$150

2019

\$?? 50

\$150

2020

\$?? 50

\$150

2021

\$?? 50

\$200

2022

\$?? 50

\$250

2023

\$?? 50

\$200

2024

\$?? 50

\$150

Expected Returns

End of Year

A

B

2025

\$?? 50

\$100

2026

\$1,050

\$?50

Questions

a.

Assuming that investments A and B are equally risky and using the 4% discount rate, apply the present

value technique to assess the acceptability of each investment and to determine the preferred investment.

Solution:

Plan A:

Discount Rate 4%

End of Year

Period

Expected Returns Present Value

0

0

-1050

-1050

2017

1

50

48.07692308

2018

2

50

46.22781065

2019

3

50

44.44981793

2020

4

50

42.74020955

2021

5

50

41.09635534

2022

6

50

39.51572629

2023

7

50

37.99589066

2024

8

50

36.53451025

2025

9

50

35.12933678

2026

10

1050

709.3423773

Net Present Value

31.10895779

IRR for Plan A:

Plan B:

End of Year

1St Jan 2017

2017

2018

2019

2020

2021

2022

2023

2024

2025

Period

0

1

2

3

4

5

6

7

8

9

Expected Returns

-1050

0

150

150

150

200

250

200

150

100

4%

Discount Rate

Present Value

-1050

0

138.683432

133.3494538

128.2206287

164.3854214

197.5786314

151.9835626

109.6035308

70.25867356

4%

2026

Net Present Value

10

50

33.77820844

77.84154258

Since NPV of both Projects are greater than zero, so both may be

accepted. Since NPV of Plan B is greater than NPV of Plan A, So Plan B

is preferred.

b.

c.

d.

e.

f.

Recognizing that investment B is more risky than investment A, reassess the two alternatives, adding the

4% risk premium to the 4% discount rate for investment A and therefore applying a 8% discount rate to

investment B. Compare your findings relative to acceptability and preference to those found for question a.

From your findings in questions a and b, indicate whether the IRR for investment A is above or below 4%

and whether that for investment B is above or below 8%. Explain.

Use the present value technique to estimate the IRR on each investment. Compare your findings and

contrast them with your response to question c.

From the information given, which, if either, of the two investments would you recommend that Dave

Indicate to Dave how much money the extra \$50 will have grown to by the end of 2026, assuming he

makes no withdrawals from the savings account.

Case Problem 4.2 The Risk-Return Tradeoff: Molly O?Rourke?s Stock Purchase Decision

Over the past 10 years, Molly O?Rourke has slowly built a diversified portfolio of common stock. Currently her

portfolio includes 20 different common stock issues and has a total market value of \$82,500.

Molly is at present considering the addition of 50 shares of either of two common stock issues?X or Y. To assess

the return and risk of each of these issues, she has gathered dividend income and share price data for both over the

last 10 years (2007?2016). Molly?s investigation of the outlook for these issues suggests that each will, on average,

tend to behave in the future just as it has in the past. She therefore believes that the expected return can be estimated

by finding the average HPR over the past 10 years for each of the stocks. The historical dividend income and stock

price data collected by Molly are given in the accompanying table.

Stock X

Stock Y

Share Price

Share Price

Dividend

Dividend

Year

Income

Beginning

Ending

Income

Beginning

Ending

2007

\$1.00

\$20.00

\$22.00

\$1.50

\$20.00

\$20.00

2008

\$1.50

\$22.00

\$21.00

\$1.60

\$20.00

\$20.00

2009

\$1.40

\$21.00

\$24.00

\$1.70

\$20.00

\$21.00

2010

\$1.70

\$24.00

\$22.00

\$1.80

\$21.00

\$21.00

2011

\$1.90

\$22.00

\$23.00

\$1.90

\$21.00

\$22.00

2012

\$1.60

\$23.00

\$26.00

\$2.00

\$22.00

\$23.00

2013

\$1.70

\$26.00

\$25.00

\$2.10

\$23.00

\$23.00

2014

\$2.00

\$25.00

\$24.00

\$2.20

\$23.00

\$24.00

2015

\$2.10

\$24.00

\$27.00

\$2.30

\$24.00

\$25.00

Stock X

Stock Y

Share Price

Share Price

Dividend

Dividend

Year

Income

Beginning

Ending

Income

Beginning

Ending

2016

\$2.20

\$27.00

\$30.00

\$2.40

\$25.00

\$25.00

Questions

a.

b.

c.

d.

