3. (Adapted from the 2002 CFA Level III examination)

Initial Client Circumstances Claire Wisman, a vice president for Spencer Design, is a 42-year-old widow who lives in the United States. She has two children: a daughter, age 21, and a son, age 7. She has a $2.2 million portfolio; half of the portfolio is invested in Spencer Design, a publicly traded common stock, which has a cost basis of $350,000. Despite a substantial drop in the value of her portfolio over the last two years, her long-term annual total returns have averaged 7 percent before tax.

The recent drop in value has caused her great anxiety, and she believes that she can no longer tolerate an annual decline greater than 10 percent.

Wisman intends to retire in 20 years, and her goals for the next 20 years, in order of priority, are as follows. The present values given are gross of taxes.

• Funding the cost of her daughter’s upcoming final year of college, which has a present value of $26,000, and her son’s future college costs, which have a present value of $130,000.

• Increasing the portfolio to a level that will fund her retirement living expenses, which she estimates to be $257,000 for the first year of her retirement.

• Building her ‘‘dream house’’ in five years, the cost of which (including land) has a present value of $535,000.

• Giving, if possible, each of her children $1 million when they reach age 40.

After subtracting the present value (before tax) of her children’s education costs and her homebuilding costs, the present value of her portfolio is $1,509,000. With returns from income and gains taxable at 30 percent and with continued annual growth of 7 percent before tax (7% × (1 − 0.30) = 4.9% after taxes), the portfolio’s value will be approximately

$3,928,000 net of taxes at the end of 20 years.

Wisman’s annual salary is $145,000, her annual living expenses are currently $100,000, and both are expected to increase at an inflation rate of 3 percent annually. Taxes on income and short-term capital gains (holding period one year or less) are substantially higher than taxes on long-term capital gains (holding period greater than one year). For planning purposes, however, Wisman wants to assume that her average tax rate on all income and gains is 30 percent. The inflation and tax rates are expected to remain constant. Currently,