Februury 1a, aom -Example 2: Cash Matching Case Study-Monthly Retirement Income Date: 1998 Your meeting with Mr. Santo went well and he has decided to retain your firm, MMR Investment Managers, to manage his rctirement income. Recall the following information from Mr. Santo's file: Primary Objective: Growth of Income Secondary Objective: Capital Appreciation Minimum Monthly Income $4000 Investment Funds $1,100,000 Before you go any further, you realize that transaction costs are a real cost to the portfolio. You estimate about 1% of the imvestrnent funds will be needed to cover these costs. Subtracting it from the investment funds amount leaves $ losa ooo to be invested. To meet Mr. Santo's objectives will require an investment in both stocks and bonds. what is Mr. Santo's annual income requirement? Eis con If $1,089,000 will be invested, then calculate the annual income yield % needed from the portfolio? Ilocove, s 1,089,000 You believe an allocation of 50% in stocks and 50% in bonds should provide the needed income and capital appreciation. Therecfore, the portfolio will contain approximately SHuSODin stocks and SEALSin bonds. You plan to purchase only safe, mostly dividend-paying stocks; so in order to minimize transactions costs you decide to hold just 10 stocks in the equity portion of the portfolio. The portfolio is to be passivelymanaged so you believe an equal investment iachis ppopiate. After several screenings you settle on the stocks in Table 1. Now, using only round lots (increments of 100 shares), determine how many shares of each stock you must purchase in order to have an (approximate) equal investment in each. Fill in the number of shares and then the total value of cach stock Table 1 indicates that each of the stocks (except MCDL) pay dividends quarterly. Based on the number of shares you will purchase, now calculate the total quarterly dividend each stock will pay and then the total amount of income generated from quarterly dividends Now fill in the Equity portion (top halt) of the Portfolio Income Worksheet on the attached page with the appropriate values you just determined. Commissions- For simplicity, assume that you will pay $100 in commissions on each stock you purchasc, regardless of the number of shares you buy. Calo stock purchases and note it on the bottom of the attached Portfolio Income Worksheet. 35 Having established the equity portion of the portfolio, you now need to do some cniculations to determine the bonds to include. Based on your selections, the equity portion of the portfolio will provide quarterly dividend income of $ Therefore, the annual dividend income is . From Table 1 the total cquity investment is $ %0 the %. Ifthe equity portion annual income yield from the dividends (%) is that the total annual income yield had to be Earlier you calculated is providing only rest of the annual income yield has to come from the bond portion as the following equation illustrates: % from the annual dividend yield and is only half the portfolio, then the (current yield on bonds) + %(annual dividend yield-annual income yield (current yield on bonds) + %( Fill in the above equation and solve for "current yield on bonds" Therefore, in addition to any other constraints or characteristics, each bond should have a current yield approximately equal to what you just calculated. In addition, you have decided to try to minimize risk by constraining the bonds to maturities S 15 years and ratings better than or equal to BBB. Like the equity part of the portfolio, you believe an (approximate) equal investment in the bonds will provide nceded diversification The S&P Bond Guide is a good source of bond information and data. A sample page is attached. You will choose your bonds from this page. In addition to the constraints/characteristics established above, you also need intcrest income for each month. Since the bonds pay interest semiannually (i.c. every 6 months), selecting 6 bonds will cover all 12 months if each bond pays interest in a different month. The bonds that meet all the criteria are listed in Table 2. Fill in the remaining cells of Table 2 with data from the S&.P Bond Guide (i.e, the months they pay interest, their recent price, and their current yields). From the first page, how much will be invested in the bonds? attached Portfolio Income Worksheet, select 6 of the bonds for the portfolio and determine the par value (i.e. how many of each) you must buy such that you have an (approximate) cqual investment in each bond. Working on the Commissions and Accrued Interest- Again, assume that you will pay $100 in commissions on each different bond issue you purchase, regardless of the number of individual bonds you buy. Calculate the total amount you will need for the bond purchases and note it on the bottom of the attached Portfolio Income