Topic and question: Practice question from core reading (Q16-23) page 468 to 470: Topic Private wealth Management.
I am pasting the relevant abstract of question number 22
ITEM SET
Adrian and Olivia Barksdale live in Australia with their 16-year-old twins. Adrian, 47, works in a highly cyclical industry as an engineering manager at a bauxite mine. Olivia, 46, is an accountant. The Barksdales are saving for their retirement and college funding for both children. Adrian’s annual salary is A$190,000; Olivia’s annual salary is A$85,000. The family’s living expenses are currently A$95,000 per year.
Both Adrian and Olivia plan to work 18 more years, and they depend on their combined income and savings to fund their goals. The Barksdales’ new financial adviser, Duncan Smith, recommends an appropriate disability insurance policy to cover Adrian, given his large salary. Because he has a highly specialized job, Adrian is willing to pay for the most comprehensive policy available.
Smith is also concerned about the Barksdales’ existing life insurance coverage. Currently, the Barksdales have a term life policy insuring Adrian with a death benefit of A$100,000. Smith assesses the family’s insurance needs in the event Adrian were to die this year. To do so, Smith uses the needs analysis method based on the financial data presented in Exhibit 1 and the following assumptions:
- The discount rate is 6.0%, and the tax rate is 30%.
- Salary and living expenses grow at 3.5% annually.
- Salary and living expenses occur at the beginning of each year.
- The following assumptions apply in the event of Adrian’s death:
- Olivia will continue to work until retirement;
- Family living expenses will decline by $30,000 per year;
- Olivia’s projected living expense will be $50,000 per year for 44 years; and
- The children’s projected living expenses will be $15,000 per year for 6 years.
Exhibit 1
Barksdale Family Financial Needs Worksheet
Cash Needs | AUD (A$) |
Final expenses and taxes payable | 20,000 |
Mortgage retirement | 400,000 |
Education fund | 300,000 |
Emergency fund | 30,000 |
Total cash needs | 750,000 |
Capital Available | |
Cash and investments | 900,000 |
Adrian: Life insurance | 100,000 |
Total capital available | 1,000,000 |
Smith turns to a discussion about the Barksdales’ investment portfolio and how total economic wealth (human capital plus financial capital) might affect asset allocation decisions. The Barksdales’ human capital is valued at $2.9 million and estimated to be 35% equity-like. Smith determines that an overall target allocation of 40% equity is appropriate for the Barksdales’ total assets on the economic balance sheet.
Q22.
Q. Based on Exhibit 1, and meeting the Barksdales’ target equity allocation for total economic wealth, the financial capital equity allocation should be closest to:
Answer given by Institute:
C is correct. The equity allocation of the Barksdale’s financial capital is calculated as follows:Total economic wealth = Human capital + Financial capital = $2,900,000 + $900,000 = $3,800,000.Target equity allocation of total economic wealth = $3,800,000 × 40% = $1,520,000Human capital equity allocation = $2,900,000 × 35% = $1,015,000Financial capital equity allocation = $1,520,000 – $1,015,000 = $505,000
% Financial capital equity allocation = Financial equity allocation/Total financial capital
= $505,000/$900,000
= 0.5611, or 56.1%
MY DOUBT: WHY HAVE THEY NOT CONSIDERED ADANI: LIFE INSURANCE VALUE OF $ 100000 IN THE CALCULATION OF FINANCIAL CAPITAL.
THE FC SHOULD HAVE BEEN 1000000 INSTEAD OF 900000.
REASON: THE CASH VALUE OF INSURANCE IS TREATED AS NON MARKETABLE FINANCIAL CAPITAL.
Insurance is not an asset that should be considered in the balance sheet. It is because the payoff of the insurance is contingent on an event i.e., the death of Adrian.
For example, consider the PV of future earnings today is $10m. This is considering that the couple continues to live in future till retirement at least. The husband wants to secure the human capital if he dies early so he gets a life insurance and the payoff of the insurance in the event of his death is fixed based on the needs in the future. Say, he gets an insurance of $4.5m and he dies after 5 years when their PV of future earnings is $7m. Now that the husband has died, this PV will fall below $7, future spending liability will reduce and the family will receive $4.5m. But, that does not mean that this insurance should be a part of the balance sheet today. The payoff will only be earned in case the insured event occurs. And when it does occur it will be reflected under Cash (receipt from insurance company). So, there will never be an asset titled Insurance.
But permanent Life insurances do have cash value. further in the core reading it’s clearly mentioned that Cash value of the insurance is a part of Financial capital and Financial capital is in turn included in the economic balance sheet .
ohk ! I see , it’s written in the question that 100000 is the death benefit . But in table they simply mentioned 100000.
I got confused, 100000 is a death benefit not cash value – so should not be included in the Financial capital .
I got it now .
Cash value is, in simple words, the amount to be received at the end of the insurance term as mentioned in the insurance contract. Here, we are basically paying premiums and receiving an amount at maturity. So, in a way, it is like an investment, where payoff is not contingent on the occurrence of the insured event. Therefore, it’s nature is that of an asset and it is thus included in the balance sheet.
Note that there may be specific terms and details to be considered regarding cash values and insurance contracts and the above explanation is just a basic idea of why cash value is included in the balance sheet.