Beruflich Dokumente
Kultur Dokumente
Assignment 2, Part 1 of 2
Please enter the names of all team members who worked together on this assignmen
Names:
Instructions
Once you have all the models and Data Tables entered for these two problems,
it should take between 15 and 20 seconds for a recalculation of this complete
Part 1 workbook.
Download this file to your computer, solve the problems, and when you have
finished, then upload your completed spreadsheet to the Canvas page for
Assignment 2, Part 1.
If you work on this assignment as a team, please upload only one file per
team. But make certain the names of all team members are shown in the
space above. (I also have to take points off if a team member's name is left
off the submission.)
- Prof. Smith
her on this assignment.
ecause the
problems,
complete
The Portfolio Effect
Near the end of page 51 in Chapter 5 in our book, Leach describes a game
involving the flip of a coin. In this game, heads pays the player $10,000, but
tails wins $0. And it costs $4,000 to play the game. The two possible
outcomes, then are $6,000 and –$4,000. With a 50-50 chance of either
outcome, the expected value (the average) is $1,000.
With a 50-50 chance of losing $4,000, most people would turn down an
opportunity to play the game just once.
But what if ten people could play as a team? The team could pool their $4,000
entrance fees and each play the game once. Then they share the net winnings.
It's like a company putting together a portfolio of investments. Each of the ten
investments costs $4,000 and pays either $6,000 or –$4,000.
Each player still plays only once. But are they better off in this "portfolio"
arrangement?
Definitely yes. In fact, Leach states that there is only about a 17% chance a
player on the team will lose money, compared to a 50% chance as a single
player. And the more such investments you make (the more players on the
team), the better your odds get.
That’s the power of a portfolio, even with such simple investments. You
should do as many of these investments as you can, as long as:
a) It doesn't take too many successes to produce positive value, and
b) Your company (and your career) can afford to take the losses on the others.
1 Start by simulating 10,000 iterations of just one play of the game. Place your
calculations and Data Table to the right of this question, in the space I have
set up, starting over in cell P43. Use a cumulative probability table with a VLOOKUP
or INDEX-MATCH function using RAND() to pull the outcome at random. This
will produce a value of –$4,000 half the time, and a value of $6,000 half the time.
What is the probability of a positive value? That is, what proportion of the 10,000
iterations is greater than zero?
You can figure the answer to this question in more than one
way. You can use FREQUENCY to construct a frequency table
with only one bin value (bin value = 0) and one extra row beyond
that bin. Or you can use COUNTIF to count the values with a
criteria of ">0" (the quotation marks must be included in the
COUNTIF function). Other methods are acceptable, too.
Probability =
Write ten identical lookup functions to pull the random outcome, and sum the ten
outcomes. Then simulate 10,000 iterations of that sum. Place your calculations
to the right of this question, in the space I have set up, starting over in cell K67.
Compute the probability of a value greater than zero when there are ten such investments.
a VLOOKUP
lf the time.
1.000 Here's the problem. Even though the expected value is positive,
there's really only about a 50% chance of having a single such
investment make money.
um the ten
Probability Cumulative Prob Outcome
0.50 0 (4,000)
0.50 0.5 6,000
n such investments.
Ten lookup functions: 6,000
1.000 (4,000)
w there's about a 62% chance of a 6,000
lue greater than zero. That's a bit better 6,000
an the 50% in Question 1, isn't it? (4,000)
(4,000)
is is pretty much how the math of the 6,000
nture capital business works. They lose 6,000
oney on lots of their investments. But (4,000)
ery once in a while, there's a Microsoft, (4,000)
a McDonald's, or an Apple, or an eBay …
Sum of ten values: 10,000
In recent years, corporations have been required to report on their balance sheets
any liabilities arising from defined benefit pensions. A defined benefit pension
guarantees a certain monthly payment to a retiree. It's an annuity. To fund those
future obligations, companies deposit funds each year into their pension accounts.
The amount necessary to fund the future payments to a retiree is calculated based
on assumptions about the rate of return on the investments in which the pension
funds are deposited.
