Question: #6

Notes:

Tax-deferred (deposits made into plan are deducted from pretax income). No current taxes paid on that money

If salary was $50,000 per year, contributing $3000 to 401(k), pay taxes on only $47,000 income.

No taxes paid while invested in plan, but you pay taxes when you withdrawal at retirement

Company has a 5% match. (will pay up to 5% match of salary but you need to contribute to get match).

401 (k) Option Notes

Most mutual funds (portfolio of assets)

Return of find is weighted average of return of assets owned by fund, minus any expenses.

Largest expense typically is management fee to fund manager (who makes all investment decisions for the fund).

Investment Options

Company Stock

o Currently privately held

o Company stock expected to go public in 3-4 years (until then, price set by board of directors).

B. S&P 500 Index Fund

o Mutual Fund that tracks S&P 500.

o Stocks in fund weighted = S&P 500

o Fund return ~ the return on S&P 500 minus expenses

o Index fund purchases assets based on composition of index, the fund manager not required to research stocks and make investment decisions. (results in low fund expenses).

o Charges 15% of assets per year

B. Small-Cap Fund

o Primarily invests in small-capitalization stocks. (returns on funds more volatile

o Fund can also invest 10% of its assets in companies based outside of U.S.

o Charges 1.70% in expenses

B. Large- Company Stock Fund

o Primarily invests in large-capitalization of stocks of companies based in the U.S.

o Funds managed by B. Company owner (outperformer of market for the last 6 of 8 years)

o Charges 1.50% in expenses

B. Bond Fund

o Invests in long-term corporate bonds issued by U.S. domiciled companies.

o Restricted to investment bonds with investment-grade credit rating

o Charges 1.40% in expenses

B. Money Market Fund

o Invests in short-term, high credit quality instruments (including treasury bills)

o Return on money market fund is only slightly higher than the return on treasury bills.

o Credit quality and nature of short-term, make it slight risk of negative return

o Charges .60% in expenses.

1. What advantages do the mutual funds offer compared to the company stock? key facts of the case and describe the decision that needs to be made by new employee

Mutual funds offered have multiple advantages over the offered company stock. This is because the return on investment in company stock is depenedent only on performance of that specific company, however, investment in mutual fund chosen is spread over a group of companies. Hence, the risk gets diversified. Low performance of company will result in setting of lower price by the company board, whereas the mutual funds are managed by professionals who keep a track of performing companies and do shuffle their investments from time to time. Moreover, depending on risk of the investor, he can chose between the small cap fund, large cap fund, S&P Fund or the bond fund. This option is not available when he chooses to invest in Company stock.

The employee should rather choose to invest in mutual fund seeing the advantages listed above except the S&P 500 Fund where the expense ratio is too high i.e. 15% of assets. Such a high expense ratio will annually erode the returns by same percentage, thus leading to high risk of low returns. If there is an option to split his investments in both company stock and mutual funds (except S&P Fund), he can take somewhat risk considering his youung age by investing 20-25% in company stock also. It has been witnessed historically that companies do tend to outperform markets over long term. In this case, a mix of assets will generate healthy returns in his portfolio and thus, he will be able to retire with a handsome amount in his kitty. Diversified mutual funds usually perform in tandem with the market over long term and since this is a retirement plan, he can choose to opt a mix of it.

2. Assume that you invest 5 percent of your salary and receive the full 5 percent match from the company. What EAR do you earn from the match? What conclusions do you draw about matching plans? Provide calculations showing how much investment will be made from your salary, employer match and cost involved in each option.

Mutual Fund represent collective representation in a group of securities rather than a specific security. Thsi helps individual/ retail investors to:

1) Participate in the Secondary market via an intermediary.

2) Retail investors can particiapte in the owning of shares with a very low investment amount. It might not be possible for the investor to own stock of an individual company thats trading at a very high price point, but with Mutual fund investment, they can still own a piece of a single stock.

3) Individual need a certin level of technical expertise in order to particiapte and profit out of primary/secondary market investments, which might not be the case with most of the investors, while in Mutual Funds, there is a intermediary Fund Manger that does the job for retail investor and does the necessary asset allocation and periodical asset rejiging in line with individual investment goals.

4) Provides diversification benefits to retail investor. A solo investment in a stock, leads to concentration risk, particularly if one doesnot have investment in other avenues, any slide in that stock will cause a huge loss in the overall earnings, with Mutual Funds, one is at liberty to invest in tailor made portfolio of stock, it might be as per sector, as per indices, as per geography, as per risk profile, as per security. Hence Mutual fund investment provide a wider array of investment opportunities, thereby enhancing portfolio diversificaiton and enabling retail investor to maintain a certain level of return irrespective of the market upheavel.

With respect ot the Investment Options given by Bledsoe Financial Services, they can be primarily divided into Stocks, Pooled Investments & Debt Instrument

Stocks- Involve direct investment into a company stock either in Primary or Secondary Market

Pooled Investments- These include Index Funds, Small Cap, Large Cap funds.

Debt Investments- These include Bond & Money Market funds.

As a new Employee, taking first step towards individual investment goals, one needs to asses his/her risk profile, and go for a porftfolio of securities that meet those investment objectives. In this csae, since the employee has just graduated from college and joined his first job, investing heavily in Equity Mutual funds would be a good starting point to build a solid and diversified portfolio of securities. As one gets more knowledgable about the stock market one can alos invest directly in shares.

Part 2:

Where k is the Interest rate, m= compounding frequency/year

in this case, a 12% (6% from Employee & 6% from employer) annual rate will return an EAR of 12.6825%, this is casued by the cumulative effect of monthly compounding of the nominal interest rate of 12% split across 12 months and compounded monthly.

