Case StudyÐ'ЈÐ'Ñ"Macmillan And Grunski Consulting

Introductory Overview

The group project, Macmillan and Grunski Consulting, consists of two sections. The first part explains the case about discounted cash flow analysis, by answering the given nine questions. The second part discusses the retirement planning.

 Case Study

Sandra Macmillan, one of the founders of Macmillan and Grunski Consulting which provides financial planning services, is now giving a short project to Mary Somkin, the firmÐ'ÐŽÐ'Їs top secretary. If she can successfully demonstrate her ability and skill of discounted cash flow (DCF) analysis, one of the most important concepts in financial planning, she can expand her role in the firm and broaden her job opportunity.

The project was an actual analysis for SandraÐ'ÐŽÐ'Їs current client. The client wants to invest their asset with a goal of achieving enough money to pay for their daughterÐ'ÐŽÐ'Їs college tuition. There are several options that should be financially analyzed in order to give optimal proposals to the client, considering their other considerations, such as home improvement, borrowing fund, or school selection. The following parts describe the details of financial analysis to get well grounded proposals. In conclusion, some key points, which can be generally applied to all DCF analysis, are extracted and pointed out by answering the given nine questions.

 Retirement Planning (Value added materials)

In addition to the case study, the second part of this project discusses about retirement planning, taking the findings of the case study into consideration. The discussion includes the importance of planning after retirement at early stage of our life. Also five guidelines for good retirement plan are addressed at the end.

CASE STUDY SOLUTION

Question 1: Choosing a Discount Rate on debt securities.

Given a discount rate i%, it is straightforward to convert a stream of cash flows into a present value, a FV (FV), or an annuity. For example, the present value of a sum of money M received in N years is worth M/(1+i)N today. However, how do we choose the discount rate? Below main factors must be considered:

• Risks: include default risk, liquidity risk and maturity risk.

• Inflation: how much will inflation reduce the future purchasing power of our money?

Each of these factors is used to Ð'ÐŽÐ'odiscountÐ'ÐŽÐ'± or diminish the PV of future earnings.

=> PV of M = M/ (1+r*)N(1+IP)N(1+DRP)N¬ (1+LP)N¬ (1+MRP)N¬ ¬¬¬¬

• Real risk-free rate of interest provided zero inflation (r*)

• A premium to offset the expected effects of inflation (IP%)

• A default risk premium that offset default risk amount (DRP%)

• A liquidity premium (LP%)

• A maturity premium (DRP%)

Since each component is small, PV of M ~ M/(1 + r*+ IP+DRP+LP+MRP)N

=> the discount rate, in this case, equals to (r*+ IP+DRP+LP+MRP)

Question 2: Let's start with one-year period!

a) & b) The goal is to compute FV of $18,000 after 1 year in case of different annual interest rates.

Known factors ??? Solution

PV=$18,000

Sub-Question N=1 year

a) i1=8.4% FV1 =PV * (1+i1) = $18,000 * (1+8.4%) = $19,512

b) i2=3.2% FV2 =PV * (1+i2) = $18,000 * (1+3.2%) = $18,576

i3=16.8% FV3 =PV * (1+i3) = $18,000 * (1+16.8%) = $21,024

Implication: given same other factors, the higher the interest rate,the higher the FV.

Figure: Relationship between interest rate and FV

c) & d) The goal is to compute Effective Annual Rates when nominal interest rate is compounded in different ways and to compute the resulted FV.

Bank First National Bank Pacific Trust Bay State

Fre. of Compounding [time] 1 2 4 365

EAR [%] 8.40 8.58 8.67 8.76

FV [$] 19,512 19,554 19,560 19,577

Implication: provided same other factors, the higher the compounding frequency, the higher the EAR & the FV become.

e) In order to be as competitive as offering of Bay State Saving & Loan, which means: FVFNB = FVSBL = $19,577 => $18,000 * (1+ iN/2)^2 = $19,577 =>iN(FNB)= 8.578%

=> First National Bank should offer 8.578% nominal interest rate, compounded semiannually

Question 4: Now broaden the financial picture to 6-year period

a) How much do the clients have to deposit now to receive $35,000 after 6 years with 8.4% annual interest rate?

b) & c) With a same $18,000 investment, in order to earn $35,000 after 6 years, how the nominal interest rates of the First National Bank differ if coumpounded annually, semiannually, quarterly and daily?

Known factors ??? Solution:

iN= n*[(FV/PV)¬1/(n*6) - 1]

FV=$35,000

PV=$18,000

N=6 year

Sub-Question n= Compounding frequency:

a) 1 (Annual) EAR = ($35,000/$18,000)¬1/6 - 1=11.72%

b) 2 (Semiannual) EAR =2* [($35,000/$18,000)¬1/(2*6) - 1]=11.40%

4 (Quarterly) EAR = 4*[($35,000/$18,000)¬1/(4*6) - 1]=11.24%%

365 (Daily) EAR = 365*[($35,000/$18,000)¬1/(365*6) - 1]=11.08%

Implication: with same