John C. Hill, sole owner of JCH Equipment Leasing Co. (JCH). is evaluating a future sale of his company aud approaches Mary Kelle, a weal adviser, for advice. Thiee discussions from their most recent mecting are shown in Exhibit 7 Discussion Number Speaker Discussion. Hill; T would like to sell JCH in three to five years and use the proceeds 10 fund my retirement. Up to this point, Ihave reinvested the majority of the profits back into the business and have not accumulated any meaningful 1 wealth outside the business. Keller: The first thing we need to consider is the cyclical nature of the equipment leasing industry, Although the economy is expanding today, the stage of the business cycle three years from now is uncertain. Hill; Ihave several good employees, but I make all of the strategic operating decisions for the company. T wake _great pride in the stellar reputation of the company and have been reluctant to cede any meaningful control. 1 have started the process of looking for a person to assist with the day-to-day operations of the company Keller: Because you are the sole owner and chief operator of the business, you are exposed 10 the consequences of a negative corporate event that may result in essentially permanent losses in wealth Hill: I believe the operating enterprise is worth $45 million, There is a good chance that a large acquirer would not want the real estate associated with it Keller Tam concemerd abou! the tital location, size, tailored nature of the stuciie, ard the old fel bunks located hehind the warehe For each discussion, identify what type of investment risk is being discussed by Hill and Keller. Sustify each choice. Answer Question J in the Template provided below Investment R Discussion | best describes systematic risk Systematic tisk is the component of risk that systematic cannot be eliminated by holding a well- diversified portfolio. Systematic risi includes macroeconomic factors such as unexpected 1 changes in the level of real business activity und unexpected changes in the inflation rate. Given non- the cyclical nature of the equipment leasing, systematic business and 3 (a 3 year larget horizon to sell he company, Hill's concentrated position in JCH is exposed to systematic risk Discussion 2 best describes non-systematic or company specific risk. This type of risk is, systematic specific to a particular company’s operations, reputation, and business environment. Hill is dhe sole owner and chief operator of JCH (key 2 person); therctore. his concentrated position exposes him toa decline in valne of the non- company should he become unable to run the systematic day-to-day operations. Such a negative corporate event may result in essentially permanent losses inn weal patio Discussion 3 best describes non-systematic risk, or property specific risk. It is the risk that the 3 value of a particular property might fall in value because Of an event dha could affect Uist ten property, but not the broader real estate market. systematic1 refers his friend, Richard Morrison, the former CEO of Masury Dridlge and Iron (MBI), t0 Keller to discuss his wealth goals, Keller meets with Morrison and gathers the following information # Richud Morrison is 50 years old and his spouse, Meredith, is 49 yeurs old, Both we healthy and both expect to live at least an additional 10 years. The Morrisons have a 20-year-old son and wonld like t transfer 5% of their wealth to him during their lifetime, = Richard Mornson retired two years ago and philanthropic boards, Meredith daes not work itends to spend his time serving on = The Morrisons own 2 million shares of MBI, currently valued at $50 million, representing approximately 9U% of thear wealth, = MBI is a larue, publicly traded company, and the Morrisons” position equals approximately 1% of the total market capitalization. 8 The Morrison family depends on dividends from MRI for their day-to-day living, expenses. = ‘The cost basis of their MBI shares is close to zero, and the capital gains tax rate is 15%. = Richard Morrison is loyal to MBI, follows the stock closely, believes he knows the company better than other investors, and expects the company to continue to be a good. investment in the future just like it has been in the past = The Morrisons" Key objective is to maintain their current standard of living during, retirement Identify and describe three primary objectives Keller would typically discuss with clients in the Morrisons" position The typical objectives Keller would discuss include reducing the risk of wealth concentration, generating liquidity to diversify and satisfy spending needs, and achieving the prior objectives in a tax-efficient manner. State and discuss Avo constraints on the Morrisons" ability to achieve their primary objectives using an outright sale of MBI shaves, Two constraints that may inhibit the Morrisons from achieving their primary objective are the tax consequences of a sale and the attachment of Mr, Morrison to his company as an investment. With a cost basis of nearly zero, an outright sale in the current year would result in the Morrisons incurring a capital gains tax of approximately $7.5 million Explain three emotional biases that may affect Richard Morrison’s decision making. A number of emotional biases can negatively affect the decision-making of holders of concentrated positions. Specifically, Richard Morrison’ decision to diversify may be negatively