Executive Summary

Background

Dave Roserio, a new financial advisor in Morton Staley & Company, was tasked to
assist one of their clients, Laura Henderson in evaluating and managing her financial
portfolio. Laura is a 71-year old lady whose financial investments are all with TECO
Energy Inc. It is divided between TECO common stock and bonds. Ever since Laura
began her portfolio, she has limited herself into investing solely with TECO, following
her father’s advise to keep with the company and believing that TECO is the “best
managed, safest company in the world”.
As a financial advisor, Dave is uneasy with keeping all of their client’s investment in
one company. He found it quite risky to depend solely on one industry, particularly
one that is experiencing rapid and unprecedented changes in its regulatory
environment. To convince Laura to diversify her investments and enjoy better
financial benefits, he is putting together a presentation that will highlight the
advantages of diversifying the current portfolio and continuing to ensure that Laura
will be financially stable for the rest of her days.

Statement of the Problem

What best investment mix should Dave Roserio advise Laura Henderson (his client)
to ensure that its profits are able to meet Laura’s requirement of having $100,000.00
yearly as her income and still have a robust investment left to her heirs.

Alternative 1: Maintain status quo

Retain investments in TECO as they are, and not invest on others, retain current
portfolio and have the same sources of income

Pros

For the longest time, Laura has put her confidence in her TECO investment. As she
also mentioned, her father has always told her that “TECO is the best managed
safest company in the world. Whatever you do, don’t let anyone talk you into selling
your TECO stock and bonds”. Keeping her investments as they are will definitely
make Laura feel more at peace, as she will continue to “obey” what her father would
have wanted her to do.

To add to this, keeping her shares and bonds as they are will allow her to enjoy
forecasted increase in earnings for TECO. The CEO has even stated that “TECO
Energy is committed to 10 percent average annual earnings growth over the long
term”. According to Dave’s retention growth rate computation, it should be at 5.58%.
This value means a relatively high payout rate (dividends) but, on the other hand can
translate to a comparatively low rate of growth in future years. Moreover, other
analysts’ 5-year forecast on the company’s growth rate amounted to 9.2%. Other
than this, a Morton Staley’s electric utility analyst also seemed positive about the
growth, estimating 6%, but also noting that the company might very well hit its 10%
target.

Also, as was mentioned in Table 4 (Press Release), given in the case, the company
seems to be seeing positive results for the current year and in the future years
mainly due to the investments of expansion in its operations and increase in
customer base. They are seeing even double-digit growth in TECO energy.
Considering the forecasted growth and expansion on operations, and the company’s
considerable stability, retaining the same set of investments and assets might very
well be a good decision for Laura.
Cons

Risks related to this however include not being able to meet the $100,000 target
income in a year (as the computation on income in previous section showed –
considering current stable/regular income and estimated inflation). Although we are
anticipating some growth in the future, there still is a risk of not attaining or even
exceeding the targets/forecasts, especially considering the high level of debt being
incurred by the company, related to their expansion activities. And having a bulk of
her investments in just 1 company (and even industry) even increases the impact of
such risks on Laura. To add to these, deregulation activities by the government have
also increased competition within the industry, thereby threatening TECO’s
profitability. As was mentioned in the case, “deregulation has helped some
companies but seriously harmed others”. TECO, being a utility company might also
be harmed by this.

Moreover, assuming that there is no change in the coupon rates and with the
assumptions below, the yearly net income without considering inflation rate show
that the earnings from Laura’s income will not be enough to support her 100K USD
per year lifestyle (61,457 USD only).

