Case Problem 10.1 Max and Veronica Develop a Bond Investment Program

/0 Comments/in /by

Case Problem 10.1 Max and Veronica Develop a Bond Investment Program

Max and Veronica Shuman, along with their teenage sons, Terry and Thomas, live in Portland, Oregon. Max is a sales rep for a major medical firm, and Veronica is a personnel officer at a local bank. Together they earn an annual income of around $100,000. Max has just learned that his recently departed rich uncle has named him in his will to the tune of some $250,000 after taxes. Needless to say, the family is elated. Max intends to spend $50,000 of his inheritance on a number of long-overdue family items (like some badly needed remodeling of their kitchen and family room, the down payment on a new Porsche Boxster, and braces to correct Tom’s overbite). Max wants to invest the remaining $200,000 in various types of fixed-income securities.

Max and Veronica have no unusual income requirements or health problems. Their only investment objectives are that they want to achieve some capital appreciation, and they want to keep their funds fully invested for at least 20 years. They would rather not have to rely on their investments as a source of current income but want to maintain some liquidity in their portfolio just in case.

Questions

a. Describe the type of bond investment program you think the Shuman family should follow. In answering this question, give appropriate consideration to both return and risk factors.

b. List several types of bonds that you would recommend for their portfolio and briefly indicate why you would recommend each.

c. Using a recent issue of the Wall Street Journal, Barron’s, or an online source, construct a $200,000 bond portfolio for the Shuman family. Use real securities and select any bonds (or notes) you like, given the following ground rules:

1. The portfolio must include at least one Treasury, one agency, and one corporate bond; also, in total, the portfolio must hold at least five but no more than eight bonds or notes.

2. No more than 5% of the portfolio can be in short-term U.S. Treasury bills (but note that if you hold a T-bill, that limits your selections to just seven other notes/bonds).

3. Ignore all transaction costs (i.e., invest the full $200,000) and assume all securities have par values of $1,000 (although they can be trading in the market at something other than par).

4. Use the latest available quotes to determine how many bonds/notes/bills you can buy.

d. Prepare a schedule listing all the securities in your recommended portfolio. Use a form like the one shown below and include the information it calls for on each security in the portfolio.

e. In one brief paragraph, note the key investment attributes of your recommended portfolio and the investment objectives you hope to achieve with it.

Security Latest Quoted Price Number of Bonds Purchased Amount Invested Annual Coupon Income Current Yield
Issuer-Coupon-Maturity
Example: U.S. Treas – 8½%-’18 1468/32 15 $21,937.50 $1,275 5.81%
1.
2.
3.
4.
5.
6.
7.
8.
Totals —   $200,000.00 $ %

Bond: Bond are almost similar to stocks. Just like stocks, bonds also provide regular incomes

and capital gains to the investors. But on comparison with stocks, one can say that bonds are

less risky and provide high current Income.

(a)

Risk: Risk is nothing but the possibility that an actual outcome of an action varies from expected

outcome.

Return: Return is the compensation for baring risk and forgoing alternative investments

opportunities.

There is a direct relationship between Risk and Return. The more risk an investor under takes,

the more return he would expect. Say for example, An investor may be satisfied with less return

on a portfolio ranging from 1 year to 2 year gestation period but the same investor expect more

return if the gestation period is more than 10 years. This is because, Risk increases along with

the gestation period.

The only way in which an investor can reduce his risk is, by diversifying it. Say, if a portfolio

consist shares of 10 different countries, then even if one company underperforms such a loss

can be compensated with the better performance of other companies.

So, Shuman’s Family must follow a long Term, highly diversified and high return portfolio with an

investment objective of Capital appreciation, without obstructing the Ground rule of liquidity.

(b)

The following bonds fit the bid and suitable to the requirements:

(1) Treasury Bonds: The maturity period of these bonds lies between 2 to 3 years. By their

basic nature these bonds are marked as “full faith and credit” by U.S government. Such a

marking makes the bond very liquid in domestic and foreign market.