Many big companies have underfunded their pension obligations. There is not
enough money in the pension accounts to support the forecast future obligations.
The amount of the underfunding now must be reported as a liability on the
company's financial statements. And for some companies, that liability is a big one.
A second reason for the attention being paid to pension liabilities these days is the
rate of return companies assume when calculating the required funding. And that's
the subject of this problem.
If a company assumes a higher rate of return on invested funds, then it does not
have to set aside as much each year to "fully" fund the future obligations. It's a
simple present value calculation: with a fixed annuity payment obligation, a higher
rate of return implies a lower present value.
For years, many big companies have been assuming an 8% rate of return on the
pension funds they have invested in stocks, bonds and other securities. Not only is
this a somewhat optimistic rate of return these days. But the variability of returns
on the securities actually increases the required level of pension funding. That
variability is rarely taken into account in the calculations of pension obligations.
The required present value is simply computed by applying an 8% discount rate to
the required annuity payment stream.
Your Problem
Assume a company will owe a retiree $50,000 per year for 25 years.
Using a basic present value calculation with an 8% discount rate, you can compute
how much must be in the account at the beginning of the 25-year retirement
period in order to cover all 25 annual payments of $50,000.
How long will the calculated present value last? What are the chances that the
calculated present value really will cover all 25 payments?
Your Assignment
Your assignment is to construct a model of the annuity, with the uncertain annual
return built in. I have started a basic structure of the model for you, below. The
annual rate of return in each year should be a random value from a normal
distribution, with a mean of 8% and a standard deviation of 12%.
Start with the calculated present value of that annuity. Then for each year, compute
the return and deduct the $50,000 payment. The ending balance in each year
becomes the beginning balance for the following year. I have inserted an
INDEX-MATCH formula to compute the first year of negative balance: the year in
which the funds will run out.
Use Monte Carlo simulation to estimate how long the present value is likely to last.
Build an Excel Data Table to run 10,000 simulations of the calculation of the first
year of negative balance. Construct a frequency table and compute the percent
frequency for each year in which the ending balance first goes negative. Then sum
the percent frequencies for the years beyond 25. That sum will give you the
answer to the question posed above and repeated below.
Answer the following two questions:
1 What are the chances that the funds in the account will last at
least 25 years? That is, what proportion of the simulations
show the first year of a negative balance to be Year 26 or
later? Hit the recalc key a few times to get a sense of the
average probability.
The Model
Annual payment amount (annuity) $50,000
Number of annual payments 25
Mean rate of return 8%
Calculated present value required $144,599,614
(Use Excel's PV function. Assume the entire amount of
the annuity payment occurs at the end of the year.)
100.0%
covering all
eviation of
tire amount of
of the year.)
Frequency Table
First Negative Year Count Percent Cumulative Probability
1 0 0.0% 0.0%
2 0 0.0% 0.0%
3 0 0.0% 0.0%
4 0 0.0% 0.0%
5 0 0.0% 0.0%
6 0 0.0% 0.0%
7 0 0.0% 0.0%
8 0 0.0% 0.0%
9 0 0.0% 0.0%
10 0 0.0% 0.0%
11 0 0.0% 0.0%
12 0 0.0% 0.0%
13 0 0.0% 0.0%
14 0 0.0% 0.0%
15 0 0.0% 0.0%
16 0 0.0% 0.0%
17 0 0.0% 0.0%
18 0 0.0% 0.0%
19 0 0.0% 0.0%
20 0 0.0% 0.0%
21 0 0.0% 0.0%
22 0 0.0% 0.0%
23 0 0.0% 0.0%
24 0 0.0% 0.0%
25 0 0.0% 0.0%
26 0 0.0% 0.0%
27 0 0.0% 0.0%
28 0 0.0% 0.0%
29 0 0.0% 0.0%
30 0 0.0% 0.0%
31 0 0.0% 0.0%
32 0 0.0% 0.0%
33 0 0.0% 0.0%
34 0 0.0% 0.0%
35 0 0.0% 0.0%
More 10000 100.0% 100.0%
Total 10000