Determine the HPR for each stock in each of the preceding 10 years. Find the expected return for each

stock, using the approach specified by Molly.

Use the HPRs and expected return calculated in question a to find the standard deviation of the HPRs for

each stock over the 10-year period.

Use your findings to evaluate and discuss the return and risk associated with stocks X and Y. Which stock

seems preferable? Explain.

Ignoring her existing portfolio, what recommendations would you give Molly with regard to stocks X and

Y?

Case Problem 2.1 Traditional Versus Modern Portfolio Theory: Who?s Right?

Walt Davies and Shane O?Brien are district managers for Lee, Inc. Over the years, as they moved through the firm?s

sales organization, they became (and still remain) close friends. Walt, who is 33 years old, currently lives in

Princeton, New Jersey. Shane, who is 35, lives in Houston, Texas. Recently, at the national sales meeting, they were

discussing various company matters, as well as bringing each other up to date on their families, when the subject of

investments came up. Each had always been fascinated by the stock market, and now that they had achieved some

degree of financial success, they had begun actively investing.

As they discussed their investments, Walt said he thought the only way an individual who does not have hundreds of

thousands of dollars can invest safely is to buy mutual fund shares. He emphasized that to be safe, a person needs to

hold a broadly diversified portfolio and that only those with a lot of money and time can achieve independently the

diversification that can be readily obtained by purchasing mutual fund shares.

Shane totally disagreed. He said, ?Diversification! Who needs it?? He thought that what one must do is look

carefully at stocks possessing desired risk-return characteristics and then invest all one?s money in the single best

stock. Walt told him he was crazy. He said, ?There is no way to measure risk conveniently?you?re just gambling.?

Shane disagreed. He explained how his stockbroker had acquainted him with beta, which is a measure of risk. Shane

said that the higher the beta, the more risky the stock, and therefore the higher its return. By looking up the betas for

potential stock investments on the Internet, he can pick stocks that have an acceptable risk level for him. Shane

explained that with beta, one does not need to diversify; one merely needs to be willing to accept the risk reflected

by beta and then hope for the best.

The conversation continued, with Walt indicating that although he knew nothing about beta, he didn?t believe one

could safely invest in a single stock. Shane continued to argue that his broker had explained to him that betas can be

calculated not just for a single stock but also for a portfolio of stocks, such as a mutual fund. He said, ?What?s the

difference between a stock with a beta of, say, 1.2 and a mutual fund with a beta of 1.2? They have the same risk and

should therefore provide similar returns.?

As Walt and Shane continued to discuss their differing opinions relative to investment strategy, they began to get

angry with each other. Neither was able to convince the other that he was right. The level of their voices now raised,

they attracted the attention of the company?s vice president of finance, Elinor Green, who was standing nearby. She

came over and indicated she had overheard their argument about investments and thought that, given her expertise

on financial matters, she might be able to resolve their disagreement. She asked them to explain the crux of their

disagreement, and each reviewed his own viewpoint. After hearing their views, Elinor responded, ?I have some good

news and some bad news for each of you. There is some validity to what each of you says, but there also are some

errors in each of your explanations. Walt tends to support the traditional approach to portfolio management. Shane?s

views are more supportive of modern portfolio theory.? Just then, the company president interrupted them, needing

to talk to Elinor immediately. Elinor apologized for having to leave and offered to continue their discussion later that

evening.

Questions

a.

b.

c.

d.

e.

Analyze Walt?s argument and explain why a mutual fund investment may be overdiversified. Also explain

why one does not necessarily have to have hundreds of thousands of dollars to diversify adequately.

Analyze Shane?s argument and explain the major error in his logic relative to the use of beta as a substitute

for diversification. Explain the key assumption underlying the use of beta as a risk measure.

Briefly describe the traditional approach to portfolio management and relate it to the approaches supported

by Walt and Shane.

Briefly describe modern portfolio theory and relate it to the approaches supported by Walt and Shane. Be

sure to mention diversifiable risk, undiversifiable risk, and total risk, along with the role of beta.

Explain how the traditional approach and modern portfolio theory can be blended into an approach to

portfolio management that might prove useful to the individual investor. Relate this to reconciling Walt?s

and Shane?s differing points of view.

Case Problem 5.2 Susan Lussier?s Inherited Portfolio: Does It Meet Her Needs?

Susan Lussier is 35 years old and employed as a tax accountant for a major oil and gas exploration company. She

earns nearly \$135,000 a year from her salary and from participation in the company?s drilling activities. An expert

on oil and gas taxation, she is not worried about job security?she is content with her income and finds it adequate

to allow her to buy and do whatever she wishes. Her current philosophy is to live each day to its fullest, not

concerning herself with retirement, which is too far in the future to require her current attention.