Worksheet. Recall that when you buy a bond, in addition to the price, you must also pay the seller the interest that has accrued up to the selling date, i.e. the accrued interest. Onc way to estimate the accrued interest you will have to pay is to set aside half of each bond's semi-annual interest payment. The amounts should avcrage out and ensure that you have enough to pay the accrued intcrest. The worksheet on the next page will help you determine the amount to set aside. Calculate the total set-aside for accrued interest and note it on the bottom of the attached Portfolio Income Worksheet. Accrued Interest Worksheet Coupon Semiannual Set-aside for Bond ValueRate Annual Interest Interest Accrued Interest Total After you have determined the bond portion of the portfolio, finish filling out the Portfolio Income Worksheet with all the subtotals and totals to determine if you have met the income requirements within the $1,100,000. Have you met the income requirement in each month? If not, what is the problem? How would you rectify the problem? Does the income you have in each month seem appropriate for the objective? Why? How should yo change it? Is your Total Cost within the $1,100,000? 37 TABLE 1-Stocks Quarterly Dividend Number Quarterly Dividend Paid Share Stock Price Share Shares Total Value AAC $1700 $0.13 50.00 24.50 10.40 Payment Months an/Apr/July/Oct anvApr/July/Oct Feb/May/Aug/Nov BBL 0.37 0.20 0.05 0.00 0.37 0.25 0.06 Dec MCDL 7.60 ME 49.00 25.50 Feb/May/Aug/Nov Jan/AprJuly/Oct Mar/June/Sept/Dec LLZ 16.25 MZN 7.15 Feb/May/Aug/Nov Jan/Apr/July/Oct 0.03 Do not use odd lots TABLE 2 Bonds Coupon Interest Dates Recent Current Price Yield 120 34 Bond Rate Maturity Rating Empire District Electric 181/8%| 2009 | A 6.73% Empire District | 7.60% | 2005 | A- | Apr/Oct 112 2 6.76% Electric Empire District Electric 7.5% | 2002 Energen Corp. 18.0090 | 2007 Engelhard Corp | 7.00% | 2001 Engelhard Corp | 738% | 2006 A Feb/Aug 104 7/8 6.67% A - Feb Aug. Illi 6.59% Enhance Financial | 6.75% | 2003 Svcs Group Enron Corp 75890 | 2004 | BBB+1 Mar/Sep 6.83% | 7 %| 2007 | BBB+ 2007 BBB+ Enron Corp Enron Corp Enron Corp 8.25%| 2012 Enron Oil & Gas | 6.5% | 2007 | A- Found in the second column from the left titled "Interest Dates" Found in the third column from the right titled "Mo. End Price Sale(s) or Bid". Expressed as a percent of par. Found in the second column from the right titled "Curr. Yicld" 38 Februury 1a, aom -Example 2: Cash Matching Case Study-Monthly Retirement Income Date: 1998 Your meeting with Mr. Santo went well and he has decided to retain your firm, MMR Investment Managers, to manage his rctirement income. Recall the following information from Mr. Santo's file: Primary Objective: Growth of Income Secondary Objective: Capital Appreciation Minimum Monthly Income $4000 Investment Funds $1,100,000 Before you go any further, you realize that transaction costs are a real cost to the portfolio. You estimate about 1% of the imvestrnent funds will be needed to cover these costs. Subtracting it from the investment funds amount leaves $ losa ooo to be invested. To meet Mr. Santo's objectives will require an investment in both stocks and bonds. what is Mr. Santo's annual income requirement? Eis con If $1,089,000 will be invested, then calculate the annual income yield % needed from the portfolio? Ilocove, s 1,089,000 You believe an allocation of 50% in stocks and 50% in bonds should provide the needed income and capital appreciation. Therecfore, the portfolio will contain approximately SHuSODin stocks and SEALSin bonds. You plan to purchase only safe, mostly dividend-paying stocks; so in order to minimize transactions costs you decide to hold just 10 stocks in the equity portion of the portfolio. The portfolio is to be passivelymanaged so you believe an equal investment iachis ppopiate. After several screenings you settle on the stocks in Table 1. Now, using only round lots (increments of 100 shares), determine how many shares of each stock you must purchase in order to have an (approximate) equal investment in each. Fill in the number of shares and then the total value of cach stock Table 1 indicates that each of the stocks (except MCDL) pay dividends quarterly. Based on the number of shares you will purchase, now calculate the total quarterly dividend each stock will pay and then the total amount of income generated from quarterly dividends Now fill in the Equity portion (top halt) of the Portfolio Income Worksheet on the attached page with the appropriate values you just determined. Commissions- For simplicity, assume that you will pay $100 in commissions on each stock you purchasc, regardless of the number of shares you buy. Calo stock purchases and note it on the bottom of the attached Portfolio Income Worksheet. 