Problem
The Central Hospital (CH) has an operating budget of $55 million and has been operating in a budget surplus for the last two years. CH has a $70 million endowment (CHE) whose sole purpose is to provide capital equipment for the hospital. The endowment's long-term expected total return is 8.0%, which includes a 3.0% income component. CHE has no minimum payout requirement and expects no future contributions. Traditionally, the CHE board of directors has determined the annual payout based on current needs. Payouts have been rising steadily- to $4.6 million two years ago and to $5 million last year. Sarah Mason, the CFO of CH, has asked for the board's guidance in establishing a long-term spending policy for CHE. She has received $5.7 million in requests to buy equipment and is concerned about the inflation rate for medical equipment prices, which is 3.5%, versus 2.0% for the Consumer Price Index. The annual management expenses of the fund are 0.2%.
1. Discuss how CHE's time horizon affects its risk tolerance.
2. Discuss the implications of the current pressure on CHE to increase spending.
3. Determine a long-term spending policy for CHE, including a spending rate as a percentage of assets, and justify the policy.