Personal Finance Define Which Stage

Personal Finance

Define which stage of the live-cycle are Jay and Rebecca in today. What important financial planning issues characterize this stage?

According to Modigliani and Brumberg (1954) there are six potential stages that an individual or couple may experience: Individual supported by parents, young single, young couple- no children, couple or individual with children, empty nesters, and retired (Personal Finance. N.D.P.1). Based on the data presented Jay and Rebecca fall into the couple or individual with children category which is characterized by: income approximately equal to expenditures, potential upgrade of house, purchase children's toys, clothing, and supplies, purchase life insurance, college tuition expenses, and debt management (Personal Finance. N.D.P.1). Financial planning should consist of saving for retirement, investing, securing adequate insurance coverage, saving for child's tuition, and estate planning.

Construct the Balance Sheet and Income Statement for the Bennett's (information is presented both as background and as listed Assets, Debt and Expenses in the table). Do Jay and Rebecca have a positive or negative net worth?

Assets: Cash-Checking $6,700

Savings in Securities $26,500

Life Insurance Cash Value $1,700

Vehicles #1, #2 $20,300

Personal Property $17,000

Total Assets $72,200

Liabilities: Car Loan #1 $7,500

Student Loan $10,500

Furniture Loan $4,600

Credit Card $2,000

Total Liabilities $24,600

Net Worth $47,600

Income Statement

Revenues Salaries $107,000 Annual- $8,916.67 Monthly

Expenses- Annual $74,610 -- Monthly $4,250.83

Debt Expense- $1,145

Rent $1,500

Life Insurance $54.17

3. Using information from the Balance Sheet and Income Statement calculate:

Current ratio- Current (liquid) Assets / Current Liabilities

33,200 (cash, savings, and investments) / 24,600 (current debts paid on= 1.35

Monthly living expense covered ratio- Current Assets / Monthly Living

Expenses: $33,200/$6,950 (all monthly expenses from data provided)=4.78

Debt Ratio- Total Liabilities / Total Assets

$24,600 / $72,200= .34

Long-term debt coverage ratio- Monthly Living Expenses / Monthly Debt Payments

$6,950 / $1,145= 6.07

Savings ratio- Total Savings / Net Income

33,200/$83,400= 40%

4. Use the information provided by the ratios and recommended ratio limits from the textbook to assess the Bennett's financial health.

The current ratio of 1.35 is below the recommended value of 2. "It is also important to track the trend of this ratio; an upward trend is recommended" (Pocket Financial Planner. N.D.P.1.). The value is above 1 however, which is satisfactory.

The monthly living expense covered ratio referred to "as the emergency fund ratio should ideally be between 3 and 6 depending on the volatility of your job" (Pocket Financial Planner. N.D.P.1.). Jay and Rebecca have a 4.78 ration which again is satisfactory.

A debt ratio "above 1 means a negative net worth; the closer the ratio is to zero, the better. When the ratio hits zero, you are debt free" (Pocket Financial Planner. N.D.P.1.). The .34 ratio suggests that the debt load is manageable and not overwhelming.

"The long-term debt coverage ratio tells you how many times over you could pay debt obligations-based your monthly living expenses. A higher ratio indicates that you could cover debt payments for a longer period of time if you had a loss of income" (Pocket Financial Planner. N.D.P.1.). The 6.07 ratio for Jay and Rebecca is quite solid and indicates financial health.

For the savings ratio "good rule of thumb is to keep these ratios above 10%

and preferably above 15%. The higher the ratio the better" (Pocket

Financial Planner. N.D.P.1.).. Jay and Rebecca

at 40% have a healthy ratio.

5. Do they have an emergency fund? How much would you recommend that they have in it?

Currently, Jay and Rebecca have no emergency fund however; they could easily allocate $1,000 for that purpose. A recommended emergency fun consists of a "cash reserve which is as liquid as possible (a high-yield online savings account is just about perfect) and should contain at least $1,000 (at first) and eventually six to twelve months of your household's take-home salary (eventually)" (the Simple Dollar. January 3, 2007. P.1.)