35 Having established the equity portion of the portfolio, you now need to do some cniculations to determine the bonds to include. Based on your selections, the equity portion of the portfolio will provide quarterly dividend income of $ Therefore, the annual dividend income is . From Table 1 the total cquity investment is $ %0 the %. Ifthe equity portion annual income yield from the dividends (%) is that the total annual income yield had to be Earlier you calculated is providing only rest of the annual income yield has to come from the bond portion as the following equation illustrates: % from the annual dividend yield and is only half the portfolio, then the (current yield on bonds) + %(annual dividend yield-annual income yield (current yield on bonds) + %( Fill in the above equation and solve for "current yield on bonds" Therefore, in addition to any other constraints or characteristics, each bond should have a current yield approximately equal to what you just calculated. In addition, you have decided to try to minimize risk by constraining the bonds to maturities S 15 years and ratings better than or equal to BBB. Like the equity part of the portfolio, you believe an (approximate) equal investment in the bonds will provide nceded diversification The S&P Bond Guide is a good source of bond information and data. A sample page is attached. You will choose your bonds from this page. In addition to the constraints/characteristics established above, you also need intcrest income for each month. Since the bonds pay interest semiannually (i.c. every 6 months), selecting 6 bonds will cover all 12 months if each bond pays interest in a different month. The bonds that meet all the criteria are listed in Table 2. Fill in the remaining cells of Table 2 with data from the S&.P Bond Guide (i.e, the months they pay interest, their recent price, and their current yields). From the first page, how much will be invested in the bonds? attached Portfolio Income Worksheet, select 6 of the bonds for the portfolio and determine the par value (i.e. how many of each) you must buy such that you have an (approximate) cqual investment in each bond. Working on the Commissions and Accrued Interest- Again, assume that you will pay $100 in commissions on each different bond issue you purchase, regardless of the number of individual bonds you buy. Calculate the total amount you will need for the bond purchases and note it on the bottom of the attached Portfolio Income Worksheet. Recall that when you buy a bond, in addition to the price, you must also pay the seller the interest that has accrued up to the selling date, i.e. the accrued interest. Onc way to estimate the accrued interest you will have to pay is to set aside half of each bond's semi-annual interest payment. The amounts should avcrage out and ensure that you have enough to pay the accrued intcrest. The worksheet on the next page will help you determine the amount to set aside. Calculate the total set-aside for accrued interest and note it on the bottom of the attached Portfolio Income Worksheet. Accrued Interest Worksheet Coupon Semiannual Set-aside for Bond ValueRate Annual Interest Interest Accrued Interest Total After you have determined the bond portion of the portfolio, finish filling out the Portfolio Income Worksheet with all the subtotals and totals to determine if you have met the income requirements within the $1,100,000. Have you met the income requirement in each month? If not, what is the problem? How would you rectify the problem? Does the income you have in each month seem appropriate for the objective? Why? How should yo change it? Is your Total Cost within the $1,100,000? 37 TABLE 1-Stocks Quarterly Dividend Number Quarterly Dividend Paid Share Stock Price Share Shares Total Value AAC $1700 $0.13 50.00 24.50 10.40 Payment Months an/Apr/July/Oct anvApr/July/Oct Feb/May/Aug/Nov BBL 0.37 0.20 0.05 0.00 0.37 0.25 0.06 Dec MCDL 7.60 ME 49.00 25.50 Feb/May/Aug/Nov Jan/AprJuly/Oct Mar/June/Sept/Dec LLZ 16.25 MZN 7.15 Feb/May/Aug/Nov Jan/Apr/July/Oct 0.03 Do not use odd lots TABLE 2 Bonds Coupon Interest Dates Recent Current Price Yield 120 34 Bond Rate Maturity Rating Empire District Electric 181/8%| 2009 | A 6.73% Empire District | 7.60% | 2005 | A- | Apr/Oct 112 2 6.76% Electric Empire District Electric 7.5% | 2002 Energen Corp. 18.0090 | 2007 Engelhard Corp | 7.00% | 2001 Engelhard Corp | 738% | 2006 A Feb/Aug 104 7/8 6.67% A - Feb Aug. Illi 6.59% Enhance Financial | 6.75% | 2003 Svcs Group Enron Corp 75890 | 2004 | BBB+1 Mar/Sep 6.83% | 7 %| 2007 | BBB+ 2007 BBB+ Enron Corp Enron Corp Enron Corp 8.25%| 2012 Enron Oil & Gas | 6.5% | 2007 | A- Found in the second column from the left titled "Interest Dates" Found in the third column from the right titled "Mo. End Price Sale(s) or Bid". Expressed as a percent of par. Found in the second column from the right titled "Curr. Yicld" 38