This is a team project. Each team will develop a lifetime financial plan designed to meet the needs a typical IU business graduate with medium risk aversion. Each team will do one out of three alternative extensions to account for: (1) higher or lower realized returns, (2) higher or lower risk aversion, and (3) the benefit of tax-favored retirement plans.

This project uses historical data on annual returns for two risky assets:

• U.S. stocks (in US $)
• Foreign stocks (in US $)

and the annual US riskfree rate and US inflation rate. The F303 Home Page provides a data file for this project in both Lotus and Excel formats. They are also available on the Instruct server for F303 Holden under the menu options EXCEL2 and LOTUS2.

Each team should guess/estimate the following for each working year for a typical IU business graduate with medium risk aversion:

• Before-tax income (forecast pay raises due to inflation plus pay raises due to real pay growth)
• Tax payments
• After-tax income
• Payment on a 30-year, Fixed-rate Mortgage
• Interest Expense
• Principal Reduction Expense
• Starting and ending years
• Other Expenses
• Savings Amount = Investment Amount

Then put together an investment plan and consumption plan covering both working years and retirement years. The investment plan should recommend how much to invest in each of the assets. To do this, you need to estimate the following:

• Inflation rate
• Riskfree interest rate
• Real riskfree return = Riskfree interest rate - Inflation rate
• Expected return each risky asset
• Excess expected return = Expected return - Real riskfree return
• Standard deviation of each risky asset
• Correlation between the risky assets

You will need to account for taxes. Here are the applicable tax rates:

• Federal taxes:

Condition Outcome

If Income < $38,000 ==> Tax = (Income) (18%)

Otherwise If Income < $91,850 ==> Tax = ($38,000) (18%) + (Income - $38,000) (28%)

Otherwise If Income < $140,000 ==> Tax = ($38,000) (18%) + ($91,850 - $38,000) (28%)

+ (Income - $91,850) (31%)

Otherwise ==> Tax = ($38,000) (18%) + ($91,850 - $38,000) (28%)

+ ($140,000 - $91,850) (31%) + (Income - $140,000) (36%)

=IF(First_Condition,First_Outcome,IF(Second_Condition,Second_Outcome,IF(Third_Condition,

Third_Outcome,Fourth_Outcome)))

@IF(First_Condition,First_Outcome,@IF(Second_Condition,Second_Outcome,@IF(Third_Condition,

Third_Outcome,Fourth_Outcome)))

• tax brackets are automatically adjusted every year for the inflation rate
• FICA:
• 6% for social security up to $60,600
• 0% for social security on income over $60,600
• 1.45% for Medicare on all income
• Indiana state taxes:
• 3% on all income

Assume that you have access to a before-tax, tax-deferred retirement account (such as a 401(k), 403(b), or Keogh account) for all of the money you are saving for retirement. For simplicity, ignore the cap on such accounts. Inside this retirement account you can invest in four assets: (1) US stocks, (2) foreign stocks, (3) the US riskfree asset, and (4) a lifetime annuity at the US riskfree rate as described below. You can freely transfer funds between these four assets while still keeping all of the funds inside the retirement account and thus deferring taxes. You only pay taxes when money is withdrawn from the retirement account to use for consumption.

When there are two risky assets, the weights of the optimal risky portfolio in asset B and asset S are given by the formula at the bottom of page 145 of the textbook:

Next put together a consumption plan for both working years and retirement years.

• Recommend what level of consumption for what years
• Check the consumption level at the end of your working years and the beginning of your retirement years -- it probably doesn’t make sense to have a huge jump in consumption level up or down at this point
• You may want to recommend a retirement annuity which pays a fixed dollar amount per month for as long as you live based on:
• sound-actuarial projection of your expected lifetime
• continued growth of the principal amount at the riskfree rate
• Peg the consumption plan to the money available if your investments grow at the expected rate of growth
• Convert the level of consumption to 1997 dollars using your estimated inflation rate.

Each team will be designated as Type-A, Type-B, or Type-C and should do the corresponding extension described below.