5,000,0
Laura's net worth (USD) = 00
Assumptions:

Investment Allocation: 30 fixed assets, 70% face value of bonds and

stocks
3,500,0
Face value of bonds and stocks (USD) = 00
1,750,0
Value of bonds (1/2) (USD) = 00
1,750,0
Value of stocks (1/2) (USD) = 00
Value of bonds with coupon rate of 8% (USD) = 750,000
Value of bonds with coupon rate of 5.35% (USD) = 500,000
Value of bonds with zero coupon rate (USD) = 500,000

Yearly Income from Bonds:

Coupon rate of 8% = 750K x 8% = 60,000

Coupon rate of 5.35% = 500K x 5.35% = 26,750

Total Income from Bonds 86,750

Add: Social Security income 15,000

101,75
Total Income from bonds and sss 0
Less: Income tax (39.6%) 40,293

61,45
Net Income Yearly 7
As previously stated, the above net income calculation did not considered inflation
yet. The compounded annual inflation rate over 30 years can be derived from the
yield of the treasury securities with 30-year maturities which is 4.84% based on Table
1. Since the real inflation-free rate of return on long-term treasury bonds has
historically ranged from 1.82 to 4.84%, with a mean of about 3%, a good assumption
for inflation rate is 1.33% (4.84% - 3.33%).

Hence, the yearly net income of Laura, discounted for inflation is as follows:

Year 1 (2003): PV 3886.42

= 4 Note: Present value is based on TODAY = January 2000.
Year 2 (2004): PV 1548.37
= 6 The bond is purchased in January 2002 and so
Year 3 (2005): PV 616.882
= 9 first interest income is in January 2003. 2003.
Year 4 (2006): PV 245.770
= 1

With consideration of inflation, the yearly net incomes of Laura are even
lower. Thus, there is a very big risk in retaining Laura’s current investment mix.

Alternative 1: Diversify the Portfolio

Retain some investments in TECO but invest also in other companies and industries

Below is the computation of the yearly income of Laura Henderson based on her
current investments and Social Security pension.

Laura's net worth =

$5million
face value of bonds and
stocks = $4.5million
half is bonds =
$2.25million
half is stocks =
$2.25million
assume zero bonds = $0.25million
half of the bonds has coupon rate of 8% =
$1million
half of the bonds has coupon rate of 5.35% =
$1million

Yearly Income from Bonds:

Coupon rate of 8% = $1million x thousan

8% = 80000 d
thousan
Coupon rate of 5.35% = $1million x 5.35% = 53500 d

thousan
Total Income from Bonds 133500 d
Add: Social Security 15000 thousan
 income d

thousan
Total Income from bonds and sss 148500 d
thousan
Less: Income tax (39.6%) 58806 d

Net Income thousan

Yearly 89694 d

This yearly net income is guaranteed cash flow (not considering yet the potential
default or call).
Although she has stocks in her portfolio, the cash flow from this will not be included
yet as this is not guaranteed. Dividends are not guaranteed and "buying and selling"
stocks cannot also be predicted at this point. For analysis of "guaranteed" cash flow,
the assumption for the meantime is that Laura will hold on to her stocks indefinitely.

The above net income calculation has not considered inflation yet. The compounded
annual inflation rate over 30 years can be derived from the yield of the treasury
securities with 30-year maturities which is 4.84% based on Table 1. Since the real
inflation-free rate of return on long-term treasury bonds has historically ranged from
2 to 4 percent, with a mean of about 3%, a good assumption for inflation rate is
1.84% (4.84% - 3%).

Hence, the yearly net income of Laura, discounted for inflation is as follows:

84919. Note: Present value is based on TODAY =

Year 1 (2003): PV = 65 January 2000.
83385. The bond is purchased in January 2002
Year 2 (2004): PV = 36 and so
81878. first interest income is in
Year 3 (2005): PV = 79 January 2003.
80399.
Year 4 (2006): PV = 44

Given the above computation, it is clear that the income Laura will receive is
below her need and requirement of $100,000.00. The present value of what she will
receive is only about $80,000.00.
Diversifying her portfolio to include investments in other industries and
companies will source for her other incomes that come with higher yields. Her new
investments can close the income gap of $20,000.00 missing from her current
portfolio. It will also minimize risk for her as the industry she is concentrating on is
undergoing deregulation and new competitors are coming in. The recent and
aggressive competition will affect the operations and profitability of TECO, which in
turn will affect its stock prices and yield.