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Question Description

MBA 6400 Case Study #1

Short-term investment returns: money market instruments Part of your responsibilities as a junior financial analyst is researching and identifying potential short-term liquid investment options for your firm. These investment vehicles are at times used by the firm during periods when their cash inflows exceed projections. The firm, at times, uses excess cash to purchase short-term debt instruments providing a low, but safe marginal return on invested capital.

Your Director, who reports to the firm’s Chief Financial Officer (CFO) has come to you seeking your recommendation on short-term investment options for the upcoming year. The Director has asked for recommendations and a report illustrating your optimal analysis for investing $2.5m of excess cash.

Current background info: We have a potential impending compound money market problem: The U.S. is issuing more debt, in part due to the recent tax cuts. Simultaneously, the Fed, China, Japan and to a lesser degree Russia have been reducing their holdings of U.S. Debt. Therefore, if the U.S. Treasury Department can’t get entities to their positions holding U.S. debt, then the pressure to increase interest rates to make newly issued securities attractive increases. Increased interest rates at the Treasury means securities prices fall with cascading impacts.

Therefore, the current interest rate environment is one where rates are expected to increase.

Parameters for the research and analysis report are as follows:

1. Investments selections are primarily short term (one year or less), but will consider U.S. Treasury Bills of shorter duration as well as TIPS.

2. A minimum of 3 short term debt money market security types are to be recommended. They may include Federal money market bills, U.S. Savings Bonds, CDs, U.S. Treasury Notes, Treasury Bills, and TIPS.

a. Note: money market investments of the range of two to five years are acceptable.

b. However, no more than 40% of the portfolio can be invested in a security of with duration of greater than 12 months.

3. A recommendation on the optimal allocation of $2.5 m across the investment portfolio is required.

4. Current (as of the date of this assignment) rates and investments are to be used.

The analysis report to be presented to the Director is to include:

1. Your concise statement and recommendation of the specific short-term investment options that meets the firm’s criteria.

Followed by:

2. A detailed summary of the investment asset and the parameters you will use in which to base your recommendation.

3. A detailed description of the upside and downside risk of each investment. The latter is of particular importance as the firm may decide to manage excess cash in one or more vehicles for longer than one year.

4. Source identifier for all investment selections

a. Example: website URL

5. A spreadsheet (embedded into the report) illustrating the following:

a. Asset category/classification

b. Specific money market instrument identifier i. Example: U.S. Treasury CUSIP

6. EAR for each investment

7. YTM for each investment

a. If held to maturity

b. If sold at the end of 12 months

8. Total return for investment portfolio if held to maturity

9. Spreadsheet model is to include all cell-based formulas for all calculations Your conclusion is to summarize the recommendation made in item #1 above Format for report.

Your report must:

1. Be presented in Word file format

2. Analysis must be between 3 to 5 pages maximum, including spreadsheet analysis

3. Excel spreadsheet is embedded into the Word file

4. Submit Excel file separately

Translation:

You can use a variety of online sites to find listings of Treasury instruments, i.e., Federal money market bills, U.S. Savings Bonds, CDs, U.S. Treasury Notes, Treasury Bills, and TIPS, as noted in the assignment. You need to list the CUSIP (Committee on Uniform Security Identification Procedures) of each instrument you select. CUSIP is the nine-digit alphanumeric code that identifies a U.S. security individually to facilitate trading. One such site is TreasuryDirect (https://www.treasurydirect.gov/instit/auctfund/work/auctime/auctime_securitiestable.htm), but the same info is available through a variety of sites. You may use more than one, but be sure to identify the ones you use for individual instruments. Also, please use the same date for your quotes

You’ll find the current rates and asking prices of these instruments in the listings.

You also need to compute the EAR (Effective Annual Rate) for each instrument. The formula is:

R = [1 + (i/n)]n – 1.

In this formula, i = the stated or nominal annual interest rate and n = the number of compounding periods of the instrument.

This formula lets you compare the yields of different instruments.

Here’s an example:

Investment A yields a 10% nominal rate, and it’s compounded monthly

Investment B yields a 10.1% nominal rate, compounded semi-annually (every six months)

For investment A, this would be: 10.47% = (1 + (10% / 12)) ^ 12 – 1

For investment B, it would be: 10.36% = (1 + (10.1% / 2)) ^ 2 – 1

As you see, A has a higher EAR, even though B’s nominal rate is higher, because it compounds more frequently.

You can calculate this yourselves in Xcel or with a financial calculator, or use an online calculator.

Here’s a calculator:

Next, you need to calculate YTM (Yield to Maturity) if held to maturity (depending on the instrument) and if held for a year from the selection date (12 months). The formula is:

YTM = n√Face value/Current Price – 1. n = number of years to maturity. If you apply this for a year, n = 1, so you use the square root of the ratio. If the maturity date is higher, you use the higher order root.

Here’s a calculator, one of many you can find on the internet:

https://www.investopedia.com/calculator/aoytm.aspx (Links to an external site.)

Once you’ve calculated this for the instruments you select (You need at least three, and you can weed out similar instruments with comparable or lower yields.), add up the totals for each to provide the interest income from investments. Note the constraints in the case study, i.e., interest rates likely will rise, and bond prices will fall, and you may select no more than 40% of the total $2.5 million investment in instruments with maturities longer than a year.

I hope it’s clear that there’s no precisely correct answer to this. What you want to do is produce favorable income from excess cash, more than you’ll make letting it sit in a normal account.

Questions or concerns, holler.