CPCU 556 Week 3 homework answers

CPCU 556 Personal Financial Planning - Part 3 Investments & Investment Planning Key Terms

Basic Investment Objective Definition: earn the maximum possible total, after-tax rate of return on the funds available for investment, consistent with the person’s investment objectives and the investment limitations or constraints under which he or she must operate

Factors in Choice of Investment (10) 1 Security of principal and income, 2 Rate of return (yield), 3 Marketability and liquidity, 4 Diversification, 5 Tax status, 6 Size of investment unit or denominations, 7 Use as collateral for loans, 8 Protection against creditor’s claims, 9 Callability, 10 Freedom from care

Financial Risk Risk issuers of investments may run into financial difficulties. E.g. Bonds where issuer defaults on interest payments/principal. Common stocks where corporation will reduce or eliminate dividend payments or go bankrupt

Market Risk Risk arising from price fluctuations for a whole securities market, for an industrial group, or for an individual security—regardless of the financial ability of a particular issuer to pay promised investment returns or stay solvent. E.g. investor market timing, market expectations out of line with reality

Interest Rate Risk (3) Price changes of existing investments because of changes in the general level of interest rates in capital markets--Inverse movement that causes selling at a discount. Rate Shock Analysis (high quality bonds) can help investor determine possible fluctuation over life of bond

1 Interest Rate Risk to income from investments (bonds & preferred stock)

2 Short-Maturity Risk for securities that mature in low interest rate period.

3 Redemption or Call Risk (preferred stock &

Donna M. Kesot, CPCU April 1, 2012


callable bonds). Issuers can pay them off before maturity.

One protection for these 3 risks is to buy longer term bonds or securities with full or partial call protection and laddering diversification.

Purchasing Power Risk When prices rise, purchasing power decreases. Some diversification includes inflation hedge investments but investment goal is to obtain best after-tax total investment return possible, consistent with other objectives.

Currency Risk When investing in international securities, the value of the foreign currency can fluctuate.

Rates of Return (include the 4 equations) Nominal Yield = annual interest or dividends/investment’s par or face value

Current Yield = annual investment income/investment’s current price or value

Yield to maturity for bond selling at a discount = (annual coupon interest + (discount/number of years to maturity))/((current market price of bond + par value)/2)

Yield to maturity for bond selling at a premium = (Annual coupon interest –(premium/number of years to maturity))/((current market price of bond/par value)/2)

Capital Gains Advantages (5) 1 Capital gains are not taxed until realized

2 Estate/heirs will get a stepped-up income tax basis in the property equal to value at time of investor death

3 can periodically sell (at capital gains tax rate) a portion of appreciated property to produce same result as a stream of interste or dividend income, selecting best investmenet assets for both investment and tax considerations

4 income tax is lower on capital gains than



ordinary income (top rate 18-20%)

5 Numerous planning techniques to avoid capital gains tax, defer taxation, or stretch out a gain

Capital Gain Limitations (3) 1 inherently uncertain

2 capital gains lock-in problem for highly appreciated assets

3 investing for capital gains places greater emphasis on investment skills (using experience, average annual compound rate of gain, rule of 72, etc.)

Rule of 72 Average annual rate of gain = Average annual compound rate of capital gain = (72/number of years it takes an investment to double in value)

Average Annual Compound (geometric) Rate of Total Return

The final value of asset or asset group includes initial value and annual cash flows (dividends, rents, etc.) during the period.

Unless the yearly total returns are exactly the same, the geometric average annual rate of return will be less than the arithmetic average annual rate of return

After Tax Yield After tax yield = yield rate *(1 - tax bracket rate)

Taxable Equivalent Yield Taxable Equivalent Yield on tax exempt asset = Asset yield/(1 - investor’s highest marginal income tax rate).

After Tax Total Return Must consider whether capital gains (or losses) are partly ordinary income and partly capital gains

3 methods of diversification Diversification = mixing types of investment media, e.g. common stocks, bonds, CDs, money market funds, preferred stocks/bonds, etc., life insurance and annuities, real estate, & other tax shelters

1. Investments made through financial institutions



that diversify their investments

2. Purchase one or more securities/units periodically over a long period of time (dollar averaging)

3. Investor follows own diversification strategy



5 Measures of value for common stocks Earnings per Share

Price–Earnings Ratio

Net Asset Value (book value) per Share

Liquidated Value per Share

Yields

Dollar Cost Averaging The investment of a certain sum of money, at regular intervals, in the same stock or stocks or the same investment intermediary.

Margin Accounts Allows investors to put up some of their own money and borrow the remainder. The (initial) minimum down is set by the Fed.

