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FIN 490 - CASE 1 TIME VALUE OF MONEY

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Question;Kevin Lee received his Ph.D. in History from a well-known Ivy-League school at the age of 22. By thetime he was 30, Kevin was one of the most widely respected historians in the country and had publishedover 20 major articles and three influential books. A few years ago he became ?extremely dissatisfied?with textbooks on the history of Western Civilization and promptly wrote his own. Not surprisingly, hisbook is now the leading seller in the field.His present (2014) income from his salary at the university, book royalties, and fees from guest lectures isfairly substantial. Kevin has also accumulated a sizeable portfolio of financial securities and some fineart. He has never been especially conscious of money but, nonetheless, is desirous of acting in a prudentmanner with his retirement savings. Kevin rarely sought any professional financial advice, yet it is hard tocriticize his investment philosophy, which is based on the principles of diversification and buy-and-hold.MORTON LOPEZMorton Lopez is president of RGD Associates, a firm specialized in financial planning. Morton islicensed to sell insurance and securities and a few years ago obtained from Kevin?s university permissionto solicit on campus. Morton had sent a memorandum to faculty, introducing a new financial product,?Equity Transfer? (see Exhibit 1). The basic idea was that individuals could borrow on the equity in theirhome and invest these funds plus any excess savings in a single-premium life insurance policy.===========================================================================EXHIBIT 1 ? EQUITY TRANSFER(Morton?s explanation of Equity Transfer)The equity in your home is the difference between the property?s market value and the balance on anymortgage. Over time, the equity can increase dramatically as housing prices rise and mortgage balancedecreases. Unfortunately, homeowners have traditionally overlooked the tremendous potential in safelyutilizing the equity. However, this large, dormant asset can be unlocked using a concept called EquityTransfer, which is nothing more than moving an asset from one portfolio to another. This is done byinvesting the excess equity within a vehicle that provides for a safe, tax-free accumulation of money. Inaddition, your family will be protected through the death benefit of the investment.===========================================================================Kevin knew that his home had appreciated in value in value and invited Morton to his office. Theychatted for some 15 minutes, during which Morton briefly talked about the concept of equity transfer butmainly took information on Kevin?s personal and financial situation. This included the following:1. Kevin was interested in accumulating additional money (who isn?t) for a possible early retirementin 20 years, or by 2034 at the age of 60. This money might also be used to defray the educationexpenses of his newborn child.2. Kevin had an ?excess? of $30,000 in a money market mutual fund that he felt certain he wouldnot need.3. The balance on his mortgage was $45,000 and carried a 7% annual rate with a yearly payment of$4,248 and had 20 years remaining.Kevin invited Morton to his home for a formal review of his situation. At this meeting, Morton broughtover 20 pages of illustrations, all very nicely bound. Morton first explained that Kevin could ?unlock?$25,000 of equity by obtaining a new mortgage (see Exhibit 2). This amount plus the excess $30,000 inthe money market could be repositioned in a single-premium life insurance policy. According to Morton,$176,392 would be accumulated in 20 years, when Kevin would reach age 60. Morton notedtriumphantly, ?This represents an annual return of 6%, which is above the 5% you are receiving now?.?Of course,? Morton said with a smile, there is a cost. There?s no such thing as free lunch, you know.?He explained that Kevin?s yearly mortgage would increase by $3,052 (i.e. from $4,248 to $7,300) butquickly added that the increase in the annual earnings for the life insurance policy would far exceed thiscost (see Exhibit 3). For example, after the first year, the $55,000 would grow to $58,300, an increase of$3,300. And during year 20, the amount invested in the life insurance would increase by $9,984, or overthree times the annual increase in Kevin?s mortgage payment.THE FINANCIAL ENTANGLEMENTSWhen Morton left Kevin leafed through the illustrations wondering what to do. He decided to call acolleague, Phyllis Comer, from the Finance Department. They were frequent tennis partners and Kevinhad much confidence in her.As Phyllis examined the materials Morton had left, she quickly noticed a number of problems.1. The analysis completely ignored taxes2. The movement of Kevin?s equity into life insurance policy would involve $5,000 in fees3. Kevin would have to give up his 7% mortgage and take a new mortgage at 9%In addition, Phyllis also noted that Kevin would be paying for life insurance that he did not need. That is,the life insurance provided an annual yield of 6%, but 7% could be earned on a long-term investment ofsimilar risk. The difference, of course, pays for the insurance. ?I am quite confident,? summed up Phyllis,?that more money can be accumulated by simply investing the $30,000 and the yearly $3,052 (theincrease in the annual