for Lady Taylor PhD<\/p>\n
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Case Problem\u00a04.1\u00a0Coates\u2019s Decision<\/span><\/strong><\/p>\n 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\u2019t 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.<\/span><\/p>\n 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 \u2212 $1,050) invested for the full 10 yeas in a savings account paying 3% interest compounded annually.<\/span><\/p>\n 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.<\/span><\/p>\n \u00a0<\/span><\/p>\n Questions<\/span><\/p>\n Case Problem\u00a04.2\u00a0The Risk-Return Tradeoff: Molly O\u2019Rourke\u2019s Stock Purchase Decision<\/span><\/strong><\/p>\n Over the past 10 years, Molly O\u2019Rourke 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.<\/span><\/p>\n Molly is at present considering the addition of 50 shares of either of two common stock issues\u2014X 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\u20132016). Molly\u2019s 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.<\/span><\/p>\n \u00a0<\/span><\/p>\n Questions<\/span><\/p>\n 1.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>LG<\/span><\/span>\u00a0<\/span><\/span>5<\/span><\/span><\/p>\n 2.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>LG<\/span><\/span>\u00a0<\/span><\/span>6<\/span><\/span><\/p>\n Walt Davies and Shane O\u2019Brien are district managers for Lee, Inc. Over the years, as they moved through the firm\u2019s 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.<\/span><\/p>\n 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.<\/span><\/p>\n Shane totally disagreed. He said, \u201cDiversification! Who needs it?\u201d He thought that what one must do is look carefully at stocks possessing desired risk-return characteristics and then invest all one\u2019s money in the single best stock. Walt told him he was crazy. He said, \u201cThere is no way to measure risk conveniently\u2014you\u2019re just gambling.\u201d 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.<\/span><\/p>\n The conversation continued, with Walt indicating that although he knew nothing about beta, he didn\u2019t 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, \u201cWhat\u2019s 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.\u201d<\/span><\/p>\n 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\u2019s 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, \u201cI 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\u2019s views are more supportive of modern portfolio theory.\u201d 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.<\/span><\/p>\n a.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>Analyze Walt\u2019s 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.<\/span><\/p>\n b.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>Analyze Shane\u2019s 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.<\/span><\/p>\n c.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>Briefly describe the traditional approach to portfolio management and relate it to the approaches supported by Walt and Shane.<\/span><\/p>\n d.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>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.<\/span><\/p>\n e.\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/span>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\u2019s and Shane\u2019s differing points of view.<\/span><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n Case Problem\u00a05.2\u00a0Susan Lussier\u2019s Inherited Portfolio: Does It Meet Her Needs?<\/span><\/strong><\/p>\n 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\u2019s drilling activities. An expert on oil and gas taxation, she is not worried about job security\u2014she 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.<\/span><\/p>\n A month ago, Susan\u2019s 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\u2019s 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.<\/span><\/p>\n Susan\u2019s father\u2019s 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\u2014probably 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.<\/span><\/p>\n \u00a0<\/span><\/p>\n \u00a0<\/span><\/p>\n 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\u2019 commissions associated with making portfolio adjustments.<\/span><\/p>\n Questions<\/span><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n \u00a0<\/span><\/strong><\/p>\n Case Problem\u00a013.1 Assessing the Stalchecks\u2019s Portfolio Performance<\/span><\/strong><\/p>\n\n
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Case Problem<\/span><\/span>\u00a0<\/span><\/span>2.1<\/span><\/span>\u00a0<\/span><\/span>Traditional Versus Modern Portfolio Theory: Who\u2019s Right?<\/span><\/h2>\n
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