Selling Short Selling securities that the investor either 1. does not possess, and therefore must borrow to settle the account; or 2. does possess, but does not wish to deliver.

Taxpayer Relief Act (1997) generally eliminated selling short-against-the box, except limited circumstances.

SIPC Securities Investor Protection Corporation, an outcome of 1970 Securities Investor Protection Act to provide funds to protect customers of an SIPC member firm if the firm becomes insolvent and is liquidated (generally fully paid securities “specifically identified” as belonging to the investor.

Types of Stocks Growth Stocks, Income Stocks, Defensive Stocks, Cyclical Stocks, Blue-Chip Stocks, Speculative Stocks (is FB a speculative stock?), Small and Midsize Company Stocks (small cap), Special Situation Stocks (e.g. new processes, product, resource, invention, etc.), Foreign Stocks

Defensive Stocks Stable and comparatively safe stocks such as utilities and food whose utility is not eliminated by



recession.

Name 4 theories of common stock investment 1. Growth Theory2. Value Investing3. Moderating Growing Industries & Income

Approach4. Depressed-Industry Approach

Degree of Risk Degree of risk = dispersion of individual yearly returns around the average return.

The larger the standard deviation, the greater the volatility. Risk is determined by the standard deviation of the arithmetic returns for the periods indicated.

Alpha = measure of an investment’s return not associated with overall market changes

Beta = price movement relative to overall market index, e.g. is it trending with the market? The higher the beta, the higher the volatility.

Bear Market A reasonably long period of time during which common stocks in general consistently decline by a significant amount (20% or more).



Operating Rate of Return Operating Rate of Return = (net operating income from property before interest and depreciation) / (purchase price for property)

Net Operating Income Net Operating Income (NOI) = annual rent or revenue – property tax and other expenses*

*other expenses do not include interest, depreciation, and income tax

Disadvantages of real estate as an investment (4) Lack of marketability Need for large initial investment Real estate cycles and leverage High risk level

Advantages of real estate as an investment (6) 1. Attractive Total ROE2. Availability of Substantial Financial

Leverage3. Favorable Cash Flow4. Hedge Against Inflation5. Tax Advantages6. Control & Pride of Ownership

Real Estate Investment Trusts (REITs)

A corporation or trust that meets the legal definition of the tax law for REITs primarily investing in real estate.

Offers advantages of centralized mgmt., limited liability, continuity of interests, and transferability of ownership.

Real Estate Classifications (4) Unimproved land Improved real estate held for rental*β Mortgages Vacation and second homes

*certified historic structures receive special tax treatment

Β Includes new & used residential property, low income housing, old buildings and certified historic



structures, other income producing real estates like office buildings, shopping centers, warehouses, hotels/motels, industrial/commercial properties.

Like-Kind Exchanges (AKA Section 1031) Tax deferred real estate exchanges of similar property

no realized capital gain income tax basis of property exchanged

carries over may incude a boot

*boot = cash/personal property received in addition to like-kind real estate

Passive Activity A tax favored treatment for:

1. a trade or business in which the taxpayer does not materially participate on a regular, continuous, and substantial basis; or

2. an activity primarily involving the rental of real estate whether the tax payer materially participates or not

IPOs Initial public offerings

Par Maturity value

Oil & Gas Ventures IDC = intangible drilling costs

Up to 80%--90% of initial cost of a productive well

Can be deducted against other income when “working interest”

Depletion allowance is also deductible

Put & Call Put = Trading in options to buy or sell common stock



Should be for cash Should be on stock or asset that the buy

wants in the portfolio

Call = option allowing purchase of stock or asset at set price (the exercise or strike price)

Should be only on securities owned by the seller (not naked call options)

Buying Options Speculative option for purchase of stock where a premium is paid for the stock speculating that it will fluctuate up or down

Futures Contract Agreement to buy/sell a commodity at a price stated in the agreement on a specified future date

Fixed Income Investments Corporate Bonds

Municipal bonds

Marketable US government obligations

US Savings Bonds

US government agency securities

Zero-coupon bonds (corporate, muni, & US gov.)

Certificates of Deposit

Guaranteed investment Contracts (GICs)

Liquid assets (cash equivelents)

Preferred stock

Zero-coupon bonds Original Issue Discount Bonds (OID)

Bonds originally issued below par and which pay no interest

Bonds Purchased at Premium Bonds purchased in the open market for more than par are bought for a premium. The bond cannot be redeemed above par. This purchase is for the income stream on interest


Economy & Finance

CPCU 556 Week 3 homework answers