mortgage payment) in some other long-term investment. You avoid commission,keep your attractive 7% mortgage and earn a higher return??Why then, Kevin asked, referring to Exhibit 3, ?does it appear that this is such a good deal? It looks tome that if I do what Morton recommends, all it would cost is the increase of $3,052 in my annualmortgage payment. And ? or so it seems ? the yearly earnings from the life insurance policy more thancovers this increase. Am I missing something???Finance?, she responded, teaches you to be alert for missed opportunities in addition to any out-ofpocket expenses. I like to think of these missed opportunities as hidden costs or hidden sacrifices?. Phyllisthen pointed out two subtle costs the analyst ignored. First, by using $3,052 a year to meet the increasedmortgage payment, Kevin gives up the opportunity to invest this money and earn interest. Second, byusing the excess $30,000 in the money market to buy the life insurance policy, he also loses the interestthat he would have earned.?These numbers?, she continued as she pointed her fingers to the last two columns of Exhibit 3, ?do notconsider all these lost interest. The annual cost should consider not only the increase in your mortgagepayment for that year but also the increase in the lost interest during the year. For example, with theseadjustments the annual cost in one year is $5,152. This includes the extra $3,052 paid at the end of yearone plus $2,100 of lost interest on the $30,000, assuming a 7% interest rate. By year 20, this annual costbecomes $18,632. Notice that both of these amounts exceed the yearly increase in earnings from the lifeinsurance investment. Thus, properly adjusted, this analysis indicates that the purchase of a singlepremium life insurance policy is a bad deal?.QUESTIONS(Ignore taxes in all your answers)1. Morton noted that the $55,000 invested in a single-premium life insurance policy would grow to$176,392 in 20 years for a return of 6% a year. Explain how this return was calculated.2. In order to reposition the equity in his home Kevin would have to take out a 30-year, $75,000mortgage at 9%. Explain how the yearly mortgage payments on this loan were obtained.3. For a 9% mortgage in Exhibit 4, find the loan balance in years 19 and 20.4. Exhibit 3 indicates that $176,392 will be accumulated after 20 years in the life insurance policy.Is this really true? [Hint: If Kevin were to make this investment, what would be his debt positionin year 20?]5. a) If the excess $30,000 were invested in a long-term asset yielding 8% a year, how much wouldbe accumulated after 20 years.b) Suppose Kevin placed $3,052 in a long-term investment paying 8% a year. How much wouldbe accumulated after 20 years (amounts are invested at the end of each year)?6. Repeat 5. And 6. but assume 7% can be earned7. Phyllis? criticism implied that the single-premium life insurance policy is an unattractiveinvestment for Kevin. What do your previous answers suggest?8. a) Suppose Kevin?s goal is to accumulate $400,000 in 20 years. Assume that the $30,000 isinvested at 8%. How much will he have to save in equal amounts at the end of each of the next 20years if he can earn 8% on any investments?b) Repeat question 9 but assume he will not be able to save any amounts in years 13 to 20.9. The yearly payment in the new 30-year, $75,000 mortgage is $7,300. This assumes one lump-sumpayment is made at the end of the each of the next 30 years. Suppose that payments must be madeat the end of each month. What would be the monthly payments? What would be the total annualpayments? Explain any differences.10. Exhibit suggest that the annual cost of the life insurance policy is $3,052. With the adjustmentsmade in the case, Phyllis calculated the cost to be $5,152 in year 1 and $18,632 by year 20assuming a 7% annual return. Explain how these were determined.===========================================================================EXHIBIT 2Morton?s calculation of the Amount of Kevin?s EquityThat Could Be Transferred to Another Investment.------------------------------------------------------------------------------------------------------------------------------Current Market Value$100,000Amount of New Mortgage (75% of Market Value)75,000Less Balance on Existing Mortgage45,000Less Closing costs on new Mortgage3,000Less Other Costs2,000Total Available Equity25,000===========================================================================EXHIBIT 3Morton?s Illustration of the annual and Cumulative Costs to Kevin of the Life Insurance PolicyCompared to the Policy?s Annual and Cumulative ValueEnd of Year01234567891011121314151617181920AccumulationValue$55,00058,30061,79865,50669,43673,60278,01982,70087,66292,92198,497104,406110,671117,311124,350131,811139,719148,103156,989166,408176,392Increase inAccumulationValue$3,3003,4983,7083,9304,1664,4164,6814,9625,2605,5755,9106,2646,6407,0397,4617,9098,3838,8869,4199,984Annual Cost$3,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,0523,052CummulativeCost$3,0526,1049,15612,20815,26018,31221,36424,41627,46830,52033,57236,62439,67642,72845,78048,83251,88454,93657,98861,040EXHIBIT 4:Amortization of Kevin?s new, 30-year mortgageMortized Loan Payment for $75,000Interest Rate of 9%End of Year1234515161718282930Balance74,45073,85073,19672,48471,70758,84556,84154,65652,27512,8426,6970

 

Paper#48616 | Written in 18-Jul-2015

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