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Dr WLS, PhD in physics and engineering
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Experience:  Online tutor since '94 in science, math & general topics
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Finance #1

Customer Question

Bernie and Pam Britten are a young married couple beginning careers and establishing a household. They will each make about $50,000 next year and will have accumulated about $40,000 to invest. They now rent an apartment but are considering purchasing a condominium for $100,000. If they do, a down payment of $10,000 will be required.

They have discussed their situation with Lew McCarthy, an investment advisor and personal friend, and he has recommended the following investments:

The condominium - expected annual increase in market value = 5%.
Municipal bonds - expected annual yield = 5%.
High-yield corporate stocks - expected dividend yield = 8%.
Savings account in a commercial bank-expected annual yield = 3%.
High-growth common stocks - expected annual increase in market value = 10%; expected dividend yield = 0.
Calculate the after-tax yields on the foregoing investments, assuming the Brittens have a 28% marginal tax rate (based on Public Law 108-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003).
How would you recommend the Brittens invest their $40,000? Explain your answer.
Submitted: 11 years ago.
Category: Homework
Expert:  Dr WLS replied 11 years ago.

Shall we assume there is zero state tax? Are we allowed to suggest a mix of "all-growth" and "value" stocks (the latter being less volatile and providing almost as good performance over the long term?) Is the $10,000 rent- or buy (down payment) decision part of the question and would it use part of the $40,000?. Will you accept the standard advice of a 60-30-10 mix of stocks/bonds/cash for asset allocation by young people without a further lengthy justification? Some might argue for more or less in stocks right now. Some might make a case for a significant amount of international investment. I would certainly not be buying stocks with an expected average dividend yeld of zero.

The after-tax yield part of your question is easy; I don't want to risk giving investment advice that u you or others may challenge or that may not fall within the parameters of the question. The hypothetical investment advisor probably has his own suggestion for asset allocation. After 45 years of investment experience, I don't trust most investment advisors.

Customer: replied 11 years ago.
Reply to Dr WLS's Post: Your assumption is correct re: the sales tax.
Yes, to your suggestion of allowing a mix.
The $10,000 would be for a down payment to buy.

This is a question that I need for a personal finance class. You can do your best to answer the question and make it more simple rather than so lenghty.

Thank you! Customer
Expert:  Dr WLS replied 11 years ago.

Assuming that there is not state INCOME tax, the effective after-tax yields are:

House down payment ($10,000):

The equity growth will be based upon the value of the house, not the down payment. There should be a net equity growth of 5% of $100,000 or $5000 per year on an investment of $10,000, which is like 50% total return on the down payment. Of course there will be property tax, maintenance and mortgage interest expenses, but these will tend to be comparable to or less than the rent that would otherwise have to be paid for less living space. Clearly they should make the down payment on a home, if that is where they intend to work and raise a family. Strictly speaking, the 50% annualized total return is not yield, since the cash flow won't show up until the house is sold. There will be an additional tax advantage that the capital gain is likely to be excluded from taxation if they live there at least two years.

Based upon a 60/30/10 asset allocation for the remaining $40,000, which is reasonable and typically recommended for young adults in order to provide good long-term average yield with a measure of safety, here are the recommendations and effective after tax yields:

Stocks or equity mutual funds ($24,000):

allocation : 60% of $40,000 = $24,000. It should be a mixture of growth, growth/income, value and international equities, in my opinion. The after-tax yeld will be

10% * (1 - 0.15) = 8.5%, after the 15% capital gains tax rate is considered.

Bonds ($6,000 + $6,000 = 12,000):

Allocate 30% of $ 40,000 = $ 12,000 here. I would put half of this ($6000) into a municipal bond mutual fund (open-ended or closed-ended ETF) and the other 50% ($6000) into a high yield mutual fund, to provide diversity and protection in case some of the junk bonds become worthless, which always happens. The after-tax yield will be 5% for the muni bonds and 8% (1 - 0.28) = 5.76% for the high-yeld corporates.

Savings Accounts ($4,000):

I would say that a bank CD or short term or a money market fund could also be used here, but let's stick with the savings account. Allocate the remaining 10% of $40,000 = $4,000 here, for safety and available cash when you need it. The after-tax yield will be 3% (1 - 0.28) = 2.16%

Customer: replied 11 years ago.
Reply to Dr WLS's Post: Dr WLS:

Thank you for your responses and the time that you took to review the posted information. However, the assignment was completed yesterday afteroon. Thank you!

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