Question

QUESTION 1

Chewe Mulenga, 55 years old and a Zambian resident, recently retired and received a K500, 000 cash payment from his employer as an early retirement incentive. He also obtained K700,000 by exercising his company stock options. Both amounts are net of tax. Mulenga is not entitled to a pension; however, his medical expenses are covered by insurance paid for by his former employer. Mulenga is in excellent health and has a normal life expectancy. Mulenga’s wife died last year after a long illness, which resulted in devastating medical expenses. All their investments, including a home, were liquidated to fully satisfy these medical expenses.

Mulenga has no assets other than the K1, 200,000 cash referenced above, and he has no debts. He plans to acquire a K300, 000 home in four months and insists on paying cash given his recent adverse experience with creditors. When presented with investment options, Mulenga consistently selects the most conservative alternative. After settling into his new home, Mulenga’s living expenses will be K2,000 per month and will rise with inflation. He does not plan to work again. Mulenga’s father and his wife’s parents died years ago.

His mother, Bwalya, is 72 years old and in excellent physical health. Her mental health, however, is deteriorating and she has relocated to a long-term care facility. Bwalya’s expenses total K2, 500 per month. Her monthly income is K1, 500 from pensions. Her income and expenses will rise with inflation. She has no investments or assets of value. Mulenga, who has no siblings, must cover Bwalya’s income shortfall. Mulenga has one child, Troy. Troy and a friend need funds immediately for a start-up business with first-year costs estimated at K200,000. The partners have no assets and have been unable to obtain outside financing. The friend’s family has offered to invest K100,000 in the business in exchange for a minority equity stake if Mulenga agrees to invest the same amount.

Mulenga would like to assist Troy; however, he is concerned about the partners’ ability to succeed, the potential loss of his funds, and whether his assets are sufficient to support his needs and to support Bwalya. He plans to make a decision on this investment very soon. If he invests K100, 000 in Troy’s business, he insists that this investment be excluded from any investment strategy developed for his remaining funds. With the above information, portfolio manager Sarah Kakombe prepared the investment policy statement for Mulenga shown below.

Chewe Investment Policy Statement

Return objective	• Income requirement is k2,000 monthly Total return requirement is 2.7% annually (K24, 000/K900, 000).
Risk tolerance	• Substantial asset base and low return requirement provide ample resources to support an aggressive, growth-oriented portfolio
Time horizon	• Client is 50 years old, recently retired, and in excellent health. • Time horizon exceeds 20 years.
Liquidity needs	K300,000 is needed in three months for purchase of home. Modest additional cash is needed for normal relocation costs. K100, 000 may be needed for possible investment in son’s business. A normal, ongoing cash reserve level should be established.
Tax concerns	• There is little need to defer income. • Mother’s expenses may have an effect.
Legal and regulatory factors	• No special considerations exist.
Unique circumstances	• Client desires to support mother. • Client insists that any investment in son’s business be excluded from long-term planning. • Client has strong aversion to debt

Evaluate the appropriateness of Mulenga’s investment policy statement with regard to the following objectives:

1. Return requirement
2. Risk tolerance
3. Time horizon
4. Liquidity requirements

Answer 1

i]

monthly income required = monthly living expenses + shortfall of mother's monthly care expenses = K2,000 + (K2,500 - K1,500) = K3,000. yearly income required = 12 * K3,000 = K36,000

funds available for investment = K900,000 - investment in Troy's startup = K900,000 - K100,000 = K800,000

Return requirement is K36,000 / K800,000 = 4.5%

ii]

the return requirement as calculated above is 4.5%, which is higher than the 2.7% in the IPS. However, this is still quite low. The assets base as calculated above is K800,000 which is lower than the K900,000 in the IPS. However, this is still a substantially large asset base

Hence, the large asset base and low return requirement provide ample resources to support an aggressive, growth-oriented portfolio

iii]

the time horizon should include the life expectancy of the mother, since Mulenga is supporting her with K1,000 per month as long as she is alive and needs care. Beyond her expected life, this expense would not be required

iv]

the liquidity requirements in the IPS are appropriate for Mulenga