Wilson, age 42, founded ‘‘Tide Tech’’ 20 yrs ago. He has just sold Tide tech to Density Inc. Wilson gets two shares of Density for each share held in Tide. Density is valued @ $45 per sgare. Wilson held 87500 shares in Tide Tech. Cost basis of Tides in his texable account is $2.00. After sale to Density, Wilson wants to enter law school which should take 3 yrs and cost $45000 per year. He is interested in establishing a law firm after graduation from law school and the start up cost of firm will total $200000. He expects his living expense which total $175000 this yr to increase at general inflation rate of 3% per yr. Cal after tax return that portfolio must earn next year. Determine his risk tolerance?
Risk Tolerance is above average because of his long term time horizon and significant asset base. Return - After selling his stock position, he will receive 7.875 million. His next year expense would be - 45000 (law school) and 175000 X 1.03 = 180250 for living expenses which is equal to 220000. Return 225250/7.875m = 2.87% + 3% of inflation = 5.87% If risk free rate was given, we could have determined the PV of 200K which he needs to start his own firm after graduation (3 years from now)
cfaboston, don’t you need to inflate next year’s living expense?
It says this year - 175000. If it was next year then yes. But for the safe side, I edited my post and put 1.03 and made the changes. I am sure that either way it is right.
It says this year but we have to caculate the return req next year. So answer does increase (175000+45000) by 3%. Rest of cfaboston answer is correct. I have two questions in this: 1) We are not considering 200k just because we do not have risk free rate? or should it be a part of liquidity constraint as the amount is required in 3 years? 2) Wilson still has concentrated stock position in Density. Infact all his investment is in one company? shouldnt we consider this in risk tolerance?
For next year - you do not worry about 300K but can list in liquidity constraint that this will be needed in 3 years. Same thing you can write in Return Objective. Concentrated position - This will come in unique constraint
hs, I was glad that we had to inflate living expenses since I did that, but it does not say in the question that the school expense changes with inflation. So I kept it at 45,000. Not sure why this would change with inflation unless they specifically say so? This is just my opinion here, but usually when they want you to consider a terminal value- in this case the 200 K for the law practice, they give you other assumptions such as the risk free rate or income from the portfolio and you use a PV calculation to get the return required. This is just asking for the return NEXT YEAR so no need to consider the 200K They way I’d look at his position in Density is that it is not the company he founded, so he’d have an easier time diversifying those shares in the market-
It looks concentrated position is never a decision factor in Risk tolerance. Its always unique constraint. I get the point about 200k but still not sure if we would have considered 200k in return requirement if risk free rate was given. It looks an amount required after 3-4 yrs or later is always a liquidity req. Thanks.
@ smokin’hot Even i did the same thing. I only inflated 175k initially. This inflation thing is really confusing.
As far as I understand it, you’re not going to lose points for writing “needs $200K in three years for law firm” under the Liquidity section…just saying.
You don’t have to include an expense 3-years out in a return requirement… PV of this amount would be part of Liquidity constraint, as Boston28 already said. I suspect, if this were a real CFA question (assume it’s not?), then they’d throw in something about Equity Holding Life and what risks he faces … because he’s clearly in the Investor Stage (rather than the Executive or Entrepreneur Stage). Focus to growing/protecting wealth, away from creating. Seeks to eliminate specific risk of the Density shares, either through diversified portfolio or indexing.
Guys, Question. It doesn’t specifically say he’s gong to law school next year, it just says he wants to. Even if it would have said he’s got admission for next year, I could use that as a justification for adding the tuition fees. I don’t get how you are just assuming its next year. Couldn’t it be 2 years down? or 3? Just wondering.