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CASE 1: S&S Air’s investment

You recently graduated from college, and your job search led you to S&S Air. Because you
felt the company’s business was taking off, you accepted a job offer. The first day on the job,
while you are finishing your employment paperwork, Chris Guthrie, who works in Finance,
stops by to inform you about
A 401(k) plan is a retirement plan offered by many companies. Such plans are tax-deferred
savings vehicles, meaning that any deposits you make into the plan are deducted from your
current pretax income, so no current taxes are paid on the money. For example, assume your
salary will be $50,000 per year. If you contribute $3,000 to the 401(k) plan, you will pay taxes
on only $47,000 in income. There are also no taxes paid on any capital gains or income while
you are invested in the plan, but you do pay taxes when you withdraw money at retirement. As
is fairly common, the company also has a 5 percent match. This means that the company will
match your contribution up to 5 percent of your salary, but you must contribute to get the match.
The 401(k) plan has several options for investments, most of which are mutual funds. A mutual
fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually
purchasing partial ownership of the fund’s assets. The return of the fund is the weighted average
of the return of the assets owned by the fund, minus any expenses. The largest expense is
typically the management fee, paid to the fund manager. The management fee is compensation
for the manager, who makes all of the investment decisions for the fund.
S&S Air uses Bledsoe Financial Services as its 401(k) plan administrator. Here are the
investment options offered for employees:
Company Stock One option in the 401(k) plan is stock in S&S Air. The company is currently
privately held. However, when you interviewed with the owners, Mark Sexton and Todd Story,
they informed you the company stock was expected to go public in the next three to four years.
Until then, a company stock price is simply set each year by the board of directors.
Bledsoe S&P 500 Index Fund This mutual fund tracks the S&P 500. Stocks in the fund are
weighted exactly the same as the S&P 500. This means the fund return is approximately the
return on the S&P 500, minus expenses. Because an index fund purchases assets based on the
composition of the index it is following, the fund manager is not required to research stocks
and make investment decisions. The result is that the fund expenses are usually low. The
Bledsoe S&P 500 Index Fund charges expenses of .15 percent of assets per year.

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Bledsoe Small-Cap Fund This fund primarily invests in small-capitalization stocks. As such,
the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in
companies based outside the United States. This fund charges 1.70 percent in expenses.
Bledsoe Large-Company Stock Fund This fund invests primarily in large-capitalization stocks
of companies based in the United States. The fund is managed by Evan Bledsoe and has
outperformed the market in six of the last eight years. The fund charges 1.50 percent in
expenses.
Bledsoe Bond Fund This fund invests in long-term corporate bonds issued by U.S.-domiciled
companies. The fund is restricted to investments in bonds with an investment-grade credit
rating. This fund charges 1.40 percent in expenses.
Bledsoe Money Market Fund This fund invests in short-term, high credit-quality debt
instruments, which include Treasury bills. As such, the return on the money market fund is
only slightly higher than the return on Treasury bills. Because of the credit quality and short-
term nature of the investments, there is only a very slight risk of negative return. The fund
charges .60 percent in expenses.

QUESTIONS
1. What advantages do mutual funds offer compared to the company stock?
2. Assume that you invest 5 percent of your salary and receive the full 5 percent match from
S&S Air. What EAR do you earn from the match? What conclusions do you draw about
matching plans?
3. Assume you decide you should invest at least part of your money in large-capitalization
stocks of companies based in the United States. What are the advantages and disadvantages of
choosing the Bledsoe Large-Company Stock Fund compared to the Bledsoe S&P 500 Index
Fund?
4. The returns on the Bledsoe Small-Cap Fund are the most volatile of all the mutual funds
offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine
the expenses of the mutual funds, you will notice that this fund also has the highest expenses.
Does this affect your decision to invest in this fund?
5. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe
ratio is calculated as the risk premium of an asset divided by its standard deviation. The

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standard deviation and return of the funds over the past 10 years are listed in the following
table. Calculate the Sharpe ratio for each of these funds. Assume that the expected return and
standard deviation of the company stock will be 18 percent and 70 percent, respectively.
Calculate the Sharpe ratio for the company stock. How appropriate is the Sharpe ratio for these
assets? When would you use the Sharpe ratio?