These bonds are very helpful for the investors who are concerned about the liquidity of the bonds

and risk averse.

Check list to match the requirement:

Whether suitable for long term investments? Yes.
Whether liquid in nature? Yes.
Scope for capital appreciation? Varies.
Repayment guarantee? Yes.
Tax advantage (with respect to periodic payments)? No

(2) Zero Coupon Bonds: These bonds do not fetch periodic regular income but they fetch

capital gain. These bonds are issued at Discount and redeemed at par value or premiun.

The advantage of these kinds of bonds is, once the investor makes up his mind regarding capital

investment in zero coupon bonds, he need not worry about reinvestment of periodic returns till

the maturity period.

(2) Zero Coupon Bonds: These bonds do not fetch periodic regular income but they fetch

capital gain. These bonds are issued at Discount and redeemed at par value or premiun.

The advantage of these kinds of bonds is, once the investor makes up his mind regarding capital

investment in zero coupon bonds, he need not worry about reinvestment of periodic returns till

the maturity period.

Check list to match the requirement:

Whether suitable for long term investments? Yes.
Whether liquid in nature? Yes.
Scope for capital appreciation? Yes.
Repayment guarantee? Yes.
Tax advantage (with respect to periodic payments)? No.

Note: Even though there is no actual interest income, Bond holders are liable to pay tax based on

Concept of ‘accrual Income’.

(3) Municipal Bonds: These bonds are generally issues by the state governments, local

authorities and political sub divisions. The peculiar feature of these bonds is that, a person other

than issuer undertakes to pay the bond holder in case of default on the part of issuer with respcet

to both the ‘periodic income’ and ‘capital appreciation’.

Check list to match the requirement:

Whether suitable for long term investments? depends
Whether liquid in nature? Yes.
Scope for capital appreciation? Very less
Repayment guarantee? Yes.
Tax advantage (with respect to periodic payments)? Yes.

(4) Agency Bond: They are similar to treasury bonds. These Bonds are issued by organisations

and agencies of US government. The main difference between Treasury bonds and Agency

bonds is that, US treasury do not accept the obligation of Agency Bonds. The peculiar feature of

these bonds is that, the holders do not physically possess the ownership certificate.

Check list to match the requirement:

Whether suitable for long term investments? depends
Whether liquid in nature? Comparatively less.
Scope for capital appreciation? Yes.
Repayment guarantee? No.
Tax advantage (with respect to periodic payments)? No.

The following types of bonds are not suitable due to the following reasons:

Name of

the Bond:

 Reasons:
Mortgaged

Backed

Securities.

 By the very nature of these securities, investors receive part of capital investment

in the form of periodic returns. It would tend to capital appropriation rather than

capital appreciation.

Hence not suitable for Shumans family.
Asset

Backed

Securities.

 These securities’ are useful for short-term investments only. The maturity period

generally falls below 5 years.

Hence not suitable for Shumans family.
Corporate

Bonds.

 Maturity period ranges between 25 to 40 years.

Hence not suitable for Shumans family.

Conclusion: Out of all different types of the above mentioned bonds, Zero Coupon Bonds best

serve the requirements of Shuman family on the following counts.

Requirements of Shumans family Feature of zero Coupon

Bond
Shumans family is not expecting regular income but capital

appreciation

 Pay nothing till issue matures
Shumans family is concerned about Liquidity Highly liquid
Shumans family is planning to invest for 20 long years Suitable for long term

investments.

(c)

We can construct profolio with given $200,000 in the following manner.

Security: Investments:

10%Treasury bond -$13,800

Agency bond -$25100

Corporate bond -$11500

Municipal Bond -$37200

Zero Coupon Bonds -$112400

Total -$200000

(d)

Compute annual coupon income for 10% treasury bonds:

=Par value*Number of shares purchased*Coupoun rate

=$1000*10*10%

=$1000*10*0.1

=$1000

Follow the same methodology for all remaining bonds.