A month ago, Susan?s only surviving parent, her father, was killed in a sailing accident. He had retired in La Jolla,

California, two years earlier and had spent most of his time sailing. Prior to retirement, he managed a children?s

clothing manufacturing firm in South Carolina. Upon retirement he sold his stock in the firm and invested the

proceeds in a security portfolio that provided him with supplemental retirement income of over \$30,000 per year. In

his will, he left his entire estate to Susan. The estate was structured in such a way that in addition to a few family

heirlooms, Susan received a security portfolio having a market value of nearly \$350,000 and about \$10,000 in cash.

Susan?s father?s portfolio contained 10 securities: 5 bonds, 2 common stocks, and 3 mutual funds. The following

table lists the securities and their key characteristics. The common stocks were issued by large, mature, well-known

firms that had exhibited continuing patterns of dividend payment over the past five years. The stocks offered only

moderate growth potential?probably no more than 2% to 3% appreciation per year. The mutual funds in the

portfolio were income funds invested in diversified portfolios of income-oriented stocks and bonds. They provided

stable streams of dividend income but offered little opportunity for capital appreciation.

Bonds

Par Value

Issue

S&amp;P Rating

Interest Income (\$)

Quoted Price (\$)

(\$)

40,000

Delta Power and Light

Total

Current

Cost (\$)

Yield (%)

AA

\$4,050

\$?98.000

\$39,200

10.33%

A

\$2,925

\$102.000

\$30,600

9.56%

AAA

\$4,750

\$? 97.000

\$48,500

9.79%

AAA

\$2,000

\$?99.000

\$19,800

10.10%

10.125% due 2029

30,000

Mountain Water

9.750% due 2021

50,000

California Gas

9.500% due 2016

20,000

Trans-Pacific Gas

Bonds

Par Value

Issue

S&amp;P Rating

Interest Income (\$)

Quoted Price (\$)

(\$)

40,000

Delta Power and Light

Total

Current

Cost (\$)

Yield (%)

AA

\$4,050

\$?98.000

\$39,200

10.33%

A

\$2,925

\$102.000

\$30,600

9.56%

AAA

\$4,750

\$? 97.000

\$48,500

9.79%

AA

\$1,975

\$100.000

\$20,000

9.88%

Beta

Dividend

10.125% due 2029

30,000

Mountain Water

9.750% due 2021

50,000

California Gas

9.500% due 2016

10.000% due 2027

20,000

Public Service 9.875%

due 2017

The Securities Portfolio That Susan Lussier Inherited

Common Stocks

Number of

Company

Shares

Dividend per

Dividend

Price per

Total Cost

Share (\$)

Income (\$)

Share (\$)

(\$)

Yield (%)

2,000

International Supply

\$2.40

\$4,800

\$22

\$44,900

0.97

10.91%

3,000

Black Motor

\$1.50

\$4,500

\$17

\$52,000

0.85

8.82%

Mutual Funds

Number of

Fund

Shares

2,000

International Capital

Dividend per

Dividend

Price per

Total

Beta

Dividend

Share Income (\$)

Income (\$)

Share (\$)

Cost

\$0.80

\$1,600

\$10

\$20,000

1.02

8.00%

\$2.00

\$2,000

\$15

\$15,000

1.10

7.50%

\$1.20

\$4,800

\$12

\$48,000

0.90

10.00%

Yield (%)

Income A Fund

1,000

Grimner Special

Income Fund

4,000

Ellis Diversified

Income Fund

Total annual

Portfolio

Portfolio current

income: \$33,400

value:

yield: 9.88%

\$338,000

Now that Susan owns the portfolio, she wishes to determine whether it is suitable for her situation. She realizes that

the high level of income provided by the portfolio will be taxed at a rate (federal plus state) of about 40%. Because

she does not currently need it, Susan plans to invest the after-tax income primarily in common stocks offering high

capital gain potential. During the coming years she clearly needs to avoid generating taxable income. (Susan is

already paying out a sizable portion of her income in taxes.) She feels fortunate to have received the portfolio and

wants to make certain it provides her with the maximum benefits, given her financial situation. The \$10,000 cash

left to her will be especially useful in paying brokers? commissions associated with making portfolio adjustments.

Questions

a.

b.

c.

d.

e.

