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Managerial Finance Assignment #3 : Spring 2020 50 Points NAME: _____________________

Investment Choices & Advantages and Disadvantages of Debt

Learning Objectives:

I. Calculate the value of various investment options

II. Compare investment options based on their expected future value

III. Evaluate investment options considering a variety of factors

Case Facts:

Jason is 25 years old. He recently graduated from UCA, married his high school sweetheart, and now has a 2 year old son. Sadly, Jasons beloved grandfather has recently died. His grandfather left Jason $60,000. Jason has a good job and does not need the money at this time. He wants to invest it for his sons college expenses and for retirement. He is considering two active investment options and two passive investment options.

Option A:

Jason buys a rent house for $60,000 and puts the net rent (Net Operating Income, NOI) - after taxes, insurance, and repair expenses into Simmons Bank. The net rent is $600/month. The after tax rate of return on the rent payments, deposited in the bank, is 3%/year, compounded monthly. Jason plans to sell the house after 15 years and add the sale proceeds to his rent account at the bank to pay for his sons college and have a nest egg started for his retirement. When Jason sells the house, he will have to pay a 20% capital gains tax on the fully depreciated value of the house. The inflation rate is 2.5%/year. The value of the house increases with the inflation rate. Ignore costs associated with the purchase and sale of the house (title insurance, survey, closing fees, realtor commission, depreciation recapture taxes, etc.).

1. 8 points) What is the expected value of Option A after Jason sells the house and pays his taxes in 15 years? (Show how you calculate the value)

Option B:

Jason buys 5 rent houses at $60,000 each. He uses his $60,000 in cash as a 20% down payment and borrows $240,000 from Simmons Bank. The net rent is used to pay off the loan over 15 years. At the end of the 15 years, Jason plans to sell the houses and put the cash into an account at Simmons Bank to pay for his sons college and establish a nest egg for retirement. The inflation rate is 2.5%. The houses increase in value with the inflation rate. When he sells the houses, he pays a 20% capital gains tax on the fully depreciated value of the houses. Ignore costs associated with the purchase and sale of the houses (title insurance, survey, closing fees, realtor commission, depreciation recapture taxes, etc.).

( 2. 8 points) What is the expected value of Option B after Jason sells the houses and pays his taxes in 15 years? (Show how you calculate the value)

Option C:

Jason doesnt want to have to deal with renters, property maintenance, property taxes, property insurance, or any other issues required to actively manage his investments. He decides to invest his $60,000 inheritance in the stock market and asks a New York Life stockbroker for advice on how to invest his money. His broker convinces Jason to invest in a mutual fund with a 4% front-end load. Jasons net investment is expected to grow at an annual rate, after brokerage fees and taxes, of 7%. After 15 years, Jason plans to convert the investment into cash and deposit the money into an account at Simmons Bank for his sons college and to establish a nest egg for his retirement.

(3. 8 points) What is the expected value of Option C when Jason deposits the money into Simmons Bank? (Show how you calculate the value)

Option D:

Jason cant decide on any other investment option. He puts his $60,000 in an account at Simmons Bank that earns 2.5% after taxes (which matches the inflation rate).

(4. 8 points) What is the expected value of Option D after 15 years? (Show how you calculate the value)

i. Compute the FV of the deposit.

( 5. 18 points) Discuss which option would be best for Jason. Include comments on the following issues as they relate to this case:

Active vs. Passive ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________Time value of Money ________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________Inflation __________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________Leverage __________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________Risk ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________Advantages and Disadvantages of Debt ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

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