affected by loyalty effects, overconfidence/familiarity, and status quo/naive extrapolation of past returns. The facts indicate that Mr. Morrison is extremely loyal to MBI (loyalty effect); he believes he knows the company better than other investors (overconfidence/familiarity); and he expects the company to continue to be a good investment as it has been in the past (status quo/naive extrapolation of past returns).Keller realizes that the Morrisons’ decision making is influenced by psychological considerations and decides to use a goal-based planning approach. Keller constructs Exhibit 2 to simplify the discussion at their next scheduled meeting. Aspirational Risk Personal Risk Bucket Market Risk Bucket Bucket 3% of Assets 7% of Assets 90% of Assets Home, $1,110,061 Equities. $1,850,503 MBI Stock, Cash/Shori-term Investments: Vixed Income: $50,000,000 $556,606 $1,800,404 nimodity. $237,980 Votal: $1,666,667 Fotal: $3,888,889 Fotal: $50,000,000 Describe Keller's use of goal-based planning to highlight the consequences of the Morrisons’ selecting an asset allocation that is 100 risky. Goal-ased planning allows the adviser to incorporate psychological considerations into the asset allocation and portfolio construction process. This approach highlights the consequences of selecting an asset allocation that 18 riskier than is appropriate tor a particular investor. A goals-based methodology extends the Markowitz framework of diversitying market nsk by incorporating scveral notional “risk buckets.” ‘The first bucket is the personal risk bnckes, which includes assets such as 4 personal residence, vertifieutes of deposit, treasury sccuritics, and other safe investments. The goal of this bucket is prowetion from poverty or a decrease in lifestyle, The second bucket is the marker risk bucket, which includes assets such as stocks and bonds. The goal of this bucket is to maintain dhe cusent standard of living, The dhisd bucket is the aspirational risk bucket and includes assets such as a privately owned business, commercial and investment real estate, and concentrated stock positions. The goal of this bucket is the opportunity lo increase wealth substantially, This type of risk allocation framework would give Keller a basis to sit dawn with the Manisons and identify the significant risk dhey face from dein concentrated position and highlight that their allocations to the personal risk and market fish buckels ave inadequate Determine if the current wealth distribution is consistent with the Morrisons’ stated key objective. Justify your response. The Morrisons’ current distribution of wealth is inconsistent with their stated ohjcetive of maintaining their current standard of living. The Morrison family portfolio has 90% of their wealth allocated to MBI stock, which falls into the high risk/high return aspirational risk bucket, and only 10% allocated to the personal risk and market risk buckets. A significantly greater allocation to the personal risk and market risk buckets combined ‘with diversification of the single asset concentration (MBI) would be consistent with the stated goal of maintaining their current standard of living into retirement. Keller tells the Morrisons “Diversification is a bedrock investment principle, and there are several tools that can be used to mitigate the risk of a concentrated single stock position. » Identify and deserihe shree tools Keller is referring to in the above statement The three tools for addressing a concentrated position in a publicly traded common stock With an outright sale, owners ean sell inelucle out the concentrated position, which gives them funds to meet a spending need or reinvest. An outright sale typically results in significant tax liabilities, Monetization stratesies provide the owners with funds to spend or reinvest without tggering a taxable event. A loan against the value of a concentrated position is an example of a monetization strategy The owner of’ concentiated position ean hedge dhe value of dhe concentiated position ith derivatives, A long put position is an example of a hedge.Keller and Richard Morrison discuss several hedging techniques and Morrison makes the following statement like the strategy that allows me t lock-in a floor price and retain unlimited upside potential.” Identify and diseuss the hedging tool that Morrison is mast lekely referring to in the above statement. The hedging tal Morrison is most likely describing is a protective put position The strategy is the combination of a long stock position and a long put position, which would provide downside protection (lock in a floor price) with unlimited upside particip Morrison wonld buy put options equivalent to the number af shares to he hedged The put options would have a strike price that is either at or, more typically, slightly below the current stock price. Morrison would pay an amount, referred to as the option premium, to acquire the puts Conceptually, this is similar to the payment af an insurance premium TF the price of MBI falls below the strike price during the term of the option, the put option could be exercised at the strike price, providing downside protection. If the share price is, above the stike price al matutily, Morison would fet the option expire and retain the upside A zero-premium collar would not accomplish Morrison's goal to lock in a floor price and retain unlimited upside potential, A cashless collar is