Question

14- a) Sam is currently 30 years of age. He owns his own business, and wants to retire at the age of 60. He has little confidence in the current Social Security system.

He wants to retire with an annual income of $72,000 a year. If Sam believes he will live to age 90, how much does he have to accumulate by the time he reaches age 60 to receive $72,000 at the end of each year for the rest of his life? Sam believes he can earn 8 percent on his money in a stock mutual fund. ( No comma, two decimals ).

b) List and briefly explain the five-step capital budgeting process. USE YOUR OWN WORDS

c) Jose Gonzalez buys a piece of equipment for $200,000. He puts down $40,000 and finances $160,000. Joe's opportunity cost is 4 percent and the lender's interest rate is 8 percent. Find the weighted average cost of capital (WACC). (Enter your answer as xx.xx without the % sign )

d) Compare speculative risk and pure risk. Provide an example of each. USE YOUR OWN WORDS

e) What are the basic factors that should be considered when establishing an individual retirement plan? USE YOUR OWN WORDS

  

Answer 1

Part a

Calculation of Amount to be accumulated at the age of 60 to receive $72,000 till the age of 90

= Annual amount to be received * PVAF (8%, 30years)

=$72,000 * 11.25778

=$ 810,560 (approx)

Part B

Five steps involved in capital budgeting Process are as under:-

1) Identifying and evaluating potential opportunities-

Under this step, various opportunities available to an enterprise should be identified and evaluated with respect to its feasibility and other benefits.

2) Estimating Costs

The operating and implementing cost required to implement the opportunity should also be identified through different sources under this step.

3) Estimating the benefits.

Under this step, cost should be compared with the revenues to determine the net benefit which will arise due to implementation of the project.

4) Assess Risk

Under this step, various risks associated with the projects are identified such as, what will be the loss to the company if the project fails.

5) Implementation

After all the above steps are performed, the final step is concerned with implementation of the project. proper implementation policy should be framed by the company.

Part C

WACC = ( Ke * weight of Equity ) + (Kd * weight of Debt )

=(4 * $40,000 / $200,000 ) + (8 * $ 160,000 / $200,000 )

= 7.2

Part D

Speculative risks are the risks the gain or loss from which remains uncertain. Under speculative risk there can be either gain or Loss i.e there are chances of both, gain as well as loss. For example- purchase of securities such as shares and debentures, starting of business etc.

Pure risk is opposite of Speculative risk. Under pure risk there are no chances of gain. There are only losses under pure risk. For example- Crime, accidents, threats etc

Part E

Basic factors to be considered while establishing an individual retirement plans are-

1) Required annual income after retirement

2) Rate of return required by individual

3) duration of Installment payment

4) Duration of receiving Income

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