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Case Studies in Finance

Case 7: Kate Myers

Basic Concepts: The Time Value of Money After graduating from Ohio State University with a degree in Finance, Kate Myers took a position as a stock broker with Merrill Lynch in Cleveland. Although she had several college loans to make payments on, her goal was to set aside funds for the next eight years in order to make a down payment on a house. After considering the various suburbs of Cleveland, Kate chose Lakewood as her desired future residency. Based on median house price data, she learned that a three-bedroom, two-bath house currently costs $98,000. To avoid paying Private Mortgage Insurance (PMI), Kate wanted to make a down payment of 20%. Because it will be eight years before Kate buys a house, the $98,000 price will surely not be the same in the future. To estimate the rate at which the median house price will increase, she considered the historical price appreciation in Lakewood. In the past, homes appreciated by nearly 4% per annum. Kate was satisfied with this estimation. Merrill Lynch provides several opportunities for Kate to invest the funds that will be devoted to the purchase of her future home. She feels that a balanced account containing stocks, bonds, and government securities would realistically achieve an annual rate of return of 8%. Questions 1. Taking into consideration the fact that the $98,000 home price will grow at 4% per year, what will be the future median home selling price in Lakewood in eight years? What amount will Kate Myers have to accumulate as a down payment if she does decide to buy a house in Lakewood? 2. Based on your answer from number 1, how much will have to be deposited into the Merrill Lynch account (which earns 8% per year) at the end of each month to accumulate the required down payment? 3. If Kate decides to make end-of-the-year deposits into the Merrill Lynch account, how much would these deposits be? Why is this amount greater than twelve times the monthly payment amount? 4. If homes in Lakewood appreciate by 6% per annum over the next eight years instead of the assumed 4%, how much would Kate have to deposit at the end of each month to make the down payment? What if the appreciation is only 2% per year? 5. If Kate decided to deposit her down payment funds in less risky certificates of deposit (CDs) earning only 4%, how much would she have to deposit at the end of each month to make the down payment? What if she pursued a more risky investment of growth stocks that have an expected return of 12%?

Case Studies in Finance

Case 8: Quilici Family

Basic Concepts: The Time Value of Money Greg and Debra Quilici own a four bedroom home in an affluent neighborhood just north of San Francisco, California. Greg is a partner in the family owned commercial painting business. Debra now stays home with their child, Brady, who is age 5. Until recently, the Quilicis have felt very comfortable with their financial position. After visiting Lawrence Krause, a family financial planner, the couple became concerned that they were spending too much and not putting enough funds aside for both their child's future education needs and their own retirement. Greg earns $85,000 per year, but with the rising costs of education, their past contribution efforts have left them short of their financial goals. To estimate the amount of money the Quilicis need to begin putting away for future security some general information was obtained by their financial planner. The couple felt that the amount of money they currently contribute to their Koegh plan would be sufficient for their retirement needs. What they had not accounted for was Brady's education. Greg is an alumni of Stanford University, a private school with an extremely high tuition of approximately $20,000 per year. Debra graduated from the University of North Carolina at Chapel Hill. The tuition expense there is only $2,500 per year. When Brady turns 18, the couple wishes to send him to either of these exceptional universities. They have a slight preference for the much more local Stanford University. The problem, however, is that with the rate at which tuition is increasing the Quilicis are not sure they can raise enough money. To assist in the calculations, assume the tuition at both universities will increase at an annual rate of 5%. Living expenses are currently estimated at $6,000 per year at both schools. This expense is expected to grow at only 3% per year. Further assume the Quilicis can deposit their money into a growth oriented mutual fund at Neuberger & Berman Management, Inc., which has historically earned a 12% return per annum (1% per month). The couple wishes to have a pre-determined monthly amount automatically drafted from their checking account. When Brady starts college they will slowly liquidate the account by making an annual payment to Brady to cover tuition and living expenses at the beginning of each year for the four years he will be in college. Questions 1. How much will be the tuition and living expenses per year when Brady is ready to attend? Give an answer for each university. 2. Once Brady starts college what will his total expenses be in each of his four years? Again, give an answer for each university. 3. How much money will Greg and Debra have to deposit per month to allow Brady to attend Stanford University? How much money will have to be deposited per month to allow Brady to attend the University of North Carolina? (HINT: To answer this question you need to consider the costs of ALL four years.) 4. What if the Quilicis feel the Neuberger & Berman mutual fund will only yield 10%. How much will have to be deposited per month in order for Brady to attend each college? 5. What is the relationship between the amount that must be deposited monthly by the parents and the future increases in both tuition and living expenses?