An Investment Problem related to Bond Portfolio

2. Akshay Banda is a financial analyst for Retirement Planning Services, Inc. who specializes in
designing retirement income portfolios for retirees using corporate bonds. He has just completed a
consultation with a client who expects to have $750,000 in liquid assets to invest when she retires
next month. Banda and his client agreed to consider upcoming bond issues from the following six
companies:

Year To
Security Return % Maturity Rating
A 8.60% 11 Excellent
D 9.50% 10 Good
E 10% 6 Fair
M 8.75% 10 Excellent
O 9.25% 7 Good
S 9% 13 Very Good

The column labeled "Return" in this table represents the expected annual yield on each bond, the
column labeled "Years to Maturity" indicates the length of time over which the bonds will be
payable, and the column labeled "Rating" indicates an independent underwriter's assessment of the
quality or risk associated with each issue.

Banda believes that all of the companies are relatively safe investments. However, to protect his
client's income, Banda and his client agreed that no more than 25% of her money should be invested
in any one investment and at least half of her money should be invested in long-term bonds that
mature in 10 or more years. Also, even though D, E, and O offer the highest returns, it was agreed
that no more than 35% of the money should be invested in these bonds because they also represent
the highest risks (Le., they were rated lower than "very good").

Banda needs to determine how to allocate his client's investments to maximize her income while
meeting their agreed upon investment restrictions.

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2. A bank has $650,000 in assets to allocate among investments in bonds, home Mortgages, car
loans, and personal loans. Bonds are expected to produce a return of 10%, mortgages 8.5%, car
loans 9.5%, and personal loans 12.5%. To make sure the portfolio is not too risky, the bank wants to
restrict personal loans to no more than the 25% of the total portfolio. The bank also wants to ensure
that more money is invested in mortgages than personal loans. The bank also wants to invest more
in bonds than personal loans.

a. Formulate an LP model for this problem with the objective of maximizing the expected return on
the portfolio.

b. Implement your model in a spreadsheet and solve it.

c. What is the optimal solution?

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3. Mr. Jai Gupta, a trust officer at the Blacksburg National Bank needs to determine how to invest
$100,000 in the following collection of bonds to maximize the annual return.

Bond Annual Return Maturity Risk Tax-Free

A 9.5% Long High Yes

B 8.0% Short Low Yes

C 9.0% Long Low No

D 9.0% Long High Yes

E 9.0% Short High No

The officer wants to invest at least 50% of the money in short-term issues and no more than 50% in
high-risk issues. At least 30% of the funds should go in tax-free investments and at least 40% of the
total annual return should be tax free.

a. Formulate an LP model for this problem.

b. Create a spreadsheet model for this problem and solve it using Solver.

c. What is the optimal solution?

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Investment

Thom Pearman's life is changing dramatically. He and his wife recently bought a new home and are
expecting their second child in a few months. These new respon insurance. Ten years ago, Thom
purchased an insurance policy that provides a death benefit of $40,000. This policy is paid for in full
and will remain in force for the rest of Thom's life. Alternatively, Thom can surrender this policy and
receive an immediate payoff of approximately $6,000 from the insurance company.

Ten years ago, the $40,000 death benefit provided by the insurance policy seemed more than
adequate. However, Thom now feels that he needs more coverage to care for his wife and children
adequately in the event of his untimely death. Thom is investigating a different kind of insurance
that would provide a death benefit of $350,000 but would also require ongoing annual payments to
keep the coverage in force. He received the following estimates of the annual premiums for this new
pol-icy in each of the next 10 years:

Year 1 2 3 4 5 6 7 8 9 10
Premium $423 $457 $489 $516 $530 $558 $595 $618 $660 $716
To pay the premiums for this new policy, one alternative Thom is considering involves surrendering
his existing policy and investing the $6,000 he would receive to generate the after-tax income
needed to pay the premiums on his new policy. However, to see if this is possible, he wants to
determine the minimum rate of return he would have to earn on his investment to generate after-
tax investment earnings that would cover the premium payments for the new policy. Thom likes the
idea of keeping the $6,000 in case of an emergency and does not want to use it to pay premiums.
Thom's marginal tax rate is 28%.