Briefly assess Susan?s financial situation and develop a portfolio objective for her that is consistent with her

needs.

Evaluate the portfolio left to Susan by her father. Assess its apparent objective and evaluate how well it

may be doing in fulfilling this objective. Use the total cost values to describe the asset allocation scheme

reflected in the portfolio. Comment on the risk, return, and tax implications of this portfolio.

If Susan decided to invest in a security portfolio consistent with her needs?indicated in response to

question a?describe the nature and mix, if any, of securities you would recommend she purchase. Discuss

the risk, return, and tax implications of such a portfolio.

From the response to question b, compare the nature of the security portfolio inherited by Susan with what

you believe would be an appropriate security portfolio for her, based on the response to question c.

What recommendations would you give Susan about the inherited portfolio? Explain the steps she should

take to adjust the portfolio to her needs.

Case Problem 13.1 Assessing the Stalchecks?s Portfolio Performance

Mary and Nick Stalcheck have an investment portfolio containing four investments. It was developed to provide

them with a balance between current income and capital appreciation. Rather than acquire mutual fund shares or

diversify within a given class of investments, they developed their portfolio with the idea of diversifying across

various asset classes. The portfolio currently contains common stock, industrial bonds, mutual fund shares, and

options. They acquired each of these investments during the past three years, and they plan to purchase other

investments sometime in the future.

Currently, the Stalchecks are interested in measuring the return on their investment and assessing how well they

have done relative to the market. They hope that the return earned over the past calendar year is in excess of what

they would have earned by investing in a portfolio consisting of the S&amp;P 500 Stock Composite Index. Their research

has indicated that the risk-free rate was 7.2% and that the (before-tax) return on the S&amp;P 500 portfolio was 10.1%

during the past year. With the aid of a friend, they have been able to estimate the beta of their portfolio, which was

1.20. In their analysis, they have planned to ignore taxes because they feel their earnings have been adequately

sheltered. Because they did not make any portfolio transactions during the past year, all of the Stalchecks?s

investments have been held more than 12 months, and they would have to consider only unrealized capital gains, if

any. To make the necessary calculations, the Stalchecks have gathered the following information on each investment

in their portfolio.

Common stock. They own 400 shares of KJ Enterprises common stock. KJ is a diversified manufacturer of metal

pipe and is known for its unbroken stream of dividends. Over the past few years, it has entered new markets and, as

a result, has offered moderate capital appreciation potential. Its share price has risen from \$17.25 at the start of the

last calendar year to \$18.75 at the end of the year. During the year, quarterly cash dividends of \$0.20, \$0.20, \$0.25,

and \$0.25 were paid.

Industrial bonds. The Stalchecks own eight Cal Industries bonds. The bonds have a \$1,000 par value, have a 9.250%

coupon, and are due in 2027. They are A-rated by Moody?s. The bonds were quoted at 97.000 at the beginning of the

year and ended the calendar year at 96.375%.

Mutual fund. The Stalchecks hold 500 shares in the Holt Fund, a balanced, no-load mutual fund. The dividend

distributions on the fund during the year consisted of \$0.60 in investment income and \$0.50 in capital gains. The

fund?s NAV at the beginning of the calendar year was \$19.45, and it ended the year at \$20.02.

Options. The Stalchecks own 100 options contracts on the stock of a company they follow. The value of these

contracts totaled \$26,000 at the beginning of the calendar year. At year-end the total value of the options contracts

was \$29,000.

Questions

a.

b.

c.

d.

e.

Calculate the holding period return on a before-tax basis for each of these four investments.

Assuming that the Stalchecks?s ordinary income is currently being taxed at a combined (federal and state)

tax rate of 38% and that they would pay a 15% capital gains tax on dividends and capital gains for holding

periods longer than 12 months, determine the after-tax HPR for each of their four investments.

Recognizing that all gains on the Stalchecks?s investments were unrealized, calculate the before-tax

portfolio HPR for their four-investment portfolio during the past calendar year. Evaluate this return relative

to its current income and capital gain components.

Use the HPR calculated in question c to compute Jensen?s measure (Jensen?s alpha). Use that measure to

analyze the performance of the Stalchecks?s portfolio on a risk-adjusted, market-adjusted basis. Comment

on your finding. Is it reasonable to use Jensen?s measure to evaluate a four-investment portfolio? Why or

why not?

On the basis of your analysis in questions a, c, and d, what, if any, recommendations might you offer the

Stalchecks relative to the revision of their portfolio? Explain your recommendations.

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This question was answered on: Feb 21, 2020

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