With respect to other avialble options:

For investment stock, since the company is privately held, any earnign will be based on the dividend policy followed aby the company and at the discretion of the majority shareholders.

For any investment done in Pooled investment:

1) Investment in Index Funds- Is cheaper as there is no Active Investment strategy followed, and the portfolio just mirrors the market index its following, hence the earnings should be atleast to whats earned by the index. Hence, the expense ratio is very low, its 0.15 of the assets managed by Financial advisors.

2) Investment in Small/Large Funds- These funds follow active Mangament strategy and hence are expected to earn over and above the market index that they are following. Hence the higher expense ratio of 1.70 & 1.50 respectively, to compnesate the Financial advisors for there financial acumen.

3) Investment in Bond Funds- Simialr to above, Investment in bond funds does come at a higher expense ratio

Nominal Interest Rate	0.060000
	Stock	Index Fund	Small Cap	Large Cap	Bond Fund	Money Market Fund
Employee	3,000.00	3,000.00	3,000.00	3,000.00	3,000.00	3,000.00
Efective Annual Interest	0.061780	0.061780	0.061780	0.061780	0.061780	0.061780
EOP value	3,185.34	3,185.34	3,185.34	3,185.34	3,185.34	3,185.34
Employer	2,500.00	2,500.00	2,500.00	2,500.00	2,500.00	2,500.00
Efective Annual Interest	0.061780	0.061780	0.061780	0.061780	0.061780	0.061780
EOP value	2,654.45	2,654.45	2,654.45	2,654.45	2,654.45	2,654.45
Cumulative Value	5,839.79	5,839.79	5,839.79	5,839.79	5,839.79	5,839.79
Management Fee	-	8.76	99.28	87.60	81.76	35.04
Net Investment Value	5,839.79	5,831.03	5,740.51	5,752.19	5,758.03	5,804.75

As can be seen form the table above, Investment value reduces by the amount of Expense fee incurred by Management towards the management of the Portfolio

3. Assume you decide you should invest at least part of your money in large-capitalization stocks of companies based in the United States. What are the advantages and -disadvantages of choosing the B Large-Company Stock Fund compared to the B S&P 500 Index Fund? Provide Analysis of each option (pros and cons)

Between Large Company Stock Fund and S&P 500 Index Fund, there are some advantages and disadvantages of both. The Large Company Stock Fund will be actively managed by the fund manager. It will invest in large capitalization stocks and the charges are also less as compared to the index fund. Since the fund will be actively managed by the fund manager, he/she will try to ensure that the portfolio is such that the investors earn the maximum profit. It has the power to change the companies in which the money is invested. This will lead to better returns for the investors.

Most of the stocks of the Index fund are those of the large stock companies. In Index fund the fund manager need not carry out active management of the fund. They simply purchase the assets as given in the index. The charges of index fund are high. Thus, investing in Large Company stock Fund looks better than investing in Index fund.

4. The returns on the B Small-Cap Fund are the most volatile of all the mutual funds offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund also has the highest expenses. Does this affect your decision to invest in this fund? process of evaluation of options. ( show understanding of the capital market history and concepts of risk, returns and variability.)

In the given question, it is stated that B Small-Cap Fund has the most volatile returns of all mutual funds that are offered in the 401(k) plan. It also has the highest expenses.

Whether one should invest in such mutual funds or not is a decision to be taken by the investor based on his/her risk appetite. An individual who is willing to take risks will be interested to invest in B Small-Cap Fund while an individual who is not in favour of taking risks will avoid investing in it. However, since the case here is that of a retirement plan so, the tendency of the investor will mostly be to not take risk. The income from the retirement plan might be the only source of income for the investor, so he/she may not want to take the risk and hence may not invest in the B Small-Cap fund. Moreover, it also has the maximum expenses involved.

Age of the investor has a very important role to play in investment decisions. A younger person would generally be willing to take the risk of investing in such funds because he/she would be hopeful that the fund has a potential for good returns. But an elderly person would be hesitant to take up such risk in his/her retirement plan.

Moreover, the fund can also invest 10% of its assets in companies based outside of U.S. This is another concern of the investor as they might not be aware about the foreign companies in which their money would be invested. So, the risk factor rises. It is also possible that the risk will be repaid with good returns as well but it is the risk part that will be of more concern to the investors of the retirement plan. Thus, all this will influence the decision to invest in the fund.

5. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviation and return of the funds over the past 10 years are listed in the following table. Calculate the Sharpe ratio for each of these funds. Assume that the expected return and standard deviation of the company stock will be 18 percent and 70 percent, respectively. Calculate the Sharpe ratio for the company stock. How appropriate is the Sharpe ratio for these assets? When would you use the Sharpe ratio? reproduce the table with additional column for Sharpe ratio for each option including Company stock. understanding of Sharpe ratio as a measure of risk adjusted performance.

B S&P 500 Index Fund

11.48% 10-Year Annual Return

15.82% Standard Deviation

B Small-Cap Fund

16.68 10-Year Annual Return

19.64 Standard Deviation

B Large-Company Stock Fund

11.85 10-Year Annual Return

15.41 Standard Deviation

B Bond Fund

9.67 10-Year Annual Return

10.83 Standard Deviation

6. What portfolio allocation would you choose? Why? Explain your thinking carefully. Should clearly show decision and reasoning. Refer to your answers to earlier questions and conclude your decision. Need at least two investments in your portion in explaining thinking.