Human Resources Department at Tri-State Corporation was asked to develop a financial planning model that would help employees address these questions. Tom Gifford was asked to lead this effort and decided to begin by developing a financial plan for himself. Tom has a degree in business and, at the age of 25, is making $34,000 per year. After two years of contributions to his companys retirement program and the receipt of a small inheritance,

Tom has accumulated a portfolio valued at $14,500. Tom plans to work 30 more years and hopes to accumulate a portfolio valued at $1,000,000. Can he do it?

Tom began with a few assumptions about his future salary, his new investment contributions, and his portfolio growth rate. He assumed 5% annual salary growth rate as reasonable and wanted to make new investment contributions at 4% of his salary. After some research on historical stock market performance, Tom decided that a 10% annual portfolio growth rate was reasonable. Using these assumptions, Tom developed the Excel worksheet shown in Figure 16.18. Toms specific situation and his assumptions are in the top portion of the worksheet (cells D3:D8). The worksheet provides a financial plan for the next five years. In computing the portfolio earnings for a given year, Tom assumed that his new investment contribution would occur evenly throughout the year, and thus half of the new investment could be included in the computation of the portfolio earnings for the year. Using Figure 16.18, we see that at age 29, Tom is projected to have a portfolio valued at $32,898.

Toms plan was to use this worksheet as a template to develop financial plans for the companys employees. The assumptions in cells D3:D8 would be different for each employee, and rows would be added to the worksheet to reflect the number of years appropriate for each employee. After adding another 25 rows to the worksheet, Tom found that he could expect to have a portfolio of $627,937 after 30 years. Tom then took his results to show his boss, Kate Riegle.

Although Kate was pleased with Toms progress, she voiced several criticisms. One of the criticisms was the assumption of a constant annual salary growth rate. She noted that most employees experience some variation in the annual salary growth rate from year to year. In addition, she pointed out that the constant annual portfolio growth rate was unrealistic and that the actual growth rate would vary considerably from year to year. She further suggested that a simulation model for the portfolio projection might allow Tom to account for the random variability in the salary growth rate and the portfolio growth rate.

After some research, Tom and Kate decided to assume that the annual salary growth rate would vary from 0% to 10% and that a uniform probability distribution would provide a realistic approximation. Tri-States accounting firm suggested that the annual portfolio growth rate could be approximated by a normal probability distribution with a mean of 10% and a standard deviation of 5%. With this information, Tom set off to develop a simulation model that could be used by the companys employees for financial planning.

Managerial Report

Play the role of Tom Gifford and develop a simulation model for financial planning. Write a report for Toms boss and, at a minimum, include the following:

1. Without considering the random variability in growth rates, extend the worksheet in

Figure 16.18 to 30 years. Confirm that by using the constant annual salary growth rate and the constant annual portfolio growth rate, Tom can expect to have a 30-year portfolio of $627,937. What would Toms annual investment rate have to increase to in order for his portfolio to reach a 30-year, $1,000,000 goal?

I confirmed that with a 30-year plan he can expect to have a portfolio of $627,937.

If Toms wants to have his portfolio reach a $1million goal in 30-years, he would need to increase his investment another 4%, bringing to a yearly investment of 8%, with a projected portfolio of $1,002,857. With the formula already established it is as easy as changing the annual investment rate and checking the ending portfolio results at the end of the 30 years.

2. Incorporate the random variability of the annual salary growth rate and the annual portfolio growth rate into a simulation model. Assume that Tom is willing to use the annual investment rate that predicted a 30-year, $1,000,000 portfolio in part 1. Show how to simulate Toms 30-year financial plan. Use results from the simulation model to comment on the uncertainty associated with Tom reaching the 30-year, $1,000,000 goal. Discuss the advantages of repeating the simulation numerous times.

A B C D E 1234 3 Age 4 Current Salary 25 34,000 FL H Salary Growth (Uniform Distribution) Smallest Value Largest Value 0% 10% Portfolio Growth (Normal Distribution) 5 Current Portfolio 14,500 6 Annual Salary Groth Rate 5% 7 Annual Investment Rate 8% 8 Annual Portfolio Growth Rate 10% Mean 9 Standard Devia 10 Year Age 11 Beginning Portfolio New Portfolio Ending Salary Investment Earnings Portfolio 12 1 25 14,500 34,000 2,720 1,586 18,806 13 2 26 18,806 35,700 2,856 2,023 23,685 14 3 27 23,685 37,485 2,999 2,518 29,203 15 4 28 29,203 39,359 3,149 3,078 35,429 16 5 29 35,429 41,327 3,306 3,708 42,444 26 15 39 158,883 67,318 5,385 16,158 180,426 31 20 44 293,682 85,916 6,873 29,712 330,267 41 30 54 901,001 139,949 11,196 90,660 1,002,857 42 43 44 E12: =D12*D7 45 F12:=(E12*$D$6)+(C12*$D$8) 46 G12: =SUM(E12:F12)+C12 47 48 And these are the formulas used from row 13-41 49 C13: =G12 50 D13:=($D$6*D12)+D12 51 E13: D13*$D$7 52 F13:=(E13*$D$6)+(C13*$D$8) 53 G13: =SUM(E13:F13)+C13 10% 5%