Abby Preston, a vice president for Spitzer Design, is a 42-year old widow who is a resident of the U.S. She has two children: a daughter, aged 21, and a son, aged 7. She has a $2,200,000 portfolio; half of the portfolio is invested in Spitzer Design, a publicly-traded common stock, which has a cost basis of $350,000. Despite a substantial drop in the value of her portfolio over the last two years, her long-term annual total returns have averaged 7 percent before tax. The recent drop in value has caused her great anxiety, and she believes that she could no longer tolerate an annual decline greater than 10 percent.

Preston intends to retire in 20 years, and her goals, in order of priority, over the next 20 years are:

• Funding the cost of her daughters upcoming final year of college, which has a present value of $18,000, and her sons future college costs, which have a present value of $91,000.
• Increasing the portfolio to a level that will fund her retirement living expenses, which she estimates to be $180,000 after tax for the first year of her retirement.
• Building a new home in five years, the cost of which (including land) has a present value of $375,000.
• Giving, if possible, each of her children $1,000,000 when they reach age 40.

After subtracting the present value (before tax) of her childrens education costs and her homebuilding costs, the present value of her portfolio is $1,509,000. With continued annual growth of 7 percent before tax, the portfolios value will be approximately $3,928,000 at the end of 20 years.

Prestons annual salary is $145,000, her annual living expenses are currently $100,000, and both are expected to increase at an inflation rate of 3 percent annually. Taxes on income and short-term capital gains (holding period of one year or less) are substantially higher than taxes on long-term capital gains (holding period greater than one year). For planning purposes, Preston wants to assume that all returns are fully taxable and that her average tax rate on all income and gains is 30 percent. The inflation and tax rates are expected to remain constant. Currently, Preston rents a townhouse, has no debt, and adamantly intends to remain debt-free. Spitzer Design has no pension plan, but provides company-paid medical insurance for executives for life and for their children to age 25. After tax, Prestons salary just covers her living expenses and therefore does not allow her to make further meaningful capital contributions to her portfolio.

Preston has prepared the following investment policy statement:

The portfolio should be invested conservatively, as I want to protect its principal value. My salary covers my current living expenses, but the portfolio will need a moderate level of liquidity to cover the college expenses. My desire to give each my of children one million dollars when they reach age 40 requires the portfolio to have a long-term focus but allows for a low return objective in keeping with my low risk tolerance. Because of my tax circumstances, the portfolio should focus on securities that generate little or no taxable income.

A.	Prepare the objectives portion of a new investment policy statement for Preston. Indicate how each of your two objectives addresses a different weakness in Prestons current investment policy statement.

B.

Prepare the constraints portion of a new investment policy statement for Preston. Indicate how each of your four constraints addresses a different weakness in Prestons current investment policy. Note: The legal and regulatory constraint is not applicable and should not be included among the constraints in your response.

Preston indicates that Spitzer Design has a leading and growing market share, as the industry is quite fragmented. The company has shown steady fundamental growth trends, and Preston intends to hold her Spitzer Design stock, which is expected to return at least 9 percent annually before tax with a standard deviation of returns of 20 percent. Preston has decided to invest the balance of her assets in one of the three alternative portfolios described in the table immediately below.

	Portfolio A		Portfolio B		Portfolio C		Expected Annual Return (before-tax)		Standard Deviation of Returns
Money Market	$51,000		$51,000		$550,000		4.2	%	2.5	%
Bonds	$491,000		$792,000		$330,000		6.4	%	7.8	%
Equities	$558,000		$257,000		$220,000		10.8	%	17.8	%
Total	$1,100,000		$1,100,000		$1,100,000

C.	Recommend which one of the three alternative portfolios (above) is most appropriate for Prestons assets. Justify your recommendation with three reasons.

Preston is considering three alternative portfolio managers for that portion of her equity portfolio that is not in Spitzer common stock. The average market return and standard deviation characteristics and fees for each of the managers are expected to be very similar. The three managers are further described in the table immediately below.

Manager	Description
F	Manager of a portfolio that is equally weighted among the stocks in the S&P 500 Index. Portfolio holdings are adjusted quarterly.
G	Manager of a market-weighted value index that consists of the half of the S&P 500 Index with the lowest price-to-book value ratios. Portfolio holdings are adjusted quarterly.
H	Manager of an actively-managed large-capitalization portfolio with an average holding period of seven years.

D.	Recommend which one of the three alternative portfolio managers (above) is most appropriate for Prestons equity portfolio. Justify your recommendation with one reason.