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MBA572 Financial Planning and Insurance

Assignment 9

Required Readings:

Book 1 (R. Frasca): Chapter 12. Book 2 (Gitman): Chapters 12.

Knowledge Points:

1. A mutual fund company is an investment company that helps pool funds from its clients (i.e., mutual fund shareholders) to invest in financial assets. The company sets up different funds with distinctive objectives to suit different investment needs. When a person buy shares of a mutual fund, the person becomes a fund investor and owns a proportionate interest in the invested assets. Two major reasons why people are interested in mutual funds are that, first, mutual funds are a convenient and relatively inexpensive means of achieving sufficient diversification of investments, and second, mutual funds are managed by professionals so it is a way to access investment expertise.

2. The value of a mutual fund (that is, Net Asset Value, NAV) solely depends on the net value of the fund’s invested assets. There can be transaction costs associated with the purchase and sale of mutual fund shares, such as the so-called loads and management fees. When a client has to pay an up-front cost at the time of buying shares of a mutual fund, it is called a front-end load. When the cost is incurred at the time of selling the mutual fund, it is called a rear-end load.

3. Some mutual funds have a fixed number of shares, so called closed-end funds. You can only get shares of this type of mutual funds when an existing holder is willing to sell his/her shares to you. On the other hand, there are mutual funds that stand ready to take more money and issue new shares at their NAV. These are open-end funds. Many retirement pension funds fall into this category.

4. Like stocks, mutual funds also pay dividends, either in cash or shares.

5. The Individual Retirement Account (IRA) provides unique tax benefits to individuals. Specifically, the contribution to a traditional IRA is tax exempt, so you don’t pay income tax on the amount you contribute to your IRA. On the other hand, a Roth-IRA exempts the tax on the income you grow in the account. Which of the two is better depends on the tax rates between now and retirement. The limit of contribution of both types are subject to phase-out as income increases.

6. If an investor is looking beyond financial assets, he/she can consider a real estate investment trust (REIT) that is a closed-end investment company who must derive at least 70% of its income from real estate and distributes no less than 90% of its income as cash dividend.

Case Study:

Lorrie is 42 years old and she recently studied the Vanguard Target Retirement 2035 Fund. The following is the description of the fund and fee structure:

Vanguard Target Retirement Funds offer a diversified portfolio within a single fund that

adjusts its underlying asset mix over time. The funds provide broad diversification while

incrementally decreasing exposure to equities and increasing exposure to bonds as each

funds target retirement date approaches. The funds continue to adjust for approximately

seven years after that date until their allocations match that of the Target Retirement

Income Fund. Investors in the funds should be able to tolerate the risks that come from

the volatility of the stock and bond markets. The 2035 fund invests in four Vanguard

index funds, holding approximately 85% of assets in equities and 15% in bonds. You may

wish to consider this fund if you’re planning to retire between 2033 and 2037.a

ahttps://personal.vanguard.com/us/funds/vanguard

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Vanguard Target Retirement 2035 Fund (VTTHX) Fees and minimums

12b-1 fee None Account service fee Yes

Purchase fee None Redemption fee None

Minimum investment $1,000.00

But at the end, Lorrie plans to invest $6,000 in one of two mutual funds: Sun Income Fund or Moon Growth Fund. Sun pays out cash dividends and Moon pays out stock dividends. The following table has the details of both funds. Suppose Lorrie has $6,000 to invest in one of the two funds on August 10, 2013, and will immediately reinvest all dividends in the same stock. Use the information to answer the following questions.

Sun Moon NAV/Share Price: August 10, 2013 $15.00 $12.00 August 10, 2014 $13.50 $13.00 August 10, 2015 $16.50 $14.00 Distributions per share: August 10, 2013 $3.00 10% August 10, 2014 $3.00 10%

1. Which of the following description of the Vanguard Target Retirement 2035 Fund is correct?

(a) There is no purchase fees, so it has no front-end load.

(b) There is no redemption fees, so it has no rear-end load.

(c) It has a target composition of 85% equity and 15% bonds, so it is an actively managed fund.

(d) It is readily available for purchase, so it is an open-end fund.

(e) All of the above are correct observations of the fund.

2. How many shares can she invest in Sun or Moon, respectively?

(a) 400 shares; 400 shares

(b) 500 shares; 400 shares

(c) 400 shares; 500 shares

(d) 500 shares; 500 shares

3. How much cash dividend will she receive from Sun on August 10, 2014?

(a) $1,000

(b) $1,200

(c) $1,400

(d) $1,600

4. How many shares does she have in total after reinvesting the cash dividend on August 10, 2014?

(a) 400 shares

(b) 450 shares

(c) 489 shares

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(d) 578 shares

5. On August 10, 2015, she receives another cash dividend. How many share in total does she have now?

(a) 400 shares

(b) 450 shares

(c) 489 shares

(d) 578 shares

6. What is the total value of her investment in Sun close to on August 10, 2015?

(a) $4,533.33

(b) $6,533.33

(c) $7,533.33

(d) $9,533.33

7. How many stock dividends would she receive from Moon on August 10, 2014?

(a) 50 shares

(b) 60 shares

(c) 70 shares

(d) 80 shares

8. On August 10, 2015, she receives another stock dividend distribution. How many shares in total does she have now?

(a) 600 shares

(b) 605 shares

(c) 500 shares

(d) 705 shares

9. What is the total value of her investment in Moon close to on August 10, 2015?

(a) $6,000

(b) $5,478

(c) $9,541

(d) $8,470

10. If the total value of each option on August 10, 2015 is the determinant factor for her decision. Which fund should she pick?

(a) Sun

(b) Moon

11. However, suppose only cash dividends are subject to income tax and stock dividends are not subject to tax until capital gains are realized, and Lorrie is in a 30% tax bracket. Which fund would you recommend to Lorrie now?

(a) The after tax account balance is $8,597.33 for Sun, which is higher than Moon

(b) Moon

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