Financial Projections - Exam302

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Question: Four Corners What will your portfolio be worth in 10 years? In 20 years? When you stop working? The Human Resources Department at Four Corners Corporation was asked to develop a financial planning model that would help employees address these questions. Tom Gifford was asked to lead this effort and decided to begin by developing a financial plan for himself. Tom has a degree in business and, at the age of 40, is making $85,000 per year. Through contributions to his company’s retirement program and the receipt of a small inheritance, Tom has accumulated a portfolio valued at $50,000. Tom plans to work 20 more years and hopes to accumulate a portfolio valued at $1,000,000. Can he do it?

Tom began with a few assumptions about his future salary, his new investment contributions, and his portfolio growth rate. He assumed a 5 percent annual salary growth rate and plans to make new investment contributions at 6 percent of his salary. After some research on historical stock market performance, Tom decided that a 10 percent annual portfolio growth rate was reasonable. Using these assumptions, Tom developed the following Excel worksheet:

The worksheet provides a financial projection for the next five years. In computing the portfolio earnings for a given year, Tom assumed that his new investment contribution would occur evenly throughout the year, and thus half of the new investment could be

included in the computation of the portfolio earnings for the year.

From the worksheet, we see that, at age 45, Tom is projected to have a portfolio valued at $116,321.

Tom’s plan was to use this worksheet as a template to develop financial plans for the company’s employees. The data in the spreadsheet would be tailored for each employee, and rows would be added to it to reflect the employee’s planning horizon. After adding another 15 rows to the worksheet, Tom found that he could expect to have a portfolio of $772,722 after 20 years. Tom then took his results to show his boss, Kate Krystkowiak.

Although Kate was pleased with Tom’s progress, she voiced several criticisms. One of the criticisms was the assumption of a constant annual salary growth rate. She noted that most employees experience some variation in the annual salary growth rate from year to year. In addition, she pointed out that the constant annual portfolio growth rate was unrealistic and that the actual growth rate would vary considerably from year to year. She further suggested that a simulation model for the portfolio projection might allow Tom to account for the random variability in the salary growth rate and the portfolio growth rate.

After some research, Tom and Kate decided to assume that the annual salary growth rate would vary from 0 to 5 percent and that a uniform probability distribution would provide a realistic approximation. Four Corner’s accountants suggested that the annual portfolio growth rate could be approximated by a normal probability distribution with a mean of 10 percent and a standard deviation of 5 percent. With this information, Tom set off to redesign his spreadsheet so that it could be used by the company’s employees for financial planning.

Managerial Report Play the role of Tom Gifford, and develop a simulation model for financial planning. Write a report for Tom’s boss and, at a minimum, include the following: 1. Without considering the random variability, extend the current worksheet to 20 years. Confirm that by using the constant annual salary growth rate and the constant annual portfolio growth rate, Tom can expect to have a 20-year portfolio of $772,722. What would Tom’s annual investment rate have to increase to in order for his portfolio to reach a 20-year, $1,000,000 goal? (hint: Use Goal Seek.)

2. Redesign the spreadsheet model to incorporate the random variability of the annual salary growth rate and the annual portfolio

growth rate into a simulation model. Assume that Tom is willing to use the annual investment rate that predicted a 20-year, $1,000,000 portfolio in part 1. Show how to simulate Tom’s 20-year financial plan. Use results from the simulation model to comment on the uncertainty associated with Tom reaching the 20-year, $1,000,000 goal.

3. What recommendations do you have for employees with a current profile similar to Tom’s after seeing the impact of the uncertainty in the annual salary growth rate and the annual portfolio growth rate?

4. Assume that Tom is willing to consider working 25 more years instead of 20 years. What is your assessment of this strategy if Tom’s goal is to have a portfolio worth $1,000,000?

5. Discuss how the financial planning model developed for Tom Gifford can be used as a template to develop a financial plan for any of the company’s employees.

Answer :

1.

Extend the data provided for an expected portfolio of $772722 as shown below:

The procedure in spreadsheet to use Goal Seek is as written below: 1. Click the Data tab in the Ribbon.

2. Click What-If-Analysis in the Forecast group, and select Goal Seek.

3. When the Goal Seek dialog box appears enter the values as shown below:

The result after applying the Goal Seek analysis is as shown below:

Therefore, a 9.13% annual investment rate will result in $1,000,000 in 20 years.

2.

The procedure in Analytic Solver Platform to find the mean and the probability that the project will result in a loss is as written below: 1. Select the cell B11 in the model worksheet.

2. Click the Analytic Solver Platform tab in the Ribbon.

3. Click Distributions in the Simulation Model group.

4. Select Discrete and click IntUniform.

5. When the $B$11 dialog box appears, in the Parameters area: Enter the lower and upper parameters.

6. Click Save.

7. Do the same up to cell B30.

8. Select the cell F11 in the model worksheet.

9. Click the Analytic Solver Platform tab in the Ribbon.

10. Click Distributions in the Simulation Model group.

11. Select Common and click Normal.

12. When the $F$11 dialog box appears, in the Parameters area: Enter the mean and stdev.

13. Click Save.

14. Do the same up to cell F30.

The spreadsheet needs to be redesigned so that the salary growth rate and portfolio growth rate can vary from year to year. The revised spreadsheet is as follows:

The output from the Analytic Solver Platform is as shown below:

Using 10,000 trials, estimates of output measures vary from simulation to simulation. There is a 0.21 probability of having $1,000,000 or more by year 20.

The 20-year portfolio varied across a wide range approximately $530,000 to $1,760,000. There is a 56% chance that the portfolio does not reach $900,000. The output from the Analytic Solver Platform is as shown below:

3.

The simulation model suggests additional strategies should be considered to obtain a reasonably high probability of reaching the $1,000,000 portfolio goal. Increasing the annual investment rate to 10% increases the probability or reaching $1,000,000 by year 20 to 0.32. A 13% annual investment rate is required to increase the probability of reaching $1,000,000 by year 20 to 0.75.

For10% investment rate the output from the Analytic Solver Platform is as shown below:

For 13% investment rate the output from the Analytic Solver Platform is as shown below:

4.

The longer 25-year period is definitely a good idea. Expanding the simulation spreadsheet by five years will show that there is a 0.99 probability of a 25-year

portfolio exceeding $1,000,000. In fact, the extra five years increased the expected portfolio from $889,000 to $1,500,000. This result demonstrates the long-term advantages of investing.

The output in Analytic Solver Platform by expanding the simulation spreadsheet by five years is as shown below:

5.

The simulation worksheet can be used for any employee. The employee may enter his/her age, current salary, current portfolio, and any assumptions he/she cares to make about salary growth rate, investment rate, and portfolio growth rate. Rows would be added to the worksheet to reflect the number of years appropriate for the employee. By varying the inputs and projecting the ultimate portfolio value, the employees should be able to make investment observations such as the following: 1. Begin early with an investment program. The more years the better the ending portfolio value.

2. Make new contributions to an investment program at the highest possible rate.

Increasing the rate 1% or 2% will have a significant impact on the long-term portfolio.

3. Resist the temptation to use assets in investment programs for short-term personal expenditures. Early withdraws can be shown to have a major impact the long-term portfolio value.

4. Be patient. Benefits of investment programs may not be significant for the first 5 to 10 years. It is really in the later years where a consistent investment program pays its biggest dividends.