Security Price

per lot.

 Assume, each lot

consists 100 units.

 Always on

Market Price.

 Always on Par

Value of 1000$

 income/price
Latest

Price

($)

 Number of Bonds

Purchased.

($)

 Amount

Invested.

($)

 Annual Coupon

Income

($)

 Current

Yield.

(%)
10%Treasury

bond

 1,380.00 10 13,800 1,000 0.72
Agency bond 1,255.00 20 25,100 2,000 1.59
Corporate

bond

 1,150.00 10 11,500 1,000 0.86
Municipal

Bond

 1,240.00 30 37,200 3,000 2.41
Zero Coupon

Bonds.

 802.85 140 112,400 NA 0.00
Total 200000 5.60

(e)

The main objective of the investment portfolio is “Capital Appreciation’. Capital appreciation is a

stated goal of all mutual funds and diversified portfolio. It is a rise in the asset value based on the

market price. An increase of a fund investment rising gradually based on the market price. The

capital appreciation is in the form of dividend and interest income etc.

1.       Explain why expected return is considered forward-looking. What challenges arise in using expected return?

/0 Comments/in /by

 

1.       Explain why expected return is considered forward-looking. What challenges arise in using expected return?

2.       Explain how differences in allocations between the risk-free security and the market portfolio can determine the level of market risk.

Use references to support your responses as needed. Be sure to cite all references using correct APA style. Your responses should be free of grammar and spelling errors, demonstrating strong written communication skills.

1.       Based on the probability and percentage of return for the three economic states in the table below, compute the expected return.

 

Economic State Probability Percentage of Return
Fast Growth 0.10 60
Slow Growth 0.50 30
Recession 0.40 -23

2.       If the risk-free rate is 7 percent and the risk premium is 4 percent, what is the required return?

3.       Suppose that the average annual return on the Standard and Poor’s 500 Index from 1969 to 2005 was 14.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk premium during these 10 years?

4.       Conglomco has a beta of 0.32. If the market return is expected to be 12 percent and the risk-free rate is 5 percent, what is Hastings’ required return? Use the capital asset pricing model (CAPM) to calculate Conglomco’s required return.

5.       Calculate the beta of a portfolio that includes the following stocks:

·         Conglomco stock, which has a beta of 3.9 and comprises 35 percent of the portfolio.

·         Supercorp stock, which has a beta of 1.7 and comprises 25 percent of the portfolio.

·         Megaorg stock, which has a beta of 0.3 and comprises 40 percent of the portfolio.

Assignment Content

/0 Comments/in /by

 

Assignment Content

  1. Resources: Gale Force Surfing , Berkshire Instruments KFC and the Colonel , and Harrod’s Sporting Goods
    *****FIND ATTACHED****
    Read the Case Study documents.

    Select a case study that resonates with you from a professional perspective.

    Post a 90- to 175-word discussion message sharing which case you chose and why it was chosen.

    Include at least one point from the case that stood out to you and why it did.

    Submit the assignment.

Question 1

/0 Comments/in /by

Question 1

Lockheed Martin has been approached by the Department of Defense to prepare a bid for

Starlight rocket launchers.

1. Use learning curve theory and prepare a cost bid for 15 Starlight rocket launchers given the following data for the prototype (i.e., the model). You must prepare a separate bid using (a) the cumulative average-time learning model, and (b) the individual unit-time learning model.

The prototype took 2,000 hours to produce and has the following cost information. The prototype can be sold as a part of the contract.

Direct materials $600,000

Direct labor (2,000 hours @ $200 per hour) $400,000 Variable direct manufacturing overhead (2,000 hours @ $100) $200,000 Other manufacturing overhead (20% of direct cost) $240,000

$1,440,000(i.e., 20% of direct materials, direct labor, and variable overhead)

Total Cost

In preparing each bid, integrate the learning curve into the bid by relying on the following historical data for the production of 16 Sky rocket launchers, which was the previous generation of the Starlight launchers.