6. Recall that the Bennett's already have a house savings fund for a future down payment (FMV of $23,000). How much will this house-savings fund be worth in 3, 5, and 10 years assuming an annual growth rate of 5%. How much will the fund be worth if they could achieve a 10% nominal rate of return for the same 3, 5 and 10 years?

At 5%

At 10%

3

$26,642.80

3

$30,613

5

$29,354.90

5

$37,041.50

10

$37,464.70

10

$59,655.10

7. How much will Jay and Rebecca have to save at the beginning of each year to accumulate $50,000 for Emily to attend university if they can earn 9% per annum, assuming she enrolls at the age of 19? If the Bennett's had to accumulate $100,000 to fund Emily's educational expenses, how much would they need to save at the beginning of each year, assuming the same rate of return? If they could earn 12% per year on their investments, how much would they need to save at the end of each year to meet the $100,000 target?

Assuming Emily just turned 3 the Bennett's would have 16 years to save $50,000. According to the future value of an annuity due formula; $1,390.05 per year. To save $100,000 earning 9% the couple would need to save $2,780.09. To save $100,000 at 12% with investment at the end of each period the future value of an ordinary annuity provides a value of $2,339.18 each year.

8. Assuming an 8% return for the current year from Jay's ETF, and a 33% marginal tax rate, how much will the Bennett's pay in taxes on their investment, either from their savings or current income this year? By how much, after taxes will their account grow this year?

$3,500* 1.08=$3,780. Gain = $2,780*.33= $917.40 taxes. $2,780- $917.40= $1,862.60 in after tax gain.

9. Calculate the amount of CPP and EI taxes withheld from Jay's and Rebecca's pay based on their current income? Total taxes annually $23,600 equals $1,966.67 monthly withheld

PART II: Cash Management

10. Jay has been on the Internet researching various investment alternatives. He has learned about T-bills and is wondering if they are an appropriate vehicle to put Bennett's savings for a house? Treasury or T-bills are short-term investments issued by national governments. "Government of Canada Treasury Bills offer attractive interest rates and are fully guaranteed by the federal government. They are available for terms of one month to one year and are essentially risk-free if held to maturity" (Canada Trust. T-Bills. N.D.P.1.). The safety of this investment would be ideal for Jay and Rebecca's house fund, although the rate of 1.32% on a one year bill does not offer a stellar return.

11. He also read about Canada Saving Bonds. How appropriate are these bonds as a saving vehicle for the same purposes? From a safety perspective these bonds offer a similar advantage to T-bills however, the rate of .65 does not offer a quality return (Government of Canda. N.D.P.1).

12. What recommendation would you give to the Bennett's with respect to their down-payment savings: hold as is or change? What investment vehicle would you recommend? For house savings I would recommend the t-bill approach or perhaps a money market account which pays a higher rate and would offer a safe and guaranteed return on investment. The key point is that this money cannot be placed at risk of loss of principal.

13. Bennett's have heard about "pay yourself first" concept. Rebecca is not sure how to do this. Give her advice about the ways to automate her savings. The "pay yourself first" concept simply means allocating income to savings prior to paying out other expenses. The simplest method to do this is a transfer of 1- 20% of paycheck income to a designated savings account. Jay and Rebecca have disposable income of $6,950 monthly and from this amount $695.00 should be automatically transferred to a separate account. The account can be a traditional savings account or perhaps an investment account. An alternative to this approach would be to save through a Canadian "registered Retirement Savings Plan (RSP) an investment account designed primarily for saving toward your retirement years" (Canada Trust. RSP. N.D.P.1).

14. The family's total monthly real disposable income (after taxes) is approximately $6,950/mth. Calculate Bennett's current monthly debt payments. Calculate and interpret their debt limit ratio.

