Balance Sheet - Richard called and said that he had compiled a list of assets and would send it. It came a few days later. His assets included a home worth $300,000, approximately $350,000 in securities, two cars worth $40,000 with loans of $15,000 against them, and other assets including jewelry (worth $5,000), art ($5,000), and furniture ($7,000). Richard and his wife had money market funds of $2,000, a bonus due of $5,000 net of taxes, and credit card payments due of $12,000. Their house had a $130,000 mortgage. He said to assume that his salary will rise 6 percent a year, and his investment income is 11 percent a year (the investment loss came a year ago). His expenses should rise 3 percent a year except for medical, which will grow at a rate of 6 percent yearly, and taxes, which will grow at about 7 percent a year.
Cash Flow - Richard said he was not worried about the losses taken. He would make them up, but Monica insisted that they save additional monies. He wanted to know what I recommended to help him save. He said he knew Monica was secretly putting away part of her household money into an account in her own name. Richard came in with his cash flow statistics below.
Inflows ($) |
Outflows ($) |
||
Salary |
100,000 |
Mortgage & Home Maintenance |
20,000 |
Investment Income |
8,000 |
Food |
5,000 |
Clothing |
8,000 |
||
Health Care |
6,000 |
||
Transportation |
2,000 |
||
Personal |
3,000 |
||
Recreation |
4,000 |
||
Cars, Entertainment |
9,000 |
||
Hobby |
1,000 |
||
Gifts & Charity |
2,000 |
||
Insurance |
6,000 |
||
Taxes |
26,000 |
Debt - Richard and Monica have diametrically opposite points of view on debt. Richard views debt as an opportunity to generate cash to make up for past investment losses. He has asked you whether he should remortgage his house and place the proceeds in the stock market. He says the present time may be appropriate to refinance because market rates for mortgage loans of 6.5 percent are well below his mortgage rate of 8 percent. He wants to use an adjustable rate that provides an even lower 4 percent rate for the first year with rates thereafter 2 percent above the five-year Treasury rate.
Richard wants a 30-year mortgage because he said he doesn’t expect “to go anywhere” and the annual repayments would be low. He said he was thinking about buying a new car. While the existing one worked well, he was tired of it. If cash flows get tight, he isn’t at all averse to using credit card debt. He says that whereas credit card rates are high, the overall impact is not great and “people manage to pay money back.” Monica has listened quietly to Richard with a pained expression on her face, occasionally shaking her head. She says she is afraid of taking on more debt and wants a budget to limit spending of all types.
Case Application Questions:
(i) Current status through balance sheet
Liabilities | amount | assets | amount |
Mortgage (against house) | 130000 | house | 300000 |
Loan Against cars | 15000 | 2 cars | 40000 |
credit card payment dues | 12000 | securities | 350000 |
Proprietory fund | 557000 | jewelery | 5000 |
art | 5000 | ||
Furniture | 7000 | ||
Money mkt fund | 2000 | ||
bonus due to receive | 5000 | ||
Total | 714000 | Total | 714000 |
ii) yes, this is a strong balance sheet as we have less amount of mortgage in comparison of assets.
iv) we can refinance our loan as we all know option 1. there is less interest will be charged i.e 6.5% in comparison to what we are paying i.e 8%, through this we can save approx 1.5% of loan principal amount and we have 2nd option that to use adjustable rate i.e floating rate it can be bit risky beacuse it is going to be change every time as that is lower as 4% in first year and thereafter 2% above of 5 year treasury rate. as treasury rate is not given we will assumed it 3%. so, the best option among fixed and floatation rate is floatation rate because it will allow less cash outflow.
(v)
Inflow | current year | 1st year | next year |
Salary | 100000 | 106000 | 112360 |
Investment income | 8000 | 8880 | 9857 |
Total inflow | 108000 | 114880 | 122217 |
Outflow | |||
Mortgage and home maintenance | 20000 | 20600 | 21218 |
food | 5000 | 5150 | 5305 |
clothing | 8000 | 8240 | 8487 |
healthcare | 6000 | 6360 | 6742 |
Transportation | 2000 | 2060 | 2122 |
Personal | 3000 | 3090 | 3183 |
recreation | 4000 | 4120 | 4243 |
car, entertainemnt | 9000 | 9270 | 9548 |
hobby | 1000 | 1030 | 1061 |
gift and charity | 2000 | 2060 | 2121 |
insurance | 6000 | 6180 | 6365 |
taxed | 26000 | 27820 | 28654 |
total | 92000 | 95980 | 99050 |
(vi) There is increasing trend in cash flow as we can see salary is increasing by 6% p.a and investment income is 11% which is higher than the expense rate increasing trend i.e most of expenses are increasing annualy 3% except medical which is 6% and taxes which is 7%. so therefore because of this there is positive trends.
(vii) if he remortgage loan and invest that money is stock market. And the remortgage is for 30 years. - we can do so also as we are seeing that investment income having increasing trend in income of 11% but as stock market is volatile in nature we can not assure that this trend is going for long period and it is also mentioned that the emi is going to be low as the loan period is for 30 year. therefore richard idea of borrowing to place in stock market is viable, but he has to keep himself update for the changes going in market so that in any adverse market situation he will be able to minimize his losses as much as possible.
(ix) refinancing option is also viable as above mentioned
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