Question

In: Finance

Advisor 1 Advisor 2 Advisor 3 Commission Fee Fee + Commission 4% initial cost to purchase...

Advisor 1

Advisor 2

Advisor 3

Commission

Fee

Fee + Commission

4% initial cost to purchase investments

1% annual fee of asset under management

$7,500 first year planning fee

Annual management fee beginning in second year

2% cost to purchase investments

0.5% Annual Management Fee beginning in second year

0.10% Annual management fee beginning in second year

8.50%

8.0%

7.50%

Compensation Method

QuotedCosts

Average historical rate of return on similar accounts

Instructions

Use this information to answer the following questions.

  1. Calculate how much Cheyenne and Scott will pay in first-year expenses for each advisor
  2. Assume that Cheyenne and Scott pay the commissions and fees directly from their $350,000.  If they hire an advisor and invest their savings on January 1, how much will they have in their account at the end of the year, assuming they can earn the advisor’s average historic rate of return?
  3. Calculate how much Cheyenne and Scott will pay in second-year expenses for each advisor (base your estimate on answers to part b).
  4. Assume that Cheyenne and Scott pay the annual management fee on January 1 of each year directly from their account.  Determine which advisor they should choose if their goal is to maximize the value of their investments after 7 years.  What does your analysis indicate regarding initial expenses and ongoing management fees?

Solutions

Expert Solution

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. All the sub parts have been answered in line. The rows highlighted in yellow contain your answer. Figures in parenthesis, if any, mean negative values. All financials are in $.

Linkage Advisor 1 Advisor 2 Advisor 3
Investment A        350,000            350,000             350,000
First year charge b 4% 1% 7500 + 2%
Part (a) First year expense C = A x b          14,000                3,500               14,500
Net investment D = A - C        336,000            346,500             335,500
Annual return r 8.5% 8.0% 7.5%
Part (b) Account balance at the end of the first year E = D x (1 + r)        364,560           374,220             360,663
Second year charge f 0.5% 1.0% 0.1%
Part (c ) Second year expense G = E x f            1,823                3,742                     361
Balance at the beginning of the second year H = E - G        362,737            370,478             360,302
Account balance at the end of the second year I = H x (1 + r)        393,570            400,116             387,324
Growth factor net of expense over next five years J = (1 + r)5(1 - f)5          1.4664              1.3973               1.4285
Part (d) Account balance at the end of the 7 years K = J x I 577,146 559,089 553,280

As the account balance at the end of 7 years is highest in case of Advisor 1,  they should choose Advisor 1, if their goal is to maximize the value of their investments after 7 years.

This is because Advisor 1 has the highest annual rate of return that gets compounded, It has higher initial cost but a moderate annual fees. So, the analysis indicate that

  • A higher initial cost gets compensated by lower annual cost.
  • A higher initial cost gets compenated by the higher annual growth rate

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