Monthly bills:

Car Pmt $485

Student Loan $150

Furniture Loan $260

Credit Card $250

$1,145 monthly debt

Debt to Income Ratio = $1,145/$6,950= 16%

15. If they would like to replace their Vehicle#2 and take on another car loan of $600/month, what would their revised debt limit ratio be? What advice would you give to Jay and Rebecca (to buy or not to buy)? The revised debt to income ratio with the new car payment would be 25%: $1,745/$6,950. One of the largest credit card companies MasterCard recommends "non-mortgage debt payments above 20% of your income indicate that steps may be needed to pay down debt. Non-mortgage debt payments over 20% exceed your net income borrowing limit" (MasterCard. N.D.P.1.). Based on this figure I would not recommend the vehicle purchase.

16. Help Rebecca and Jay apply four steps of the smart buying process to decide whether to replace Vehicle #2. What sources of consumer information might be useful to them? According to Auto Channel the four steps are: Determine your practical needs for a new vehicle, determine your budget and stick to it, determine your emotional needs, which car or truck really makes you happy when you drive it, and test drive, test drive, test drive, test drive (Gordon, B.N.D.P.1.). Resources which may be useful include: Consumer Reports, Edmunds, Kelly Blue Book, and Kiplinger's

17. Calculate the Bennett's gross monthly income and monthly debt repayments. What is the maximum mortgage amount for which Rebecca and Jay could qualify? Gross monthly income is $107,000 / 12= $8,916.67

Monthly debt payments are $1,145. There are two ratios to be calculated here the front end ratio and back end ratio. The front end ratio indicates "your monthly mortgage payment, including principal, interest, real estate taxes and homeowners insurance, should not exceed 28% of your gross monthly income" (BankRate.com. N.D.P.1.). In this case the front end ratio yields a value of $2,496.67. The back end ratio "shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees. In general, your total monthly debt obligation should not exceed 36% of your gross income" (BankRate.com. N.D.P.1.). In this case the back end ratio yields a value of $3,210. Based on these values and using a mortgage calculator, Jay and Rebecca can purchase a home up to $274,926 with 20% down (Key Bank. N.D.P.1.)

18. How has Rebecca's student loan affected her creditworthiness in applying for a mortgage? What is the relationship between GDS and consumer credit when calculating the 36-percent qualification rule? As above the Back end ratio or gross debt serve ratio is 36% of gross income which yields a value of $3,210 for Jay and Rebecca. This means their house expenses and debt load cannot exceed $3,210. The student loan payment is used in the calculation because she is paying on it. If she was in school and graduating more than 12 months out the payment would not be figured in.

19. Rebecca would like to consider a 15-year mortgage so that the house would be paid for before Emily enters university. Explain how the factors of monthly payment, total interest paid, and time value of money impact this decision. A fifteen year mortgage increases the monthly payment amount on the mortgage however; the total interest paid is cut dramatically. From a time value of money perspective the shorter mortgage is not advantageous because a dollar today is worth more than a dollar tomorrow. As such a fixed monthly payment will over 30 years be considerably less in terms of the future income available to make the payment.

20. Please provide your recommendation to Rebecca and Jay with respect to their life insurance. Is Jay's their current insurance satisfactory? If not, what changes would you recommend? Jay has a whole life insurance policy because he has cash value of $1,700. Based on quote information available, a monthly payment of $54.17 which Jay currently makes places the policy at approximately $100,000. Based on their current circumstances which include a child and the possibility of purchasing a home, the recommendation would be for a policy of at least $250,000. It also makes more sense to purchase a term policy which will allow for lower payments and higher coverage.