established by buying, put selling calls on the shares to be hedged. The long put protects the owner of the shares from any loss below the strike price of the puts. However, the investor forteits some of tial of he underlying stock, Like a cashless collar, a prepaid variable forward (PVF) would not accomplish Morrison’s goal. A PVF combines the economi. of a collar and borrowing against the underlying stock within a single instrument. ‘and Explain one drawhack of this hedging strategy There are two potential drawhacks with this hedging strategy The strategy requires an out-of-pocket expenditure to purchase the put options, which can be significant depending on a number of factors, including the volatility of the stock, the strike price, and maturity. Another potential drawback is the credit risk of the counterparty. Counterparty risk is greater for an over-the-counter (OTC) derivative because the investor incurs Ue credit tisk of a single Counterparty, Will respect to exclanue-tracled unients, because a clearinghouse is the counterparty and guarantees dhe insu ument, the investor incurs significantly less counterparty risk Keller also discusses a yield enancement strategy and asks Mortison to establish a liquidation value at which he would be willing to sell 10% of his position in MBI . State and discuss the tool Keller is most likely recommending to Morrison, Keller is most likely recommending writing covered calls against 10% of Morrison's shares in MBI, Morrison would sell call options with a strike price that is above the current price of MBI and in return receive premium income (yield enhancement) from the sale of the call options, The strategy effectively allows the investor to establish a Liquidanon valne (the strike price) for the shares he/she writes call options against. If the stock price increases ahove the strike price at maturity, the calls will be exercised and Morrison will deliver his long shares. Ie would receive a total sum equal to the strike price of the calls and the premium from the initial sale of the calls. If MBI closes at or helow the strike price at expiration, the calls will expire worthless and Morrison will retain the option premium and the long shares. One of the most significant benefits of implementing a covered call writing program is that it can psychologically prepare the ‘owner to dispose of his/her shares. Explain éve dhawbacks (this strategy There are two potential drawbacks with this strategy: The investor retains full downside exposure to the shares (to the extent the share price decreases by more than the premium received), and the upside potential is limited (the call strike price plus the premium received).Keller and John C. Hill, the sole owner of JCH Equipment Leasing Co. (ICH), meet to further consider alternate strategies to achieve his objectives of selling JCH, diversifying his single asset concentration, minimizing taxes, and retiring within a 3-5 year time period. Hill believes. that tax rates are likely to increase in the near future. In the course of a discussion with Hill, Keller recommends that Hill meet with a reputable “middle market” private equity firm to discuss a leveraged recapitalization strategy. Describe a leveraged recapitalization strategy and determine if this strategy will accomplish Hill’s objectives. A leveraged recapitalization is a strategy that involves retooling a company’s balance sheet in parmership with a private equity firm. A recapitalization stratezy is a “staged exit strategy, which allows the cwner to have two liquidity events, one up-front and a second typically within a 3 to 5 ycar timeframe, when the private equity firm cashes out of the investment. The private equity firm generally invests equity capital and urranges debt with senior ar subordinated lenders ‘The owner transfers his/her stock for cash and an ownership interest in the newly capitalized entity. This allows the owner to monetize a significant portion of his/her business equity (ly pically 60% (o 80%) and retain significant upside potential with the remaining ownership (typically 20% to 40%). The after-tax proceeds the investor receives could be deployed into other asset classes to help build a diversified portfolio, Additionally, the retained stake motivates the owner to grow the business, From a tax perspective, the owner is taxed currently on the cash received and typically receives a tax deferral on the stock rolled aver into the new entity. This strategy would be appealing to a business owner considering selling a private business in the near future and residing in a jurisdiction where ix rates are scheduled to increase, A leveraged recapitalization strategy appears to be appropriate to meet Hill’s objectives The strategy would allow Hill to reduce the risk of his wealth concentration, generate liquidity to diversify his single asset concentration, minimize his tax liability before tax rates increase, and retire in a 3~S year time period Explai avo disadvantages to this exit plan, There are two potential disadvantages to employing a leveraged recapitalization strategy Private equity firms are financial buyers and, as such, they typically will not pay as high a price as strategic buyers because they do not have the same opportunity as strategic buyers to take advantage of financial and operating synergies. A second potential disadvantage is that the owner relinquishes control of the company.