Modify the consumption plan for: (A) low average realized returns from the risky assets and (B) high average realized returns from the risky assets.

• Peg the low consumption plan to the money available if the average realized returns from the risky assets are lower than expected (and specifically, lower than the US riskfree rate)
• Peg the high consumption plan to the money available if the average realized returns from the risky assets are higher than expected. The high average realized returns should be the same amount above the expected return as low average realized returns are below the expected return. That is, they should be mirror images.
• Convert the level of consumption in the high and low plans to 1997 dollars using your estimated inflation rate and compare with the base case in 1997 dollars.

Modify the investment and consumption plan for: (A) a high risk aversion investor and (B) a low risk aversion investor.

Modify the investment and consumption plan by assuming that no tax-favored retirement accounts (such as a 401(k), 403(b), Keogh plan, or IRA) are available. Specifically, compare the difference in consumption plans between using a before-tax, tax-deferred retirement account vs. using an after-tax, non-deferred retirement account.

On Thursday, February 20th, half of the teams will make a brief sales presentation to the class to summarize their findings. Each team will have twelve minutes to present their results, there will two minutes for questions, and one minute for transition between teams. These time limits will be strictly observed in order to be fair to everyone. A computer projector with Lotus FreeLance and Microsoft PowerPoint will be available. All teams are required to use one of these two presentation software packages. With presentation software, it is typical for one team member to operate the computer presentation while other members to talk.

Professors Holden, Mysker, or Wedig will evaluate the presentation based on:

• the quality of the presentation (see presentation tips below) and
• each class member’s ratings of the presentations of the other teams (excluding one’s own team) of how well each proposed strategy meets the client’s needs.

A written report is also due in class on Thursday, February 20th. The format is one-page executive summary, four-page double-spaced body, and no more than ten pages of appendices, including all graphs, spreadsheets, and presentation print outs. The body of the paper should tell the complete story. It should be written as if we were very busy bosses, who probably would not look at the appendices at all.

The project is graded as follows:

Confidential peer evaluations of individual contributions to the team project will made. Individuals who have contributed significantly more or significantly less than the group average will be rewarded or penalized accordingly. The purpose of these peer evaluations is to provide direct incentives for individual contributions to the team project.

Here are some general suggestions for report exposition that would apply to a broad range of reports:

1. Layering. Provide an executive summary, then the main analysis, then more details of analysis.

• Create an executive summary with your major results on the first page. Provide the big picture / overview. A good approach is to use bullets for your major points and a summary table with the numerical results of the base case and the extension.
• Do the main analysis on the next four pages.
• Put more details in the appendices.

1. Summarize. Highlight your key assumptions and your key results ("the bottom line"). Skip the "intermediate calculations." Focus on the key actions to take or key decisions to be made and give your recommendations.

 

2. Motivate. Justify your key assumptions and general modeling approach.

• Why are these "reasonable" assumptions?
• Why is this a sensible way to do the calculations?

Here are some general suggestions for a quality presentation that would apply to a broad range of presentations:

1. Summarize. Highlight your key assumptions and your key results ("the bottom line"). Skip the "intermediate calculations." Focus on the key actions to take or key decisions to be made and give your recommendations.

 

2. Connect. Reach your audience by:

• making eye contact
• speaking loud enough for everyone to hear
• conveying enthusiasm for your presentation
• not turning your back to the audience to read off the screen

1. Backup. Always have backup transparency slides in case of computer hardware / software problems.

Here are sample spreadsheet layouts for the two cases: (1) when savings are before-tax and tax-deferred and (2) when savings are after-tax and not tax-deferred.

1. Double-click on the Netscape icon.

 

2. Enter the Web address: www.bus.indiana.edu/finweb/f303home.htm

 

3. Click on Project 2 dataset in Excel 5.0 or higher or Project 2 dataset in Lotus for Windows 4.0 or higher.

 

4. When you see the Netscape message "No Viewer Configured," click on "Save to Disk." Alternatively, if you see the Microsoft Internet Explorer message "Confirm File Open," click on "Save As."

 

5. Open the downloaded file in Excel or Lotus as usual.