PART III: Investments

21. Based on the Bennett's stage in the lifecycle, what type of investment asset allocation would be appropriate, assuming they want to establish a retirement savings fund? What types of stocks should they consider for the equity portion of their asset allocation? What type of bonds would be appropriate for the fixed income portion of their portfolio? (List the bond maturity, rating and type of issuer). Please provide your asset allocation recommendation (use of charts and tables is recommended). As a couple that is relatively young and has time to save for retirement they can afford to have more of their investments in equities. The most simple investment option is the use of mutual funds or index funds. A mutual fund "is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund" (Investopedia- Mutual fund. N.D.P.1.). An index fund is "a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover" (Investopedia- Index Funds. N.D.P.1.). Choosing specific stocks can be time consuming and may not adequately diversify a portfolio. Jay and Rebecca should consider being more aggressive though in their portfolio which could follow this program. "The old rule of thumb used to be that you should subtract your age from 100 - and that's the percentage of your portfolio that you should keep in stocks. For example, if you're 30, you should keep 70% of your portfolio in stocks. If you're 70, you should keep 30% of your portfolio in stocks" (CNNMoney.com. N.D.P.1.). The Bennett's should have 70% investment in equities. Their fixed income portfolio could also be a bond fund such as PIMCO Total Return which invests in a mix of corporate, treasury, municipal and foreign bonds. These bonds are typically rated AAA and AA.

(Carther, S.N.D.P.1)

22. What investment risks should be of primary concern to the Bennett's when choosing a savings or investment account for their emergency fund? What account would be most appropriate? Why? Loss of principal is the primary concern for the emergency fund. The account should be parked in a safe investment such as CD or high yield money market account to ensure security of principal.

23. Rebecca's parents recently gave the Bennett's $25,000 to start education fund for Emily. An investment advisor has recommended that they include a 10-year corporate bond in the education saving fund. The bond currently yields 6.75% per year and sells for $1,000. If interest rates increase by 2 percentage points and the bond is sold, how much will the bond sell for at that time? Calculate the bond price if rates fall 1%. What investing rule has this proved? If the rate increases to 8.75% the bond would be sold for $867. If rates fell by 1% the bond would sell for $1,076. This investment rule indicates that interest rates and bond values move in the opposite direction. An investor must be concerned not only with return but also valuation of the bond.

24. The same advisor who recommended a bond for Emily's education fund also recommended to include a preferred stock paying a $5 annual dividend, currently selling for $53/share. If the Bennett's required rate of return is 10%, how much should the preferred stock sell for? The stock based on a $100 par value should sell at $50 (Business Finance Online. N.D.P.1.).

where

Pp = the preferred stock price,

Dp = the preferred dividend, and r = the required return on the stock

25. The Bennett's, in the 33% marginal tax bracket, are concerned about the taxes paid on investment earnings. Show the calculations to answer the following questions:

a. A money market mutual fund is currently yielding 1.5%. Should Jay and Rebecca move their savings into this fund or keep their money in a savings account at the bank paying 1%. "Equivalent taxable yield is calculated by dividing the available tax-exempt yield by one minus the investor's marginal tax rate" (Investor Glossary. N.D.P.1.). In this case .015/.67= 2% required return to make up for taxes so the Bennett's should not move their money.

b. A Government of Canada bond is currently yielding 4.2%. What is the minimum yield that the Bennett's must receive in order to obtain an equivalent return on a pure equity mutual fund with about 75% of its returns in capital gains and 25% in dividends from Canadian companies?

"Equivalent taxable yield is calculated by dividing the available tax-exempt yield by one minus the investor's marginal tax rate" (Investor Glossary. N.D.P.1.). In this case the required return would be .042 / .67= 6.0%

PART IV: Life cycle planning

26. Jay and Rebecca plan to retire in 35 years. They estimate their living expenses at approximately $60,000/year after taxes when they retire.

a. How much before-tax income will they need to retire on, assuming an average tax rate of 19% during their retirement? The couple will need approximately $74,000 in pre-tax annual income.

b. Assume that through a combination of savings, government benefits and pension distributions Jay and Rebecca can earn $50,000 annually in retirement. Determine their retirement income shortfall. Assuming a 3% long-term inflation rate and 35 years until retirement, calculate their inflation-adjusted shortfall. The shortfall is $10,000 a year. The inflation adjusted shortfall $10,000 * Future value of a single amount 35 -- %= $10,000* 2.8139= $28,139