6. What portfolio allocation would you choose? Why? Explain your thinking carefully.

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 CASE 1: SOLUTION
401k plan has deferred tax, and only pays tax when withdrawing to retirement
Match contribution 5%
● Mutual fund: Income (basic on the weight of each asset) – expense
● The management fee is the biggest (compensate for the manager of the fund)
Investment option
1. Company stock
S&S air stock – privately held
Stock expected to go public in the next 3 or 4 years
Company stock price set each year by BOD
2. S&P 500 Index fund (ETF)
Based on the S&P index
Expense low – 0.15%/ total asset/ year
3. Bledsoe Small-Cap Fund
Invest in small capitalization stock
Return is volatile
10% invest outside the US
1.7% expense fee
4. Bledsoe Large-Company Stock Fund
Invest in more extensive cap stock inside the US
Outperformed in 6/8 last year, 1.5% expense fee
5. Bledsoe Bond Fund
Invest in long-term corp bonds
Restricted investment in bonds with investment credit rating, 1.4% expense fee
6. Bledsoe Money Market Fund
Invest in high-quality short-term debt instruments (T bills)
Slight risk of negative return, a 0.6% expense fee

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Question 1:
A mutual fund is safer than a company stock. Because the mutual fund is active as the Index
market performs, however, the company stock price is put by the BOD of the firm. They will
neglect the benefit of the un-crowded stockholder.
Furthermore, the fee of a mutual fund is quite low and the risk that investors have to take is
lower than other kinds of investment instrument sets.
If the stock of the company will not be initial, investors will lose holding opportunities cost
and no capital gain for this investment.
Question 2:
5% 12
𝐸𝐴𝑅 = (1 + ) − 1 = 5.11% > 5% 𝑚𝑎𝑡𝑐ℎ𝑖𝑛𝑔 𝑓𝑟𝑜𝑚 𝑖𝑛𝑐𝑜𝑚𝑒
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The matching plan is beneficial for the employee when they make monthly contributions from
their salary.
Question 3:
Investing in Bledsoe Large-Company Stock Fund needs to pay more fees (1.5% > 0.15%) than
Bledsoe S&P 500 Index Fund. Moreover, investing in large-cap company stock requires
comprehension expertise about all kinds of investment firms. However, the investment from
large companies may be higher than the average market because they are the flagship – stock
of all markets, and they are expected to get higher return performance than other firms.
Question 4:
Bledsoe Small-Cap Fund usually prefers high beta stock, so the price volatility is higher than
other investment funds.
Although the fee is high, the asset allocated outside the US is an advantage. Because they can
find another national economy with lower interest. So the discount rate for investment
instruments in that nation is lower -> Appreciate the value of the investment.
Bledsoe Small-Cap Fund is believed to be extremely effective when the economy is booming,
put in a low-interest rate scenario.

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Question 5:

Company stock 18% 70% 0.194285714

S&P index fund 11.48% 15.82% 0.447534766

Small cap fund 16.68% 19.64% 0.625254582

Large cap fund 11.85% 15.41% 0.483452304

Bond fund 9.67% 10.83% 0.486611265

SHARP ratios = (Rm – Rf)/ Standard deviation

Rf = 4.4% (10-year gave bond yield)
The Sharpe ratio is appropriate to assess the risk in this kind of investment instrument.
The Sharpe ratio is one of the most widely used methods for measuring risk-adjusted relative
returns.
RISK: default risk, maturity risk, liquidity risk, and inflation risk

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Question 6:
A retirement plan is long-term investment liquidity and a high premium for the risk of the
market.

10-year Standard SHARPE Weighted Average

deviation RATIO return

Small cap 16.68% 19.64% 0.625254582 15% 2.50200%

fund

Bond fund 9.67% 10.83% 0.486611265 20% 1.93400%

Large-cap 11.85% 15.41% 0.483452304 20% 2.37000%

S&P index 11.48% 15.82% 0.447534766 35% 4.01800%

fund

Company 18% 70% 0.194285714 10% 1.80000%

stock

? 12.62400%

QUALITATIVE BASE

Client Employee

Time horizon horizon

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Risk tolerance Varies by fund

Income needs Retirement plan

Liquidity needs Typically low

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