Unit Number Labor Hours
1 3900
2 3650
3 3100
4 2750
5 2450
6 2475
7 2200
8 2100
9 2150
10 2100
11 1900
12 1850
13 1775
14 1800
15 1750
16 1700

2. Prepare another bid that has no learning. Comment on the difference. Discuss the implications of these results for the company with respect to its labor policy.

Continue to Q2….

Question 2 (Please use Excel Dataset labeled “Marks and Spencer International (MSI)_Final Exam Data” for this question)

MSI, a department store chain, is trying to upgrade its customer service in order to compete with a rival chain which has recently moved into its territory and has a very strong customer-service reputation. MSI management knows that customer service is currently high in some of its stores but low in others. On average, its current reputation for service is less than outstanding. In order to build support for better customer service throughout the chain, MSI management decides to analyze existing data to show how much more profitable its own high-service stores are than its low-service stores.

MSI has created a customer-service indicator which is composed of a combination of ratings from “mystery shoppers” and surveys of customers by an independent organization. The scale for this indicator ranges from 1 to 60, which is a continuous variable with higher numbers indicating higher quality. MSI also has data on a number of factors that are likely to influence store profits. These include store size, rural versus urban location, manager performance rating (1 to 5 scale, where 5 is high), per capita income in the surrounding region (low to high ranges, summarized on a 1 to 5 scale, where 5 is high), non-managerial employee skill index (a measurement the Human Resources department has created, which ranges from 1 to 20; high numbers are better) and age of the store (which implies how long it has been in operation).

Based on regression analysis, what can you tell MSI about customer service? For example:

a. How big an effect on profit does customer service have?

b. Does customer service have a bigger effect on profits in some portions of the customer- service range than others? That is does the effect of customer service on profit have diminishing or increasing returns?

c. Is the effect of customer service on profit similar for large versus small stores?

d. Is the effect of customer service on profit similar for urban versus rural stores?

e. What are the factors that influence the level of customer-service quality?

Continue to Q3….

Question 3

PART A

The RBC case describes two methods for computing the lifetime value of a customer. One method (Markov Chain and Transition matrices) takes into account the expected likelihood that a customer holding a particular product portfolio will migrate to another portfolio or leave the bank in the future.

Assume that RBC has only two products: Car Loan (CL) and Credit Card (CC). The annual profitability for each of the two products is (-$100) (i.e., $100 loss) for CL and +$1000 for CC.

RBC has made the following observation for customers in the 25-30 year segment:

· If they have a car loan at the end of a given year, the probability of also acquiring a credit card during the following year is 50%

· The probability of losing even this one product during the following year is 20%

· The probability that the customer retains only the car loan during the following year is 20%

· The probability that the customer drops the car loan but acquires a credit card during the following year is 10%

Similar observations can be made for individuals who begin the year with only a credit card, both products, or neither product. These observations are summarized in the following matrix of probabilities.

Probabilities for year t+1 product mix for all possible combinations of product mixes for year t.

Product mix in year t+1
Product mix in year t CL CC CL+CC None
CL 0.2 0.1 0.5 0.2
CC 0.1 0.5 0.2 0.2
CL+CC 0.1 0.1 0.7 0.1
None 0 0 0 1

Answer the following questions using a 8% discount rate:

a. Consider a customer who has only a credit card in year t. What is

i. The expected profit generated by this customer in year t+1?

ii. The present value of expected profits from this customer for both years combined?

b. Consider a customer who has both a car loan and credit card in time t. What is

i. The expected profit generated by this customer in year t+1?

ii. The present value of expected profits from this customer for both years combined?

c. Discuss how these results will be useful for you to design a market strategy. Be specific in your suggestions and provide concrete suggestions.

