12,500 shares in his $1.25 million defined contribution pension plan portfolio and 87,500 shares
in a taxable investment portfolio. The cost basis of the Tides stock in his taxable investment
portfolio is $2.00. Exhibit 1 shows the allocation of his pension portfolio prior to the buyout by
Destiny.
Exhibit 1: J. Wilson Pension Portfolio Prior to Sale of Tides
Cost Basis
Current Share Value
Investments Weight
(%)
($)
Tides equity 30 8.00 30.00
Equity fund 40 10.00 15.00
Balanced portfolio 10 34.00 44.00
Bond fund 15 12.50 13.75
Money market
fund 5 1.00 1.00
After the sale to Destiny is completed, Wilson wants to enter law school, which should take three
years and cost $45,000 the first year, increasing annually by the rate of inflation of 3%. Given his
entrepreneurial background and contacts, his future income potential after law school is high.
Although he has no plans of marriage, Wilson will provide care for his autistic brother, Tom. Total
after-tax current annual expenses, including care for his brother, will amount to $175,000.
With the help of a financial planner, Wilson has compiled risk and return characteristics for three
asset classes as well as their correlations with one another and with Wilson's human capital. The
data are shown in Exhibits 2 and 3.
Exhibit 2: Risk and Returns for Asset Classes
Expected
Expected Standard
Asset Class Expected Yield
Growth (%)
Deviation (%)
Cash 1.5 0.0 2.4
Bonds 5.0 0.0 8.3
Stock 3.0 6.0 15.4
Exhibit 3: Asset Class Correlations
Class Cash Bonds Stock Human Capital
Cash 1.00 0.65 0.27 0.41
Bonds - 1.00 0.36 0.60
Stock - - 1.00 0.15
Human capital - - - 1.00
...
QUESTION 8 HAS TWO PARTS (A, B) FOR A TOTAL OF 18 MINUTES
A. Explain using the specifics of Wilson's ownership of Tides stock in his taxable portfolio how
he has progressed through the stages of executive, entrepreneur, and investor, as well as how
his exposure to systematic and company-specific risk and his desire for diversification have most
likely changed in each stage. Assume that Wilson's taxable portfolio starts out as 100% Tides
stock.
Grading Guide
Answer for Question 8-A
Wilson began as the entrepreneur and founder of Tides. As a start up private company and as
the sole asset in the taxable portfolio, he had high company-specific risk. Entrepreneurs
generally do not want diversification and accept high specific risk in the effort to create wealth.
When Wilson took the company public 10 years ago, he became an executive but still retained
control of the company, functioning as an entrepreneur with relatively little desire for
diversification. In both these first two stages, he had market and high specific risk. The specific
risk of his portfolio was likely declining as he accumulated other portfolio assets and as the
company matured and went public.
Post-sale Wilson will be an investor with no control over the company. While we do not know his
total assets, he will receive 2 × $45 × 100,000 = $9,000,000 of pretax value. While this larger
public company likely has lower specific risk, increasing diversification is appropriate for Wilson
as an "investor." He can tailor his portfolio to his desired level of market risk.
Candidate discussion: Maximum 9 points. 3 points for describing how Wilson has progressed
through the three different stages. 3 points for explaining how his risk exposure has changed in
each stage. 3 points for explaining how his desire for diversification has changed during each
stage.
(Study Session 5, LOS 11.a)
B. Post-sale of the Tides stock, explain how each of the following strategies could be used to
provide diversification in the portfolio. Comment on any differences between the three strategies
in regard to upside or downside risk exposure to Destiny, Inc., and whether a loan will be
required to provide diversification. Do not discuss taxation.
Strategy Choices:
i. Total return equity swap.
ii. Out-of-the-money protective put.
iii. Prepaid variable forward.
Answer for Question 8-B
Total return equity swap, the return of Destiny stock could be swapped for the return on a desired
index to provide diversification of return with no loan needed. Alternatively, the Destiny return
could be swapped for LIBOR and then this hedged position in Destiny could be used to borrow
and use the funds to purchase a diversified portfolio. Upside and downside exposure to Destiny
is removed.
OTM protective put would limit downside risk in Destiny to the strike price. This hedge should
facilitate a loan with a high LTV, providing funds for diversification. Upside potential in Destiny
would remain.
Prepaid variable forward, no separate loan is needed because the PVF effectively packages the
loan as part of the PVF. Cash is received and can be used for diversification. Downside risk is
removed as the Destiny shares will be delivered to repay the loan. Some upside is retained as a
smaller number of shares can be delivered if Destiny's stock price increases.
Candidate discussion: Maximum 9 points. 1 point each for describing how each strategy
provides diversification. 1 point each for commenting on upside or downside risk exposure. 1
point each for discussing whether a loan is required.
(Study Session 5, LOS 11.h)
QUESTION 9 HAS TWO PARTS (A, B) FOR A TOTAL OF 15 MINUTES
Wilson is meeting with his financial adviser, Drew Goebel, CFA, to review his financial situation.
Wilson is particularly interested in establishing a law practice after graduation from law school.
He estimates start-up costs for the practice, including reference books, furniture, and advertising,
will total $200,000. He expects his living expenses and care for his brother, which totaled
$175,000 this year, to increase at the general rate of inflation of 3% per year.
A. Formulate the return portion of Wilson's investment policy statement (IPS) for his taxable
investment portfolio and calculate the total after-tax return that portfolio must earn next year, his
first year in law school. Show your calculations. (You should ignore Wilson's pension assets and
any tax effects associated with the sale of Tides.)
Answer for Question 9-A
Generate return sufficient to provide law school tuition, pay his living expenses, pay his brother's
care, and maintain purchasing power of portfolio.
Portfolio value = 87,500 × 2 × $45 = $7,875,000
Required after-tax real return = [$45,000 + ($175,000)(1.03)] / $7,875,000 = 2.86%
Required after-tax nominal return = 2.86% + 3.00% = 5.86% (arithmetic)
or
Required after-tax nominal return = (1.0286)(1.03) - 1 = 5.95% (geometric)
Candidate discussion:
Formulate the return should be interpreted as listing or stating the objectives. That is not a
calculation. This is good practice, even if not required, in order to determine what must be
calculated. Thinking of a time line and clearly identifying when things will happen is often
important. In this case the return period starts now, so the investable base is just the assets
available (including the stock sale). The $175,000 is the past year and must be increased by
inflation for the coming year needs. The $200,000 is needed in three years (see the case facts in
question 7). It does not need to be earned this year nor is it being distributed, so it should not be
removed from the investable base. The law school tuition is an ongoing expense for three years,
so treating it as a return requirement is normal. Lastly, the future rate of inflation must be
considered in order to maintain the real value of the portfolio. The question has more in it than
many recent exam questions, but it tests your ability to read and organize the data to reach an
expected solution. That is fair game for the exam.
Candidate discussion: Maximum 10 points. 2 points for correct portfolio value. 4 points for
formulation of return requirement; 1 point for each component listed. 1 point for adjusting
spending requirements for inflation. 2 points for correct real return. 1 point for adding inflation to
the real return.
(Study Session 4, LOS 8.g, j)
B. Determine whether Wilson's ability to tolerate for risk would be considered above average,
average, or below average. Support your decision with two reasons.
Answer for Question 9-B
Wilson's
ability to
tolerate risk
Support with two reasons
would be
considered:
(Circle one)
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