PART B

You are the manager of a bank. You need to decide whether to approve a 10-year loan application from a 25 year old student to finance her MBA. The loan will yield a loss of $250 per year to the bank for the duration of the loan. After 10 years, the student will likely buy other products and therefore she will yield a profit of $500 per year until she is 65. After age 65, she will yield a profit of $1,000 per year until she is 85, when she will stop being a customer. The likelihood that she stops being a customer after she repays her MBA loan is 2% each year. The discount rate that the bank uses is 7% per year.

Would you approve the loan? Please explain with numerical support.

Continue to Q4….

Question 4

We have discussed many cases in this course where we classify the type of data analytics problem as either descriptive, predictive, or prescriptive. For each type of data analytics (descriptive, predictive, prescriptive) select one case from the course and discuss why it belongs to the particular analytics category (thus, you will have three cases to select). Your discussion should (a) provide relevant case details from the cases chosen, (b) make use of the associated readings for the case, and (c) justification for the classification.

Part 1 (ONE): 

/0 Comments/in /by

Part 1 (ONE):

Please respond to the follow question.

• Why is a booming stock market not always a good thing for the economy?

*** 100-200 WORDS ***

Part 2 (TWO):

Respond to this classmate’s discussion below using 50+ words.

“A booming stock market refers to a bull market which is when there is an increase in commercial activity. This means that the economy is looking great right? GDP is up and the stocks are rising in price making investors happy. What happens when the stocks start reaching their plateau or the stocks reach their cap? The economy will eventually slow down and the stock market will drop as well. The stock market is kind of like a roller coaster. It goes up slowly or rapidly and it can just as easily come crashing down. The one thing that we do know is that no matter how steady and great the market looks, at some point, it will turn. The problem with that is we are never 100% certain when or how drastic these changes will occur. When stockholders start losing a bunch of money, this means investing is also at a loss. The whole economy then becomes affected like a domino effect.”

Part 1

/0 Comments/in /by

Part 1

INPUTS USED IN THE MODEL
P0 $50.00
Net Ppf $30.00
Dpf $3.30
D0 $2.10
g 7%
B-T rd 10%
Skye’s beta 0.83
Market risk premium, RPM 6.0%
Risk free rate, rRF 6.5%
Target capital structure from debt 45%
Target capital structure from preferred stock 5%
Target capital structure from common stock 50%
Tax rate 35%
Flotation cost for common 10%
a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock (including flotation costs), and the cost of equity (ignoring flotation costs). Use both the the CAPM method and the dividend growth approach to find the cost of equity.
Cost of debt:
B-T rd × (1 – T) = A-T rd
Cost of preferred stock (including flotation costs):
Dpf / Net Ppf = rpf
Cost of common equity, dividend growth approach (ignoring flotation costs):
D1 / P0 + g = rs
Cost of common equity, CAPM:
rRF + b × RPM = rs
IMPORTANT NOTE: HERE THE CAPM AND THE DIVIDEND GROWTH METHODS PRODUCE APPROXIMATELY THE SAME COST OF EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT FORCED THE SAME RESULT. ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS.
b. Calculate the cost of new stock using the dividend growth approach.
D0 × (1 + g) / P0 × (1 – F) + g = re
$2.25 $45.00
DII Labs: F is flotation cost.		 7% 11.99%
c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as determined by the dividend growth approach and add that differential to the CAPM value for rs.)
rs + Differential = re
Again, we would not normally find that the CAPM and dividend growth methods yield identical results.
d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the company’s WACC?
wd 45.0%
wpf 5.0%
ws 50.0%
100.0%
wd × A-T rd + wpf × rpf + ws × rs = WACC
e. Suppose Gao is evaluating three projects with the following characteristics:
(1) Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred
stock, and common equity. The cost of the common equity for each project should be based on the beta estimated for
the project. All equity will come from reinvested earnings.
(2) Equity invested in Project A would have a beta of 0.5. The project has an expected return of 9.0%.
(3) Equity invested in Project B would have a beta of 1.0. The project has an expected return of 10.0%.
(4) Equity invested in Project C would have a beta of 2.0. The project has an expected return of 11.0%.
Analyze the company’s situation and explain why each project should be accepted or rejected.
Beta rs rps rd(1 – T) WACC Expected return on project
Project A 0.5
Project B 1.0
Project C 2.0
The expected returns on Projects A and B both exceed their risk-adjusted WACCs, so they should be accepted. However, Project C’s WACC exceeds its expected rate of return, so it should be rejected.

Part 2

Gardial Fisheries is considering two mutually exclusive investments. The projects’ expected net cash flows are as follows:
Expected Net Cash Flows
Time Project A Project B
0 ($375) ($575)
1 ($300) $190
2 ($200) $190
3 ($100) $190
4 $600 $190
5 $600 $190
6 $926 $190
7 ($200) $0
a. If each project’s cost of capital is 12%, which project should be selected? If the cost of capital is 18%, what project is the proper choice?
@ 12% cost of capital @ 18% cost of capital
Use Excel’s NPV function as explained in this chapter’s Tool Kit. Note that the range does not include the costs, which are added separately.
WACC = 12% WACC = 18%
NPV A = DII Labs: Net Present Value of “A” discounted at a WACC of 12% NPV A =
DII Labs: Net Present Value of “A” discounted at a WACC of 18% NPV B = NPV B =
At a cost of capital of 12%, Project A should be selected. However, if the cost of capital rises to 18%, then the choice is reversed, and Project B should be accepted.
b. Construct NPV profiles for Projects A and B.
Before we can graph the NPV profiles for these projects, we must create a data table of project NPVs relative to differing costs of capital.
Project A Project B
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%
c. What is each project’s IRR?
We find the internal rate of return with Excel’s IRR function:
IRR A = Note in the graph above that the X-axis intercepts are equal to the two projects’ IRRs.
IRR B =
d. What is the crossover rate, and what is its significance?
Cash flow
Time differential
0
DII Labs: The difference in cash flows between Project “A” and Project “B”. 1
2 Crossover rate =
DII Labs: The IRR for the Cash Flow Differential 3
4 The crossover rate represents the cost of capital at which the two projects value, at a cost of capital of 13.14% is: have the same net present value. In this scenario, that common net present
5
6
7
e. What is each project’s MIRR at a cost of capital of 12%? At r = 18%? Hint: note that B is a 6-year project.
@ 12% cost of capital @ 18% cost of capital
MIRR A = DII Labs: Use Excel’s MIRR function MIRR A =
MIRR B = MIRR B =
f. What is the regular payback period for these two projects?
Project A
Time period 0 1 2 3 4 5 6 7
Cash flow (100) 600 600 926 (200) $0 $0 $0
Cumulative cash flow
Intermediate calculation for payback
Payback using intermediate calculations
Project B
Time period 0 1 2 3 4 5 6 7
Cash flow
Cumulative cash flow
Intermediate calculation for payback
Payback using intermediate calculations
Payback using PERCENTRANK Ok because cash flows follow normal pattern.
g. At a cost of capital of 12%, what is the discounted payback period for these two projects?
WACC = 12%
Project A
Time period 0 1 2 3 4 5 6 7
Cash flow
Disc. cash flow
Disc. cum. cash flow
Intermediate calculation for payback
Payback using intermediate calculations
Project B
Time period 0 1 2 3 4 5 6 7
Cash flow
Disc. cash flow
Disc. cum. cash flow
Intermediate calculation for payback
Payback using intermediate calculations
Discounted Payback using PERCENTRANK Ok because cash flows follow normal pattern.
h. What is the profitability index for each project if the cost of capital is 12%?
PV of future cash flows for A:
PI of A:
PV of future cash flows for B:
PI of B: