Chapter 1—Solutions Manual Beginning Your Financial Journey: The Interior Finance Point of View
Introduction to Personal Finance: Beginning Your Financial Journey By John Grable and Lance Palmer Learning Objectives 1.1 Describe how your financial knowledge, experience, risk tolerance, and feelings of control influence the way you view the financial world. 1.2 Explain how your human and social capital relate to your financial well-being. 1.3 Discuss how financial risk tolerance relates to financial goal achievement. 1.4 Use your unique time perspective to create SMART financial goals. 1.5 Describe strategies to overcome mental biases and improve financial decision making and well-being. Key to metadata for questions: LO: Learning objective number BT: Bloom’s taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H)] TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), Not Applicable (n/a)
Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes for instructor: Each writing question will have criteria which are specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criterion will be assessed and the associated points for each level of performance are found in columns 2–5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criterion (row) is worth up to 4 points (column 2).
Rubric: (It is suggested that the rubric be shared with the students.) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking incomplete and significant details limited
Answer is realistic/relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
The response does not represent realistic or relevant understanding of topic
Adequate organization
Limited organization
Poor organization
Organization/clarity of thought Well organized (25% of score)
25% of points (1 out of 4)
A clear Appropriate conclusion or Conclusion or recommendations recommendation recommendation Conclusion or No conclusion or and conclusions are is presented that is is mostly clear recommendation recommendation reached appropriate given and appropriate is incomplete is provided (25% of score) the content given the content discussed Please refer to the sample writing assignment rubric in the solutions manual.
1.1 Describe how your financial knowledge, experience, risk tolerance, and feelings of control influence the way you view the financial world.
1.1 Multiple-Choice Questions 1. b. how well you understand personal finance information. Answer: b; Section: 1.1; LO: 1.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. c. I and II only. Answer: c; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a . 3. d. your financial knowledge, financial risk-taking, and feelings of control over your situation.
Answer: d; Section: 1.1; LO: 1.1; BT: K; Diff: E; TOT: 2 min; AACSB: RT 4. c. believe strongly in luck and fate Answer: c; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: RT 5. a. more knowledgeable about the financial marketplace over time and increase his personal wealth. Answer: a; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: RT 6. c. Having and raising a child. Answer: c; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 7. a. Consumer spending. Answer: a; Section: 1.1; LO: 1.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 8. b. GDP would fall because consumers would spend less on goods and services. Answer: b; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: RT 9. a. A willingness to save money on a regular basis. Answer: a; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. c. Michelle, who gives regularly to charity, reads about investing and is self-confident. Answer: c; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.1 Adventures in Personal Finance Short Answer 1. Answer: High-quality responses should include a discussion of how the wealth was
accumulated, work effort, and locus of control (chance versus work), and also include a discussion of the student’s perception of his or her locus of control. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.1; LO: 1.1; BT: C; Diff: M; TOT: 15 min; AACSB: RT, E 2. Answer: Risk tolerance describes your willingness to engage in financial activities
that have uncertain outcomes. Individuals with low risk tolerance may be fearful of the financial markets and financial activities and avoid them. As your financial literacy increases and risk perceptions are properly understood, your willingness to engage in risks may increase. Section: 1.1; LO: 1.1; BT: Ap; Diff: M; TOT: 5 min; AACSB: RT, A
3. Answer: High-quality responses should include a discussion of how savings behavior
may differ between generations. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.1; LO: 1.1; BT: Ap or An; Diff: M; TOT: 20 min; AACSB: RT, D 4. List 10 life events and occurrences, and identify whether they require any short-term
or long-term financial resources. Section: 1.1; LO: 1.1; BT: Ap; Diff: M; TOT: 20 min; AACSB: n/a
Explore 1. Visit the U.S. Census Bureau website and locate the Real Gross Domestic Product, Chained (2005) Dollars—Annual Percent Change: 1990 to 2010 table. The table provides data showing the percent change in GDP from one year to the next. Look specifically for the years 2006, 2007, 2008, and 2009 (these years represent what has since been termed the Great Recession). What happened to national GDP during those years? What might explain the data? Answer: GDP decreased during this time period. A recession is a decrease in GDP. Section: 1.1; LO: 1.1; BT: An; Diff: E; TOT: 10 min; AACSB: A
2. Conduct an Internet search using the phrase “financial literacy.” What type of programs, study materials, and quizzes are available for free? Share your best findings with others in class. Answer: High-quality responses should include a discussion of material that the student
found as well as the student’s assessment of that material. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 20 min; AACSB: T
3. The National Football League (NFL) and Visa, Inc. have teamed up to promote financial literacy. You can play a realistic football game online either against the computer or a friend. Visit the game’s website by searching the Internet for “practical money skills training camp.” Next, play a short 5- or 10-minute game. To progress downfield and score points you must answer financial literacy questions. At the end of the game assess how well you did, both in points and questions answered correctly. Do you think this type of game would help others learn about financial issues? Why or why not? Answer: High-quality responses should include a discussion of how well the student
performed in the game and the student’s assessment whether this type of learning platform is helpful for others. Students should justify their responses. Please refer to the sample writing assignment rubric in the solutions manual.
Section: 1.1; LO: 1.1; BT: An; Diff: M; TOT: 20 min; AACSB: n/a
1.1 Expanded Learning Activity Visit Google Scholar and enter “financial literacy” as a keyword search. Choose a paper that matches the search. Read the paper and write a short (300- to 500-word) reaction to the paper. Note that these are research papers, which means that most have references to statistics and other quantitative analyses. When writing your reaction, focus on the key results related to financial literacy rather than the methods used by the paper’s authors. Answer: High-quality responses should discuss the results of the research and how those
results relate to financial planning. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.1; LO: 1.1; BT: Ap; Diff: H; TOT: 120 min; AACSB: C
1.1 Practice Questions 1. Which of the following elements influence your view of the financial world? I. Your risk tolerance. II. How much you believe you control your financial future. III. Knowledge about personal finance topics. a. II only. b. II and III only. c. I and II only. d. I, II, and III. Answer: d; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: RT 2. Someone who feels that investing is too difficult to understand likely a. has a lower level of financial literacy. b. is positioned to maximize lifetime wealth accumulation goals. c. has a high tolerance for financial risk. d. feels in control of his or her financial situation. Answer: a; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. Why might some people who are nearing retirement feel less confident about their financial future? a. They have too much debt. b. They have not saved enough over their lifetime. c. They live too frugally and cannot enjoy the joys of retirement. d. Both they have too much debt and they have not saved enough over their lifetime. Answer: d; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. Someone who reports strongly agree with (a) the thought of taking a risk is exciting to me, (b) in terms of investing, high returns are more important than safety, and (c) making money in stocks and bonds is based on knowledge is most likely a. willing to take more financial risk. b. willing to take no financial risk. c. believing in luck and fate.
d. feeling that he or she cannot control his or her financial future. Answer: a; Section: 1.1; LO: 1.1; BT: C; Diff: M; TOT: 2 min; AACSB: n/a 5. All of the following are pathways to wealth, except a. saving money on a regular basis. b. keeping good records. c. spending less than income earned. d. minimizing insurance expenditures. Answer: d; Section: 1.1; LO: 1.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.2 Explain how your human and social capital relate to your financial well-being.
1.2 Multiple-Choice Questions 1. 1. b. human capital. Answer: b; Section: 1.2; LO: 1.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. b. Michelle. Answer: b; Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: RT Solution: Human capital is your ability and willingness to work, learn, earn, and make wise decisions about how to save and invest money. Earnings are often closely associated with your level of formal education (see Illustration 1.2.1). Holding an advanced degree is often a pathway to higher income and human capital. Those with an advanced academic degree tend to do better when the economy turns downward. Michelle does not have an advanced degree.
3. a. Healthy people spend more money on food and exercise, which reduces their lifetime wealth accumulation. Answer: a; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. c. Tammy.
Answer: c; Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: RT Solution: In addition to education, your health affects human capital in both the short run and the long run. Generally, healthy people work more hours and for a longer period of years over their life span compared to those with health problems. Thus, healthy people tend to earn more money on an annual basis, as well as over their lifetimes. Poor health may result in a lower standard of living across the life span. Actively managing your health by eating a healthy diet, avoiding substance abuse, and preventing and minimizing accidents (by wearing your seat belt and never texting while driving) all add up to a healthy lifestyle that will extend your life and increase your human capital. Lance is a smoker, and Rob regularly texts while driving. 5. a. Relocate to a place where his welding skills will be valued in the marketplace. Answer: a; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: RT 6. a. Converting human capital to financial wealth depends on wise planning and management. Answer: a; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 7. b. Jorge. Answer: b; Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: RT Solution: Unlike human capital, social capital is not found in individuals themselves but rather in the space between individuals or the network of connections among people. Your social capital is shaped by informal and formal networks, like Jorge’s fraternity. 8. a. A formal network Answer: a; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. b. Option 2. Answer: b; Section: 1.2; LO: 1.2; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: Option 2 has a $40,000/year payback, where Option 1 only has a $35,000/year payback. The higher payback amount will achieve a quicker breakeven. WileyPlus Version – #9 Multiple-Choice. Answer: Reconsider her decision (chosen area of study or school) because the cost is high compared to her potential earnings. Solution: Your earnings are an indicator of the value of your human capital in the labor market. While earnings are often closely associated with your level of formal education, the supply and demand for a particular skill or knowledge will ultimately determine the relative value. For example, a physician is clearly more valuable than an anthropologist and is reflected in typical earnings. 10. d. only go back to school if the time and effort will result in an increase in personal satisfaction and fulfillment. Answer: d; Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: RT Solution: Regardless of the type of school or educational program you are interested in pursuing, you would be wise to compare the cost of the program to the additional annual income you’ll earn once you have completed it. You can use the following formula to estimate how long it will take you to earn back your investment. This is called the investment payback period. The longer the payback period, the more you should question the economic value of your investment. Total costs Payback period = Increase in annual income Payback period =
$75,000 cost of degree + $50,000 lost annual wages = 25 years $55,000 new earnings − $50,000 past earnings
It turns out that it is going to take Ruby about 25 years to break even on her investment, which is 8 years past her expected retirement at 67 years of age. The payback period is helpful in making education decisions, but it shouldn’t be the only factor considered. For example, the investment payback period calculation doesn’t account for the value of Ruby’s human and social capital that she’ll obtain by finishing school. There’s also the personal feeling of satisfaction that is hard to value.
1.2 Adventures in Personal Finance Short Answer 1. Answer: High-quality responses should address the specific questions. Please refer to the
sample writing assignment rubric in the solutions manual. Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 15 min; AACSB: RT
2. Answer: High-quality responses should include a discussion of protection measures such as
seat belts, exercise/good health practices, safe driving, and stress management. Responses may also include health insurance, life insurance, disability insurance, and other forms of insurance on the individual (NOT property insurance). Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 20 min; AACSB: RT 3. Answer: High-quality responses should include a discussion of whom these relationships
are with and how those relationships can be strengthened. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.2; LO: 1.2; BT: An; Diff: M; TOT: 30 min; AACSB: RT, C
4. Answer: e—1; b—2; h—3; a—4; g—5; j—6; f—7; i—8; d—9; c—10. Solution: (1) physician, (2) dentist, (3) lawyer, (4) personal financial advisor, (5) construction manager, (6) electrical engineer, (7) police officer, (8) kindergarten teacher, (9) social worker, (10) massage therapist. Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 5 min; AACSB: RT
Explore 1. Take an inventory of your assets—the things you own. What approximately are they worth? Now calculate the value of your human capital? A rough estimate of your human capital is your annual pay (or expected annual pay after you graduate) divided by .06. How does this number compare to the value of your other assets? Summarize your calculations and write one to two paragraphs on what you found. Answer: High-quality responses should include a discussion of the student’s estimated human capital and how it compares with his or her other assets. Please refer to the sample writing assignment rubric in the solutions manual.
Section: 1.2; LO: 1.2; BT: An; Diff: H; TOT: 40 min; AACSB: RT, C, A
2. Conduct an internet search using your name as the search term. Based on what you see about yourself, would you feel comfortable if you knew your current and future employers were looking at the same material, including social media webpage(s)? Would they conclude that you are professional and a perfect candidate for the job, or would they have reservations? Do you think the image portrayed of you is accurate? If not, what do you need to change? Answer: High-quality responses should include a discussion of how the student perceives his or her online image and how it could be improved or maintained. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.2; LO: 1.2; BT: An; Diff: M; TOT: 20 min; AACSB: RT, T
1.2 Expanded Learning Activity Estimate the payback period for your educational investment. Specifically, calculate how much tuition, books, fees, and other expenses will be before you complete your desired schooling. Do not include these expenses if someone else is paying these bills (grants, scholarships, employer, and parents). Add in any student loans you have taken out. You can also include what you would be making if you were working instead of attending school, but only if you would be working. The total approximates your investment in education. Next, look at what you realistically will be earning after you graduate in your desired field. Use information from the U.S. Census Bureau, Bureau of Labor Statistics, and your school’s career center to determine your likely annual salary. Subtract this from what you would earn without your degree (use the minimum wage or approximate a wage of $10 per hour). The difference is the ballpark annual return on investment. Divide the total costs by the annual increase in earnings, and this is your payback period. a. How long will it take you to payback the investment, or earn back all of the money you have invested and will invest in your education? b. Does it seem like a good investment? Can you think of another investment that would give you as large of a return? Will the return on another investment last as long? c. What are some things that you could do that would make your educational investment even better? Can you reduce the costs, or increase the annual return by redirecting your studies or relocating after you graduate? Answer: High-quality responses should include a discussion of the student’s chosen career, estimated income, and estimated cost of education as well as thoughtful responses to questions (a), (b), and (c). Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.2; LO: 1.2; BT: S; Diff: H; TOT: 90 min; AACSB: RT, C, A, T
1.2 Practice Questions 1. Lifetime earnings and education are positively related. Select the ranking that represents the median lifetime earnings based on education achievement from lowest to highest.
a. High School Diploma, Associates Degree, Some College, Master’s Degree. b. Professional Degree, Bachelor’s Degree, Associate’s Degree, High School Diploma. c. High School Diploma, Bachelor’s Degree, Doctoral Degree, Professional Degree. d. Bachelor’s Degree, Professional Degree, Master’s Degree, Doctoral Degree. Answer: c; Section: 1.2; LO: 1.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Your earnings are an indicator of the value of your human capital in the labor market. Earnings are often closely associated with your level of formal education. Illustration 1.2.1 shows how annual earnings increase with formal education.
2. All of the following influence your human capital, except a. your health. b. your income. c. your educational level. d. your skill(s). Answer: b; Section: 1.2; LO: 1.2; BT: K; Diff: E; TOT: 2 min; AACSB: RT 3. As people age, their human capital can decline due to changes in the marketplace that demand different skills and abilities. One way to boost human capital is to a. enroll in a continuing education program. b. go back to school and learn a new skill. c. begin working out in order to look younger. d. both enroll in a continuing education program and go back to school and learn a new skill. Answer: d; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. Which of the following is most likely to reduce your social capital among those who may be likely to hire you for a job? a. Posting pictures of yourself with influential politicians in your community. b. Sending notes to business colleagues congratulating them on their accomplishment. c. “Liking” someone’s photo posted on a social media site. d. Posting pictures of yourself drinking at a bar. Answer: d; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: RT 5. Which of the following occupations is likely to have the highest median salary?
a. Kindergarten teacher. b. Massage therapist. c. Construction worker. d. Personal financial advisor. Answer: d; Section: 1.2; LO: 1.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.3 Discuss how financial risk tolerance relates to financial goal achievement.
1.3 Multiple-Choice Questions 1. a. on a scale that can change over time. Answer: a; Section: 1.3; LO: 1.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. d. not be worried because her risk tolerance will increase as her knowledge and experience increase. Answer: d; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. d. It is impossible to know what Terry’s financial risk tolerance is given the information provided. Answer: d; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. c. The person who is willing to take risk after adequate research. Answer: c; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. c. generate the lowest returns. Answer: c; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 6. a. The greater the return required, the greater the risk that must be taken. Answer: a; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 7. d. They have a relatively low level of financial literacy, and they view playing the lottery as a form of entertainment. Answer: d; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. c. risk perception. Answer: c; Section: 1.3; LO: 1.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. a. risk preference. Answer: a; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. b. a general change in perceptions about the chain’s quality of food. Answer: b; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.3 Adventures in Personal Finance Short Answer 1. Answer: Uncertainty in financial decision refers to financial risk. Other behaviors also have risk or uncertain outcomes. Examples of risky behavior include texting while driving, drinking alcohol excessively, driving without a seat belt, chronic overeating, and sedentary lifestyle. Many activities in our daily life are inherently risky. Section: 1.3; LO: 1.3; BT: Ap or An; Diff: M; TOT: 20 min; AACSB: A
2. Answer: Risk perception is the cognitive evaluation of potential gains and losses. Risk preference is the amount of uncertainty individuals desire or seek. Risk tolerance is the willingness to engage in financial activities with uncertain outcomes. Section: 1.3; LO: 1.3; BT: Ap; Diff: M; TOT: 15 min; AACSB: An 3. Answer: Students should clearly state the activity and its rating for questions (a), (b), and (c). Section: 1.3; LO: 1.3; BT: Ap; Diff: M; TOT: 20 min; AACSB: RT
Explore 1. Write a brief reaction paper to the following statement: If you take recreational risks, you are also more likely to take financial risks. Be sure to address the following questions: Do you agree with this statement? What evidence exists from your personal experience that supports your position? What does the research say about this relationship? Answer: High-quality responses should include a discussion of whether the student agrees
with the risk statement and provides evidence from his or her personal experience that supports his or her position, including research on this topic. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.3; LO: 1.3; BT: S; Diff: M; TOT: 30 min; AACSB: C, RT, A
2. Conduct an internet search using the phrase “Rutgers Risk Quiz.” Take the free risk-tolerance questionnaire at this site, making sure to answer all questions honestly based on your current situation. When you finish the questionnaire, you’ll receive a risk score. How accurate is the score in your opinion? Talk to others in class about the accuracy of their risk scores. Answer: High-quality responses should include a discussion of the student’s perception of
how accurate the risk score is. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.3; LO: 1.3; BT: Ap; Diff: E; TOT: 20 min; AACSB: RT
3. Search the Internet to find the odds associated with events that are commonly reported in the news (some of these events may not be financial). Write a brief report showing each event and its corresponding odds of occurrence in a year. Which event was more likely? Is your perception of these events accurate? Did you think any of these events were more or less common than they really are? Be sure to report if the odds matched your initial expectations. Answer: High-quality responses should clearly identify events and the odds or probabilities of
those events occurring; additionally, students should also discuss their perceptions of those events occurring and whether they actually occur more or less frequently than what they thought. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.3; LO: 1.3; BT: S; Diff: M; TOT: 60 min; AACSB: RT, C, A
1.3 Expanded Learning Activity
Have you heard of Bernie Madoff or Enron Corporation? Bernie Madoff stole billions of dollars from investors. Enron was a company that faked its sales and earnings. The company eventually went bankrupt, and investors lost billions of dollars. People remember these things, because they are, in fact, quite unusual. However, people come to perceive these events as being representative of all aspects of the financial markets. How does this insight help explain why some people think the stock market is a big gamble? Do some research to see how many large U.S. corporations went bankrupt last year. Also look at how much money people lost to investment fraud compared with how much money is invested in the stock market. If you were giving advice to a novice, investor how would you counsel them about their perceptions of companies going out of business and investment advisors stealing his or her money?
Answer: High-quality responses should include a thorough discussion of why some people think
the stock market is a big gamble. The discussion should also include the actual number of corporate bankruptcies and frauds in which people lost their money in relation to the number of publicly traded companies. High-quality responses should also include recommendations or advice or direction for a novice investor who thinks the stock market is a big gamble. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.3; LO: 1.3; BT: S; Diff: M; TOT: 30 min; AACSB: C, RT, A
1.3 Practice Questions 1. Financial risk tolerance refers to your a. perception of the riskiness of a situation or investment. b. preference when choosing between two or more investments. c. willingness to engage in a risk in which an outcome is uncertain. d. capacity to sustain an expected loss. Answer: c; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
2. The fact that nearly everyone would like to be wealthier rather than poorer refers to his or her risk a. perception. b. preference. c. tolerance. d. capacity. Answer: b; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
3. It is possible to increase your financial risk tolerance over time. What is the process of risk tolerance change? a. Knowledge leads to confidence, which leads to experience, understanding, and an increase in risk tolerance. b. Experience leads to understanding, which leads to confidence, knowledge, and an increase in risk tolerance. c. Risk tolerance leads to confidence, which leads to understanding, experience, and increased knowledge. d. Understanding leads to risk tolerance, which leads to experience, confidence, and increased knowledge.
Answer: a; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: RT
4. Loraine is thinking about her future retirement goals and needs. She has 25 years until retirement. She needs to save quite a bit of money to reach her retirement goal. Unfortunately, Loraine’s risk tolerance is low. Given these facts, what is the best recommendation for Loraine? a. Postpone retirement to offset the fact that her tolerance for risk is so low. b. Invest more aggressively knowing that she has time on her side to withstand any temporary setbacks with these riskier investments. c. Obtain a second job to double her savings into low-risk investments. d. Supplement her savings with the use of lottery tickets in the hopes of earning a large windfall. Answer: b; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
5. Nicki is meeting with her financial planner. She is new to investing and does not have much experience in the markets. She recently took a risk-tolerance quiz and scored below average in terms of risk tolerance. Her financial planner is now recommending that she purchase shares in an aggressive mutual fund that invests in very risky small companies. The financial planner’s argument is that Nicki needs to take risk to achieve decent returns. Do you agree with the financial planner? a. Yes, because the only way to make money is to take big risks. b. No, because Nicki’s risk tolerance does not match the mutual fund’s risk profile. c. Yes, because Nicki’s risk tolerance should only be used to indicate the minimum level of risk she should take. d. No, because the only way to make money is to take small incremental risks. Answer: b; Section: 1.3; LO: 1.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.4 Use your unique time perspective to create SMART financial goals.
1.4 Multiple-Choice Questions 1. a. Specific. Answer: a; Section: 1.4; LO: 1.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. d. Long term. Answer: d; Section: 1.4; LO: 1.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. b. If the value of the assets were to fall, there would not be enough time to recoup the loss. Answer: b; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: A 4. c. help you reach your long-term goals. Answer: c; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. a. Past. Answer: a; Section: 1.4; LO: 1.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: RT Solution: Most people view the world primarily from one of three time perspectives or lenses: • Past-oriented: based on memories, whether good or bad. Those who view past events negatively have the most trouble staying on their financial path. Sancho is past-oriented. Present-oriented: based on either (a) a hedonistic perspective (doing things for pleasure, experience, and excitement of the action) or (b) a fatalistic perspective (unable to visualize a
•
meaningful future). Understandably, those with a fatalistic outlook sometimes have a hard time reaching their long-term financial goals. Future-oriented: based on a calculation of the consequences of actions in terms of a future payoff. Those with a future orientation tend to be very goal-oriented. As such, they might do a better job of managing their personal financial situation in the long run but may miss out on some opportunities along the way.
6. c. Present-hedonistic. Answer: c; Section: 1.4; LO: 1.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: RT Solution: Most people view the world primarily from one of three time perspectives or lenses: • Past-oriented: based on memories, whether good or bad. Those who view past events negatively have the most trouble staying on their financial path. • Present-oriented: based on either (a) a hedonistic perspective (doing things for pleasure, experience, and excitement of the action) or (b) a fatalistic perspective (unable to visualize a meaningful future). Understandably, those with a fatalistic outlook sometimes have a hard time reaching their long-term financial goals. Arnold has a present-hedonistic orientation. • Future-oriented: based on a calculation of the consequences of actions in terms of a future payoff. Those with a future orientation tend to be very goal-oriented. As such, they might do a better job of managing their personal financial situation in the long run but may miss out on some opportunities along the way.
7. a. Those who resist temptation today. Answer: a; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. c. 70%. Answer: c; Section: 1.4; LO: 1.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: The marshmallow experiment was first undertaken by Walter Mischel, a Columbia University faculty member, in the 1960s. Mischel was tempting young children with an almost irresistible treat. At the core of the temptation is the notion of time perspective. Mischel wanted to determine who was willing to forgo immediate rewards for a larger payoff in the future: It turns out that two-thirds of the children ate the marshmallow before the researcher returned. Subsequent research indicates that about 70% of Americans—both children and adults—fall prey to temptation. They tend to be impulsive and quick acting. 9. b. Receiving a bonus. Answer: b; Section: 1.4; LO: 1.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 10. b. Most Americans naturally tend to hold a future time orientation. Answer: b; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.4 Adventures in Personal Finance Short Answer
1. Answer: High-quality responses should include two SMART goals that address all the areas of
a SMART goal. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: S; Diff: M; TOT: 15 min; AACSB: RT, C
2. Answer: a—3; b—5; c—1; d—4; e—2. Solution: a. Past-negative.
3. You let past experiences and emotions upset you and sometimes feel regretful. b. Past-positive. 5. You love to daydream and think about the good things that have already happened to you. c. Present-hedonistic. 1. You seek out pleasure, good times, and experiences when given the opportunity. d. Present-fatalistic. 4. You would like to take control of your future but feel trapped and unable to change things today. e. Future-oriented. 2. You strive to reach your goals, almost at any cost. Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 10 min; AACSB: n/a
3. Answer: High-quality responses should include a list of strategies for altering time perspectives. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: S; Diff: M; TOT: 20 min; AACSB: RT
4. Answer: High-quality responses should address each of the points (a)–(d) posed in the
question. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: An; Diff: M; TOT: 20 min; AACSB: RT, C
Explore 1. Not everyone believes that developing goals using the SMART approach is effective. Conduct an Internet search to find videos or websites that argue against SMART goal methods. Based on your findings, write one to two paragraphs discussing the advantages and disadvantages associated with using SMART to formalize goals. Answer: High-quality responses should include a discussion of the advantages and
disadvantages of SMART goals. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: An; Diff: M; TOT: 40 min; AACSB: A, C 2. Make a list of your 10 highest-priority goals. Then search the Internet using “most popular goals.” Click on two or three of the most popular sites and then list the top 10 goals shown on these sites. Of all the goals listed, how many are financial in nature? Now compare your list to the compiled list. What are the similarities and differences? Answer: High-quality responses should include two lists: (1) students’ top 10 goals and
(2) top 10 most common goals from the Internet. Students should also discuss these goals to determine how many of the goals are financial. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: An; Diff: M; TOT: 20 min; AACSB: RT, C, A 3. Our discussion has only touched the tip of the iceberg in terms of time perspective. Visit Dr. Philip Zimbardo’s website and complete the full-time perspective inventory by typing in
“Zimbardo Time Perspective Inventory.” Print your final score. Write a brief narrative regarding the accuracy of your score in predicting your time perspective orientation. Answer: High-quality responses should include a discussion of the student’s score on the
inventory and the student’s response to the score. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: An; Diff: M; TOT: 45 min; AACSB: RT, C, A
1.4 Expanded Learning Activity According to psychological researchers, culture is an important factor that determines someone’s time perspective. For example, children raised in households that value sharing, giving, and strong work values often hold a future-oriented time perspective. On the other hand, children who are raised in households in which immediate gratification is the norm tend to use a present time perspective when making decisions. Other factors include age, gender, income, experience, and knowledge. All these elements point to the positive conclusion that time perspective can change to be more in tune with wealth accumulation, debt reduction, and overall increased financial well-being. Write a brief review of your own childhood, paying special attention to the way you made and were rewarded for choices. When writing your review, comment on whether you would make the same decisions today. If not, what has changed? Answer: High-quality responses should include a discussion of the student’s childhood, paying
special attention to the way he or she made choices and how he or she was rewarded for those choices, and a discussion of how or whether he or she wants that to change. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.4; LO: 1.4; BT: Ap; Diff: M; TOT: 30 min; AACSB: RT, C, A
1.4 Practice Questions 1. The “A” in SMART stands for a. actionable. b. always. c. available. d. attainable. Answer: d; Section: 1.4; LO: 1.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Which of the following goals is the most clearly stated? a. To retire in 20 years. b. To purchase an $18,000 car in 20 years. c. To fund a $3,500 vacation in San Diego in 9 months. d. To purchase a home in 7 years with a sizeable down payment. Answer: c; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. Kaylee has been dreaming of a grand vacation for several years. Last year, she started to save for this once-in-a-lifetime event. So far, she has saved $2,000 toward a goal of $25,000. Her plan is to travel in 6 years. What is Kaylee’s goal time horizon? a. Short term. b. Short–intermediate term. c. Long–intermediate term. d. Long term.
Answer: c; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. Which of the following time orientations is most closely associated with a lack of goal orientation, a general feeling of hopelessness, and general pessimism? a. Past-positive. b. Past-negative. c. Present-hedonistic. d. Future goal. Answer: b; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. A person’s time orientation can shape life outcomes. Which of the following is most closely associated with lifetime wealth accumulation? a. Present-hedonistic. b. Past-positive. c. Future goal. d. Present-fatalistic. Answer: c; Section: 1.4; LO: 1.4; BT: C; Diff: E; TOT: 2 min; AACSB: RT
1.5 Describe strategies to overcome mental biases and improve financial decision making and well-being.
1.5 Multiple-Choice Questions 1. c. she feels that the likelihood of getting the full $550 is less than that of getting a guaranteed $515. Answer: c; Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: The status quo bias is your personal preference for keeping things just like they currently are. This bias is prevalent because most people are usually comfortable with their current situation, even when much better options are available. Melinda would not be changing her situation, regardless of which payment option she elects to take. Hyperbolic discounting is a form of procrastination, where a person places a greater value on the immediate option, while discounting a future greater benefit further away. However, if both benefits are not immediate, the greater benefit regardless of time will be of greater value. The choice of taking the money today over a greater sum in the future is a form of loss aversion: the feeling “. . . that the likelihood of getting the full $550 is less than getting a guaranteed $515.” 2. b. Never buy stocks on a Monday. Answer: b; Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Heuristics are based on past experiences or learning that the mind applies to new situations. Most heuristics are automatic and rarely used with forethought. Although heuristics can help you make quick decisions, they sometimes lead to problematic choices and outcomes because of behavioral biases. “Never buy stocks on a Monday” is an example of confirmation bias, where past negative outcomes of purchasing stocks on a Monday lead to a belief that it’s bad luck to do it. 3. c. status quo bias. Answer: c; Section: 1.5; LO: 1.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. c. Status quo. Answer: c; Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: The status quo bias is your personal preference for keeping things just like they currently are. This bias is prevalent because most people are usually comfortable with their current situation, even when much better options are available.
5. b. loss aversion. Answer: b; Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Loss aversion is a behavioral bias toward losing money. Behavioral economists have concluded that if you lose, your emotional pain—your feelings of loss and the regret associated with making a bad decision—will also be two times as great as the joy of winning. As a result, people generally focus much of their attention on avoiding losses because the joy of a gain is smothered by the pain of a loss. 6. a. optimism bias. Answer: a; Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Optimism bias is a behavioral bias toward having overconfidence and a lack of risk averseness. A history of taking risks without negative consequence builds this bias. 7. c. confirmatory bias. Answer: c; Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Confirmation bias is a behavioral bias believing that acts of skill are to attribute toward successful outcomes rather than coincidence and chance. Rationalizing acts of expertise to confirm the assessments of successful outcomes will lead to overconfidence in future decisions. 8. b. Precommitting to decisions. Answer: b; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. b. automating good decisions. Answer: b; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 10. a. I only. Answer: a; Section: 1.5; LO: 1.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
1.5 Adventures in Personal Finance Short Answer 1. Answer: a—3; b—1; c—4; d—5; e—2. Section: 1.5; LO: 1.5; BT: C; Diff: E; TOT: 10 min; AACSB: n/a
2. Answer: High-quality responses should include a list of three tasks and action steps to
prevent procrastination on those tasks. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.5; LO: 1.5; BT: Ap; Diff: E; TOT: 10 min; AACSB: RT
3. Answer: High-quality responses should include a discussion of past experiences when
overconfidence or optimism bias led to unwise decisions. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 15 min; AACSB: RT
4. Answer: High-quality responses should include a discussion of how a clear picture of your
future financial goals influences or would influence current choices and whether a long-term goal or a clear picture of the future would be most impactful in reaching future goals. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.5; LO: 1.5; BT: S; Diff: H; TOT: 30 min; AACSB: RT, C Explore 1. Search the YouTube website for “behavioral biases in decision-making” and then select a video to watch. After watching it, describe your reaction to it in one to two paragraphs. Be sure to note whether you were surprised by what you did, and did not, see. Also, comment on how well the video illustrates the tendency of people to be fooled by behavioral biases. Answer: High-quality responses should describe the video that was watched, what the video
was teaching, and the student’s reaction to the video. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 30 min; AACSB: RT 2. Many people pay late fees simply because they forget to pay their bills. Go through your current recurring bills, such as those for utilities, phone, or loans. Check to see if any of these companies offer electronic billing. Now, check with your bank (or credit union) and see if it offers electronic bill payment services. Through this service, you may be able to have the company bill you, and then your bank will automatically pay the bill on-time each month. By automating your bill payment method, you could potentially avoid late fees and improve your finances. Besides, you are saving on postage. Write a short summary about your findings and if you will (or why you won’t) begin to use these services. Answer: High-quality responses should include a discussion of how automating bill payments
will benefit the student. Please refer to the sample writing assignment rubric in the solutions manual. Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 20 min; AACSB: RT, T, C
1.5 Expanded Learning Activity Behavioral economic concepts apply to many areas of daily life, including marketing, diet, and exercise. Conduct an analysis of ways government and business use behavioral economic techniques to change your personal financial management behaviors. Write a brief summary of your findings. Based on your research, create a “to-do” list for saving. Be sure to share with your instructor and other students any techniques that you find unethical or manipulative? Answer: High-quality responses should include a summary of findings, a “to-do” list for saving,
and a discussion of any techniques that you find unethical or manipulative. Please refer to the sample writing assignment rubric in the solutions manual.
Section: 1.5; LO: 1.5; BT: Ap; Diff: H; TOT: 40 min; AACSB: RT, C, A
1.5 Practice Questions 1. Which of the following best describes a procrastinator? a. They value the present more than the future. b. They value the future more than the present. c. They value neither the future nor the present. d. They value the future and present equally. Answer: a; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: RT 2. When people make financial decisions, they rely on a. cognitive evaluations. b. feelings. c. mental shortcuts. d. All of these answer choices are correct. Answer: d; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: RT 3. People become overconfident when they a. experience losses. b. procrastinate. c. seek out confirmation of their beliefs and opinions. d. focus on the present. Answer: c; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: RT 4. Asking someone to start saving next week, rather than some time later, helps the person a. precommit to his or her decision. b. reduce his or her confirmation bias. c. increase future loss aversion. d. stay focused on the achievement of long-term goals. Answer: a; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: RT, C 5. Which behavioral economics bias can result in someone forgoing possible long-term growth of assets because he or she wants his or her investments to be safe? a. Loss aversion. b. Overconfidence. c. Status quo. d. Optimism. Answer: a; Section: 1.5; LO: 1.5; BT: K; Diff: E; TOT: 2 min; AACSB: RT
Chapter 1 End-of-Chapter Summary Assessment Continuing Case: Tarek’s Financial Journey Beginning with this chapter, you will have an opportunity to assist Tarek begin his financial journey. You will have a chance to catch up with Tarek at the end of each of the remaining chapters. Let’s meet Tarek and learn a bit about his current financial situation. Tarek, age 26, is single, although he is in a committed relationship. After graduating from college, he moved to the Midwest to begin his career. His interest in learning about personal finance topics and money management has increased over the past few months. Like many people his age he went through school with little interest in these topics. Now that he is working
and thinking about his future, he wants to make sure that he is making the best financial decisions. Let’s help Tarek begin his financial journey by learning more about his interior financial attitudes and expectations. When Tarek heard about the idea of time perspectives, he was curious about his own preferences. He found the following questions online.1 He knew there are no correct or incorrect responses.
Strongly Agree
Agree
Disagree
Strongly Disagree
Time Perspective Questionnaire
1. I believe that getting together with my friends to party is one of life’s important pleasures. 2. I believe that a person’s day should be planned ahead each morning. 3. I often think of what I should have done differently in my life. 1. Let’s say that Tarek answers the first question as disagree, the second question as strongly agree, and the third question as strongly disagree. Based on his answers what is his time perspective? Answer: Tarek most likely has a future time perspective. The answer is based on the following guidelines: Question 1—If you “agree” or “strongly agree” with this statement, you probably have a present perspective. Question 2—If you answered “agree” or “strongly agree” to this one, it means that you are likely directed by a future goal perspective. Question 3—Answering “agree” or “strongly agree” to this item means that you probably see the
1
These and similar questions can be found in: D’Alessio, M., Guarino, V. D. P., and Zimbardo, P. G. (2003), Testing Zimbardo’s Stanford Time Perspective Inventory (STPI)—short form: An Italian study. Time & Society, 12(2/3), pp. 333-347. See also: Zimbardo P. and Boyd J., Putting Time in Perspective: A Valid, Reliable Individual-Difference Metric, The Journal of Personality and Social Psychology, Vol. 77, 1999, pp. 1271-1288.
world using a past perspective.
Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 5 min; AACSB: A
2. What does Tarek’s time perspective indicate about his potential money management ability? Answer: In general, those who hold a future perspective, particularly those who are goaloriented, do a better job of managing their personal financial situation. This bodes well for Tarek as he attempts to reach his life and financial goals. Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 5 min; AACSB: A
3. Tarek’s girlfriend, Samantha, is thinking about going on to earn a master’s degree in history from an Ivy League university. Samantha loves everything there is to know about ancient middle eastern philosophy. She found a scholar who is exploring this very topic from a historical perspective. If Samantha decides to go back to school, she anticipates paying two years of tuition equal to $63,000 yearly. She plans to borrow most of this amount. This amount includes tuition, room, food, books, and other fees. She would need to quit her current job, which will lead to a loss of income of $33,000 per year. She believes that having a master’s degree will allow her to teach high school history, which should increase her annual income to $35,000 per year. Based on this information, what is Samantha’s payback period? Answer: 96 years. Solution: Her two primary expenses include a lost income of $66,000 and educational expenses of $126,000. Combined, the cost of the master’s degree will be $192,000. However, she is expecting to earn only $2,000 more per year. As such, her payback period is 96 years ($192,000/$2,000). Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 20 min; AACSB: A
4. Based on your analysis from the previous question, does it make economic sense for Samantha to go back to school at this time? What might be an alternative? Answer: It will take her approximately 96 years to break even on the costs associated with obtaining this particular degree. So, no, it does not make sense to invest in this master’s degree at this time. An alternative is to obtain a master’s degree from a less expensive college or university or work toward her degree on a part-time basis. Another alternative is to change her degree to something that offers a quicker payback period. Section: 1.5; LO: 1.5; BT: S; Diff: M; TOT: 10 min; AACSB: A
Calculating the Cost of Life’s Financial Journey Researchers at some of the nation’s leading universities have been studying financial literacy for years. Results from their work provide interesting insights into the financial capabilities of the average American. Their findings are a bit sad. The average American is, well, basically a “C” student when it comes to financial issues—and we are talking about adults! What follows are a number of questions that these researchers ask survey participants to think about. See if you can beat the national averages for correct and incorrect responses! a. If the chance of getting a disease is 10 percent, how many people out of 1,000 would be expected to get the disease? Answer: 100. Solution: 10% of 1,000 people is 100. 1,000 people × 0.10 = 100 people. Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 5 min; AACSB: RT b. If 5 people all have the winning number in the lottery and the prize is $2 million, how much will each of them get? Answer: $400,000. $2,000,000 prize Solution: = $400,000 per person 5 people Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 5 min; AACSB: RT c. Let’s say you have $200 in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years? Answer: $242. Solution: Calculate the interest earned each year on the beginning balance, and add to your balance to calculate the ending balance. This calculation will compute the compound interest you earn every year. First year: $200 balance × 0.10 interest rate = $20 interest earned. Ending balance = $220. Second year: $220 balance × 0.10 interest rate = $22 interest earned. Ending balance = $242. Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 5 min; AACSB: RT
d. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow: more than $102, exactly $102, or less than $102? Answer: More than $102. Solution: Calculate the interest earned each year on the beginning balance, and add to your balance to calculate the ending balance. This calculation will compute the compound interest you earn every year. After 5 years, the balance will be greater than $102, because it’s $104.04 after 2 years. First year: $100 balance × 0.02 interest rate = $2 interest earned. Ending balance = $102. Second year: $102 balance × 0.02 interest rate = $2.04 interest earned. Ending balance = $104.04. Section: 1.5; LO: 1.5; BT: An; Diff: M; TOT: 5 min; AACSB: RT e. Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
Answer: Less than today. Solution: Inflation reduces purchasing power, whereas earning interest increases purchasing power. Since the inflation rate of 2% is greater than the 1% interest rate you can earn, you will lose purchasing power in this scenario by 1% per year. Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 5 min; AACSB: RT f. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.” Answer: False. Solution: By owning one stock, you will risk your entire fortune on the stock. By diversifying your fortune by holding more than one stock, such as in a mutual fund, you are diversifying the business risk of any individual company that you own. Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 5 min; AACSB: RT
Planning for the Future Edmond, age 33, is thinking about his financial future. After reading the chapter material, he has decided to focus his efforts on reaching the following three financial goals: ✓ Retire at age 55, ✓ Purchase a new pickup truck in 2 years to replace his late model car, and ✓ Go back to school in 5 years and obtain an MBA. Based on this information, please do the following: a. Categorize each goal based on the goal time horizon guidelines presented in the chapter. Answer: Retirement is a long-term goal, purchasing the pickup truck is a short-term goal, and going back to college is a short–intermediate-term goal. Section: 1.5; LO: 1.5; BT: C; Diff: E; TOT: 5 min; AACSB: A
b. Rank the goals in terms of funding importance. Answer: (1) Purchasing a new vehicle is important because having reliable transportation is essential to generating income and reducing maintenance expenses; (2) investing in human capital is also important as a way to increase earnings and assets; and (3) while retirement is very important, retiring this young is aspirational. Implementation of the other two goals will help Edmond achieve this retirement goal. Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 5 min; AACSB: A
c. Choose one of Edmond’s three goals. Using the following table, help Edmond clearly describe the goal using the SMART procedure; be as detailed as possible when providing guidance on each element. Specific
Measurable
Attainable
Section: 1.5; LO: 1.5; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
Realistic
Timely
Chapter 2 – Solutions Manual Learning Objectives 2.1 Discuss the role of compound interest in managing your finances. 2.2 Identify how time value of money concepts affect financial goals and decisions. 2.3 Calculate the effect of time and interest on financial decisions pertaining to planning, investing, and borrowing. 2.4 2.4 Describe how to use a balance sheet as a financial-management tool to track changes in assets, liabilities, and net worth. 2.5 Explain how to use a personal budget to track and forecast cash flow to achieve financial goals. 2.6 Describe how to create a personal financial plan.
Key to metadata for questions: LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes For Instructor: Each writing question will have criteria which is specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criteria will be assessed and the associated points for each level of performance are found in columns 2 – 5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criteria (row) is worth up to 4 pts (column 2).
Rubric: (It is suggested the rubric be shared with the students) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking incomplete and significant detail limited
Amounts and information Answer is realistic / discussed are relevant relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
Does not represent realistic or relevant understanding of topic.
Organization/clarity of thought Well organized (25% of score)
Adequate organization
Limited organization
Poor organization
Appropriate recommendations and conclusions are reached. (25% of score)
A clear conclusion or recommendation is presented that is appropriate given the content discussed
Conclusion or recommendation Conclusion or No conclusion/ is mostly clear recommendation recommendation and appropriate is incomplete provided given the content
2.1 End-of-Topic Assessment 2.1 Multiple-choice Questions 1.c. Douglas who is borrowing money to pay for a vacation. ANSWER: c; LO 2.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 2.a. interest being reinvested and earning additional interest. ANSWER: a; LO 2.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.a. The longer you let your money grow, the more it will produce. ANSWER: a; LO 2.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. b. annual percentage rate.
25% of points (1 out of 4)
ANSWER: b; LO 2.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5.a. 22.80% SOLUTION: 1.9% x 12 = 22.80%. ANSWER: a; LO 2.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 6.a. daily. ANSWER: a; LO 2.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 7.c. 12.68% SOLUTION: (1+.01)12 - 1 = 12.68%. ANSWER: c; LO 2.1; BT: K; Difficulty: M; TOT: 2 min; AACSB: A 8.c. Earning periodic interest rate of 1.25% compounded semiannually SOLUTION: (1+.002)12 - 1 = 2.43% (1+.006)4 - 1 = 2.42% (1+.0125)2 - 1 = 2.52%. (1+.025)1 - 1 = 2.50% ANSWER: c; LO 2.1; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 9.c. 11 years SOLUTION: 72/6.50 = 11.08. ANSWER: c; LO 2.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 10.b. Ravi, who earns 8% interest over a 10-year period. SOLUTION: Amal: Doubles money in 24 years (72/3) Ravi: Doubles money in 9 years (72/9) Gayle: Doubles money in 14 years (72/5) Luis: Doubles money in 36 years (72/2) ANSWER: b; LO 2.1; BT: An; Difficulty: H; TOT: 2 min; AACSB: A
2.1 Adventures in Personal Finance Short Answer 1. Assume you are evaluating two different savings account options. One bank is offering an APR of 1.2% compounded monthly (monthly interest rate of 0.1%). The other bank is offering an APY of 1.25%. Assuming all other factors are equal, which offer is better?
Answer: The equivalent APY for an APR of 1.2% compounded monthly is APY = [1+(.012/12)12] – 1 = .01207 or 1.207%. The 1.25% APY account is the better offer. LO 2.1; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
2. You just received a credit card offer in the mail. The credit card has an APR of 22.99%, with the interest being calculated and charged on a monthly basis. What is the APY on this credit card? Answer: The equivalent APY for a 22.99% APR loan that charges interest monthly is APY = [1 + (.2299/12)12] – 1 = .2557 or 25.57%. LO 2.1; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
3. You just received your credit card statement that showed that you charged $200 with your card for the month. If you choose not to pay off your credit card debt, how much interest will be charged on this debt for the month if the APR is 22.99%?
Answer: Solution: Interest would be charged based on the monthly periodic rate, which is the APR divided by 12, or 22.99%/12 = 1.916% monthly. $200 X 1.916% = $3.83 in interest charges. LO 2.1; BT: An; Difficulty: H; TOT: 10 min; AACSB: A
Explore 1. Assume a short-term cash lender is located in your neighborhood. Your friend John is short on cash this month and talks to the lender. The lender tells John that he can get a $100 loan for 9 days. John will get his pay check in 9 days and will be able to pay back the loan at that time: the $100 borrowed, plus a fee (interest) of $5, for a total of $105. John knows that 22.99% APR on credit cards is really high, so he is reluctant to use his credit card. What is the APR on the $100 from the short-term neighborhood lender? What is the APY on the same loan? Would your friend be better off using his credit card or taking the short-term loan? Answer: Solution: The APR on the pay-day loan is APR = Periodic Rate X Number of Payment Periods in a Year. To calculate APR, you first need to calculate the Periodic Rate, which can be found by dividing the interest charged by the balance of the loan and then multiplying by 100 (to convert it to an interest rate), or $5/$100 X 100 = 5%. The next thing that must be determined is the Number of Payment Periods in a Year. The loan is for 9 days, so 365/9 = 40.6. Thus, the APR = 5% X 40.6 = 203%. The APY = [1 + (2.03/40.6)40.6] – 1 = 6.25, or 625%. Clearly your friend would be better off using his credit card and paying an APR of 22.99% rather than 203.00%. LO 2.1; BT: S; Difficulty: H; TOT: 20 min; AACSB: A
2. Say that your money actually could grow as fast as the rabbit population in Australia grew, which is approximately equal to an APY of 38%. Assuming that you found a bank that would pay 38% APY and you deposited $100 into your account, how much money would you have in your account after 1 year? After 2 years? After 5, 7, and 10 years? Answer: Solution: After 1 year the balance would be $138 found by FV = 100(1+.38) 1); after 2 years it would be $190.44 found by FV = 100(1+.38)2; after 5 years it would be $500.49 found by FV = 100(1+.38)5; after 7 years it would be $953.13; after 10 years it would be $2,504.90. LO 2.1; BT: An; Difficulty: M; TOT: 15 min; AACSB: A
2.1 Expanded Learning Research (Presentation) Visit the websites of the following online banks and credit unions: • Ally® • Discover® • Nationwide® • Connexus® • CapitalOne 360® Create a chart showing the APY paid by each institution on deposits. If available, show the APR charged on loans. Summarize your findings by recommending the best bank or credit union for those wanting to maximize the interest earned on their savings. Be sure to share the results of your analysis with others in class. Answer: High quality responses should include a chart containing the APY and and APR
by institution, a written summary, and recommendation on the best option for those seeking to maximize their interest earned. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.1; BT: S; Difficulty: M; TOT: 30 min; AACSB: A, C
2.1 Concept Checks 1. Return on your savings is called: a. Education. b. Training. c. Interest. d. Human Capital. ANSWER: c; LO 2.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. In order to earn a higher rate of interest on your savings, you must: a. Loan your money for a longer period of time. b. Take on more risk.
c. Require that the borrower use collateral to secure the loan. d. Either loan your money for a longer period of time or take on more risk. ANSWER: d; LO 2.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 3. What is used when comparing savings rate offers? a. An Annual Percentage Yield. b. An Annual Percentage Rate. c. The Compound Rate of Return. d. The Geometric Average. ANSWER: a; LO 2.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Mary uses her credit card frequently. Which of the following is the best strategy to minimize the amount of interest paid when using a credit card? a. Pay off the credit card balance monthly. b. Search for and use a credit card with the lowest APR. c. Pay more than the minimum monthly balance each month. d. Search for and use a credit card that compounds interest monthly. ANSWER: a; LO 2.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Tula can earn ½ of 1 percent interest on her savings each month. What is Tula’s APY? a. 5.00% b. 5.17% c. 6.00% d. 6.17% ANSWER: d SOLUTION: (1+.005)12 - 1 = 6.17 LO 2.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A
2.2 End-of-Topic Assessment 2.2 Multiple-choice 1.c. time value of money calculations. ANSWER: c; LO 2.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.c. Three inputs (the interest rate, and time period, and payment amount). ANSWER: d; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 3.b. annuity. ANSWER: b; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 4.b. a series of payments occurring at the beginning of the month. ANSWER: b; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.b. future value of a lump sum.
ANSWER: c; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 6.c. future value of an annuity. ANSWER: c; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 7.a. Both calculate the present value of the annuity payments and compare it to the $100,000 lump sum option, and calculate the monthly payments (annuity) that could be generated using a $100,000 PV and compare the payments to the $1,000 payment option. ANSWER: a; LO 2.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: A 8.b. Amortization schedule. ANSWER: b; LO 2.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: A
9.c. Solve for the number of periods and Rule of 72. ANSWER: c; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 10.b. prefer ANSWER: b; LO 2.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: n/a
2.2 Adventures in Personal Finance Short Answer 1. You’d like to purchase a new car when you graduate and start working. The car that you would really like costs $35,000. You’ve checked with the bank and based on your income, you would qualify for a car loan with an annual interest rate of 5.9% with a 3-year repayment period. What would be your monthly car loan payment? To answer this question, conduct an Internet search and find at least two online TVM calculators. Compare your answers from the two calculators and reconcile any differences. Answer: PV = $35,000, N = 36, I = 5.9%/12; PMT = $1,063.18. LO 2.2; BT: An; Difficulty: M; TOT: 20 min; AACSB: A, T 2. You’d like to purchase a new car when you graduate and start working. The car that you would really like costs $35,000. You’ve checked with the bank and based on your income, you would qualify for a car loan with an annual interest rate of 5.9% with a 3-year repayment period. You now realize that you’re not able to afford this car payment each month and still pay your other monthly expenses. The bank offers a 5-year car loan with the same interest rate. If you were to choose the 5year car loan instead of the 3-year car loan, how much lower would your monthly payment be? To
answer this question, conduct an internet search and find at least two online TVM calculators. Compare your answers from the two calculators and reconciled any differences. Answer: PV = $35,000, N = 36, I = 5.9%/12; PMT = $1,063.18 compared to PV = $35,000, N = 60, I = 5.9%/12; PMT = $675.02. LO 2.2; BT: An; Difficulty: E; TOT: 20 min; AACSB: A, T
3. Your friend Beth just graduated and has two job offers that she is considering. Both job offers pay the same, but Job A contributes $2,000 annually to Beth’s retirement plan while Job B does not offer a retirement plan at all. Assuming that Beth will be at her first job for 5 years and that she will earn 8% annually on her retirement savings plan, how much will Beth have in her retirement plan at Job A? Answer: Beth will have $11,733.20. SOLUTION: N = 5, PMT = $2,000, I = 8.0%. You can use an internet search to find an online TVM calculator to enter the N, PMNT, and I to return the FV. Or, using the future value of annuity of investing $1 table, go to the row for 5 periods, and across to the column for 8%. You will find the future value factor 5.86660. $2,000 x 5.8660 = $11,733.20.
LO 2.2; BT: An; Difficulty: M; TOT: 2 min; AACSB: A
Explore 1. There are hundreds of TVM calculators available online. Conduct an Internet search and find five online calculators. Using the same data, solve a present value and future value problem using each calculator. Write a summary of your findings, focusing on whether the outputs were the same for each calculator. If the solutions were different, how large were the differences? Finally, recommend the one calculator that you believe was accurate and the easiest to use. Answer: High quality responses should include clear identification of five online calculators
and a comparison of the results from those findings and summary of the comparison. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.2; BT: An; Difficulty: E; TOT: 30 min; AACSB: C, T 2. The interest rate used in TVM calculations is very important and can have a big impact on the outcome of the problem. As a result, it needs to be as accurate as possible. Conduct an Internet search for the following interest rates or rates of return (assume you qualify for the best rate): a. Savings account interest rates. b. 3-year auto loan. c. 5-year auto loan. d. 30-year mortgage. e. Historical rates of return in the stock market. Answer: High quality responses should include specific interest rates. LO 2.2; BT: S; Difficulty: M; TOT: 30 min; AACSB: n/a
2.2 Expanded Learning Research (Writing) (Groupwork) As you have learned in this topic, TVM functions need to be used whenever money, interest, and time are involved in a financial goal. Chances are most people don’t know that they are utilizing TVM in their daily lives. Identify some common items that utilize TVM (such as any type of loan payment, long-term savings plans, etc.). Talk to four people that are at least five years older than you. Ask them if they ever use TVM functions in their financial decisions. Then ask them if they are involved in any of the financial activities you identified that utilize TVM. If they are, find out more information, such as who determined the loan payment for them or how they know how much they should be savings for retirement. Work with a group of 2 to 3 other students and write a 300-500-word paper summarizing how these people use, or fail to use, TVM concepts in their financial decisions and transactions. Answer: High quality responses should include a discussion of who was asked about
retirement, how they use TVM, and whether others made the calculations for them. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.2; BT: An; Difficulty: M; TOT: 120 min; AACSB: A, C
2.2 Concept Checks 1. TVM calculations should be used when the following three things are part of a financial goal. a. Money, time, and interest. b. Risk, money, and insurance. c. Human capital, social capital, and budgeting. d. Risk preference, risk tolerance, and budgeting. ANSWER: a; LO 2.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: A 2. If you wanted to know how long it would take $1,500 in an account earning 5.50% interest to double in value, what TVM variable would you want to solve for? a. PMT. b. FV. c. N. d. PV. ANSWER: c; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 3. Sancho would like to know what his savings will be worth in 5 years if he can earn a 6% return on his investment. Which TVM variable would Sancho want to solve for? a. PMT. b. N. c. FV. d. PV. ANSWER: c; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 4. Sandeep wants to save some money each month for to purchase a wedding ring and pay for a honeymoon in two years. What TVM variable would Sandeep want to solve for? a. PMT. b. N.
c. FV. d. PV. ANSWER: a; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 5. The Rule of 72 provides an estimate of how long it will take money to? a. Increase by one half. b. Double. c. Triple. d. Be repaid. ANSWER: b; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: A
2.3 End-of-Topic Assessment 2.3 Multiple-choice Questions 1.c. $3,675 SOLUTION: PV = $3,000; I/Y = 7; N = 3; FV = $3,675. ANSWER: c; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 2.c. $217,189 SOLUTION: PV = $100,000; I/Y = 9; N = 9; FV = $217,189. ANSWER: c; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 3.c. $23,140 SOLUTION: N = 5; FV = $34,000; I/Y = 8; PV = $23,140. ANSWER: c; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 4.a. $5,900 SOLUTION: FV = $7,500; N = 6; I/Y = 4; PV = $5,927 rounded to $5,900. ANSWER: a; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 5.d. $71,718 SOLUTION: PMT = $4,500; I/Y = 10; N = 10; FV = $71,718. ANSWER: d; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 6.a. He should take an immediate payment of $10,000. SOLUTION: The payment option results in a lower present value: PMT = $3,000; I/Y = 9; N = 4; PV = $9,719. ANSWER: a; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 7.c. annuity payments.
ANSWER: c; LO 2.3; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.c. $226 per month for 60 months from John’s bank SOLUTION: Dealer 1: PMT = 247; N = 60; PMT = 247 Bank: PV = $12,000; I/Y = 4.9/12 or .4083; N = 60; PMT = $226 Dealer 2: PV = $12,000; I/Y = 5.9/12 or .4917; N = 60; PMT = $231. ANSWER: c; LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 9.b. 23.5 years SOLUTION:Rule of 72: 72/3 = 24 years or PV = $1,000; I/Y = 3; FV = $2,000; N = 23.45 years. ANSWER: b; LO 2.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 10.b. 10.4 percent SOLUTION: N = 7; PV = $75,000; FV $150,000; I/Y = 10.41%. ANSWER: b; LO 2.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A
2.3 Adventures in Personal Finance Short Answer 1. Which variable has the biggest impact on TVM calculations? Examine a FV of an annuity problem where annual payments are $2,000, the rate of return is 8%, and the number of years is 10. Using these inputs, the FV of the annuity is $28,973.12. For the following questions, use the originally stated variables (PMT = $2,000, N = 10, and I = 8%) except as directed in the question: a. What is the FV if the annual payment is doubled from $2,000 to $4,000? b. What is the FV if the interest rate is doubled from 8% to 16%? c. What is the FV if the time period is doubled from 10 years to 20 years? Answer: Time has the biggest impact in a TVM calculation, holding other inputs constant. In this questions: A. Doubling the payment increases the FV from $28,973.12 to $57,946.25. B. Doubling the interest rate increases the FV from $28,973.12 to $42,642.94. C. Doubling the time period from 10 years to 20 years increases the FV from $28,973.12 to $91,523.93.
LO 2.3; BT: An; Difficulty: H; TOT: 20 min; AACSB: A
2. Seth was hoping to travel around the world for $25,000 in 4 years and currently has $12,500 set aside for the trip. He realizes that in order to achieve this goal, he has to earn an extremely high rate of return. The problem is that Seth is very loss-averse and has a relatively low tolerance for financial risk. While he does want to take his world cruise vacation, he decides to delay it, knowing that he could never sleep at night if he lost a large percentage of his savings. Based on this information, how much will Seth accumulate if he earns 5% annually in a low-risk investment for 15 years? Does the future value amount meet his $25,000 goal?
Answer: This is a future value calculation: FV = $12,500 x (1.05)15 = $25,000 x 2.0789 = $25,987 (rounded); yes. LO 2.3; BT: An; Difficulty: E; TOT: 5 min; AACSB: A 3. Let’s say that you can choose between the following two alternatives: (1) you will be given $50,000, the money will be placed in an account earning 10% interest, and you may have the future value in 20 years; or (2) $7,500 will be placed in an account every year for 20 years, the account will earn 8% an annual basis, and you may have the future value in 20 years. If your goal is to maximize your savings, which alternative should you choose?
Answer: Although both choices are good ones, you should choose the $7,500 annual payment option. Option 1 (the lump sum) will generate $336,375 over the 20 year period. Here’s the calculation: FV = $50,000 x (1.10)20 = $50,000 x 6.7275 = $336,375 (rounded). Option 2 results in a future value of $343,215 (rounded). To estimate this value, you must use the future value of an annuity formula, as follows: Step 1: FVA = ($7,500/.08) x [(1 + .08)20 – 1]; Step 2: FVA = $93,750 x 3.6610; Step 3: FVA = $343,214.73.
LO 2.3; BT: An; Difficulty: H; TOT: 20 min; AACSB: A
Explore 1. The internet has greatly simplified TVM calculations for those willing to search out and understand these tools. Think of one financial goal that you have that is related to time and money. Find an appropriate TVM calculator that is specifically designed for your situation (i.e., retirement). Input your information into the calculator and find an answer. How helpful is this information? Is the amount you were looking for more, less, or about the same as you expected? What could you do to change the output of the calculator? Answer: High quality responses should the specifics of the TVM calculator utilized, how
helpful it was to the student in answering the question, and how flexible the calculator was. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.3; BT: An; Difficulty: M; TOT: 20 min; AACSB: A, T 2. Financial planners tend to use TVM calculators produced by Hewlett Packard (HP) and Texas Instruments (TI). Search these firms’ websites and find information about the HP 12c, HP 10bII, and TI BAII Plus calculators. Compare and contrast the features of each calculator. Write a summary of your findings. Answer: High quality responses should include a comparison of the two calculators. Please
refer to the sample writing assignment rubric in the solutions manual. LO 2.3; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: C
2.3 Expanded Learning Research Juan started with virtually nothing when he started his business. His initial investment into his business was $1,000 for a computer. He worked very hard to make customers happy and grow his
business. Now, after 5 years, Juan is selling his business for $1,500,000. What is Juan’s rate of return on his investment? How likely is it for entrepreneurs to experience success similar to Juan’s? Answer: Juan’s average annual rate of return is at least 332%. Juan’s pay from the business could also be included as a return on the business investment an included in the calculation, which would make the rate of return even higher. Clearly, Juan’s high rate of return is not simply from putting his $1,000 to work. Rather, the rate of return is high because it is reflecting the return on both the financial investment ($1,000) and Juan’s human capital that he invested into the business. Since it is difficult to know the value of human capital Juan invested, it is not include in the amount invested. However, when the business is sold, all of Juan’s human capital investment into the business is converted to a monetary amount in the form of the selling price. Successful entrepreneurs can experience tremendous rates of return on their investments, however, they can also experience tremendous financial loss as well. Please refer to the sample writing assignment rubric in the
solutions manual. LO 2.3; BT: An; Difficulty: H; TOT: 20 min; AACSB: A, C
2.3 Concept Checks 1. How many inputs do you need to know before calculating a typical TVM formula? a. Two. b. Three. c. Four. d. Only one if you use the Rule of 72. ANSWER: b; LO 2.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. If you had $1,500 in an account earning 5.50% interest, how long (approximately) would it take for you to double your money to $3,000? a. 7 years. b. 9 years. c. 13 years. d. 15 years. ANSWER: c; SOLUTION: PV = $1,500; FV = $3,000; I/Y = 5.50; N = 12.95. LO 2.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 3. Sancho would like to know how long it will take him to double his money if he can earn a 3% return on his investment. If he uses the Rule of 70 it is: a. 36 years. b. 24 years. c. 23.33 years. d. 17.50 years. ANSWER: c; SOLUTION: 70/3 = 23.33 years. LO 2.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 4. How much will you accumulate if you invest $2,000 per year into a retirement plan (e.g., Roth IRA) for 35 years if you can earn an annualized rate of 8.50% (please round your answer)?
a. $22,176. b. $34,759. c. $379,750. d. $385,403. ANSWER: d; SOLUTION: PMT = $2,000; N = 35; I/Y = 8.50; FV = $385,403. LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 5. After getting married, Tamara decided that she and her husband needed to start doing serious retirement planning. She determined that they will need $1,000,000 in 25 years to live a comfortable life. If Tamara and her husband have $100,000 currently saved, what rate of return must they earn, on an annual basis, to meet their goal? a. 8.60% b. 9.00% c. 9.65% d. 10.00% ANSWER: c; SOLUTION: FV = $1,000,000; N = 25; PV = $100,000; I/Y = 9.65%. LO 2.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A
2.4 End-of-Topic Assessment 2.4 Multiple-choice Questions 1.c. Balance sheet. ANSWER: c; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.c. Assets – Liabilities. ANSWER: c; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: A 3.d. Stocks. ANSWER: d; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.b. The trade-in value of the car. ANSWER: b; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5.a. A balance owed on a credit card statement. ANSWER: a; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.a. $4,000 SOLUTION: $4,000 + $3,000 - $2,000 - $1,000 = $4,000. ANSWER: a; LO 2.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A
7.c. $53,200 SOLUTION: $500 + $5,000 + $15,000 - + $50,000 - $300 - $5,000 - $12,000 = $3,200 = $53,200. ANSWER: c; LO 2.4; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 8.c. 1.67 SOLUTION: $500/$300 = 1.67. ANSWER: c; LO 2.4; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 9.a. 0.25 SOLUTION: $17,300/$70,500 = .2454. ANSWER: a; LO 2.4; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 10.a. The greater the debt ratio, the worse the financial situation. ANSWER: a; LO 2.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: A
2.4 Adventures in Personal Finance Short Answer 1. Explain how a balance sheet helps explain the status of a person’s current financial situation. ANSWER: The balance sheet gives a snapshot of an individual’s assets, liabilities, and net worth. It indicates whether an individual has savings that could be used to cover an emergency, or if the individual has excessive debt relative to their assets and net worth. LO 2.4; BT: C; Difficulty: M; TOT: 10 min; AACSB: C 2. Describe some of the personal and environmental factors that can help shape someone’s net worth position today and in the future. Answer: High quality responses should include a discussion of personal and environmental
factors that can help shape someone’s net worth. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.4; BT: C; Difficulty: M; TOT: 10 min; AACSB: C 3. Assuming that you own the following property, determine the order that these will be listed on the balance sheet: Stamp Collection, Checking Account, Car, Boat, Furniture. Answer: (1) Checking Account, (2) Car, (3) Furniture, (4) Boat, (5) Stamp Collection, LO 2.4; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a 4. Your neighbor would like some help getting his finances in order. He has asked that you review the following list of his assets and liabilities: • Savings Account: $1,000
• • • • • • • • a) b) c) d) e) f)
6-month Certificate of Deposit: $200 Car: $3,500 Baseball Card Collection: $75 Clothes: $450 Furniture: $600 Credit Card Bills: $375 Money Owed to Friend: $100 Car Loan: $1,000 What is your neighbor’s net worth? Which asset is considered a monetary asset on the balance sheet? What is the total amount owed for current debts/liabilities? What is his current ratio? What is his debt ratio? Interpret the current and debt ratio calculations.
Answer: a) Assets = $5,825; Liabilities = $1,475; $5,825 - $1,475 = $4,350. b) The bank account and CD are considered monetary assets; even though the certificate of deposit is not as liquid as the account, it is still a short-term CD and therefore it should be classified as a monetary asset. c) Current debts and liabilities include those bills which are payable within one year. This means both the credit cards and the money owed to his friend are short-term debts for a total of $475. d) Monetary Assets / Short-term debts = $1,200 / $475 = 2.53. e) Total Liabilities / Total Assets = $1,475 / $5,825 = .25 or 25 percent. f) Your neighbor is doing quite well in terms of the current ratio. He has $2.53 in cash for every $1 in short term (current) debt. He is doing quite well in terms of debts to assets. The debt ratio currently stands at 25 percent; the benchmark is 40% or lower. This means that he is managing his debt load well.
LO 2.4; BT: An; Difficulty: H; TOT: 25 min; AACSB: A
Explore 1. Your best friend Ashanda is creating her balance sheet. She owns a basic 2015 Ford Focus hatchback SE. As of today, the car has been driven 22,000 miles. When you looked at the car, you saw normal wear and tear but no major mechanical problems. Go to either edmunds.com or kbb.com to find both the trade-in and private-party value of the car. Which is higher and why? Which value should Ashanda use on her balance sheet? Answer: High quality responses should include a discussion of the car’s value under each
category. Ashanda should use the lower value because it is more conservative and does not overestimate the value of the car. LO 2.4; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 2. As you have learned from this chapter, the value of your human capital is not shown on the balance sheet as an asset. However, this is very important information for lenders to know when deciding whether to give you a loan. If you were a lender, what information would you be interested in knowing to assess the value of someone’s human capital and whether they would be able to repay a loan on time?
ANSWER: Education level, employment, how long they have been working at their current job.
Please refer to the sample writing assignment rubric in the solutions manual. LO 2.4; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A
2.4 Expanded Learning Research Complete a personal balance sheet for yourself if you are single, or for your family if you have others in your household. Be sure to carefully document all the assets you own and obtain fair market value estimates for your assets. Similarly, gather information on all unpaid liabilities and other debts. Once these data have been input into the balance sheet, calculate your net worth and the current and debt ratios for your situation. Be sure to comment on the status of your asset and liability situation and what the financial ratios indicate about your financial situation. Answer: High quality responses should include the student’s balance sheet and a discussion of
the student’s assets, liabilities, and ratios. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.4; BT: An; Difficulty: H; TOT: 30 min; AACSB: A
2.4 Concept Checks 1. An asset is: a. Something you own. b. Something you owe. c. Something you must insure. d. Both something you own and something you must insure. ANSWER: a; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Fair market value is: a. The price you would pay someone else for an asset. b. The price you paid for an asset. c. The price you could sell an asset for in the marketplace. d. The price you would pay to replace an asset. ANSWER: c; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Roger owns a boat and has a boat loan. As he prepares his balance sheet, what value should he use as a liability related to the boat? a. The price he paid for the boat. b. The monthly payment on the boat loan. c. The amount remaining on the boat loan. d. The price of a similar boat if he were buying a boat today. ANSWER: c; LO 2.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Who is more likely to have a negative net worth? a. A retiree. b. A married couple whose children have just graduated from college. c. A newlywed couple who just graduated from college. d. A high school student.
ANSWER: c; LO 2.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Which is the most liquid asset? a. Money held in stocks. b. Investments in bonds. c. Savings in a bank account. d. Cash in your wallet. ANSWER: d; LO 2.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
2.5 End-of-Topic Assessment 2.5 Multiple-choice Questions 1.d. III, II, IV, and I. ANSWER: d; LO 2.5; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Income and expense statement. ANSWER: d; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.c. travel and entertainment expenses. ANSWER: c; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.c. spending more than you are earning. ANSWER: c; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: A 5.d. Either it means that she will need to borrow money to fund the deficit or it means that she will need to sell assets to fund the deficit. ANSWER: d; LO 2.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: A
Use the following information to answer the questions that follow about John. Item
Budget
Actual
Income
$9,000
$9,000
Rent
$2,000
$2,000
Utilities
$1,000
$800
Taxes
$3,000
$3,100
Difference
Transportation
$500
$700
Food at Home
$400
$300
Food Away from Home
$500
$800
Debt Payments
$1,200
$1,200
Savings
$400
$25
Total Expenses
$9,000
$8,925
Surplus/Deficit
6.b. John ran a $75 surplus for the month. SOLUTION: Expenses = 2,000 + 800 + 3,100 + 700 + 300 + 800 + 1,200 + 25 = 8,925 total expenses. Income 9,000 – Expenses 8,925 = $75 surplus. ANSWER: b; LO 2.5; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 7.c. Food away from home. SOLUTION: In calculating the difference between the projection and actual: Utilities: 1,000 – 800 = 200; Taxes: 3,100 – 3,000 = 100; Transportation: 700 – 500 = 200; food at home: 400 – 300 = 100; Food away from home: 800 – 500 = 300. Of these differences, Food away from home is the greatest difference at 300. ANSWER: c; LO 2.5; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 8.b. Although John did not exceed his budget, he was not able to save as much as projected. ANSWER: b; LO 2.5; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 9.c. 4% SOLUTION: $400/$9,000 = 4.44%. ANSWER: c; LO 2.5; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 10.b. Purchasing a moderately priced new car in 3 years. ANSWER: b; LO 2.5; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A
2.5 Adventures in Personal Finance Short Answer 1. Determine which of the following statements are true about managing resources. If false, indicate why. a. Having clear financial goals is the first step in managing your money.
b. Setting up spending guidelines, or a budget, is the first step in managing your money. c. Tracking expenses and setting up a budget is the same thing. d. Most people know exactly how they spend their money each month, regardless of whether they track their expenses. e. Savings is an essential element of any budget. f. Managing your money is only necessary during your working years or while you are preparing for retirement; once retired, you will no longer need to monitor your spending. Answer: A. True; B. False; C. False; D. False; E. True; F. False. LO 2.5; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a
2. Take a moment to look at Hannah’s budget in Illustration 2.5.4. You can see that she overspent on food. How could the budget help Hannah better manage her spending on food? Answer: By expanding the Food category into sub-categories, such as “Eating Out” and “Groceries,” Hannah would be better able to determine why she went over budget. She would know whether she is spending too much on eating out, or she could tell that she needs to be more frugal at the grocery store. LO 2.5; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A 3. Although it is a lot of work, tracking expenses on a weekly or sometimes daily basis can be helpful. Describe why this would be a good recommendation to follow. Specifically, what is the problem with compiling your expenses at the end of the month and comparing the results to what you had budgeted for that month? Answer: If budgeted and actual expenses are only compared once a month then you will only know whether you have a surplus or a deficit. However, you will not be able to make any adjustments to your spending during the month. Comparing actual spending to budgeted spending more frequently, will allow you to make adjustments. LO 2.5; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a Explore 1. There are many ways that you can create and track a budget. Several websites, smartphone and tablet apps, and software programs make it easy by doing the math for you. Some services automatically link all of your financial accounts (bank accounts, credit cards, and the like) to your budget, so that you can see how much money you have left in each of your budget categories. Conduct an Internet search and identify six different methods of budgeting and tracking your expenses. List the pros and cons associated with each method, and identify one that you would use for yourself. Be sure to share the results of your research with others in your class.
Answer: High quality responses should include a discussion and comparison of various
budgeting tools including pros and cons of each and which one the student would choose to use. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.5; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: T, C 2. A group of college students was asked to track their expenses for a three-month period. At the end of each month, the students were asked to write a short response to the question: “Is my spending consistent with my personal values?” During this three-month period, they were also asked to set some personal financial goals and to set up a budget the last month. At the end of the three months, more than 75% of students reported becoming aware of problematic spending habits that they had not realized they had prior to tracking their expenses. Additionally, 60% of the students who realized that they had problematic spending behaviors were able to change their behavior during the three-month period. The most commonly reported spending-problem areas were eating out, alcohol, and clothing. Fortunately, students also reported the most improvement in their spending in these same areas. Do you think college students in general would identify these same problem areas? What do you identify as your problem-spending areas? Answer: High quality responses should include a discussion of general spending
categories that college students find challenging and a specific discussion of spending categories that the students finds challenging. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.5; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: RT
2.5 Expanded Learning Research Do a quick survey of 20 students and find out how many of them track all of their expenses? Also ask them what they think the biggest challenge with budgeting and tracking is. See if they have come up with any solutions. Summarize your findings in a one to two-page paper and share it with your classmates. Answer: High quality responses should include a discussion of student responses and suggestions.
Please refer to the sample writing assignment rubric in the solutions manual. LO 2.5; BT: An; Difficulty: M; TOT: 60 min; AACSB: C, RT
2.5 Concept Checks 1. A tool that helps you determine how you want to spend your income is known as a(n): a. Income and Expense Statement. b. Balance Sheet. c. Budget. d. Cash Flow Statement. ANSWER: c; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. All of the following are sections of a budget, except:
a. Income. b. Savings. c. Expenses. d. Assets. ANSWER: d; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. One purpose of a budget is: a. To help you see where you are spending money on a regular basis. b. To track the change in value of assets. c. To determine increases and decreases in liabilities. d. To see how money is spent, track changes in asset values, and identify changes in liabilities. ANSWER: a; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Many college age students are likely to overspend on a monthly basis on some or all of the following items, except: a. Eating out. b. Entertainment. c. Clothing. d. Charitable donations. ANSWER: d; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. How can someone turn a projected budget deficit into a surplus? a. Cut variable expenses. b. Sell assets and use the proceeds as income. c. Decrease federal tax payments. d. Both cut variable expenses and sell assets and use the proceeds as income. ANSWER: d; LO 2.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: A
2.6 End-of-Topic Assessment 2.6 Multiple-choice Questions 1.a. lack of experience. ANSWER: a; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.a. very risk-tolerant. ANSWER: a; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.d. financial capacity and time horizon. ANSWER: d; LO 2.6; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 4.a. make the best financial decisions. ANSWER: a; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
5.d. All the answer choices are correct. ANSWER: d; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. Saving $75,000 for the down payment on a home that will be purchased in 4 years. ANSWER: d; LO 2.6; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 7.b. financial capacity. ANSWER: b; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. 1.50 SOLUTION: $3,000/$2,000 = 1.50. ANSWER: d; LO 2.6; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 9.a. allows someone to take more risk to meet a goal. ANSWER: a; LO 2.6; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a 10.c. She will fall short of the goal by $12,633 SOLUTION: PMT = $6,000; N = 5; I/Y = 11; FV = $37,367 - $50,000 = $12,633 shortfall. ANSWER: c; LO 2.6; BT: An; Difficulty: M; TOT: 2 min; AACSB: A
2.6 Adventures in Personal Finance Short Answer 1. Describe the attributes of a SMART financial goal within a financial plan. ANSWER: Specific, Measurable, Attainable, Relevant or Realistic, and Time bound. LO 2.6; BT: C; Difficulty: E; TOT: 5 min; AACSB: A 2. Ana recently calculated her financial score. She was stunned to see how low it turned out to be. Undaunted, Ana has determined to turn her financial situation around. To do this, she has set a financial goal to create an emergency savings fund. She can save $300 per month ($3,600 per year). She would like to accumulate $15,000 over the next four years. If Ana can earn 3% on her yearly savings, do you think she will accomplish her goal? ANSWER: Ana should accomplish her goal. Using the future value of an annuity formula from the chapter, Ana will accumulate $15,279.36 in the account at the end of 4 years [($300/ .0025) x (1.002548 – 1)]. This is $120,000 * .12733 = $15,279.36. You could also use a financial calculator ($300 = PMT; 3/12 = I/YR; 4*12 = N; $0 = PV; CPT (solve for) FV) and the answer is $15,279.36. LO 2.6; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
3.
(Group) As a class, split into groups of three or four students. As a team, discuss ways someone can gain experience in the financial marketplace if someone has limited resources. Be sure to come together as a class and discuss each group’s insights. Answer: High quality responses should include a thoughtful presentation / discussion of the group’s ideas. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: Ap; Difficulty: E; TOT: 15 min; AACSB: C, RT
4.
(Writing) Write a short reaction paper about the following statement: “The longer the investment time horizon, the more risk that can be taken.” In your paper, include your thoughts about whether you agree with this statement, and what impact the outcome of this statement has on the types of investments someone with a long time horizon should select when building a portfolio. Answer: High quality responses should include the student’s response to the question posed and what assets are more appropriate for long-term horizons. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: Ap; Difficulty: M; TOT: 25 min; AACSB: C, RT
5. (Group) As you have been learning throughout this book, obtaining a base level of financial literacy is only the starting point in your financial life journey. However, for at least part of your life, you probably won’t be making that journey alone. For this assignment, find a partner (e.g., classmate, friend, relative, or significant other) and ask him or her to complete the three questionnaires in this topic. Calculate his or her score and compare it to your own. What does your partner’s score tell you about his or her financial readiness? When viewed together, what do your combined scores tell you about how you might work as a team to reach future financial goals? Answer: High quality responses should include a discussion of each partners’ individual score
and the groups collective score. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: Ap; Difficulty: M; TOT: 40 min; AACSB: A, C, RT
Explore 1. (Writing) Conduct an internet search using the following phrase: “personal finance and locus of control.” Visit at least three sites that match the search phrase and read the material. Write a brief reaction paper describing your findings. Specifically, does there appear to be a relationship between a person’s locus of control and the way household financial resources are managed? Answer: High quality responses should clearly address the following question: “Does there
appear to be a relationship between a person’s locus of control and the way household financial resources are managed? Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: Ap; Difficulty: M; TOT: 60 min; AACSB: C, RT 2. You saw how easy it was for Andi to put together a financial plan—a roadmap to financial goal achievement—in this topic. Use the five-step financial plan development process to create your own
financial plan to meet at least one goal. Your financial goal can be anything you like, including paying down debt, saving for a spring break trip, buying a car or house, planning for retirement, or any other objective that meets the requirements of a SMART goal. Answer: High quality responses should include a clear plan to reach the students desired goal.
Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: S; Difficulty: M; TOT: 60 min; AACSB: RT
2.6 Expanded Learning Research (Writing) As you have been learning throughout this book, obtaining a base level of financial literacy is only the starting point in your financial life journey. You may desire to continue your education into graduate school, start a business, or purchase a home quickly. Thinking of your next major step in your financial journey, develop a financial plan that will map out how you will achieve the financial aspects of your goal. For example, if your next step is to attend graduate school, how much will the schooling cost (tuition, housing, etc.), where will it be, what financial aid (if any) is available, and what will you need to do to be ready for it? If part of your financial plan for graduate school is to take out student loans, how much debt will you require and what will your payments be when it comes time to repay the student loans? Use the internet to answer these questions. Write a two to three-page summary of your financial plan for the next major milestone of your life. Answer: High quality responses should include a clear conceptualization of the desired outcome
or goal as well as a clear plan of action that should be taken to achieve the goal. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: An; Difficulty: H; TOT: 120 min; AACSB: C, RT, A
2.6 Concept Checks 1. Someone who believes that investing is too difficult to understand is likely: a. Very risk-tolerant. b. Somewhat risk-tolerant. c. Risk seeking. d. Not at all risk-tolerant. ANSWER: d; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. How can you improve your financial capacity? a. Gain financial experience. b. Become overwhelmed with new knowledge. c. Hire a professional to manage your financial affairs. d. Both a and b. ANSWER: a; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Conti has a high sense of control. Which of the following statements is she most likely to strongly agree with? a. I am being pushed around in my life. b. There is really no way I can solve some of my problems. c. What happens to me in the future depends on me. d. I feel helpless in dealing with the problems of life.
ANSWER: c; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Before Ethan can build a long-lasting financial plan, he must have all of the following, except: a. Some willingness to take financial risk. b. The financial knowledge to make informed decisions. c. Control over his spending. d. A willingness to spend, rather than save, for certain life luxuries. ANSWER: d; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Choose the correct formula that leads to determining your financial score: a. Control+ Risk Tolerance – Time Horizon b. Financial Knowledge + Risk Tolerance + Control c. Experience – Financial Knowledge + Risk Tolerance d. Risk Tolerance + Financial Knowledge - Control ANSWER: d; LO 2.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
Chapter 2 Summary Solutions Continuing Case: Tarek’s Financial Journey In Chapter One, you had a chance to meet Tarek. Beginning with this chapter, you will have an opportunity to assist Tarek as he begins to navigate his financial journey. As you know, Tarek is 26 years old and single, although he is in a committed relationship with his girlfriend Samantha. Let’s help Tarek begin his financial journey. Tarek has prepared a monthly budget and a balance sheet for your review. Use this information in these documents to answer the following questions. Tarek’s Personal Monthly Budget Budget
Actual
Income
$ 3,900
$ 3,900
Interest
$
$
TOTAL INCOME
$ 3,990
$ 3,975
Taxes
$
883
$
883
Rent
$
850
$
850
Vehicle Insurance
$
200
$
200
Food & Eating Out
$
290
$
320
Sources of Income
90
75
Sources of Expenses
Car Payment
$
395
$
395
Student Loans
$
298
$
298
Sports & Hobbies
$
240
$
300
Phone & Household
$
100
$
135
Retirement
$
156
$
156
Vacations
$
300
$
300
Credit Cards
$
275
$
275
TOTAL EXPENSES
$ 3,987
$ 4,112
SURPLUS/DEFICIT
Tarek’s Balance Sheet Assets Checking
$
350
Savings
$ 1,100
Automobile
$ 11,000
Motorcycle
$ 3,750
Furnishings
$
Clothes
$ 2,100
Other Household
$
Sports Equipment
$ 2,500
Collections
$
401(k)
$ 19,000
800
900
750
TOTAL ASSETS
$ 42,250 Liabilities
Credit Cards
$ 3,500
Student Loans
$ 25,900
Car Loans
$ 3,000
TOTAL LIABILITIES
$ 32,400
1. How close is Tarek to meeting his monthly spending plan? Is there anything that he can do to improve his situation? ANSWER: Tarek’s budget has little room for flexibility. He was projecting a surplus of $3 for the month; however, he actually had a deficit of $137 ($3,975 - $4,112). He earned $15 less than expected and spent $125 more than projected. At this point, Tarek need to cut back on some expenses. Areas for consideration include eating out, sports and hobbies, and vacations. LO 2.5; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
2. What is Tarek’s current net worth situation? How does this compare, in general, to others his age? ANSWER: Tarek has a net worth of $9,850 ($42,250 - $32,400). Having a positive net worth, at this age, is a good sign. He is doing better than others his age. Tarek currently has a high balance on student loans. This is an example of “good” debt. LO 2.4; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
3. What is Tarek’s budgeted savings ratio? Does this meet the guideline discussed in this chapter? ANSWER: Based on his budget, Tarek is saving approximately 4% of his income ($156 / $3900). All his savings (excluding the $3 in projected monthly surplus) is in his retirement plan. Overall, Tarek is not meeting the savings guideline presented in the chapter. LO 2.5; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
4. How well is Tarek managing his debt at this time? Be sure to calculate the current ratio, debt ratio, debt-to-income ratio, and the long-term debt coverage ratio when answering this question. ANSWER: Overall, Tarek is doing an acceptable job managing his debt. His current ratio (41%) should be greater than 1.0. He needs to focus on building the value of his monetary assets while at the same time reducing his credit card debt. When he does this the current debt ratio (.77) will fall. His debt-to-income ratio (17%) is close to the recommended guideline of <15%, while his long-term debt coverage ratio (13.39) exceeds the guideline of 2.50 (his primary long-term debt payment is associated with his student loan). Current Ratio: monetary assets / current liabilities or ($350 + $1,100) / $3,500 = .41. Debt Ratio: total liabilities / total assets or $32,400 / $42,250 = .77. Debt-to-Income Ratio: Consumer Debt Payments / Income or ($395 + $275) / $3900 = .17. Long-Term Debt Coverage Ratio: Income / LT Debt Payments or $3,990 / 298 = 13.39. LO 2.4, 2.6; BT: An; Difficulty: M; TOT: 10 min; AACSB: A 5. If Tarek were to lose his job, how long could he live, assuming he cut back expenses to
those things that were essential in an emergency situation? Has he met the guideline discussed in the chapter? ANSWER: The answer to this question is based on calculating the emergency fund ratio. Assuming total expenses less taxes, sport and hobbies, retirement, and vacations, he can meet less than 1 month’s worth of emergency expenses (0.60 months). This falls below the recommended guideline of 3 to 6 months. He needs to increase his monetary assets.
Savings Ratio: Monetary Assets / Monthly Living Expenses or ($350 + $1,100) / ($3,987 - $883 $240 - $156 - $300) = .60. LO 2.4, 2.5, and 2.6; BT: S; Difficulty: M; TOT: 10 min; AACSB: A
Calculating the Cost of Life’s Financial Journey Theba and Marek have been married for nearly 20 years. They are both 45 years of age and have two children in high school. They are concerned about how to fund their future retirement costs, as well as how to help their children pay for college. Use your skills learned in this chapter to answer the following questions: a. Assume that Theba and Marek have a combined annual income of $95,000. Also assume that they want to retire at age 67. If inflation—or the annual cost of living— increases by 3% per year, how much will they need to earn at retirement to maintain their current standard of living? ANSWER: $182,030 SOLUTION: n = 22; i = 3%; pv = $95,000; CPT FV. LO 2.6; BT: An; Difficulty: M; TOT: 5 min; AACSB: A SOLUTION: $182,029.82. = [$95,000 * (1.03)22]
b. Marek is very interested in purchasing a second home overlooking a mountain lake. He believes that they should buy this home soon, make payments while they are working, use it for vacations, and once they retire, move into the house permanently. If they need a down payment of $35,000, how much do they need to save annually over the next seven years in order to save enough for the down payment? Assume that they can earn 7% on their annual savings. ANSWER: $4,044 SOLUTION: n = 7; i = 7%; fv = $35,000; CPT PMT. LO 2.6; BT: An; Difficulty: M; TOT: 5 min; AACSB: A
c. Their daughter, Chyna, is interested in attending a prestigious college. The annual tuition, plus room and board and other fees, is about $65,000 per year. College costs are increasing at a 5% rate per year. The college typically awards scholarships and grants for applicants with a household income of $95,000 equal to 70% of the total cost of college. Help Theba and Marek determine how much college will cost, based on this information and assuming that Chyna is 15 years of age and will start college at age 18: 1. What will be the total cost of college when Chyna starts? ANSWER: $75,246 SOLUTION: n = 3; i = 5%; pv = $65,000; CPT FV. LO 2.6; BT: An; Difficulty: M; TOT: 5 min; AACSB: A
2. How much will Theba and Marek need to pay when Chyna starts college? ANSWER: $22,574 SOLUTION: $75,246 x (1 - .70) or $75,246 x 30%.
LO 2.6; BT: An; Difficulty: M; TOT: 5 min; AACSB: A
3. Based on your answer, how much will they need to save per year starting today in order to fund one year’s worth of net college expenses if they can earn 7% APY on their savings?
ANSWER: $7,022 SOLUTION: n = 3; i = 7%; fv = $22,574; CPT PMT. LO 2.6; BT: An; Difficulty: M; TOT: 5 min; AACSB: A
Planning for the Future Marie is a senior in college and has just received a job offer with a business that she is excited about working for. Her starting salary will be $40,000 per year. The total amount of taxes (federal, state, FICA, etc.) withheld from her paycheck annually is $8,700, leaving Marie with $31,700 of net income. Marie has a car loan with monthly payments of $150, and she also has a student loan that will have monthly payments of $150. Using this information determine a realistic monthly budget for Marie that allows or to accomplish the following: 1) Meet her current living needs for housing, utilities, phone and internet, transportation, clothing, and other necessary expenses; 2) Repay her debts, and; 3) Prepare for the future. Based on what you recommend to Marie, will she be able to enjoy her current life style, repay her debts, and prepare for the future? If you could recommend to Marie to do one thing, what would it be? Answer: Yes, Marie will be able to meet her desired goals. It will be tight, but she should be able to make it work. She will definitely start savings for her future and start increasing the amount of savings over time. Please refer to the sample writing assignment rubric in the solutions manual. LO 2.6; BT: S; Difficulty: H; TOT: 30 min; AACSB: A
Chapter 3—Solutions Manual Earnings and Income: The Building Blocks of Your Financial Journey Introduction to Personal Finance: Beginning Your Financial Journey By John Grable and Lance Palmer
Learning Objectives 3.1 Discuss how to create wealth through increasing income, limiting expenses, and investing in your human capital. 3.2 Identify the different forms of employee earnings. 3.3 Compare the financial pros and cons of self-employment and ways to structure a business. 3.4 Discuss the sources and characteristics of unearned income. 3.5 Explain how to use capital assets to produce income and build wealth. 3.6 Explain financial safety-net programs available to employees and citizens. Key to metadata for questions: LO: Learning objective number BT: Bloom’s taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H)] TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), Not Applicable (n/a) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes for instructor: Each writing question will have criteria which are specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criterion will be assessed and the associated points for each level of performance are found in columns 2–5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criterion (row) is worth up to 4 points (column 2).
Rubric: (It is suggested that the rubric be shared with the students.) Full points 75% of points 50% of points Criteria (4 out of 4) (3 out of 4) (2 out of 4)
25% of points (1 out of 4)
Thoroughness of answer to the
The response is incomplete and
The question is answered
The response is lacking a few
The response is lacking
question
thoroughly
details
significant details limited
Answer is realistic/relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the responses are irrelevant to the question
Most of the responses is irrelevant, unrealistic, or overly simplistic
The response does not represent realistic or relevant understanding of topic
Adequate organization
Limited organization
Poor organization
Organization/clarity of thought Well organized (25% of score) Appropriate recommendations and conclusions are reached (25% of score)
A clear conclusion or Conclusion or recommendation recommendation Conclusion or No conclusion or is presented that is is mostly clear recommendation recommendation appropriate given and appropriate is incomplete is provided the content given the content discussed
3.1 Discuss how to create wealth by increasing income, limiting expenses, and investing in your human capital. 3.1 Multiple-Choice Questions 1. c. $275. Answer: c; LO: 3.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: Out of the monthly income of $3,300, Burt pays taxes, rent, food, car payments, gas and maintenance, and entertainment expenses. Therefore, after paying for all these expenses, he is left with a surplus of $275 as shown next. $3,300 − $800 − $700 − $450 − $225 − $150 − $700 = $275 2. b. Approximately $254,000. Answer: b; LO: 3.1; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: Investing $3,000 per year, at 9% for the next 25 years, Zelda will accumulate approximately $254,000. When using financial calculators and Excel spreadsheet TVM functions, annuity payments are expressed as negative numbers because payments are technically cash outflows and the future value (FV) represents aggregate savings. Financial Calculator PMT = −$3,000 N = 25 I/Y = 9 PV = 0 CPT FV = $254,103 Excel Spreadsheet
=FV(rate,nper,pmt,pv) =FV(0.09,25,−3,000,0) => $254,103 TVM Equation 𝐹𝑉 = 𝑃𝑀𝑇 ×
(1+𝐼)𝑁 −1 𝐼
(1 + 0.09)25 − 1 𝐹𝑉 = $3,000 × 0.09
8.62308 − 1 0.09 7.62308 𝐹𝑉 = $3,000 × 0.09 𝐹𝑉 = $3,000 × 84.7009 FV = $254,103 𝐹𝑉 = $3,000 ×
3. c. 11.00%. Answer: c; LO: 3.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: Savings ratio equals the dollar amount saved per month divided by the monthly income. Shaquita has a monthly income of $4,750 and saves $525 per month. Therefore, the savings ratio equals 11% as computed next. Monthly savings Monthly income $525 Savings ratio = = 𝟎. 𝟏𝟏~11% $4,750 Savings ratio =
4. b. 11.40%. Answer: b; LO: 3.1; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: The savings ratio equals the dollar amount saved per month after paying for all expenses divided by monthly income. The monthly savings can be calculated by subtracting all monthly expenses from monthly income. Add all the monthly expenses first. Then, deduct monthly expenses from monthly income. This will indicate the dollar amount saved per month. Now divide the dollar amount saved per month by the monthly income to get the savings rate. Dollar amount saved = $7,000 (monthly income) − $1,000 (rent) − $1,000 (recreation) − $500 (food) − $400 (auto) − $300 (gas and maintenance) − $700 (loan pmts) − $300 (credit card pmts) − $2,000 (miscellaneous expenses) = $800 savings Monthly savings Savings rate = Monthly income $800 Savings rate = = 0.1143~𝟏𝟏. 𝟒𝟑% $7,000 5. c. Heejung is saving less than the target savings rate given his age.
Answer: c; LO: 3.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a Solution: To compute the savings rate, you need to divide the dollar amount saved by the income. In this case, the dollar amount saved is $325 and the income is $3,300 Monthly savings Savings rate = Monthly income $325 Savings rate = = 𝟎. 𝟎𝟗𝟖𝟓~𝟗. 𝟖𝟓% $3,300 < 𝟏𝟐% 𝐫𝐞𝐜𝐨𝐦𝐦𝐞𝐧𝐝𝐞𝐝 𝐫𝐚𝐭𝐞 𝐟𝐨𝐫 𝐚 𝟐𝟗 𝐲𝐞𝐚𝐫 𝐨𝐥𝐝 Since Heejung is saving only 9.85% of the salary, it is below the target savings rate of 12% recommended at his age. 6. a. $330 per month. Answer: a; LO: 3.1; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: The savings rate is calculated based on gross income; it is savings divided by the corresponding gross income for that period. Target savings rates help to keep you progressing toward long-term goal achievement. A targeted savings rate is the savings ratio applied over a specific time period. If you are younger than age 30, your target should be to save 12% of income per year toward retirement. If you are between ages 30 and 40, your target savings rate should be at least 15% of income per year. If you wait to start saving for retirement until you are age 40, you will need a target retirement savings rate of 20% of income per year for each year until age 65. Lisa is 25 years old so her target savings should be 12%. Monthly savings Monthly income Monthly savings Target savings ratio of 0.12 = $33,000/12 months Target monthly savings = $2,750(0.12) = $330 Savings ratio =
7. c. beneath the maximum ratio. Answer: c; LO: 3.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a Solution: The total debt-to-income ratio shows the percentage of your income that you are spending to pay down your debts. The ratio is calculated as follows: Total debt-to-income ratio = (Total required debt payments ÷ Gross income) × 100 Your monthly debt payments should not exceed 36% of your gross income. If the ratio is higher, then you may lack the financial flexibility necessary to save and build financial wealth, as well as respond to unexpected events. However, you may need to take on debt in the short term to increase your future financial wealth later. 8. c. 34%. Answer: c; LO: 3.1; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: The total debt-to-income ratio shows the percentage of your income that you are spending to pay down your debts. The ratio is calculated as follows:
Total debt-to-income ratio = (Total required debt payments ÷ Gross income) × 100 $1,000 (rent) + $400 (auto) + $700 (student loan) + $300 (credit card) = $2,400 Debt Payments. Total required debt payments Total debt to income ratio = Gross income $2,400 Total debt to income ratio = = 𝟎. 𝟑𝟒~𝟑𝟒% $7,000 9. c. fund a long vacation. Answer: c; LO: 3.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. b. $108 monthly car loan payment. Answer: b; LO: 3.1; BT: An; Diff: E; TOT: 2 min; AACSB: A Solution: The recommended debt-to-income ratio is 36%. Therefore, she needs to keep her monthly debt payments at or below 36% of her monthly income. If we multiply her monthly income by 36%, we will get the monthly limit on the dollar amount of debt payments. Total required debt payments Total debt to income ratio = Gross income Total required debt payments Maximum total debt to income ratio of 0.36 = $40,000 Total required debt payments = $40,000(0.36) = $14,400 annual limit ~ $1,200 monthly limit. Amount available for monthly car payments = $1,200 monthly limit − $342 (student loan) − $750 (rent) = $108.
3.1 Adventures in Personal Finance Short Answer 1. Answer: 12% Solution: Target savings rates help to keep you progressing toward long-term goal achievement. A targeted savings rate is the savings ratio applied over a specific time period. If you are younger than age 30, your target should be to save 12% of income per year toward retirement. If you are between ages 30 and 40, your target savings rate should be at least 15% of income per year. If you wait to start saving for retirement until you are age 40, you will need a target retirement savings rate of 20% of income per year for each year until age 65. LO: 3.1; BT: Ap; Diff: M; TOT: 5 min; AACSB: n/a 2. Answer: 4 years LO: 3.1; BT: Ap; Diff: M; TOT: 5 min; AACSB: A Solution: Richard Thaler’s strategy called “Save More Tomorrow” involves simply committing half of every future raise toward creating an income surplus. Bartolo’s income will increase an average of 5% per year through raises. He saves 3% of his pay each year,
and after 4 years, he will have an annual savings rate of 13%. This accelerating effect is shown in Illustration 3.1.6:
3. a. Answer: $173 Solution: The total debt-to-income ratio shows the percentage of your income that you are spending to pay down your debts. The ratio is calculated as follows: Debt − to − income ratio =
Total required debt payments Gross income
$182 student loan + $125 credit card + $600 rent + car payment $3,000 gross income 0.36 × $3,000 = $182 + $125 + $600 + car payment $1,080 = $182 + $125 + $600 + car payment $173 = car payment 0.36 =
LO: 3.1; BT: An; Diff: E; TOT: 5 min; AACSB: A 3. b. Answer: Neil could do a variety of things to improve his situation, including focusing on increasing his income, paying down his credit card debt so that his monthly required payment is smaller, or moving to a less expensive apartment. The student loan debt payment would be difficult, if not impossible, to change. In each case, Neil should wait to take out a new car loan for a better car until he lowers his current debt-to-income ratio. LO: 3.1; BT: S; Diff: E; TOT: 10 min; AACSB: n/a
Explore 1. Answer: Based on the current information the student finds. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.1; BT: An; Diff: E; TOT: 30 min; AACSB: A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.1; BT: Ap; Diff: M; TOT: 20 min; AACSB: C, RT
3.1 Expanded Learning Activity Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.1; BT: An; Diff: M; TOT: 90 min; AACSB: C, RT
3.1 Practice Questions 1. The best way to accumulate wealth over your life is to a. spend less than you earn. b. play the lottery. c. borrow money and invest the proceeds. d. develop a network of friends. Answer: a; LO: 3.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Someone who waits until age 40 to start saving for their retirement will need to save how much of the yearly income to become financially independent? a. 10%. b. 12%. c. 18%. d. 20%. Answer: d; LO: 3.1; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: A targeted savings rate is the savings ratio applied over a specific time period. If you are younger than age 30, your target should be to save 12% of income per year toward retirement. If you are between ages 30 and 40, your target savings rate should be at least 15% of income per year. If you wait to start saving for retirement until you are age 40, you will need a target retirement savings rate of 20% of income per year for each year until age 65. 3. Marc is having trouble meeting his targeted savings rate. Which of the following strategies can he use to ensure that he will reach his savings goal in the future? a. Commit to saving at least half of each raise in income over the next 5–10 years. b. Play the lottery. c. Borrow money and invest the proceeds. d. Develop a network of friends. Answer: a; LO: 3.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a 4. All of the following statements are true, except: a. As your debt-to-income ratio declines, your financial flexibility expands. b. As your savings ratio increases, your financial flexibility increases. c. As your savings ratio declines, your financial flexibility decreases. d. As your debt-to-income ratio increases, your financial flexibility expands. Answer: d; LO: 3.1; BT: An; Diff: M; TOT: 2 min; AACSB: n/a Solution: The total debt-to-income ratio shows the percentage of your income that you are spending to pay down your debts. When you have a lot of debt, you need to devote a large portion of your income to repay the debt and interest. This means that you have less income to save. Thus, too much debt (high debt-to-income ratio) will lower financial flexibility. The savings ratio indicates the percentage of income that you are actively saving (savings as a percentage of your income). As your savings ratio increases, your wealth builds and you gain greater financial flexibility. 5. Investing in your own human capital will make it easier to generate surpluses over your working years by a. increasing your net worth. b. increasing your ability to earn higher income. c. increasing your debt ratio.
d. decreasing your expenses. Answer: b; LO: 3.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: A
3.2 Identify the different forms of employee earnings. 3.2 Multiple-Choice Questions 1. d. Hourly wages, salary, and commissions. Answer: d; LO: 3.2; BT: An; Diff: E; TOT: 2 min; AACSB: A 2. c. $467.50. Answer: c; LO: 3.2; BT: An; Diff: E; TOT: 2 min; AACSB: A Solution: Maria gets $8.50 per hour for regular hours per week, and she gets paid one and half times the regular wage rate for hours over and above her regular hours of 40 hours per week. Therefore, her total wages will be regular hourly wages plus overtime wages. Regular hourly wages per week: 40 × $8.50 = $340 Overtime pay per hour: $8.50 × 1.50 = $12.75 Overtime pay for 10 hours: $12.75 × 10 = $127.50 Total wages: $340 + $127.50 = $𝟒𝟔𝟕. 𝟓𝟎 3. a. $44,000. Answer: a; LO: 3.2; BT: An; Diff: E; TOT: 2 min; AACSB: A Solution: Your wage rate is $22 per hour. You worked 40 hours per week. There are 52 weeks in a year. You only worked 50 weeks during the year, because you got 2 weeks of unpaid vacation. Total number of hours worked during the year = 40 hours per week × 50 weeks in a year = 2,000 hours per year. Total wages for one year = $22/hour × 2,000 hours = $44,000 OR Total wages for one year =
$22 40 hours × × 50 weeks = $𝟒𝟒, 𝟎𝟎𝟎 hour week
4. c. Because he is employed by his family, he is not entitled to extra pay or overtime pay. Answer: c; LO: 3.2; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a
5. b. fast food restaurants. Answer: b; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
6. a. A high school graduate. Answer: a; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 7. a. more. Answer: a; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. a. salary. Answer: a; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. d. Bonus. Answer: c; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. d. $370. Answer: d; LO: 3.2; BT: An; Diff: E; TOT: 2 min; AACSB: A Solution: There are three components of total earnings for Ernest. Total earnings = regular hourly wages + overtime wages + commission Regular hourly wages = Number of hours worked during the week × hourly wage rate Number of hours worked during the week = 30 hours × $9 = $270 There is no overtime work this week. Commission = 0.10 × $1,000 sales= $100 Total earnings = $270 + $100 = $370
3.2 Adventures in Personal Finance Short Answer 1. Answer: $14,500 Solution: Calculate the annual earnings based on a $7.25 per hour wage, 40-hour workweek, and 50 weeks worked in a year. $7.25 hourly wage × 40 hours per week worked × 50 weeks worked in a year = $14,500 LO: 3.2; BT: An; Diff: M; TOT: 10 min; AACSB: A
2. a1) Answer: −$980 Solution: To determine Mitch’s savings, his annual expenses must be subtracted from his annual earnings. Annual earnings = $7.25 hourly wage × 40 hours per week worked × 50 weeks worked in a year = $14,500
Monthly expenses = $500 rent + $300 groceries + $100 taxes + $200 entertainment + $100 clothing + $90 phone = $1,290 monthly expenses Annual expenses = $1,290 monthly expenses × 12 months = $15,480 Annual savings = $14,500 annual earnings − $15,480 annual expenses = −$980 LO: 3.2; BT: An; Diff: H; TOT: 2 min; AACSB: A 2. a2) Answer: Mitch lives $980 beyond his means. He can increase his earnings by either working more hours or finding a better paying job. He can also reduce his expenses. His entertainment and clothing expenses seem disproportionately high compared to his essential expenses. LO: 3.2; BT: An; Diff: M; TOT: 2 min; AACSB: A 3. Answer: Job 3 Solution: Based on each job’s annual estimated earnings, Job 3 with $30,000 expected annual earnings is the best (highest expected earnings). Job 1 Annual earnings = $13 hourly wage × 40 hours per week worked × 50 weeks worked in a year = $26,000 Job 2 Annual earnings = $29,000 salary Job 3 Annual expected sales commissions = $600,000 expected annual sales × 4% commission rate (0.04) = $24,000 Annual earnings = $6,000 salary + $24,000 expected sales commissions = $30,000 LO: 3.2; BT: An; Diff: M; TOT: 20 min; AACSB: A Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.2; BT: An; Diff: M; TOT: 60 min; AACSB: C 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.2; BT: Ap; Diff: M; TOT: 60 min; AACSB: C, E 3.2 Expanded Learning Research 3.2 Answer: Based on the current information found at the Bureau of Labor Statistics. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.2; BT: Ap; Diff: M; TOT: 30 min; AACSB: n/a 3.2 Practice Questions
1. Who is more likely to receive overtime pay? a. Butch who works as a senior manager in a midsized software development firm. b. Linda who works as a college professor. c. Tommy who works as a used car salesperson. d. Bonnie who works in an automobile assembly plant. Answer: d; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 2. Which of the following occupations is most likely to be paid a salary? a. Lifeguard. b. Preschool teacher. c. Janitor. d. Historian. Answer: d; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. Assume that Lisa earns $10 per hour working in a clothing store. She gets one and one-half times her wage if she works over 40 hours. In addition, she can earn a 20% commission on the sale of clothes sold during her time at work. How much can Lisa earn this week if she works 50 hours and sells $3,000 worth of clothing? a. $1,000. b. $1,100. c. $1,150. d. $1,350. Answer: c; LO: 3.2; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: There are three components of Ernest’s total earnings. Total earnings = regular hourly wages + overtime wages + sales commission Regular wage earnings = 40 regular hours worked × $10 per regular hourly rate = $400 Overtime wage earnings = 10 overtime hours worked × $15 per overtime hourly rate* = $150 *Overtime wage rate1 = $10 per regular hourly rate × 1.5 overtime premium = $15 per hour Sales commissions = $3,000 sales × 20% (0.20) commission rate = $600 Total earnings = $400 regular wages + $150 overtime wages + $600 commission = $1,150
4. Dale wants a career that will provide the greatest opportunity to make a lot of money. He should prepare for a job in a. public administration. b. corporate management. c. government service. d. sales. Answer: d; LO: 3.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. Federal minimum wages laws allow certain employers to pay less than the national wage rate. Which of the following employees are allowed to be paid less than the minimum wage? a. Farmworkers. b. Children who work in a family business. c. Those employed in a hospital. d. All of the answer choices are correct. Answer: d; LO: 3.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
3.3 Compare the financial pros and cons of self-employment and ways to structure a business. 3.3 Multiple-Choice Questions 1. d. II, III, and IV only. Answer: d; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. c. Her paycheck withholds FICA taxes. Answer: c; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. b. Professional services. Answer: b; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. c. sole proprietorship. Answer: c; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. d. Both if a customer sued him for using lead in a child’s ring and if his jewelry company failed to pay a debt. Answer: d; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 6. c. Partnership. Answer: c; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 7. b. If Yolinda stops making her share of the car expenses, Wes will be liable for Yolinda’s share. Answer: b; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 8. d. Either a limited liability partnership or a limited liability company. Answer: d; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. d. Both sole proprietorship and limited liability company. Answer: d; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 10. d. I, II, and III. Answer: d; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
3.3 Adventures in Personal Finance Short Answer 1. Answer: The IRS generally classifies people as self-employed if he or she possesses any of the following factors: • They carry on a trade or business as a sole proprietor or an independent contractor. • They are a member of a partnership that carries on a trade or business. • They are otherwise in business for yourself (including a part-time business). If you are self-employed, then you earn income from a business that you operate. As a result, being self-employed means that you • set your own hours of work. • charge for your products or services. • pay your own taxes. LO: 3.3; BT: Ap; Diff: E; TOT: 20 min; AACSB: n/a
2. Answer: Employers prefer to hire people as contractors because the employer is not
required to pay payroll taxes, unemployment taxes, withhold income taxes, and provide healthcare and retirement benefits for contracted employees. Payroll taxes include FICA (6.2% Employer Social Security tax and 1.45% Employer Medicare tax). Employers typically are required to provide federally regulated healthcare benefits and retirement plan benefits to most all employees. LO: 3.3; BT: Ap; Diff: E; TOT: 15 min; AACSB: E
3. Answer: Pros: freedom to be in charge of your own destiny and to set work hours; potential for higher financial success, building wealth through business ownership. Cons: working long hours; may not have sufficient income; no employer-provided benefits. LO: 3.3; BT: An; Diff: M; TOT: 20 min; AACSB: n/a Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.3; BT: An; Diff: M; TOT: 40 min; AACSB: RT, C 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.3; BT: S; Diff: E; TOT: 180 min; AACSB: C, RT, A 3. Answer: Discussion should include the payment of self-employment tax, quarterly estimated tax payments, deduction of half of self-employment tax, and other deductions available to self-employed individuals. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.3; BT: An; Diff: M; TOT: 120; AACSB: C 3.3 Expanded Learning Research
Answer: Basic steps include: (1) write a business plan, (2) get help or training, (3) choose your business location, (4) understand your financing options, (5) decide on a business structure, (6) register your business name, (7) get a tax ID, (8) register with tax authorities, (9) apply for permits and licenses, and (10) hire employees. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.3; BT: Ap; Diff: M; TOT: 60 min; AACSB: C 3.3 Practice Questions 1. A small business owner is considered to be a(n) a. self-employed individual. b. individual involved in a partnership arrangement. c. dual employee. d. corporate partner. Answer: a; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2.
According to the topic readings, what proportion of small businesses are still in existence 10 years after they were started? a. 1 in 10. b. One-third. c. One-half. d. Two-thirds. Answer: b; LO: 3.3; BT: K; Diff: M; TOT: 2 min; AACSB: n/a Solution: Based on statistics from the U.S. Small Business Administration (SBA), only about half (50%) of small business start-ups are still around after 5 years, and only one-third (33%) are still in business after 10 years. 3. The government agency charged with supporting small business development in the United States is the a. U.S. Department of Labor. b. U.S. Census Bureau. c. U.S. Department of Treasury. d. U.S. Small Business Administration. Answer: d; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4.
A large number of millionaires report owning their own business. What accounts for this phenomenon? a. A large number of small firms go out of business shortly after they get started. b. Small business ownership is risky, which leads to higher returns for some small business owners. c. Self-employed individuals, on average, make much more money than those who are employed by others. d. Small business owners tend to be smarter than others. Answer: b; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5.
Which of the following business structures provides the greatest level of protection against claims from creditors? a. Corporation. b. Sole proprietorship.
c. Partnership. d. Both sole proprietorship and partnership. Answer: a; LO: 3.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3.4 Discuss the sources and characteristics of unearned income. 3.4 Multiple-Choice Questions 1. b. interest received from a savings account. Answer: b; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. a. The $4,000 from his job. Answer: a; LO: 3.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Sources of earned income include wages, tips, salaries, commissions, bonuses, and self-employment. Sources of unearned income, according to the Social Security Administration, include but are not limited to interest from savings accounts, dividends, capital gains, monetary gifts you receive, government benefits, unemployment insurance, Social Security benefits, lottery winnings, money received by inheritance, proceeds from savings bonds, child support, and alimony. 3. d. $7,500. Answer: d; LO: 3.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Sources of earned income include wages, tips, salaries, commissions, bonuses, and self-employment. Sources of unearned income, according to the Social Security Administration, include but are not limited to interest from savings accounts, dividends, capital gains, monetary gifts you receive, government benefits, unemployment insurance, Social Security benefits, lottery winnings, money received by inheritance, proceeds from savings bonds, child support, and alimony. Total income = $4,000 (income from job) + $1,000 (unemployment insurance) + $2,000 (gain from sale of motorcycle) + $500 (interest from investment) = $7,500 4. b. lender. Answer: b; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. c. He can expect $125,000 because his balance was less than the maximum insured amount. Answer: c; LO: 3.4; BT: M; Diff: M; TOT: 2 min; AACSB: n/a Solution: Your money is FDIC-insured up to $250,000 by the federal government per depositor, per insured bank, and per account type. 6. b. investor. Answer: b; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
7. c. In the form of dividends. Answer: c; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 8. a. dividend. Answer: a; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. b. 3%. Answer: b; LO: 3.4; BT: A; Diff: E; TOT: 2 min; AACSB: A Solution: The rate of return is the net gain/loss over a particular period. Investments typically offer two forms of income over a period of time: capital gain/loss and cash flow in the form of dividends or interest. Capital gain (or loss) + Dividend (or interest) Rate of return = Cost of investment $3,000 dividend Rate of return = = 𝟎. 𝟎𝟑~𝟑% $100,000 cost 10. d. decrease; increase. Answer: d; LO: 3.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3.4 Adventures in Personal Finance Short Answer 1. Answer: a. Earned, b. unearned, c. unearned, d. earned, e. unearned LO: 3.4; BT: C; Diff: E; TOT: 10 min; AACSB: n/a 2. Answer: 70 years at 1%, 18 years at 4%, and 9 years at 8% Solution: You can estimate the time it takes to double an investment by the Rule of 70 or 72, and by actually calculating the number of years, a hypothetical $100 will grow to $200 at an APY. Financial Calculator (PV is expressed as a negative number representing a cash outflow, typically an initial investment.) I (1); PV (−100); FV (200); Cpt N (69.7) I (4); PV (−100); FV (200); Cpt N (17.7) I (8); PV (−100); FV (200); Cpt N (9.0)
Excel Spreadsheet (PV is expressed as a negative number representing a cash outflow, typically an initial investment.) =NPER(rate, pmt, pv, fv) =NPER(0.01, 0, −100, 200) => 69.7 =NPER(0.04, 0, −100, 200) => 17.7 =NPER(0.08, 0, −100, 200) => 9.0
TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM. TVM Formula The future value of a lump-sum formula: FV = PV(1 + i)N $200 = $100(1 + 0.01)N $200 = (1.01)𝑁 $100 2 = (1.01)N The next step is to eliminate exponent N. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 2) = N × (natural logarithm 1.01) 0.69315 = 0.00995N 0.69315 = 𝑁 = 𝟔𝟗. 𝟕 𝐲𝐞𝐚𝐫𝐬 0.00995 $200 = $100 (1 + 0.04)N $200 = (1.04)𝑁 $100 2 = (1.04)N The next step is to eliminate exponent N. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 2) = N × (natural logarithm 1.04) 0.69315 = 0.03922N 0.69315 = 𝑁 = 𝟏𝟕. 𝟕 𝐲𝐞𝐚𝐫𝐬 0.03922 $200 = $100 (1 + 0.08)N $200 = (1.08)𝑁 $100 2 = (1.08)N The next step is to eliminate exponent N. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 2) = N × (natural logarithm 1.08) 0.69315 = 0.07696N 0.69315 = 𝑁 = 𝟗. 𝟎 𝐲𝐞𝐚𝐫𝐬 0.07696 Rule of 70/72 Estimate (The Rule of 72 is most appropriate for estimating how long it will take to double your money for an APY from 5% to 25%. For an APY less than 5%, substituting 70 for 72 is more accurate) 72 ) Number of years = ( APY
70 = 70 years 1 70 = 17.5 years 4 72 = 9 years 8 LO: 3.4; BT: An; Diff: E; TOT: 5 min; AACSB: A 3. Answer: Investors, rather than lenders, take more risk with their money. Lenders have a legal obligation from borrowers to repay principal and interest in a specific manner (interest amount, interval, and maturity). There is legal recourse for the lender to pursue if the borrower defaults. Investors do not have any legal obligation from the company that issued the respective stock as to how much, when, how often, or if a dividend will be paid. Dividends are decided by the leadership of the respective company as to their dividend policy. While the supply and demand for the stock may be affected by the dividend policy, there is no obligation whatsoever to pay a dividend. The uncertainty risk of dividends is compensated by the potential future growth of the stock. While loans and stocks share the potential loss associated with the issuer’s demise, stock ownership has unlimited potential for growth and loans can only return your principal. The typical risk/reward scenario will steer individuals to be lenders or investors based on their respective risk averseness and requirements in achieving their goals. Earning interest will be most appropriate for individuals that require a fixed income. Loans provide permanence and definition: a stated maturity, stated interest periods, stated interest amount, and return of principal. LO: 3.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a 4. Answer: 2.50% Solution: The rate of return is the net gain/loss over a particular period. Investments typically offer two forms of income over a period of time: capital gain/loss and cash flow in the form of dividends or interest. Julianna has no capital gain/loss but $50 in interest for a $2,000 loan. Capital gain (or loss) + Dividend (or interest) Rate of return = Cost of investment (or loan principal) $50 interest Rate of return = = 𝟎. 𝟎𝟐𝟓~𝟐. 𝟓% $2,000 principal LO: 3.4; BT: An; Diff: E; TOT: 5 min; AACSB: A Explore 1. Answer: Open student response. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.4; BT: Ap; Diff: M; TOT: 40 min; AACSB: C. 2. Answer: Open student response depending on findings. Please refer to the sample writing assignment rubric in the solutions manual.
LO: 3.4; BT: An; Diff: M; TOT: 40 min; AACSB: C 3. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.4; BT: Ap; Diff: H; TOT: 60 min; AACSB: C 3.4 Expanded Learning Research Answer: Open student response depending on current circumstances. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.2; BT: Ap; Diff: M; TOT: 60 min; AACSB: C 3.4 Practice Questions 1. Mike owns his own business. The income he receives from the business is called a. earned income. b. unearned income. c. corporate income. d. total income. Answer: a; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. All of the following are examples of unearned income, except a. lottery winnings. b. Social Security benefits. c. self-employment income. d. money received as a gift. Answer: c; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. How are people who lend money to others compensated? a. They charge interest to the borrower. b. They receive a commission on the amount borrowed. c. They pay a commission to the borrower. d. They charge an investment fee to the borrower. Answer: a; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. Most retirees pay expenses from a. dividends. b. wages. c. interest. d. both dividends and interest. Answer: d; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Someone who owns the assets of a business is called a(n) a. borrower. b. lender. c. investor. d. account executive. Answer: c; LO: 3.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3.5 Explain how to use capital assets to produce income and build wealth.
3.5 Multiple-Choice Questions 1. c. creating or buying assets that increased in value over time. Answer: c; LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. b. Your human capital. Answer: b; LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. a. Sales Price − Basis − Selling Costs = Gain/Loss. Answer: a; LO: 3.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. c. Loss of $100. Answer: c; LO: 3.5; BT: An; Diff: M; TOT: 2 min; AACSB: n/a Solution: Larry bought a stamp for $2,500 and then later sold the stamp for $3,000 and paid a 20% commission on the sale. The profit/loss is the net sale proceeds less his cost. Sales commission = $3,000 sale − 20% commission = $3,000 × 0.20 = $600 Net sale proceeds = $3,000 sale − $600 commission = $2,400 Profit/Loss = Net sale proceeds − cost Profit/Loss = $2,400 − $2,500 = -$100 ~ $100 loss 5. b. 200%. Answer: b; LO: 3.5; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: Capital gain/loss is the difference between the net sale proceeds of an investment and the total cost of the investment. Sales proceeds typically are adjusted for sales commission, and total cost is typically adjusted for purchase commission and any maintenance required for the property during the period held as an investment. Capital gain/loss does not consider cash flows such as dividends. Sale proceeds = 100 shares × $300 = $30,000 Total cost = 100 shares × $100 = $10,000 Capital gain/loss = $30,000 proceeds − $10,000 cost = +$20,000 ~ $20,000 profit Gain or loss Percentage gain/loss = Cost $20,000 Percentage gain/loss = = 2.0~200% gain $10,000 6. b. 20%. Answer: b; LO: 3.5; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: Capital gain/loss is the difference between the net sale proceeds of an investment and the total cost of the investment. Sales proceeds typically are adjusted for sales commission, and total cost is typically adjusted for purchase commission and any
maintenance required for the property during the period held as an investment. Capital gain/loss does not consider cash flows such as dividends. Sale proceeds = 100 shares × $12 = $1,200 Total cost = 100 shares × $10 = $1,000 Capital gain/loss = $1,200 proceeds − $1,000 cost = +$200 ~ $200 profit Gain or loss Percentage gain/loss = Cost $200 Percentage gain/loss = = 0.20~20% gain $1,000 7. c. broke even. Answer: c; LO: 3.5; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: Bob engaged in three transactions. His profit or loss from three transactions is $0. He broke even. Asset Antique Stock Car Total
Sale Proceeds $500 $500 $9,800 $10,800
Cost $300 $1,000 $9,500 $10,800
Profit/Loss $200 −$500 $300 $0
Realized a gain if profit/loss > 0 Incurred a loss if profit/loss < 0 Broke even if profit/loss = 0 8. a. $100. Answer: a; LO: 3.5; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: The basis of property, or your cost of the asset, has an impact on your capital gain outcome. The concept of basis can get complicated. The basis of investment assets (e.g., stocks) you purchase is generally the purchase price plus any costs of acquiring the asset, such as commissions and recording or transfer fees. Although Helen’s total cost of the investment is $10,000, her per share basis is $100 (the question specifically asked for per share basis). 9. a. Helen’s total basis invested increased from $10,000 to $11,000. Answer: a; LO: 3.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: The basis of property, or your cost of the asset, has an impact on your capital gain outcome. The concept of basis can get complicated. The basis of investment assets (e.g., stocks) you purchase is generally the purchase price plus any costs of acquiring the asset, such as commissions and recording or transfer fees. When you use investment earnings to purchase more of the underlying investment, the basis of your investment increases. Reinvesting dividends is a common example of this practice. Although Helen’s original cost of the investment is $10,000, she reinvested a $1,000 dividend. Thus, her total cost basis
increased by the $1,000 reinvestment to $11,000. Cost basis is always expressed in currency denominations, not units or shares. 10. b. 6 years. Answer: b; LO: 3.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: You can estimate the time it takes to double an investment at a 12% average rate of return by the Rule of 72, and by actually calculating the number of years, a hypothetical $100 will grow to $200 at an APY of 12%. Financial Calculator PV (−100); I (12); FV (200); Cpt N {6.12} (PV is expressed as a negative number representing a cash outflow, typically an initial investment.) Excel Spreadsheet =NPER(rate, pmt, pv, fv) =NPER(0.12, 0, −100, 200) => 6.12 (PV is expressed as a negative number representing a cash outflow, typically an initial investment.) TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM. TVM Formula The future value of a lump-sum formula: FV = PV(1 + i)N $200 = $100(1 + 0.12)N $200 = (1.12)𝑁 $100 2 = (1.12)N The next step is to eliminate exponent N. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 2) = N × (natural logarithm 1.12) 0.69315 = 0.11333N 0.69315 = 𝑁 = 𝟔. 𝟏𝟐 0.11333 Rule of 72 Estimate 72 Number of years = (APY) 72 = 6 years 12 3.5 Adventures in Personal Finance
Short Answer 1. Answer:
Capital asset: Something you own that can be used for personal or investment purposes. Basis: The price you pay for an asset. Capital gain: Occurs when the sale price of an asset is greater than the basis of the property. Capital loss: Occurs when the sale price of an asset is less than the basis of the property. LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Answer: Short-term capital gain: $60 Solution: $100 sales proceeds − $40 cost = $60 gain. The sale occurred within one year of the purchase; thus, the sale is a short-term gain. LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. Answer: (a) I, (b) IV, (c) 1, (d) II, (e) III Solution: Earned income: $15,000 based on 20 hours of work at $15 per hour for 50 weeks. Unearned capital gain income: $1,400 from the sale of property for $2,000 with a basis of $600. Earned income: $900 in tips. Unearned interest income: $300 based on 3.0% APY on money deposited at the bank. Unearned dividend income: $100 from profit distributions made to shareholders. LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.5; BT: Ap; Diff: M; TOT: 60 min; AACSB: C 2. Answer: Students should find that up to $250,000 (Single and Head of Household filing status, $500,000 for Married Filing Jointly) of long-term capital gain can be excluded from income on the sale of a principal residence. In general, to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test. You’re eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least 2 years out of the 5 years prior to its date of sale. Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the 2-year period prior to the sale of your home. There are additional requirements and exceptions that can be found in IRS Publication 523. The primary goal of this assignment is to get students using IRS tax materials and to recognize that gains are taxed differently depending on the asset that generates the gain. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.5; BT: An; Diff: H; TOT: 75 min; AACSB: C 3.5 Expanded Learning Research Answer: Students should find that short-term capital gains are taxed as ordinary income and long-term capital gains are taxed at lower tax rates (0%, 15%, 20%). Up to $3,000 of capital losses can be deducted against ordinary income. The primary goal of this assignment is to help students recognize that gains are taxed differently depending on how long the asset has
been owned or held. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.5; BT: An; Diff: H; TOT: 75 min; AACSB: C 3.5 Practice Questions 1. What is the commonality among the 10 richest people living in the United States? a. They were super savers. b. They were early adopters of technology. c. They invested in businesses. d. They lent money at high rates of interest. Answer: c; LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. All of the following are forms of unearned income, except a. dividends. b. interest. c. capital gains. d. wages. Answer: d; LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. Which of the following strategies offers the best way to achieve lifetime wealth? a. Earning interest. b. Making a high annual income. c. Owning a business. d. Saving money. Answer: c; LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. Which of the following activities results in a recognized capital gain or loss? a. Selling a comic book collection at a garage sale. b. Owning Google stock. c. Selling furniture at an auction. d. Both selling a comic book collection at a garage sale and selling furniture at an auction. Answer: d; LO: 3.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Which of the following statements is true? a. When you invest money, you are taxed each year on any capital gains even if you do not sell the asset. b. You will be taxed each year that you receive a dividend from an investment. c. Interest earned on an investment is considered to be tax free until you sell the investment. d. Both when you invest money, you are taxed each year on any capital gains even if you do not sell the asset and you will be taxed each year that you receive a dividend from an investment are correct. Answer: b; LO: 3.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Dividends and interest received each year are recognized as taxable unearned income in the year received (some municipal bond interest is not recognized). Capital gains are not recognized and taxed until the investment asset is sold.
3.6 Explain financial safety-net programs available to employees and citizens. 3.6 Multiple-Choice Questions 1. d. unemployment insurance benefit. Answer: d; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. d. emergency savings and unemployment benefits. Answer: d; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. d. Medicaid. Answer: d; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. d. SNAP, TANF, and refundable tax credits. Answer: d; LO: 3.6; BT: K; Diff: M; TOT: 2 min; AACSB: n/a Solution: In addition to unemployment benefits and Medicaid, refundable tax credits, SNAP, and TANF should be considered. Supplemental Nutrition Assistance Program (SNAP) provides money to low-income households to purchase food (also commonly referred to as food stamps). Temporary Assistance for Needy Families (TANF) provides supplemental income to very-low-income unemployed households, typically with children. To apply for these benefits, evidence of financial situation, proof of U.S. residency (in most states), and verification of each family member’s age and earnings situation are required. 5. b. taxes and borrowing. Answer: b; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 6. a. Social Security benefits. Answer: a; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a Solution: Although Social Security tax is based on income when earned, it’s not based on “current” income when benefits are made. Social Security contributions are based on earned income when taxed but not related to any income when distributions (benefits) are made. 7. a. Social Security. Answer: a; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 8. c. Taxes from current workers are used to fund payments to current retirees. Answer: c; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. d. Be at least age 62 and retired, or become permanently disabled. Answer: d; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
10. b. $5,146.00. Answer: b; LO: 3.6; BT: An; Diff: H; TOT: 5 min; AACSB: A Solution: Social Security tax is 12.4% of gross earned income up to an annual cap ($132,900 in 2019). Self-employed workers pay 100% of the 12.4% tax. Employees pay half, 6.2%, and their employer pays the other half, 6.2%. Linda is an employee earning $83,000 per year, so her Social Security tax is $5,146.00 (6.2% of $83,000). $83,000 gross earnings × 0.062 Social Security tax rate = $5,146.00 3.6 Adventures in Personal Finance Short Answer 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.6; BT: Ap; Diff: M; TOT: 45 min; AACSB: C, RT 2. Answer: 3: a—III; b—III; c—I; d—I; e—II; f—III; g—III Solution: a. Temporary Assistance for Needy Families: benefit based on current year income b. Supplemental Nutrition Assistance Program: benefit based on current year income c. Military service member’s education benefits: benefit based on earnings history d. Social Security retirement benefits: benefit based on earnings history e. Medicare: benefit not based on earnings history f. Education grants and loan subsidies: benefit based on current year income g. Unemployment benefits: benefit based on current year income LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a Explore 1. Answer: 2034; 61 million; sufficient Solution: Current projections have the trust fund being depleted in approximately 2034. About 61 million people currently receive Social Security benefits. Currently, current tax revenues slightly exceed current trust fund expenditures for Social Security. Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.6; BT: Ap; Diff: M; TOT: 45 min; AACSB: C, A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.6; BT: Ap; Diff: M; TOT: 75 min; AACSB: C, A 3. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.6; BT: Ap; Diff: H; TOT: 120 min; AACSB: C, A
3.6 Expanded Learning Research Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO: 3.6; BT: Ap; Diff: M; TOT: 60 min; AACSB: C 3.6 Practice Questions 1. Financial educators often recommend that individuals
a. plan to use government benefits as an important source of income prior to retirement. b. plan to use government benefits as an emergency source of income. c. never accept government benefits. d. both plan to use government benefits as an important source of income prior to retirement and plan to use government benefits as an emergency source of income are correct. Answer: b; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Unemployment benefits typically a. replace 100% of an unemployed person’s previous income. b. last for only a limited number of weeks. c. include medical and disability insurance benefits. d. are only paid to workers that have been employed for at least 2 years. Answer: b; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. Medicaid is available to a. anyone age 62 or older. b. anyone with dependent children. c. individuals who have low income and limited assets and meet other qualifications. d. anyone who requires long-term care assistance. Answer: c; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. At what age can someone obtain Medicare coverage? a. Age 55. b. Age 60. c. Age 62. d. Age 65. Answer: d; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. All of the following are related to a person’s earnings history, except a. Social Security benefits. b. Medicare. c. military service member’s education benefits. d. both Medicare and military service member’s education benefits. Answer: b; LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
Chapter 3 End-of-Chapter Summary Assessment Continuing Case: Tarek’s Financial Journey Let’s catch up with Tarek. In Chapter 2, Tarek presented his budget and balance sheet. These are shown again as follows: Tarek’s Personal Monthly Budget Budget Sources of Income
Actual
Income Interest TOTAL INCOME Sources of Expenses Taxes Rent Vehicle Insurance Food and Eating Out Car Payment Student Loans Sports and Hobbies Phone and Household Retirement Vacations Credit Cards TOTAL EXPENSES SURPLUS/DEFICIT
$3,900 90 $3,990
$3,900 75 $3,975
883 850 200 290 395 298 240 100 156 300 275 3,987
883 850 200 320 395 298 300 135 156 300 275 4,112
Tarek’s Balance Sheet Checking Savings Automobile Motorcycle Furnishings Clothes Other Household Sports Equipment Collections 401(k) TOTAL ASSETS
Assets $350 1,100 11,000 3,750 800 2,100 900 2,500 750 19,000
$23,250 Liabilities Credit Cards $3,500 Student Loans 25,900 Car Loans 3,000 TOTAL LIABILITIES $32,400
a. Answer: $3 Solution: Budgeted income surplus = $3,990 budgeted income − $3,987 budgeted expenses = $3 LO: 3.6; BT: An; Diff: M; TOT: 10 min; AACSB: A
b. Answer: 4%; And is BELO:W the recommended benchmark Solution: The savings ratio is calculated based on gross income; it is savings divided by the corresponding gross income for that period. Monthly savings Monthly income $3 income surplus + $156 retirement savings Savings ratio = = $0.04~4% $3,990 Savings ratio =
If you are younger than age 30, your target should be to save 12% of income per year toward retirement. If you are between ages 30 and 40, your target savings rate should be at least 15% of income per year. If you wait to start saving for retirement until you are age 40, you will need a target retirement savings rate of 20% of income per year for each year until age 65. Tarek is 26 years old so his target savings should be 12%. His 4% savings ratio is below his 12% recommended target. LO: 3.6; BT: An; Diff: M; TOT: 5 min; AACSB: A c. Answer: 48% Solution: The total debt-to-income ratio shows the percentage of your income that you are spending to pay down your debts. The ratio is calculated as follows: Total required debt payments Total debt − to − income ratio = Gross income Debt − to − income ratio $850 rent + $395 car payment + $298 student loan + $275 credit card = $3,990 = 𝟎. 𝟒𝟖~𝟒𝟖% Tarek’s total debt-to-income ratio is 48%, which is higher than the benchmark of 36%. He needs to reduce his spending and/or earn additional income. Then with the increase in income, surplus he can reduce his debt. LO: 3.6; BT: An; Diff: M; TOT: 5 min; AACSB: A d. Answer: $24.38; higher than national minimum wage. Solution: Tarek earns $3,900 in monthly wages. Based on a month having 4 weeks and assuming Tarek works 40 hours per week, his hourly wage rate is $24.38. Monthly earnings Regular hourly wage = Hours per month $3,900 Regular hourly wage = = $24.38 40 hours per week × 4 work weeks in a month Tarek is earning $24.38 per hour, which is higher than the national minimum wage. LO: 3.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a e. Answer: $350; 88% Solution: The collection was sold for $750 (fair market value), and it was purchased for $400. The capital gain is $750 sale proceeds less the cost basis of $400 or $350. His percentage return is 88%.
Capital gain or loss + Investment income Cost basis of invetsment $350 Percentage return = = 0.88~88% $400 Percentage return =
LO: 3.6; BT: An; Diff: M; TOT: 5 min; AACSB: A Calculating the Cost of Life’s Financial Journey a. Answer: 9 years Solution: Create a table based on an initial 3% savings rate. Annual raises are 4%, where half of each year’s raise is used to increase the savings rate. The end of the year’s savings rate will be the prior year’s ending savings rate plus this year’s increase in savings.
Year
1 2 3 4 5 6 7 8 9 Note1 Note2 Note3
Savings Rate1
Raise
Savings Increase (1/2 Raise)2
End-ofYear Savings Rate3
5% 7 9 11 13 15 17 19 21 9 years to reach 20% savings rate Savings rate is the prior year’s ending savings rate, except initial year. Savings increase is half of each year’s raise. End of the year’s saving rate is beginning savings rate plus savings increase. 3% 5 7 9 11 13 15 17 19
4% 4 4 4 4 4 4 4 4
2% 2 2 2 2 2 2 2 2
LO: 3.6; BT: Ap; Diff: M; TOT: 10 min; AACSB: A, RT b. Answer: $52,751 Solution: Create a table based on an initial 3% savings rate. Annual raises are 4%, where half of each year’s raise is used to increase the savings rate. The end of the year’s savings rate will be the prior year’s ending savings rate plus this year’s increase in savings. Earnings are increased by the year’s raise (except the initial year). The 10-year savings will be the total of every year’s savings based on the year’s earnings multiplied by that year’s ending savings rate.
Year 1 2 3 4 5 6 7 8 9 10
Note1 Note2 Note3 Note4 Note5
Savings Rate1
Raise
Savings Increase (1/2 Raise)2
End-of-Year Savings Rate3
Earnings4
Savings5
$30,000 $1,500 31,200 2,184 32,448 2,920 33,746 3,712 35,096 4,562 36,500 5,475 37,960 6,453 39,478 7,501 41,057 8,622 42,699 9,821 TOTAL SAVINGS FOR 10 YEARS $52,751 Savings rate is the prior year’s ending savings rate, except the initial year. Savings increase is half of each year’s raise. End of year’s saving rate is beginning savings rate plus savings increase. Earnings is the last year’s earnings plus this year’s raise, except the initial year. Savings is the year’s earnings multiplied by the end-of-year savings rate. 3% 5 7 9 11 13 15 17 19 21
4% 4 4 4 4 4 4 4 4 4
2% 2 2 2 2 2 2 2 2 2
5% 7 9 11 13 15 17 19 21 23
LO: 3.6; BT: An; Diff: H; TOT: 10 min; AACSB: A
Planning for the Future a. Answer: It is likely that they are running their business as a sole proprietorship, although the state in which they do business may consider the business a partnership. While an easy form of business to establish, the sole proprietorship (and partnership) exposes Tom and Lucy to unlimited liability. As such, they should change their business structure before they expand. LO: 3.6; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a b. Answer: A limited liability company (LLC) would be a good suggestion for Tom and Lucy. An LLC limits the liability of the firm’s owners while passing through all profits and losses to the company’s owners. Also, LLCs are inexpensive to establish and maintain. LO: 3.6; BT: Ap; Diff: M; TOT: 5 min; AACSB: A c. Answer: Loss of $3,000; Loss 7% Solution: The profit/loss is based on the sale proceeds (sale less commission and/or fees)
less the cost basis of the asset (purchase price plus commission and/or fees). Sale proceeds = $50,000 sale − $10,000 commission (or 20% of sale) = $40,000 $40,000 sale proceeds − $43,000 cost = −$3,000 ~ $3,000 loss Percentage loss =
−$3,000 loss = −0.07~ − 7% $43,000 cost
LO: 3.6; BT: An; Diff: M; TOT: 10 min; AACSB: A d. Answer: They will lose their employer-provided fringe benefits, such as healthcare, dental, group life, accidental life, pension or 401(k) plan, and employer-subsidized FICA. This means that they will need to purchase their own insurance, save for retirement directly rather than through their employer, and pay quarterly income taxes and the full FICA taxes. LO: 3.6; BT: An; Diff: M; TOT: 10 min; AACSB: n/a e. Answer: Not eligible Solution: They will not be eligible for unemployment benefits. These benefits are generally available only to those who lose their job involuntarily and due to no fault of their own. LO: 3.6; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a
Chapter 4 – Solutions Manual Learning Objectives 4.1 Explain the purpose and types of taxes. 4.2 Describe how to calculate taxable income. 4.3 Describe how to calculate marginal and effective tax rates on income and capital assets. 4.4 Discuss how federal income tax credits for education, health insurance, and households with children can help to lower income taxes. 4.5 Explain how to apply Medicare and Social Security taxes to self-employed individuals. 4.6 Identify income tax-planning strategies to minimize taxes and maximize after-tax wealth.
Key to metadata for questions: LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), not applicable (NA) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes For Instructor: Each writing question will have criteria which is specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criteria will be assessed and the associated points for each level of performance are found in columns 2 – 5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criteria (row) is worth up to 4 pts (column 2).
Rubric: (It is suggested the rubric be shared with the students) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking incomplete and significant detail limited
Amounts and information Answer is realistic / discussed are relevant relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
Does not represent realistic or relevant understanding of topic.
Organization/clarity of thought Well organized (25% of score)
Adequate organization
Limited organization
Poor organization
Appropriate recommendations and conclusions are reached. (25% of score)
A clear conclusion or recommendation is presented that is appropriate given the content discussed
25% of points (1 out of 4)
Conclusion or recommendation Conclusion or No conclusion/ is mostly clear recommendation recommendation and appropriate is incomplete provided given the content
Please refer to the sample writing assignment rubric in the solutions manual.
4.1 End-of-Topic Assessment 4.1 Multiple-Choice Questions 1. d. build infrastructure, provide social welfare, pay for national defense. ANSWER: d; LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB – NA 2. c. regressive tax. ANSWER: c; LO 4.1 BT: K Difficulty: E TOT: 2 min AACSB: NA 3. c. $0.70. ANSWER: c; LO 4.1 BT: An Difficulty: E TOT: 2 min AACSB: A
4. a. Tax Base X Tax Rate. ANSWER: a; LO 4.1 BT: K Difficulty: E TOT: 2 min AACSB: A 5. d. I, II, and III. ANSWER: d; LO 4.1 BT: K Difficulty: E TOT: 2 min AACSB: NA 6. a. Flat tax systems avoid being regressive by allowing large reductions in the tax base. ANSWER: a; LO 4.1 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 7. b. regressive tax. ANSWER: b; LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB: D 8. b. deficit. ANSWER: b; LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB: NA 9. a. who should pay taxes. ANSWER: a; LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB: D 10. d. progressive. ANSWER: d; LO 4.1 BT: K Difficulty: E TOT: 2 min AACSB: NA
4.1 Adventures in Personal Finance Short Answer 1. a. ANSWER: Yes, you still owe taxes. LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB: NA b. Answer: Generally, you will need to pay as you earn the income (quarterly basis) or at the end of the year, depending on how much tax you owe.
LO 4.1 BT: C Difficulty: M TOT: 2 min AACSB: NA 2. ANSWER: This is open to discussion about how it is applied. Generally, middle to high income households own property, so the tax is applying disproportionately to middle and high income households and low income households have little or no property tax. This is progressive. However, the tax rate for property taxes is flat, such that everyone subject to the tax pays the same proportional amount, this is a flat tax system. LO 4.1 BT: Ap Difficulty: H TOT: 15 min AACSB: A 3. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 4.1 BT: S Difficulty: H TOT: 20 min AACSB: A
Explore 1. ANSWER: High quality responses should identify at least one person and address questions (a) through (c). Please refer to the sample writing assignment rubric in the solutions manual. LO 4.1 BT: Ap Difficulty: H TOT: 20 min AACSB: E 2. ANSWER: High quality responses should address why a state would assess on weight rather than value, how the student’s state of residence assess tax on automobiles, and whether the student considers it to be progressive. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.1 BT: Ap Difficulty: H TOT: 15 min AACSB: A, RT Expanded Learning Activity Although you might dislike the idea of taxes, think about what benefits you receive directly from the government. These benefits could include financial aid, such as Pell Grants and Work-Study programs. Direct government transfers to you may also include large tax refunds at tax time that exceed your withholding, such as the Earned Income Credit, Child Tax Credit, and American Opportunity Credit. You may also be getting health insurance through a government supported program, such as Medicaid or a subsidy to purchase health insurance through the Health Insurance Marketplace. When you think of how much tax you might pay in contrast to the amount of government transfers that you receive, are you a net payer of taxes or a net beneficiary of other people’s taxes? More importantly, as you complete school and begin your career, what might change regarding your current net taxpayer or recipient situation? Write a two page reflection on your thoughts in response to these questions.
ANSWER: High quality responses should include a discussion of the different types of government transfers the student receives and how that relates to the amount of taxes that they pay, both now and in the future when they are working in their chosen career path. Please refer to the sample writing
assignment rubric in the solutions manual. LO 4.1 BT: S Difficulty: H TOT: 60 min AACSB: A, D, RT
4.1 Concept Checks 1. OASDI and HI are part of which of the following US tax systems: a. Federal income tax. b. Federal Insurance Contributions Act. c. Property Tax. d. Unemployment insurance. ANSWER: b; LO 4.1 BT: K Difficulty: E TOT: 2 min AACSB: NA 2. In communities where food purchased to prepare at home is exempt from sales tax, what part of the basic tax formula does this affect? a. Tax Rate. b. Tax Base. c. Tax Deduction. d. Taxable Income. ANSWER: b; LO 4.1 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 3. Compared with other developed countries in the world, the US has a ___________ tax system: a. Flat. b. Equally distributed. c. Regressive. d. Progressive. ANSWER: d; LO 4.1 BT: K Difficulty: E TOT: 2 min AACSB: NA 4. Whether you are an employee or self-employed, taxes on earned income must be paid: a. Once when the tax return is filed. b. As the income is paid, or every three months for self-employed individuals. c. At least once per month or as often as the employer issues paychecks. d. None of the above. ANSWER: b; LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB: NA 5. Failure to file a tax return when you have earned taxable income as an employee a. Will result in a penalty from the IRS, even if it was an accident.
b. Will not result in a penalty unless the IRS finds you guilty of committing fraud. c. Will not be known by the IRS. d. Both b and c are correct ANSWER: a; LO 4.1 BT: C Difficulty: E TOT: 2 min AACSB: E
4.2 End-of-Topic Assessment 4.2 Multiple-Choice Questions 1. d. I, II, and III. ANSWER: d; LO 4.2 BT: C Difficulty: M TOT: 2 min AACSB: E 2. d. Employers, financial institutions, and other entities that make substantial payments to you during the tax year. ANSWER: d; LO 4.2 BT: K Difficulty: E TOT: 2 min AACSB: NA 3. d. Either married filing jointly or married filing separately. ANSWER: d; LO 4.2 BT: K Difficulty: M TOT: 2 min AACSB: E 4. a. They should file married filing jointly. ANSWER: a; LO 4.2 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 5. c. You cannot claim a personal exemption for yourself. ANSWER: c; LO 4.2 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 6. d. Interest earned on a savings account. ANSWER: d; LO 4.2 BT: K Difficulty: E TOT: 2 min AACSB: NA 7. d. $0. ANSWER: d; LO 4.2 BT: Ap Difficulty: E TOT: 2 min AACSB: A
Solution: Michael’s Adjusted Gross Income is $90,000 (no deductions FOR AGI are given in the problem). The student loan interest deduction is completely phased-out for a single individual if their AGI is more than $80,000. 8. a. $12,000 ANSWER: a; LO 4.2 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Sharina can claim the higher of her standard deduction or her itemized deduction. Her standard deduction, because she is single, is $12,000. Her itemized deduction would be $5,500 ($3,000 + $500 + $2,000). 9. a. Standard Deduction of $5,350. ANSWER: a; LO 4.2 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: The standard deduction for dependents is the greater of: 1) earned income plus $350 up to the standard deduction for single non-dependents, or $1,050. Swarn’s standard deduction is $5,350 ($5,000 + $350). 10. c. taxable Income. ANSWER: c; LO 4.2 BT: C Difficulty: E TOT: 2 min AACSB: NA
4.2 Adventures in Personal Finance Short Answer 1. ANSWER: D, E, and F are NOT deductible FOR AGI. All of these are a deduction FROM AGI. LO 4.2 BT: Ap Difficulty: M TOT: 10 min AACSB: NA
2. ANSWER: Gross income is the amount of income before any allowed deductions are claimed. All taxpayers have some deductions that can offset their gross income, such as the standard deduction. Taxable income is that amount remaining after all deductions have been claimed. LO 4.2 BT: Ap Difficulty: M TOT: 10 min AACSB: A, C 3. ANSWER: An unmarried individual with no children will file as single. An unmarried individual with a child that they live with and provide for can file as head of household.
A married couple can choose to file as married filing jointly or as married filing separately. An unmarried surviving spouse, who is providing a home for a dependent child, can file as surviving spouse for the two years following their spouse’s death. LO 4.2 BT: Ap Difficulty: H TOT: 10 min AACSB: A
4. ANSWER: You can claim a refund for income taxes withheld from your paycheck. You may also qualify for tax credits. LO 4.2 BT: Ap Difficulty: M TOT: 5 min AACSB: C, E
Explore
1. ANSWER: a = 4, b = 1, c = 6, d = 8, e = 7, f = 2, g = 5. LO 4.2 BT: Ap Difficulty: M TOT: 10 min AACSB: T, E
2. ANSWER: High quality responses should identify whether a VITA site is located near the student, and the student’s attitude toward receiving and providing services at that site. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.2 BT: Ap Difficulty: M TOT: 20 min AACSB: T
Expanded Learning Activity Go to www.irs.gov and search for “Form 1040.” Open the form as a PDF. As you look at Form 1040, you will see that in the “Adjusted Gross Income” section, starting on line 23, there are a number of very specific deductions. Some of these deductions can be grouped together in general categories, such as health, retirement, education, and employment. Write a two-page paper responding to the following questions: Who benefits the most from these expenditures? Why would Congress let individuals deduct these expenses to lower their tax base? What would you need to do to take advantage of any of these deductions? Write a two to three page response to these questions summarizing your thoughts. ANSWER: High quality responses should address the nature of the deductions and who benefits most from claiming these deductions. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.2 BT: An Difficulty: H TOT: 40 min AACSB: C, RT, A
Concept Checks (online-only assessment questions) 1. Adjusted Gross Income is calculated using which of the following procedures: a. Gross Income – Taxable Income b. Taxable Income – Deductions FOR AGI c. Taxable Income – Deductions From AGI d. Gross Income – Deductions FOR AGI ANSWER: d; LO 4.2 BT: C Difficulty: E TOT: 2 min AACSB: A 2. Which type of income is not taxed: a. Unearned income. b. Excluded income. c. Unemployment income. d. Scholarship income in excess of tuition, fees, and required books and supplies. ANSWER: b; LO 4.2 BT: C Difficulty: E TOT: 2 min AACSB: NA 3. Filing statuses are determined using which of the following taxpayer characteristics: i. Spousal preference. ii. Marital status as of December 31st. iii. Presence of dependent children. a. Only i. b. Only i and ii. c. Only ii and iii. d. Only i, ii, and iii. ANSWER: d; LO 4.2 BT: C Difficulty: M TOT: 2 min AACSB: NA 4. Taxable income is calculated in which of the following ways: a. Gross Income – Exclusions – AGI b. AGI – Deduction FROM AGI c. AGI – Taxable Income d. AGI – Deduction For AGI ANSWER: b; LO 4.2 BT: C Difficulty: E TOT: 2 min AACSB: A 5. Judy is single and has a five-year-old qualifying child. What is her standard deduction? a. $24,000. b. $8,100.
c. $18,000. d. $12,000. ANSWER: c; LO 4.2 BT: C Difficulty: E TOT: 2 min AACSB: A
4.3 End-of-Topic Assessment 4.3 Multiple-Choice Questions 1. a. larger. ANSWER: a; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: A 2. b. 37%. ANSWER: b; LO 4.3 BT: K Difficulty: E TOT: 2 min AACSB: NA 3. a. $2,809.50. ANSWER: a; LO 4.3 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Refer to the 2018 Federal Tax Brackets for Single tax filers. The first $9,525 of John’s $25,000 of taxable income is taxed at 10% and results in $952.50 ($9,525 X 0.10) of tax. The next $15,475 ($25,000 - $9,525) is taxed at 12% and results in $1,857 ($15,475 X 0.12). Total tax is $2,809.50 ($952.50 + $1,857). 4. c. $1,249.50. ANSWER: c; LO 4.3 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Use the 2018 Federal Tax Brackets for Single tax filers. The first $9,525 of Maria’s $12,000 of taxable income is taxed at 10% and results in $952.50 ($9,525 X 0.10) of tax. The next $2,475 ($12,000 - $9,525) is taxed at 12% and results in $297 ($2,475 X 0.12). Total tax is $1,249.50 ($952.50 + $297). 5. c. 10% and 10%. ANSWER: c; LO 4.3 BT: Ap Difficulty: M TOT: 2 min AACSB: A Solution: Both Sam and Adam will have their income first taxed at 10% (the first brackets) and then at subsequently higher tax rates for any remaining taxable income. 6. c. 24%. ANSWER: c; LO 4.3 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Marginal tax rate is the change in tax divided by the change in income. The change in tax is $1,200 ($6,100 - $4,900) and the change in income is $5,000. The marginal tax rate is 24% (($1,200 / $5,000) X 100). 7. a. 0%.
ANSWER: a; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: NA 8. a. $0. ANSWER: a; LO 4.3 BT: Ap Difficulty: M TOT: 2 min AACSB: A Solution: Eric has a $500 gain. His taxable income is less than $38,600 so his long-term capital gain tax rate is 0%. 9. b. lower. ANSWER: b; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: NA 10. a. 9.6%. ANSWER: a; LO 4.3 BT: Ap Difficulty: M TOT: 2 min AACSB: A Solution: Xavier’s effective tax rate is his tax divided by his gross income, or 9.57% (($4,786 / $50,000) X 100). The answer is rounded to 9.6%.
4.3 Adventures in Financial Personal Finance Short Answer 1. ANSWER: In 2018, they will pay $13,879 in federal income taxes ($8,907 + ($100,000 $77,400)*0.22). This places them in the 22% marginal tax bracket. LO 4.3 BT: An Difficulty: M TOT: 10 min AACSB: A 2. ANSWER: As a single person, Thomas will pay $18,289.50 in federal income taxes ($14,089.50 + ($100,000 - $82,500)*0.24). This places him in the 24% marginal tax bracket. LO 4.3 BT: C Difficulty: M TOT: 10 min AACSB: A 3. ANSWER: The difference is due to the size of the tax brackets for single individuals compared to married individuals. LO 4.3 BT: S Difficulty: M TOT: 10 min AACSB: A Explore
1. ANSWER: High quality responses should include a discussion of each the tax brackets and a discussion of how the brackets relate to each other. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.3 BT: Ap Difficulty: E TOT: 5 min AACSB: A, D 2. ANSWER: High quality responses should include a discussion and comparison of at least two states income tax systems. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.3 BT: Ap Difficulty: M TOT: 20 min AACSB: C
Expanded Learning Activity Based on your estimated annual income and standard deduction, what is your taxable income and what is your marginal tax rate? Discuss whether this is a fair amount of tax. Now think forward to when you plan to graduate and start working in your chosen career path. How much will you earn annually? Use this higher earnings number to estimate your tax after graduation (use 2018year standard deduction and tax brackets to estimate this). Discuss whether this is a fair amount of tax. ANSWER: High quality responses should include a discussion of current and future tax brackets and tax liability and a discussion of how this will change over time and whether the student agrees with that. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.3 BT: S Difficulty: H TOT: 20 min AACSB: RT, E
4.3 Concept Checks 1. Carla is single and had taxable income of $22,000, what is her tax? a. $0. b. $1,269. c. $2,200. d. $2,449.50. ANSWER: d; LO 4.3 BT: An Difficulty: M TOT: 5 min AACSB: A Solution: Use the 2018 Federal Tax Brackets for Single tax filers. The first $9,525 of Carla’s $22,000 of taxable income is taxed at 10% and results in $952.50 ($9,525 X 0.10) of tax. The next $12,475 ($22,000 - $9,525) is taxed at 12% and results in $1,497 ($12,475 X 0.12). Total tax is $2,449.50 ($952.50 + $1,497).
2. Higher-income household pay a proportionately larger share of total taxes in a a. Progressive tax system. b. Regressive tax system. c. Flat tax system. d. None of the other answer choices are correct. ANSWER: a; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: NA 3. The lowest long-term capital gains tax rate for individuals is a. 0%. b. 10%. c. 15%. d. 25%. ANSWER: a; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: NA 4. Income tax rates are determined by a. The type of income earned. b. The filing status of the taxpayer. c. The amount of taxable income reported on the tax return. d. Type of income earned, filing status, and the amount of taxable income reported on the tax return. ANSWER: d; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: A 5. An individual’s effective tax rate is always _______ than their marginal tax rate. a. Higher. b. Lower. c. Equal to. d. Effective tax rates have no relation to marginal tax rates. ANSWER: b; LO 4.3 BT: C Difficulty: E TOT: 2 min AACSB: A
4.4 End-of-Topic Assessment 4.4 Multiple-Choice Questions 1. c. refundable tax credits.
ANSWER: c; LO 4.4 BT: K Difficulty: E TOT: 2 min AACSB: NA 2. d. 40%. ANSWER: d; LO 4.4 BT: K Difficulty: E TOT: 2 min AACSB: NA 3. d. both may result in the federal government giving money back in excess of taxes paid and may result in a negative effective tax rate are correct. ANSWER: d; LO 4.4 BT: K Difficulty: E TOT: 2 min AACSB: NA 4. b. eliminate your tax liability. ANSWER: b; LO 4.4 BT: K Difficulty: E TOT: 2 min AACSB: NA 5. a. American Opportunity Credit. ANSWER: a; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: NA 6. a. $1,000. ANSWER: a; LO 4.4 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 7. c. $2,500. ANSWER: c; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: NA 8. d. Middle- and lower-income households. ANSWER: d; LO 4.4 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 9. a. I, II, and III. ANSWER: a; LO 4.4 BT: Ap Difficulty: E TOT: 2 min AACSB: NA Solution: The college student is likely to qualify for the American Opportunity Credit, the single mother with a young child is likely to qualify for the Earned Income Credit and Child Tax Credit, and the individual purchasing health insurance through the marketplace can qualify for the Premium Tax Credit. Therefore, “a” is correct. 10. b. W-4. ANSWER: b; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: NA
4.4 Adventures in Personal Finance Short Answer 1. ANSWER: A. $1,000, B. $1,000, C. $240, D. $0 to $240, depends on whether there are other itemized deductions and if the total amount of itemized deductions exceed the standard deduction. LO 4.4 BT: An Difficulty: M TOT: 10 min AACSB: A Solution: A. $1,000 refundable tax credit saves $1,000; B. The $1,000 non-refundable tax credit can only save up to $1,000 or the amount of tax owed, whichever is less, for someone in the 24% bracket, they will likely save $1,000 in taxes from the nonrefundable tax credit; C. The For AGI deduction of $1,000 will reduce taxable income by $1,000 saving them $240 in taxes ($1,000 X 24%). D. The $1,000 itemized deduction is from AGI and can only be claimed if the taxpayer itemizes their deductions. Since this taxpayer is claiming the standard deduction, $0 in taxes are saved from the itemized deduction (it is not claimed). 2. ANSWER: Undergraduate students in their third year of post-secondary education would prefer the American Opportunity credit because a portion of it is refundable and the maximum amount of the credit is $2,500 compared to a maximum credit of $2,000 for the Lifetime Learning credit. Additionally, students only need to spend $4,000 to get the maximum American Opportunity Credit, while students have to spend $10,000 to get the maximum Lifetime Learning credit. LO 4.4 BT: Ap Difficulty: M TOT: 10 min AACSB: C, A 3. ANSWER: Negative effective tax rates make the U.S. system even more progressive than the standard tax bracket rates. Because of refundable tax credits, effective tax rates in the U.S. range from approximately -25% to +25%. LO 4.4 BT: C Difficulty: E TOT: 5 min AACSB: E
Explore 1. ANSWER: High quality response should include whether the student qualifies for the premium tax credit. Please refer to the sample writing assignment rubric in the solutions manual.
LO 4.4 BT: Ap Difficulty: M TOT: 20 min AACSB: NA 2. ANSWER: High quality responses should discuss the federal tax credit, the students perception of the credit, and whether the state where the student lives offers such a credit at the state level. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.4 BT: Ap Difficulty: M TOT: 2 min AACSB: E, RT Expanded Learning Activity Many individuals like to have excess income tax withholdings taken from their paycheck and feel that it is “forced savings,” knowing that they will get the excess withholdings back as a tax refund when they file their taxes. Tax refunds are commonly used to get caught up on past-due bills, pay off debts, purchase a large ticket item, buy something special, or just set some money aside in savings. 1. Discuss the pros and cons of using excess income tax withholdings as a forced savings plan. What are the benefits, and what is the cost of such a strategy? 2. What alternative “forced savings” plans would be better than excess withholdings? ANSWER: High quality responses should address points 1 and 2. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.4 BT: Ap Difficulty: M TOT: 15 min AACSB: A
4.4 Concept Checks (online-only assessment questions) 1. Negative effective tax rates make the U.S. tax system _________ progressive. a. More. b. Less. c. Unfair. d. Negative tax rates are not associated with the progressiveness of the tax code. ANSWER: a; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: NA 2. Refundable tax credits are a type of a. Government transfers. b. Elderly assistance. c. Welfare.
d. Child support. ANSWER: a; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: NA 3. Which of the following individuals can claim the American Opportunity Credit on their tax return? a. The student. b. The parents of the student. c. Whoever claims the student’s personal/dependency exemption. d. The person that pays the tuition for the student.
ANSWER: c; LO 4.4 BT: Ap Difficulty: E TOT: 2 min AACSB: A 4. The Lifetime Learning Credit a. Is a refundable credit. b. Is available to only graduate students. c. Provides a maximum tax credit amount of $2,000. d. Is a refundable credit, available to only graduate students, and provides a maximum credit of $2,000.
ANSWER: c; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: NA 5. Which of the following individuals should file a tax return? a. A single mother with $12,000 of income and a dependent child. b. A college student with $5,000 of income. c. A young married couple who are both working full-time. d. A single mother with $12,000 of income and a dependent child, a college student with $5,000 of income, and a young married couple who are both working fulltime should file a tax return.
ANSWER: d; LO 4.4 BT: C Difficulty: E TOT: 2 min AACSB: A
4.5 End-of-Topic Assessment 4.5 Multiple-Choice Questions 1. c. whether you receive a W2 or a Form 1099 MISC. ANSWER: c; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA
2. b. taxes that employees and employers also pay. ANSWER: b; LO 4.5 BT: Ap Difficulty: M TOT: 2 min AACSB: NA 3. d. employers, employees, and self-employed individuals. ANSWER: d; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA 4. c. 12.40%. ANSWER: c; LO 4.5 BT: C Difficulty: M TOT: 2 min AACSB: NA 5. d. 6.2%; 1.45%. ANSWER: d; LO 4.5 BT: K Difficulty: E TOT: 2 min AACSB: NA 6. b. make correct and on-time estimated tax payments. ANSWER: b; LO 4.5 BT: Ap Difficulty: E TOT: 2 AACSB: E 7. b. quarterly. ANSWER: b; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA 8. d. 2.90%. ANSWER: d; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: A 9. a. $565. ANSWER: a; LO 4.5 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Jeff’s Self-Employment tax is calculated by first multiplying his selfemployment income by 0.9235, which equals $3,694 ($4,000 X 0.9235). Then multiply the $3,694 by the self-employment tax of 15.3% resulting in selfemployment tax of $565.18 ($3,694 X 15.3%).
10. c. $750. ANSWER: c; LO 4.5 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Ben can deduct 50% of his self-employment tax as a “for AGI” deduction, or $750 ($1,500 X 0.5).
Adventures in Personal Finance Short Answer 1. ANSWER: Samantha should keep track of her miles driven to meet her students. If she buys any supplies for her tutoring she should keep track of those and deduct them against her expenses. Depending on how much she uses her phone and internet services for work, she may be able to deduct part of these expenses as work expenses. Any licenses she needs to maintain in order to tutor would also be deductible. LO 4.5 BT: Ap Difficulty: M TOT: 10 min AACSB: A, E 2. ANSWER: Tax benefits of being self-employed include being able to deduct many more expenses against income. This includes mileage driven (employees cannot deduct commuting miles, but self-employed individuals can if their main business office is their home), access to special retirement plans, ability to deduct health insurance premiums as a FOR AGI expense, as well as all of the expenses associated with running their business. Self-employed individuals, including business owners, are typically among the highest income households in the country. While there is not limit on how much self-employed people can make, there is also no limit on how much they can lose if their business does not do well. The opportunities and risk are substantial. LO 4.5 BT: Ap Difficulty: H TOT: 15 min AACSB: A, E 3. ANSWER: OASDI fund Social Security benefits. Social Security benefits are capped for individuals, so the tax is also capped based on the maximum benefits. LO 4.5 BT: Ap Difficulty: M TOT: 2 min AACSB: RT, A
Explore 1. ANSWER: People that have substantial capital gains and other investment income will also need to make estimated tax payments. Retirees may be receiving distributions from retirement plans and they can choose to have the retirement plan withhold taxes, or the retiree can elect to make estimated tax payments based on the distributions. Estimated tax payments on investment income is just for income tax since self-employment tax is not charged on investment income. LO 4.5 BT: S Difficulty: M TOT: 20 min and the AACSB: E, A
2. ANSWER: Look at your pay stub. If FICA taxes (OASDI and HI) taxes and federal income taxes have been withheld, you are an employee, otherwise you are an independent contractor. Also, if you completed a W-4 when you were hired, you are an employee. LO 4.5 BT Ap Difficulty: E TOT: 5 min AACSB: E Expanded Learning Activity If you are self-employed, it might be easy to overlook that you need to set aside some of your earnings to pay taxes. Remember that your estimated tax payment includes both an estimate of your income tax as well as an estimate of your self-employment tax. Do you have enough money in your checking or savings account to pay the estimated tax payment amount? Consider that a self-employed individual earning $10,000 a year may need to pay approximately $1,413 in selfemployment taxes, or $353 on a quarterly basis. If you were subject to estimated tax payments, but did not typically have sufficient money in your checking or savings account, what are some strategies you could use to be sure you have the money needed to make the estimated tax payment? ANSWER: High quality responses should include clearly identified strategies. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.5 BT: An Difficulty: H TOT: 20 min AACSB: C, RT, T
4.5 Concept Checks 1. Self-employment tax is made up of two taxes, ___________ and _________. a. Social Security; Medicare. b. FICA; Medicaid. c. Social Security; FICA. d. Medicaid; Disability. ANSWER: a; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA 2. Self-employed individuals should do which of the following every three months? a. Determine their net earnings. b. Make an estimated tax payment. c. Find new sales opportunities. d. Both determine their net earnings and make an estimated tax payment are correct. ANSWER: b; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA
3. Which of the following individuals are required to pay taxes to fund Social Security and Medicare? a. Employees. b. Employers. c. Self-employed individuals. d. Employees, employers, and self-employed individuals are required to pay taxes to support Social Security and Medicare. ANSWER: d; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: 4 4. The total self-employment tax rate is: a. 15.3%. b. 12.4%. c. 7.65%. d. 2.90%. ANSWER: a; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA 5. The tax base for calculating self-employment taxes is: a. Net earnings from self-employment. b. Total revenue from self-employment. c. Total income from self-employment and employee wages. d. Net earnings from self-employment multiplied by 0.9235. ANSWER: d; LO 4.5 BT: C Difficulty: E TOT: 2 min AACSB: NA
4.6 End-of-Topic Assessment 4.6 Multiple-Choice Questions 1. d. both legal and expected of taxpayers and structuring transactions so that taxes are minimized. ANSWER: d; LO 4.6 BT: K Difficulty: E TOT: 2 min AACSB: E 2. b. underreporting recognizable income. ANSWER: b; LO 4.6 BT: K Difficulty: E TOT: 2 min AACSB: E
3. b. Realized income occurs when money is earned, and recognized income is when realized income is taxed. ANSWER: b; LO 4.6 BT: C Difficulty: E TOT: 2 min AACSB: E, A 4. d. form of tax avoidance, an effective tax planning strategy, and a form of tax evasion unless Congress has specifically allowed it. ANSWER: d; LO 4.6 BT: C Difficulty: E TOT: 2 min AACSB: E 5. b. Employer-sponsored savings plans are beneficial because the employer pays the taxes on the money contributed to retirement savings. ANSWER: b; LO 4.6 BT: Ap Difficulty: E TOT: 2 min AACSB: NA 6. d. II & III only. ANSWER: d; LO 4.6 BT: C Difficulty: M TOT: 2 min AACSB: NA 7. a. I & II. ANSWER: a; LO 4.6 BT: C Difficulty: M TOT: 2 min AACSB: NA 8. d. Tax loopholes and tax deferral. ANSWER: d; LO 4.6 BT: Ap Difficulty: M TOT: 2 min AACSB: E 9. b. II only. ANSWER: b; LO 4.6 BT: K Difficulty: E TOT: 2 min AACSB: E 10. a. $1,362.50 (for 2018). ANSWER: a; LO 4.6 BT: Ap Difficulty: M TOT: 2 min AACSB: A Solution: The federal mileage rate for 2018 is 54.5 cents per mile. The deduction is $1,362.50 (2,500 X $0.545).
4.6 Adventures in Personal Finance Short Answer
1. ANSWER: Tuition and required fees and books, supplies, and equipment needed for a course of study. LO 4.6 BT: Ap Difficulty: M TOT: 15 min AACSB: E 2. ANSWER: To substantiate tuition and fees the best document is Form 1098-T. For books and other expenses the best document is the receipt of purchase. LO 4.6 BT: Ap Difficulty: E TOT: 5 min AACSB: E 3. ANSWER: High quality answers should include a list of expenses that the student can track and claim as deductions on their tax return. LO 4.6 BT: Ap Difficulty: M TOT: 5 min AACSB: NA Explore 1. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 4.6 BT: Ap Difficulty: M TOT: 20 min AACSB: T 2. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 4.6 BT: S Difficulty: H TOT: 60 min AACSB: E, C Expanded Learning Activity Based on your monthly budget developed in earlier chapters, determine whether any of your routine expenditures are tax-deductible or enable you to claim a tax credit. Identify the appropriate IRS publication to learn more about the appropriate deduction or credit. How much could you save in taxes by claiming the deduction or credit? What additional record-keeping do you need to claim the full value of the deduction or credit? ANSWER: High quality response should include a discussion of deductible expenses and how much could be saved by claiming these expenses as deductions, as well as how these records should be documented. Please refer to the sample writing assignment rubric in the solutions manual. LO 4.6 BT: An Difficulty: M TOT: 20 min AACSB: RT
4.6 Concept Checks
1. Most taxpayers engage in: a. Tax avoidance. b. Tax evasion. c. Tax realization. d. All of these answer choices are correct. ANSWER: a; LO 4.6 BT: C Difficulty: E TOT: 2 min AACSB: E 2. Recognized income is: a. When income is earned. b. When an individual identifies it as theirs. c. Included in taxable income. d. Always in the form of wages. ANSWER: c; LO 4.6 BT: K Difficulty: E TOT: 2 min AACSB: NA 3. Tax deferral: a. Allows taxes to be paid at a future time, rather than each year the money is earned. b. Allows taxpayers to receive tax free income. c. Provides taxpayers with a deduction. d. Is a form of tax evasion. ANSWER: a; LO 4.6 BT: K Difficulty: E TOT: 2 min AACSB: NA 4. Joe volunteers at his church each Tuesday night to provide free tutoring. He drives 15 miles round-trip to provide this service. What is Joe’s mileage deduction amount on a daily basis? a. $4.20. b. $2.85. c. $8.10. d. $15.00. ANSWER: a; LO 4.6 BT: Ap Difficulty: M TOT: 2 min AACSB: A Solution: The 2018 mileage rate for miles driven in behalf of a charity is 14 cents per mile. The round-trip is 30 miles multiplied by the charitable mileage rate equals $4.20 (30 X $0.14). 5. What is Karen’s daily mileage deduction amount if she drives a total of 50 miles to see her doctor?
a. b. c. d.
$7.00. $9.00. $27.00. $50.00.
ANSWER: b; LO 4.6 BT: Ap Difficulty: M TOT: 2 min AACSB: A Solution: The medical mileage rate for 2018 is 18 cents a mile. The medical expense for the miles driven is $9.00 (50 X $0.18).
Chapter Summary Solutions Continuing Case: Tarek’s Financial Journey Tarek’s job is going great and this past year he decided to work part-time, so that he could go to school full-time for his master’s degree. Tarek went to a highly ranked school, and tuition and fees were $15,000 for the year. He paid for his tuition and fees using a combination of savings, current income, scholarship, employer provided tuition assistance, and student loans. It is the end of the year and Tarek is filing his tax return. His total income and benefits is as follows: Wages: $30,000 (as reported on his W2) Employer provided tuition assistance: $5,000 Scholarship: $2,000 Student loan proceeds: $5,000 In addition to tuition, Tarek had the following expenditures: Student loan interest: $1,000 (as reported to Tarek by his lender on Form 1098-E) Books: $1,000 Rent: $8,000 Federal income taxes withheld: $4,000 (as reported on his W2) It is now time for Tarek to complete his tax return. Tarek is single and is 26 years old. Instructions (You may also want to reference IRS Publication 970 as a refresher.) 1. ANSWER: Filing status is single. His standard deduction is $12,000. LO 4.2 BT: Ap Difficulty: E TOT: 2 min AACSB: A
2. ANSWER: On Form 1040 Tarek would report wages of $30,000. Employer provided tuition assistance less than $5,250 is excludable from gross income (not recognized). Scholarship income used for tuition is also excluded from gross income (not recognized). Loan proceeds are also excluded from gross income. LO 4.2, 4.6 BT: Ap Difficulty: M TOT: 2 min AACSB: A 3. ANSWER: Since Tarek has already graduated with his undergraduate degree, he is not eligible for the American Opportunity Credit. He is eligible for the Lifetime Learning tax credit. The lifetime learning credit is equal to 20% of the amount of tuition and fee expenses, with a maximum credit amount of $2,000. LO 4.4 BT: Ap Difficulty: M TOT: 5 min AACSB: NA 4. ANSWER: Student loan interest paid is a FOR AGI deduction capped at $2,500 and phased out based on income. Tarek is below the income phase out and maximum benefit amount and can deduct all $1,000 of student loan interest. No deduction is allowed for books or rent. LO 4.4, 4.6 BT: Ap Difficulty: M TOT: 5 min AACSB: NA 5. ANSWER: Tarek’s Gross Income is $30,000. His AGI is $29,000 because of the $1,000 student loan interest deduction. His Taxable Income is $17,000 ($29,000 - $12,000). He is in the 12% tax bracket so $9,525 is taxed at 10% and $7,475 is taxed at 12% for a total tax of $1,849.50. LO 4.2, 4.3, 4.4 BT: An Difficulty: H TOT: 10 min AACSB: NA Calculating the Cost of Life’s Financial Journey In this chapter, you learned the importance of tax minimization. One of the simplest tax minimization strategies is to contribute to a ROTH IRA, which may not be right for everyone. (Some individuals, particularly low-income households that may be eligible for tax credits due to young children in the home, may benefit more from contributions to a traditional IRA.) But for comparison purposes help Paula identify the best retirement savings option for her. Paula is 25, single, and makes $40,000 a year. Paula does not have access to an employer sponsored retirement plan but she really wants to start saving for retirement. She can contribute $5,000 of pretax money to a traditional IRA, or she can contribute $4,400 of after-tax money to a Roth IRA. The $750 difference represents that tax that Paula must pay. Assume Paula continues to make this same annual contribution for 30 years and earns 9% on her investment.
1.Assuming Paula continues to save aggressively for retirement and accumulates enough retirement wealth so that she will be in the 22% tax bracket in retirement, which option is better for Paula, a traditional IRA or a Roth IRA? ANSWER: FV of the traditional IRA = $681,537.69; FV of the Roth IRA = $579,307.04. These amounts can be compared using applicable tax rates in retirement. LO 4.6 BT: S Difficulty: H TOT: 20 min AACSB: A 2.Use TVM formulas to calculate what the future value will be and how much she will have after taxes are paid in retirement by completing the following table? Money Available to Save Tax on Money Available to Save Net Annual Contributions Number of Years Contributions are Made Future Value at 9% Retirement Tax Rate
Tax After Tax Wealth
Traditional IRA $5,000 $0 $5,000 30
ROTH IRA $5,000 $600 $4,400 30
$681,537.69 22%
$599,753.17 0%, Qualified ROTH IRA distributions are tax free $0 $599,753.17
$149,938.29 $531,599.40
LO 4.6 BT: S Difficulty: H TOT: 20 min AACSB: A Solution: To calculate the Traditional IRA FV, use N = 30, Pmt = $5,000, and I = 9, then CPT FV. To calculate the Roth IRA FV, use N = 30, Pmt = $4,400, and I = 9, then CPT FV. To calculate the tax paid on the distribution, multiply the tax rate by the FV that was calculated, $681,537.69 X 22% = $149,938.29. There is no tax paid on the qualified retirement distribution from a Roth IRA so that tax is $0. The after tax wealth is simply the FV – tax. For the Traditional IRA the after tax wealth is $531,599.40 ($681,537.69 – $149,938.29) and the after tax wealth for the Roth IRA is $599,753.17 because there is no tax on the distribution.
Planning for the Future Ashley is a Junior at State College. To offset the cost of attending college full-time, Ashley has a part-time job. During the tax year, Ashley earned $9,000. Her parents also provide some support for her and claim her on their tax return. During the tax year, Ashley paid $3,000 of her tuition bill and her parents paid $3,000. Ashley also paid for her own books, which cost $500. Her
parents helped her by paying part of her rent and grocery bill. After reading about refundable tax credits, Ashley realized that she, or her parents, were eligible to claim the American Opportunity Credit. Help Ashley answer the following questions about her tax situation: 1. ANSWER: Filing status is single; Standard deduction for dependents is earned income + $350 = $9,350; Taxable income is $0 ($9,000 - $9,350 = $0). LO 4.2 BT: Ap Difficulty: M TOT: 10 min AACSB: NA 2. ANSWER: $0, since she has no taxable income, she will not have any tax. LO 4.2 BT: Ap Difficulty: M TOT: 2 min AACSB: NA 3. ANSWER: IF Ashley were eligible to claim the American Opportunity Credit, she would only be able to claim the refundable portion of the credit since she does no have a tax liability. The refundable portion of the credit is 40% of the total credit. Ashley’s expenses exceed the maximum qualified expenses, so she qualifies for the maximum credit of $2,500, of which 40% or $1,000 is refundable. However, since Ashley is claimed by her parents, she cannot claim any credit. LO 4.4 BT: S Difficulty: H TOT: 10 min AACSB: NA 4. ANSWER: The maximum American Opportunity Credit for Ashley’s parents would be $2,500 [(100% * $2,000) + (25% * $2,000)]. The refundable portion is 40% of the $2,500, or $1,000. The nonrefundable portion is equal to the lesser of $1,500 (remaining portion of the credit) or their assessed tax, $5,000. In this case the nonrefundable portion is $1,500. However, since the total assessed tax is more than the nonrefundable portion, the refundable portion of the credit is simply applied against the assessed tax. In this instance, all $2,500 of the American Opportunity Credit would be used to reduce the assessed tax. Ashley’s parents can claim the American Opportunity Credit because they claim Ashley as a dependent. LO 4.4 BT: S Difficulty: H TOT: 10 min AACSB: A
Chapter 4 Appendix A: 2019 Tax Information
End-of-Topic Assessment Solutions Manual Key to metadata for questions:
LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete 1. ANSWER: As a single person with taxable income of $52,000, Lindsey would pay $7,380.00 (rounded) in federal income taxes in 2018: 10% x $9,525 = $953.00 12% x ($38,700 – $9,526) = $3,501.00 22% x ($52,000 - $38,701) = $2,926.00 $953.00 + $3,501.00 +$2,926.00 = $7,380 In 2019, she would pay $7,298.00 (rounded): 10% x $9,700 = $970.00 12% x ($39,475 - $9,701) = $3,573.00 22% x ($52,000 - $39,476) = $2,755.00 $970.00 + $3,573.00 + $2,755.00 = $7,298.00 $7,380 - $7,298 = $82 The difference is $82. While she is still in the 22% marginal tax bracket in 2019, she will pay approximately $82 less in federal tax because, with the revised tax brackets, less of her income is being taxed at the 22% rate. SECTION 4A; LO 4.3; BT: An; Difficulty: M; TOT: 10 min; AACSB: A
2. ANSWER: The dollar amounts increased approximately 1.84% between 2018 and 2019. This rate of increase can be calculated using the 10% tax bracket for individuals filing as Single: Mathematical formula: (2019 10% tax bracket – 2018 10% tax bracket) 2018 10% tax bracket = ($9,700 - $9,525) $9,525 = .0184 or 1.84%
Financial Calculator: FV = 9700 PV = -9525 N=1 CPT I/Y = 1.8373 An internet search will reveal that the inflation rate between 2018 to 2019 was approximately 1.80% to 2.00%. The fact that the increase in marginal tax rates matched closely with the official inflation rate is not a coincidence. Federal income tax brackets are adjusted from one year to the next based on a modified rate of inflation. SECTION 4A; LO 4.3; BT: An; Difficulty: M; TOT: 5 min; AACSB: A
Chapter 5—Solutions Manual Checking Accounts, Credit Scores, and Credit Cards
Introduction to Personal Finance: Beginning Your Financial Journey By John Grable and Lance Palmer
Learning Objectives 5.1 Explain the development and purpose of checks and checking accounts. 5.2 Identify the differences and similarities among debit cards, prepaid cards, electronic transfers, and checking accounts. 5.3 Determine the costs associated with borrowing money. 5.4 Know the purpose of a credit report. 5.5 Describe how credit scores are developed, calculated, and used. 5.6 Explain the role of credit cards as a financial-management tool. Key to metadata for questions: LO: Learning objective number BT: Bloom’s taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H)] TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), Not Applicable (NA) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes for instructor: Each writing question will have criteria which are specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criterion will be assessed and the associated points for each level of performance are found in columns 2–5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criterion (row) is worth up to 4 points (column 2).
Rubric: (It is suggested that the rubric be shared with the students.) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
25% of points (1 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking significant incomplete and details limited
Answer is realistic/relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
The response does not represent realistic or relevant understanding of topic
Organization/clarity of thought (25% of score)
Well organized
Adequate organization
Limited organization
Poor organization
Appropriate recommendations and conclusions are reached (25% of score)
A clear conclusion or recommendation is presented that is appropriate given the content discussed
Conclusion or recommendation is Conclusion or mostly clear and recommendation appropriate given is incomplete the content
No conclusion or recommendation is provided
5.1 Explain the development and purpose of checks and checking accounts. 5.1 Multiple-Choice Questions 1. d. Address of payee. Answer: d Section 5.1; LO 5.1; BT: K Diff: E TOT: 2 min AACSB: n/a 2. c. Date of check. Answer: c Section 5.1; LO 5.1; BT: K Diff: E TOT: 2 min AACSB: n/a 3. c. He could purchase a cashier’s check made payable to “Cash.”
Answer: c Section 5.1; LO 5.1; BT: Ap Difficulty: M TOT: 2 min AACSB: n/a Solution: A certified check is a personal check issued by a bank that guarantees the amount will be paid; the bank charges a fee for this type of check. A cashier’s check is a check of a bank or other financial institution that can be purchased by paying the amount of the check plus a service fee. Both are considered guaranteed funds by the issuing bank. The cashier’s check is drawn from the bank’s own account, where the certified check is a personal check that is certified by the bank on the reserved funds. Xavier does not have a checking account so he cannot write a personal check that may be certified. The best choice is he could purchase a cashier’s check made payable to “Cash,” although he can be better protected by having the check payable to the car dealership with the purchase order written on the memo. 4. c. Restricted endorsement. Answer: c Section 5.1; LO 5.1; BT: C Diff: E TOT: 2 min AACSB: n/a
5. c. $3 per transaction fee for in-network ATMs. Answer: c Section 5.1; LO 5.1; BT: C Diff: E TOT: 2 min AACSB: n/a
6. d. making several deposits and withdrawals every month. Answer: d Section 5.1; LO 5.1; BT: Ap Diff: M TOT: 2 min AACSB: n/a Solution: Before opening an account for you, banks and credit unions use ChexSystems® to evaluate your previous bank account history. If you have mismanaged an account in the past, you may find that you either can no longer open a new account or may be subject to higher fees and restrictions. Common red flags within ChexSystems include allowing an account balance to go to zero and bouncing a check. Bouncing a check refers to writing a check for an amount greater than your account balance (this is also known as an overdraft or non-sufficient funds). Another name for this is writing a bad check. Not only is this embarrassing, it is also against the law in most states. When this happens, the person trying to cash your check will be denied access to the promised payment. Sometimes, your bank will pay the amount of the check, but it will then turn around and charge you a hefty overdraft fee, which is a penalty assessed by the bank.
7. Answer: c. Inactive account fee. Section 5.1; LO 5.1; BT: Ap Diff: M TOT: 2 min AACSB: n/a Solution: By law, if a checking account is described as “free” or “no cost,” you can’t be asked to pay a monthly service fee or a fee for exceeding a specified number of transactions or any fee to deposit, withdraw, or transfer money. Even so, financial institutions can still charge for the use of an automated teller machine (ATM), overdraft fees, bounced check fees, balance inquiry fees, fees to stop payment on a check, fees on an inactive account, and check-printing fees.
8. b. $903 Answer: b Section 5.1; LO 5.1; BT: S Diff: H TOT: 10 min AACSB: n/a Solution: Bank statement balance − outstanding check #94 = reconciled balance $983 ending statement balance − $80 check not yet cleared = $903 reconciled balance
9. b. Check #94. Answer: b Section 5.1; LO 5.1; BT: S Diff: H TOT: 10 min AACSB: n/a Solution: Check #94 has been written and recorded in check register; however, the bank statement does not reflect this check being presented and paid. Checks #93 and #95 have been presented and paid, and thus reflected in ending statement balance. Without reconciling this difference, the bank statement is overstating your account balance by this outstanding check. This is the common reason for overdrafts. 10. d. 12%. Answer: d Section 5.1; LO 5.1; BT: Ap Diff: M TOT: 5 min AACSB: A Solution: The $5 monthly fee is equal to 0.01 (1.0%) monthly periodic rate: $5 fee Monthly periodic rate = = 0.01 ~1.0% $500 balance Annualized rate = 0.01 monthly periodic rate × 12 months in year = 0.12 ~12.0%
5.1 Adventures in Personal Finance Short Answer 1. Answer: Liquidity, direct deposit of paychecks, FDIC insurance, debit cards. Section 5.1; LO 5.1; BT: Ap Diff: M TOT: 5 min AACSB: n/a 2. Answer: Direct deposit saves time, eliminates the need to “cash” a check, and saves money by avoiding check-cashing fees. Section 5.1; LO 5.1; BT: An Diff: M TOT: 5 min AACSB: n/a
3. Answer: An overdraft occurs when a check is written and presented to the bank, and there are insufficient funds in the bank to cover the check. The bank will charge a fee to the account for overdrawing the account and may or may not pay the check. An overdraft fee is also called nonsufficient funds fee. It can be avoided by keeping track of checking account balances and reconciling accounts regularly. Section 5.1; LO 5.1; BT: Ap Diff: M TOT: 5 min AACSB: n/a
4. Answer: ChexSystems is a network of financial institutions that report information on checking and savings accounts. Banks use it to see if consumers overdrew their accounts and then closed them
while they were in the negative. Consumers may not like this because bad behavior at one bank will prevent them from opening an account at another bank. Section 5.1; LO 5.1; BT: An Diff: H TOT: 5 min AACSB: n/a 5. Answer: d—1; a—2; c—3; b—4. Solution: a. Bank routing number = 2. A digital code on a check that helps facilitate check processing. b. FDIC deposit insurance coverage = 4. Coverage that provides up to $250,000 in protection for an account holder. c. Overdraft = 3. The act of writing a check for an amount greater than what is in the account. d. Reconciliation = 1. Balancing a monthly bank statement with a check register. Section 5.1; LO 5.1; BT: K Diff: E TOT: 3 min AACSB: n/a 6. Answer: Low or no monthly service charge, no-fee debit cards, free in-network ATM use, unlimited withdrawals and checks. Section 5.1; LO 5.1; BT: C Diff: E TOT: 5 min AACSB: n/a 7.
Answer: Outstanding checks = $190 Solution: A checking account reconciliation form is used to determine the dollar value of all outstanding checks. The outstanding checks will total the difference between the balance from the bank statement ($683) and the net balance on the checkbook after bank fees, credits, and deposits are accounted for. Use the following information in your calculations: a. The monthly service charge was $10. b. Interest earned was $3. c. No deposits were made. Checking Account Reconciliation Checkbook balance
$500.00
Less: Service charges
$10.00
Plus: Interest earned
$3.00
Plus: Deposits
$–
Net balance
$493.00
Balance from bank statement
$683.00
Plus: Deposits not shown on statement
$–
Less: Checks outstanding
$190.00
Reconciled balance (this should match checkbook balance)
$500.00
Section 5.1; LO 5.1; BT: S Diff: H TOT: 5 min AACSB: A Explore 1. Visit the Consumer Financial Protection Bureau website and research the advantages and disadvantages associated with overdraft protection. Specifically, determine if adding overdraft protection to a checking account may be an appropriate financial planning strategy. Also, describe the type of consumer who should avoid overdraft protection. Section 5.1; LO 5.1; BT: S Diff: M TOT: 20 min AACSB: E
Answer: The answer should discuss overdraft protection options offered through banks such as fund transfers from another account, lines of credit, or credit cards in addition to the bank simply taking the account into the negative. A key disadvantage of these services at some banks is the high fees associated with these costs. These services are appropriate when they are low cost and/or if the individual has a habit of not keeping track of his or her balance. 2. Under the Fair and Accurate Credit Transaction Act (FACTA), all consumers are entitled to a free copy of their consumer report once every 12 months. This report can have a significant influence on the type and costs of a checking account offered to you. Go to the ChexSystems website and request your free personal consumer report. If you have questions about specific aspects of the report, what help options are available to you? Section 5.1; LO 5.1; BT: An Diff: H TOT: 20 min AACSB: n/a Answer: Students should request their ChexSystems reports. 3. Visit three local banks or credit unions (either in person or online). Create a comparison table showing the features, benefits, and costs associated with each institution’s checking account offerings. Share the results of your research with others in class by recommending the “best” checking account for a student. Section 5.1; LO 5.1; BT: S Diff: H TOT: 30–120 min AACSB: n/a Answer: Some of the categories of comparison should be as follows: fees associated with the account (transaction fee, overdraft fee, maintenance fee, etc.), whether the account is interest bearing, restrictions, and requirements (minimum balance, direct deposit, etc.).
5.1 Expanded Learning Activity Write a one-page report on strategies that people can use to reestablish a checking account if they have had a negative history of bouncing checks. A good place to start your research is the FDIC website. Be sure to share the results of your research with your class.
Section 5.1; LO 5.1; BT: S Diff: H TOT: 30–120 min AACSB: n/a Answer: Some strategies include working with financial institutions that offer “second chance,” limited, or restricted accounts. Look for errors on the ChexSystems report; talk with the local institution to correct the issue. Many communities offer classes that can requalify an individual to open a bank account.
5.1 Practice Questions 1. How much should you expect to pay to use a debit card that is linked to your checking account? a. Nothing. b. $5 per transaction. c. $20 per month. d. $240 per year. Answer: a Section 5.1; LO 5.1; BT: K Diff: E TOT: 2 min AACSB: n/a 2. A bank check issued by a financial institution can be purchased by paying the amount of the check plus a service fee is called a(n) a. cashier’s check. b. certified check. c. money order. d. traveler’s check. Answer: a Section 5.1; LO 5.1; BT: K Diff: E TOT: 2 min AACSB: n/a 3. A digital code on a check that helps facilitate check processing is known as a(n) a. check register. b. bank routing number. c. check number. d. FDIC tracking account. Answer: b Section 5.1; LO 5.1; BT: K Diff: E TOT: 2 min AACSB: n/a 4. Carolyn maintains an average monthly balance of $700 in her checking account. If her bank charges $14.00 per month as a minimum service fee, what would the annual interest rate (APY) need to be to just cover the monthly service fee? a. 1%. b. 24%.
c. 5%. d. 10%. Answer: b Section 5.1; LO 5.1; BT: Ap Diff: M TOT: 5 min AACSB: A Solution: The $14 monthly fee needs to be considered as a monthly return required to offset it. The fee represents a 2% (0.02) monthly periodic rate. The total annual fee is 24% (0.24) when annualized as an APR. Carolyn requires an APY that can offset the 24% APR for her checking account. 5. The difference between a bank and a credit union is as follows: a. A bank shares profits with all depositors, whereas a credit union shares earnings with shareholders. b. A credit union depositor is known as a member, but a bank depositor is simply a customer. c. A bank depositor is known as a member, whereas a credit union depositor is a shareholder. d. A credit union offers more products and services than a bank. Answer: b Section 5.1; LO 5.1; BT: C Diff: E TOT: 2 min AACSB: n/a
5.2 Identify the differences and similarities among debit cards, prepaid cards, electronic transfers, and checking accounts. 5.2 Multiple-Choice Questions
1. d. debit cards. Answer: d Section 5.2; LO 5.2; BT: K Diff: E TOT: 2 min AACSB: n/a
2. b. personal identification number. Answer: b Section 5.2; LO 5.2; BT: C Diff: E TOT: 2 min AACSB: n/a
3. b. debit card with signature. Answer: b Section 5.2; LO 5.2; BT: K Diff: E TOT: 2 min AACSB: n/a
4. a. Added overdraft protection transfers from her savings account to her checking account. Answer: a Section 5.2; LO 5.2; BT: Ap Diff: E TOT: 2 min AACSB: n/a
5. c. cash. Answer: c Section 5.2; LO 5.2; BT: C Diff: E TOT: 2 min AACSB: n/a
6. b. I, II, IV, and III. Answer: b Section 5.2; LO 5.2; BT: K Diff: E TOT: 2 min AACSB: n/a
7. b. Automated Clearing House transfer. Answer: b Section 5.2; LO 5.2; BT: C Diff: E TOT: 2 min AACSB: n/a
8. a. $0. Answer: a Section 5.2; LO 5.2; BT: Ap Diff: E TOT: 2 min AACSB: n/a
9. d. Cut up or shred his old card(s). Answer: d Section 5.2; LO 5.2; BT: Ap Diff: M TOT: 2 min AACSB: n/a Solution: You need to be careful whenever you use a debit or prepaid card. Some precautions to minimize the possibility of someone using your card in a fraudulent manner are: ✓ Don’t give your account number over the phone (unless you initiated the call). ✓ Keep a record of all your accounts and cards in a safe place. ✓ Don’t sign a blank debit slip. ✓ Reconcile your bank account(s) monthly. ✓ Carry only the card(s) you need and use. ✓ Don’t carry your PIN in your wallet or purse, and never write it down on something that can get lost. ✓ Double-check all transactions on your monthly statement against your receipts. ✓ Shred copies of old receipts and old cards.
10. d. She must report the card immediately before any unauthorized withdrawals are made. Answer: d Section 5.2; LO 5.2; BT: Ap Diff: M TOT: 2 min AACSB: n/a Solution: If card is reported lost before any unauthorized withdrawals, your loss liability is limited to $0. If loss is reported within 2 business days after card lost, your loss liability is limited to $50. If loss is reported after 2 business days but before 60 days, your loss liability is limited to $500. You have unlimited loss liability after 60 days.
5.2 Adventures in Personal Finance Short Answer
1. Section 5.2; LO 5.2; BT: C Diff: E TOT: 5 min AACSB: n/a Answer: The liability is $0 if lost card is reported before unauthorized transactions occur, $50 if lost card is reported within 2 days, $500 limit if lost card is reported between 2 and 60 days from the time of being stolen, and unlimited if lost card is reported after 60 days. 2. Section 5.2; LO 5.2; BT: Ap Diff: M TOT: 5 min AACSB: n/a Answer: The personal identification number that is required to use a debit card, and the ability to cancel lost or stolen cards. 3. LO:5.2 BT: Ap Diff: M TOT: 5 min AACSB: n/a Answer: The transaction was completed using the check to electronic conversion payment system. The cousin can simply check her account to make sure that the appropriate funds were withdrawn. 4. Section 5.2; LO 5.2; BT: An Diff: H TOT: 5 min AACSB: n/a Answer: Prepaid cards are not credit cards, and the money on the card is the consumer’s own money; therefore, credit checks are not relevant. Prepaid cards do not allow overdrafts so there are no overdraft fees; however, there are other fees such as activation fees, monthly service fees, or other fees. Explore 1. There are many online resources that offer suggestions for how to avoid debit-card fraud, such as never giving another person your PIN. Using at least two online websites, list five other ways to protect yourself against debit-card fraud. Note the online resources that you use in your research. Section 5.2; LO 5.2; BT: An Diff: M TOT: 15 min AACSB: n/a Answer: Some answers include the following: Check your accounts and statements frequently; immediately report fraudulent activities; and never share personal account information via text message, e-mail, or phone. 2. Many banks now include Visa Mobile Location Confirmation in their smartphone apps. The app will use a debit cardholder’s smartphone location ability to verify that this person is near where the card is being used. Go online to learn more about this type of debit-card protection. What might be the pros and cons of this app? Section 5.2; LO 5.2; BT: An Diff: M TOT: 15 min AACSB: n/a
Answer: The write-up could include a thoughtful discussion of the benefits of this account, such as added security, and a discussion of the disadvantages of this account such as the loss of privacy and the potential for that data to be sold to third parties for marketing purposes. 3. Find out how much banks and credit unions in your area charge in fees for overdraft or
insufficient funds. Based on this information, how much would someone pay if he or she had five overdraft charges in a year? Write a brief summary of your findings, highlighting which financial institution has the lowest overall cost for overdrafts. Be sure to share your findings with others in class. Section 5.2; LO 5.2; BT: Ap Diff: M TOT: 30 min AACSB: n/a Answers will vary based on student experiences. The sample grading rubric found in the solutions manual can be adapted to grade this assignment.
4. Visit the Department of Justice (DOJ) or Federal Bureau of Investigation (FBI) website. Conduct a search using the phrase “debit-card fraud.” Choose one or two reports of particularly alarming events that DOJ and FBI have on their websites. Summarize the reports and share your stories with others in your class. Section 5.2; LO 5.2; BT: Ap Diff: M TOT: 30 min AACSB: n/a
5.2 Expanded Learning Activity Opening a prepaid card is one way for those without a stellar credit history to purchase items and services quickly and efficiently. Firms such as WalMart, Target, and Macy’s offer prepaid cards that can only be used to make purchases from one retailer. These firms and others also offer Visa® and MasterCard® prepaid cards that can be used worldwide. Technically, anyone can open a prepaid card by providing his or her name, address, birthdate, Social Security number, phone number, and proof of residency. Knowing this, visit at least three stores or online outlets that offer prepaid cards and make notes about each firm’s ownership requirements, minimum deposit conditions, and fraud protection. Once you’ve put together your notes, share these with your class and discuss which prepaid card(s) offer(s) the best deal from a consumer’s point of view. Section 5.2; LO 5.2; BT: S Diff: H TOT: 45–60 min AACSB: n/a
5.2 Practice Questions 1. Of the following options listed, which is the primary source of payment when Americans go shopping? a. Checks. b. Cash from ATMs.
c. Prepaid cards. d. Debit cards. Answer: d Section 5.2; LO 5.2; BT: C Diff: E TOT: 2 min AACSB: n/a 2. A payment method that has had money loaded onto a card in advance is known as a a. secured credit card. b. direct debit card. c. prepaid card. d. debit card. Answer: c Section 5.2; LO 5.2; BT: K Diff: E TOT: 2 min AACSB: n/a 3. If you discover that someone has used your debit card fraudulently, you should first a. e-mail your bank, credit union, or card issuer. b. send a letter to your bank, credit union, or card issuer. c. call your insurance company immediately and file a claim. d. call your bank, credit union, or card issuer. Answer: d Section 5.2; LO 5.2; BT: Ap Diff: C TOT: 2 min AACSB: n/a 4. Irene has a debit card but rarely uses it. Last night, she determined that her card was lost and had been for some time. What is Irene’s potential maximum liability if someone uses the card without her permission? a. Unlimited up to the amount in her account. b. $0. c. $50. d. $250. Answer: a Section 5.2; LO 5.2; BT: C Diff: E TOT: 2 min AACSB: n/a 5. All of the following are typical fees associated with the use of a debit card except a. lost card fee. b. direct deposit credit fee. c. out-of-network ATM fee. d. monthly maintenance fee. Answer: b Section 5.2; LO 5.2; BT: K Diff: E TOT: 2 min AACSB: n/a
5.3 Determine the costs associated with borrowing money. 5.3 Multiple-Choice Questions 1. c. $1,150. Answer: c Section 5.3; LO 5.3; BT: An Diff: M TOT: 5 min AACSB: A
Solution: $1,000 (interest) + $150 (loan fees) = $1,150
2. a. $28.00. Answer: a Section 5.3; LO 5.3; BT: An Diff: M TOT: 5 min AACSB: A
Solution: Formula: Interest owed = Monthly periodic rate × Outstanding balance
Monthly periodic rate is 0.084 APR/12 months = 0.007. Interest owed = 0.007 monthly periodic rate × $4,000 balance = $28.00 3. b. $157.99. Answer: b Section 5.3; LO 5.3; BT: An Diff: H TOT: 10 min AACSB: A
Solution: An amortization table must be completed. As shown next. Payment Payment Number Amount Interest Principal Interest
Calculation
Principal
Balance
Calculation
0
$4,000.00
1
$181.64
$28.00
2
$181.64
$26.92
3
$181.64
$25.84
4
$181.64
$24.75
5
$181.64
$23.65
0.007 × $4,000.00 0.007 × $3,846.36 0.007 × $3,691.64 0.007 × $3,535.85 0.007 × $3,378.96
$181.64 − $28.00 $181.64 − $26.92 $181.64 − $25.84 $181.64 − $24.75 $181.64 − $26.64
$153.64 $154.72 $155.80 $156.89 $157.99
$3,846.36 $3,691.64 $3,535.85 $3,378.96 $3,220.97
4. b. $1.26. Answer: b Section 5.3; LO 5.3; BT: An Diff: H TOT: 10 min AACSB: A
Solution: An amortization table can answer this question. See next. Payment Payment Number Amount Interest Principal Interest
Calculation
Principal
Balance
Calculation
0 1
$4,000.00 $181.64
$28.00
0.007 × $4,000.00
$153.64
$181.64 − $28.00
$3,846.36
2
$181.64
3
$181.64
4
$181.64
5
$181.64
20 21 22
$181.64 $181.64 $181.64
23 24
$181.64 $181.64
0.007 × $26.92 $3,846.36 $154.72 0.007 × $25.84 $3,691.64 $155.80 0.007 × $24.75 $3,535.85 $156.89 0.007 × $23.65 $3,378.96 $157.99 Break in table—skips payments 6–19 $6.23 0.007 × $890.00 $175.41 $5.00 0.007 × $714.02 $176.64 $3.76 0.007 × $537.38 $177.88 $2.52 0.007 × $359.50 $179.12
$181.64 − $6.23 $181.64 − $5.00 $181.64 − $3.76 $181.64 − $2.52
0.007 × $180.38
$181.64 − $1.26
$1.26
$181.64 − $26.92 $181.64 − $25.84 $181.64 − $24.75 $181.64 − $26.64
$180.38
$3,691.64 $3,535.85 $3,378.96 $3,220.97 $714.02 $537.38 $359.50 $180.38 ($0.00)
5. b. $359. Answer: b Section 5.3; LO 5.3; BT: An Diff: H TOT: 10 min AACSB: A
Solution: An amortization table is helpful to answer this question. See next. Payment Payment Number Amount Interest Principal Interest
Calculation
Principal
Calculation
0
Total
Balance
$4,000.00
1
$181.64
2
$181.64
3
$181.64
4
$181.64
5
$181.64
20 21 22 23 24
$181.64 $181.64 $181.64 $181.64 $181.64
0.007 × $28.00 $4,000.00 $153.64 0.007 × $26.92 $3,846.36 $154.72 0.007 × $25.84 $3,691.64 $155.80 0.007 × $24.75 $3,535.85 $156.89 0.007 × $23.65 $3,378.96 $157.99 Break in table—skips payments 6–19 $6.23 0.007 × $890.00 $175.41 $5.00 0.007 × $714.02 $176.64 $3.76 0.007 × $537.38 $177.88 $2.52 0.007 × $359.50 $179.12 $1.26 0.007 × $180.38 $180.38 $359.35
$181.64 − $28.00 $181.64 − $26.92 $181.64 − $25.84 $181.64 − $24.75 $181.64 − $26.64 $181.64 − $6.23 $181.64 − $5.00 $181.64 − $3.76 $181.64 − $2.52 $181.64 − $1.26
$3,846.36 $3,691.64 $3,535.85 $3,378.96 $3,220.97 $714.02 $537.38 $359.50 $180.38 ($0.00)
6. d. Both borrowing for a car and borrowing for education are correct. Answer: d Section 5.3; LO 5.3; BT: C Diff: E TOT: 2 min AACSB: A
7. c. using the APR for the loan. Answer: c Section 5.3; LO 5.3; BT: Ap Diff: M TOT: 2 min AACSB: n/a
Solution: The APR is used to calculate the interest cost of a loan. As a way to simplify comparison shopping for consumers, the federal government requires lenders to disclose the annual percentage rate (APR) charged on a loan. The APR is a broad measure of the cost of borrowing and includes both the interest rate charged and any required fees for the loan. Although the finance charge is also the total cost of borrowing money and includes the interest that will be paid, plus any fees associated with borrowing the money and any fees paid as the loan is repaid, finance charges are generally stated in absolute dollars.
8. d. Each of the answer choices can be either fixed or variable installment loans. Answer: d Section 5.3; LO 5.3; BT: C Diff: E TOT: 2 min AACSB: n/a
9. d. All of the answer choices are correct. Answer: d Section 5.3; LO 5.3; BT: Ap Diff: E TOT: 2 min AACSB: n/a
10. a. The APR is higher than 5%. Answer: a Section 5.3; LO 5.3; BT: Ap Diff: M TOT: 2 min AACSB: n/a Solution: The APR is used to calculate the interest cost of a loan. As a way to simplify
comparison shopping for consumers, the federal government requires lenders to disclose the annual percentage rate (APR) charged on a loan. The APR is a broad measure of the cost of borrowing and includes both the interest rate charged and any required fees for the loan. If the stated interest rate is 5% and an additional fee exists (origination fee), then the APR will be higher than 5% to include the other fee(s).
5.3 Adventures in Personal Finance Short Answer
1. Section 5.3; LO 5.3; BT: Ap Diff: M TOT: 10 min AACSB: RT Answer: Reasonable loans for home purchases, education, and even an automobile to get back and forth to work, a small business loan, can all lead to greater wealth, higher income, or reduced expenses in the future. Loans for consumable goods, entertainment, or other items will not increase future income and will decrease future income. 2. Section 5.3; LO 5.3; BT: K Diff: E TOT: 2 min AACSB: n/a Answer: Banks, credit unions, and other deposit institutions.
3. Section 5.3; LO 5.3; BT: S Diff: M TOT: 10 min AACSB: n/a Answer: If the amount borrowed is greater than the benefit that will be realized, then borrowing would be unwise. If the career following education will not be able to pay the loan payments; if the mortgage payment for the home will cause long-term financial strain, or it is likely that you will not be living in the area for more than 3 or 4 years; if the automobile is more expensive than the benefits derived from it. In all circumstances, if the loan terms are unfavorable (high interest rate), then it likely will not make sense. 4. Section 5.3; LO 5.3; BT: Ap Diff: E TOT: 2 min AACSB: n/a Answer: The annual percentage rate (APR), which takes all of these numbers into account. 5. Section 5.3; LO 5.3; BT: S Diff: H TOT: 5 min AACSB: n/a Answer: Consumers like the certainty fixed rates provide. Banks like variable rates, because as interest rates in the economy change, banks can adjust the rates to remain profitable. Explore 1. Some credit unions and banks are now offering short-term loans on their mobile apps. Compare the short-term loans available at three different credit unions or banks. Which short-term loan has the lowest APR? Which short-term loan is most favorable and why? Section 5.3; LO 5.3; BT: An Diff: H TOT: 30 min AACSB: n/a 2. In the example from this topic, Javier invested borrowed money in education because that increased his ability to earn income. If you were (or are) working full time now, how much do you (or could you) earn annually? After you graduate with a college degree in
your chosen field of study, what is the average annual income? (You can check the Occupational Outlook Handbook at the Bureau of Labor Statistics website for this information, although keep in mind that the reported earnings include all workers, regardless of their years of experience.) How much will your investment in college increase your earnings potential? Section 5.3; LO 5.3; BT: S Diff: H TOT: 20 min AACSB: n/a
5.3 Expanded Learning Activity Think of your own situation. Are you currently borrowing any money? If so, what are you using that money for? Additionally, what might you do to improve your borrowing behavior? (Hint: If your spending is too focused on current consumption, how can you change this?) Write a one-page analysis of your current borrowing behavior and whether it is benefiting your future self. Section 5.3; LO 5.3; BT: S Diff: H TOT: 30 min AACSB: C, RT
5.3 Practice Questions 1. Which of the following are included in the finance charge for a loan? a. Interest charged for the loan. b. Loan origination fees (the cost of creating the loan). c. Annual loan account fees. d. All of the answer choices are correct. Answer: d Section 5.3; LO 5.3; BT: K Diff: E TOT: 2 min AACSB: n/a 2. Which of the following terms best represents the amount of money that is borrowed, and which must be repaid? a. Principal. b. Interest. c. Loan repayment cost. d. Financial charge. Answer: a Section 5.3; LO 5.3; BT: K Diff: E TOT: 2 min AACSB: n/a 3. Which of the following terms best represents the money paid to the lender for the use of their money? a. Principal. b. Interest. c. Fees.
d. Finance charge. Answer: b Section 5.3; LO 5.3; BT: K Diff: E TOT: 2 min AACSB: n/a 4. Eric borrows $5,000 on January 1 for one year. Interest is calculated annually. He does not have to make any monthly payments, but he has to repay the entire loan plus interest on December 31 of the same year. If the loan has an annual interest rate of 9%, what amount will Eric have to repay on December 31? a. $450. b. $5,000. c. $5,450. d. $5,500. Answer: c Section 5.3; LO 5.3; BT: An Diff: M TOT: 5 min AACSB: A Solution: Principal is $5,000. APR is 9% (0.90). Principal and interest all due at maturity. Loan repayment = Principal + Interest Loan repayment = $5,000 principal + ($5,000 × 0.90) interest = $5,450 5. Eric borrows $5,000 on January 1 for one year at an interest rate of 9%. Interest is calculated monthly and payments are due at the end of each month, starting January 31. How much interest will Eric owe on the loan for the month of January? Assume that there are 12 equal months in the year. a. $37.50. b. $45.00. c. $50.00. d. $437.26. Answer: a Section 5.3; LO 5.3; BT: An Diff: M TOT: 5 min AACSB: A Solution: Interest owed for the month is calculated by multiplying the monthly balance by its periodic rate. Monthly balance = $5,000 (no further borrowing or payments made in this month) APR 0.09 Monthly periodic rate = = = 0.0075 ~0.75% 12 months 12 months Interest cost = periodic balance × periodic rate = $5,000 × 0.0075 = $37.50.
5.4 Know the purpose of a credit report. 5.4 Multiple-Choice Questions
1. b. A summary of an individual’s credit history. Answer: b Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
2. d. I, II, and III only. Answer: d Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
3. a. TransUnion, Equifax, and Experian. Answer: a Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
4. b. credit. Answer: b Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
5. a. race. Answer: a Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
6. d. creditors. Answer: d Section 5.4; LO 5.4; BT: C Diff: E TOT: 2 min AACSB: n/a
7. c. Insurance companies can view a customer’s credit report when underwriting insurance policies. Answer: c Section 5.4; LO 5.4; BT: C Diff: E TOT: 2 min AACSB: n/a
8. a. One time. Answer: a Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
9. d. identity theft. Answer: d Section 5.4; LO 5.4; BT: C Diff: E TOT: 2 min AACSB: n/a
10. d. Contact the primary national credit bureaus by writing a letter and notifying them of the inaccurate information. Answer: d Section 5.4; LO 5.4; BT: Ap Diff: M TOT: 2 min AACSB: n/a Solution: If you find that you are the victim of identity theft or erroneous information: (1) Write to each of the credit bureaus directly, telling them that the information is inaccurate. This forces the company to investigate the fraud within 30 days. A fraud alert can be added to your credit
file; this will alert creditors to be more cautious when dealing with your credit file. (2) At the same time, write to the merchant(s) and dispute any items purchased that you did not buy.
5.4 Adventures in Personal Finance Short Answer 1. Section 5.4; LO 5.4; BT: Ap Diff: M TOT: 10 min AACSB: n/a Answer: Whether you have borrowed money using collateral; applied, approved, and used a credit card; a student loan; declared bankruptcy; experienced foreclosure; and/or other negative financial judgments against you. 2. Section 5.4; LO 5.4; BT: Ap Diff: M TOT: 10 min AACSB: n/a Answer: Race, medical history, current income, and number of children. 3. Section 5.4; LO 5.4; BT: K Diff: E TOT: 5 min AACSB: n/a Answer: Bankruptcy stays on for 10 years. Other negative information stays on for 7 years. Some information stays on permanently. 4. Section 5.4; LO 5.4; BT: Ap Diff: M TOT: 5 min AACSB: n/a Answer: Variations in credit reports are caused by different lenders not reporting all lending transactions to each of the credit bureaus. Variations can be confusing and can result in major differences between credit bureaus; hence, it is important to check all three credit bureaus.
Explore 1. Go to the Annual Credit Report website and request a free copy of your credit report. Be sure to check that the information in the report is accurate, complete, and up to date. What should you do if any information needs to be corrected or is missing? Section 5.4; LO 5.4; BT: Ap Diff: H TOT: 30 min AACSB: C, RT Answer: If any information is incorrect or missing, you should contact the credit bureau immediately.
2. Go to one of the three national credit bureau websites and research ways these firms recommend building credit. What are two potential ways that most students can build their credit? Section 5.4; LO 5.4; BT: Ap Diff: M TOT: 30–60 min AACSB: n/a Answer: Common answers would include the following: open a credit card with a low limit, get a secured card, increase their credit limit, obtain an installment loan, pay student loans (and all bills) on time, and request that the creditor and credit bureau use an expanded credit score to make the lending decision.
5.4 Expanded Learning Activity Visit the U.S. Federal Trade Commission website on consumer scam alerts. Search through the listing of credit and financial scams and find five that relate to credit reports and credit history. Write a one-page summary describing the shared aims of these scams and frauds. Be sure to share your findings with others in class. Section 5.4; LO 5.4; BT: M Diff: M TOT: 30 min AACSB: n/a
5.4 Practice Questions 1. Which of the following information will not be included in a credit report? a. Age. b. Medical history. c. Limited employment history. d. Marital status. Answer: b Section 5.4; LO 5.4; BT: C Diff: M TOT: 2 min AACSB: n/a 2. Which of the following negative financial behaviors will stay on your credit report the longest? a. Making late payments on a credit card. b. Skipping payments to a merchant. c. Being turned down for credit. d. Declaring bankruptcy. Answer: d Section 5.4; LO 5.4; BT: Ap Diff: M TOT: 2 min AACSB: n/a 3. Under current law, which of the following requests is allowed? a. The Federal Aviation Administration requests your credit report before issuing you a pilot’s license. b. A car dealer requests your credit report before taking you on a test drive.
c. Both the Federal Aviation Administration requests your credit report before issuing you a pilot’s license and a car dealer requests your credit report before taking you on a test drive. d. Neither the Federal Aviation Administration requests your credit report before issuing you a pilot’s license and a car dealer requests your credit report before taking you on a test drive. Answer: c Section 5.4; LO 5.4; BT: C Diff: M TOT: 2 min AACSB: n/a 4. Which of the following court- and government-related items may appear on a credit report? a. Voter registration information. b. Parking ticket that was paid on time. c. Underage possession of alcohol. d. Unpaid late fees and fines owed to a local library. Answer: d Section 5.4; LO 5.4; BT: C Diff: E TOT: 2 min AACSB: n/a 5. Credit reports are created for individuals when they a. receive a Social Security number. b. borrow money from a lender that reports loans to credit bureaus. c. declare bankruptcy. d. borrow money from a lender that reports loans to credit bureaus or declare bankruptcy. Answer: d Section 5.4; LO 5.4; BT: K Diff: E TOT: 2 min AACSB: n/a
5.5 Describe how credit scores are developed, calculated, and used. 5.5 Multiple-Choice Questions
1. b. Higher credit scores are associated with lower credit risk. Answer: b Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
2. d. Both age and marital status are correct. Answer: d Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
3. c. Public record information. Answer: c Section 5.5; LO 5.5; BT: K Diff: E TOT: 2 min AACSB: n/a
4. d. Types of credit. Answer: d Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
5. c. 640. Answer: c Section 5.5; LO 5.5; BT: Ap Diff: M TOT: 2 min AACSB: n/a
Solution: FICO scores range from 300 to 850, with high scores representing people with the lowest risk of failing to make a loan payment. Although there are no hard and fast rules, you can use the following guidelines to determine the quality of your credit history: • 300–550: A score this low is really bad, which will usually lead to rejections for new credit. Typically, missed payments, high debt-to-credit ratio, and poor history of credit management. • 550–620: This range is considered subprime, which indicates a high-risk borrower. A score in this range means the lender will charge high interest and high annual fees, and limit the amount of credit issued. Typically, late payments, high debt-to-credit ratio, and poor history of credit management. • 620–680: This range represents the minimum score needed to be accepted for most loans. Typically, good payment history, moderate debt-to-credit ratio, and good history of credit management. • 680–740: This range represents what lenders consider to be individuals with good credit. The terms and conditions of a loan will be relatively favorable. Typically, no late payments, low debt-to-credit ratio, and excellent credit history. • 740–850: A score this high is considered excellent. These borrowers have stellar previous payment histories and always receive the best borrowing terms. Typically, long and spotless credit history, balanced debt products, and very low debt-to-credit ratio.
6. d. charged higher interest rates on loans and charged higher insurance premiums. Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
7. c. when an individual requests his or her own credit report, it is considered a hard inquiry. Answer: c Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
8. d. All of the answer choices are correct. Answer: d Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
9. a. A 100-word statement describing the mistake. Answer: a Section 5.5; LO 5.5; BT: K Diff: E TOT: 2 min AACSB: n/a
10. d. The same good credit behaviors, such as on-time payments and low debt-to-credit ratios, will lead to good credit scores regardless of the credit-scoring model. Answer: d Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
5.5 Adventures in Personal Finance Short Answer 1. Section 5.5; LO 5.5; BT: K Diff: E TOT: 2 min AACSB: n/a Answer: Payment history (highest), amount of credit (next highest), and length of credit history (third highest importance). Payment history is the most easily changed by simply making payments on time. 2. Section 5.5; LO 5.5; BT: Ap Diff: M TOT: 10 min AACSB: n/a Answer: Open a credit card or secured credit card, buy one or two necessary items like groceries or gas, and then pay off the entire balance when you get your statement, repeat this process for 4–6 months. 3. Section 5.5; LO 5.5; BT: An Diff: M TOT: 30–60 min AACSB: C , RT Answer: To determine whether they will issue you credit, how much credit is issued, and the interest rate that will be charged. Insurance companies may use credit scores in the
process of setting insurance premiums. Some employers will check credit scores during the hiring process. Explore 1. Search the Internet using the following key words: “understanding your FICO score.” Find the PDF document published by Fair Isaacs Corporation. Use this document to create a list of five strategies that can be used to improve a FICO score. Section 5.5; LO 5.5; BT: S Diff: M TOT: 30 min AACSB: n/a Answer: These strategies should align with the basic scoring breakdown: pay bills on time, keep the amount of debt borrowed low relative to available credit, keep your accounts open for a long time, don’t apply for credit very often, and obtain a variety of different types of loans over time (credit card, auto loan, mortgage, etc.). 2. Conduct an Internet search to determine how to correct an error on a credit report. Write a brief summary of a consumer’s rights under the Fair Credit Reporting Act. Be sure to note the steps a consumer must take, and when the steps must be taken, to dispute an error. Section 5.5; LO 5.5; BT: An Diff: M TOT: 30 min AACSB: C, E Answer: In addition to summarizing consumer’s rights under the Fair Credit Reporting Act, an answer might include the following: Step 1 is to notify the credit reporting agency in writing which information is potentially inaccurate and credit bureaus must investigate the item within 30 days; Step 2 is to notify the information provider (i.e., the person/company reporting the information to the credit bureau) that you are disputing the information that they provided. Individuals can also add a statement to the credit file, if negative items are not removed, stating why they believe there is an error. 3. If you have not already done so, request a copy of your free annual credit report by visiting the Annual Credit Report website. Be careful if you do an Internet search. The web is loaded with fake and fraudulent websites designed to steal your identity. Only the Annual Credit Report website is linked to the three major credit reporting agencies. Once you get a copy of your report, answer these questions: What is the oldest credit account that is still open? How old is it? What is the newest credit account that you have? How new is it? Do you have a variety of credit, or is there just one type of credit showing on your credit report? Section 5.5; LO 5.5; BT: An Diff: M TOT: 30–60 min AACSB: C, RT
5.5 Expanded Learning Activity Within your class, split into teams. Work with your teammates to develop your own financial-scoring system. Your scoring technique should include at least five categories of personal financial-management
skills and attributes. Once you have developed your categories, build a scoring system that allows you to add up scores or create a weighted score. For example, you may decide that someone who has a parttime job should score higher than someone who does not work. Focus your team’s efforts on financialmanagement topics. After all teams have finished, compare team results. What scoring factors are similar among the teams? What are some of the differences? How closely do the results from this exercise match the factors used to develop FICO scores? Section 5.5; LO 5.5; BT: S Diff: M TOT: 20 min AACSB: C
5.5 Practice Questions 1. A credit reporting bureau, such as Equifax or TransUnion, is engaged primary in business to a. develop credit scores. b. compile credit usage information about consumers. c. help consumers pay off their debt. d. help companies manage their use of credit. Answer: b Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a 2. Brackley would like to increase her credit score. If she can only do one of the following, which should she focus on as a way to improve her score? a. Apply for a new credit card account. b. Close a seldom used credit card account. c. Make all bill and debt payments on time. d. Max out at least one credit card. Answer: c Section 5.5; LO 5.5; BT: K Diff: E TOT: 2 min AACSB: n/a 3. Alisa has 4 credit cards, each with a $2,500 credit limit. Currently, she owns $2,000 across all of the cards. Alisa’s credit usage ratio is _________________, which is ______________ the level needed to drop her credit score. a. $10,000; below. b. 50%; above. c. 20%; above. d. 20%; below. Answer: d Section 5.5; LO 5.5; BT: An Diff: M TOT: 2 min AACSB: A Solution: Total amount of credit available across all cards is $10,000 ($2,500 limit × 4 cards). Credit usage across all cards is $2,500. Credit usage ratio =
Total credit used Total credit limits
Credit usage ratio =
$2,000 = 0.20 ~20% $10,000
4. Individuals with low credit scores are more likely to be a. denied rental/leased housing.
b. denied employment. c. denied professional licenses. d. All of these answer choices are correct. Answer: d Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a 5. Latisha is shopping for a car and an auto loan to purchase the car. All of the following statements are true, except: a. Latish should shop around at different lenders to find the best loan terms possible for her auto loan. b. If Latisha applies for credit at multiple auto lenders for the same amount within the same week, most credit scoring models will treat this as one credit application. c. Latisha should avoid shopping for the lowest auto loan interest rate possible, because multiple credit applications will cause her credit score to go lower, leading to a higher interest rate. d. All of these answer statements are exceptions. Answer: c Section 5.5; LO 5.5; BT: C Diff: E TOT: 2 min AACSB: n/a
5.6 Explain the role of credit cards as a financial-management tool. 5.6 Multiple-Choice Questions
1. b. make a minimum monthly payment based on the outstanding balance. Answer: b Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
2. a. You may pay off a credit card balance at any time without incurring any additional penalty. Answer: a Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
3. c. penalty APR. Answer: c Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
4. d. 19%. Answer: d Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
5. c. 21 days. Answer: c Section 5.6; LO 5.6; BT: K Diff: E TOT: 2 min AACSB: n/a
6. d. reward card. Answer: d Section 5.6; LO 5.6; BT: Ap Diff: M TOT: 2 min AACSB: n/a
Solution: Travel and entertainment cards, such as American Express® and Carte Blanche® are charge cards, which typically require cardholders to pay off their balance on a monthly basis. Reward credit cards are credit cards that provide benefits linked to how much the cardholder purchases with his or her card. These benefits can include cash back, airline and hotel travel points, and other valuable benefits. Martie owns a reward credit card.
7. b. $120. Answer: b Section 5.6; LO 5.6; BT: An Diff: M TOT: 2 min AACSB: A Solution: The minimum monthly payment on the credit card is 4% (0.04 in decimal form) of the outstanding balance. So, it would be $3,000 outstanding balance × 0.04 minimum percentage = $120.
8. c. $46.85. Answer: c Section 5.6; LO 5.6; BT: An Diff: M TOT: 2 min AACSB: A
Solution: Multiply the monthly periodic rate with the ending outstanding balance. The monthly periodic rate is based on 30 days in the billing cycle. Banks typically use 365 days in the year for calculations. Annual percentage rate Interest cost = × Days in month × Balance 365 Compounding periods in a year 0.19
Interest cost = 365 × 30 × $3,000 = $𝟒𝟔. 𝟖𝟓 9. d. All of the answer choices are correct. Answer: d Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
10. d. All of the answer choices are correct.
Answer: d Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
5.6 Adventures in Personal Finance Short Answer 1. Section 5.6; LO 5.6; BT: Ap Diff: M TOT: 5 min AACSB: n/a Answer: If only the minimum payment were made over time, the payment would decrease over time until it reached some minimum threshold. The decreasing payment would extend the repayment period and maximize the amount of interest charged on the loan. 2. Section 5.6; LO 5.6; BT: S Diff: M TOT: 10 min AACSB: n/a Answer: Pay off the balance of the credit card in full each time a statement is received, never charge more than the limit on the credit card, avoid signing up for credit cards that have annual fees, and avoid cash advances as those create instant interest and fees. 3. Section 5.6; LO 5.6; BT: S Diff: M TOT: 10 min AACSB: n/a Answer: Credit cards allow ease of use when renting cars, reserving hotel rooms, or booking airline tickets online. They also provide fraud protection for online and other purchases. Credit cards can also provide immediate funds in case of an emergency. 4. Section 5.6; LO 5.6; BT: S Diff: H TOT: 5 min AACSB: n/a Answer: If other secured loans, such as a mortgage, utility bill, or car payment cannot be paid unless the credit card minimum payment is made. Most of the time a budget and emergency fund will allow you to avoid having to decide between paying a utility bill and paying off your credit card in full. Explore 1. Making only the minimum payment on a credit card can be costly because you will pay much more in interest over the life of the loan. For this exercise, assume the following facts: • Credit card balance is $1,000. • Credit card APR is 20%. • Minimum payment is 2% of the outstanding balance or $15 (whichever is greater).
Visit an online credit card calculator (such as that provided by the Navy Federal Credit Union) to answer the following questions. a. What is the minimum payment this month on the credit card? b. How long will it take to pay off the credit card balance if only the minimum payment is made? c. How much interest will be paid on the loan if only the minimum payment is made? d. What is the best way to reduce the total cost of interest paid on a credit card loan? Section 5.6; LO 5.6; BT: S Diff: H TOT: 30 min AACSB: n/a Answer: a. $20, b. 3,656 months or 304 years and 8 months, c. $4,999.98, d. Pay it off as quickly as possible by paying the entire balance or as much as you can pay. Solution: Create an amortization table based on the following: $1,000 beginning balance, 20% APR (1.66667% monthly periodic rate), and minimum monthly payment of 2% of balance. It will take almost forever (over 304 years) to pay off a balance when only paying a minimum 2% of the outstanding balance. Most lenders will require a minimum dollar payment as well as a minimum percentage payment (whichever is greater) so the loan can amortize in a realistic manner based on a typical low dollar minimum (i.e., $20). The best method to try to accelerate the payoff, while under cash-flow restraints, is to pay a fixed-dollar payment that exceeds your monthly minimum payment. The online credit card calculators (i.e., Navy Federal Credit Union or Capital One Bank) will show you how much quicker the payoff can be by making fixed-dollar payments, such as $25, $50, and $100 that exceed the required minimum. AMORTIZATION OF CREDIT CARD BALANCE Initial balance $1,000.00 APR 20.0% Minimum payment required 2.0% * Minimum payment equals Begin balance × Minimum payment required (%) *Interest cost equals Begin balance × Monthly periodic rate * Principal paid equals Minimum payment less Interest cost * End balance equals Begin balance less Principal paid Begin Minimum End Balance Payment Interest Principal Balance Month Years ($) ($) Cost ($) Paid ($) ($) 1 0.08 1,000.00 20.00 16.67 3.33 996.67 2 0.17 996.67 19.93 16.61 3.32 993.34
3 4 5 6 7 8 9 10 11 12
0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92 1.00
993.34 990.03 986.73 983.44 980.17 976.90 973.64 970.40 967.16 963.94
19.87 19.80 19.73 19.67 19.60 19.54 19.47 19.41 19.34 19.28
16.56 16.50 16.45 16.39 16.34 16.28 16.23 16.17 16.12 16.07
3.31 3.30 3.29 3.28 3.27 3.26 3.25 3.23 3.22 3.21
990.03 986.73 983.44 980.17 976.90 973.64 970.40 967.16 963.94 960.73
304.00 304.08 304.17 304.25 304.33 304.42 304.50 304.58 304.67
0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 $ 4,999.98
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 $ 1,000.00
0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.00
….. 3,648 3,649 3,650 3,651 3,652 3,653 3,654 3,655 3,656 TOTAL
2. Contact at least two local financial institutions in your community. Obtain information about their best credit card rates (APR, not just introductory APR). Then visit the Bankrate website and compare the APR offers from the local financial institutions with the offers from national credit card lenders. Which has the best offers? Section 5.6; LO 5.6; BT: An Diff: E TOT: 20 min AACSB: n/a 3. Visit the Federal Reserve website on credit cards. What information was most helpful to you? Section 5.6; LO 5.6; BT: K Diff: E TOT: 20 min AACSB: n/a 4. A national shift toward smart-chip technology (sometimes called EMV) is revolutionizing the credit card industry. Investigate the primary reasons credit card companies are moving toward smart-chip technology and away from traditional credit cards with a magnetic stripe. Prepare a brief report and present your findings in class. Section 5.6; LO 5.6; BT: An Diff: M TOT: 20 min AACSB: n/a
5.6 Expanded Learning Activity The Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009 took full effect on February 22, 2010. The Consumer Financial Protection Bureau (CFPB) administers it. Research this legislation using resources available on the CFPB website. Write a fact sheet that highlights the major consumer benefits provided by the act. Additionally, find a credit card disclosure statement and determine how easy it would be for someone without a credit card to understand the terms and conditions offered by the credit card issuer. Section 5.6; LO 5.6; BT: S Diff: H TOT: 60–120 min AACSB: n/a
5.6 Practice Questions 1. A credit card a. allows a user to revolve the loan balance from month to month. b. provides users with a fixed monthly payment. c. requires the loan balance to be paid off each month or within a 30-day period. d. both provides users with a fixed monthly payment and requires the loan balance to be paid off each month or within a 30-day period. Answer: a Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a 2. All credit cards a. require the user to make a minimum monthly payment if there is a loan balance outstanding. b. charge an annual fee. c. charge a transaction fee. d. All of these answer choices are correct. Answer: a Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a 3. Emily is the type of consumer who pays her bills on time and in full each month. She very rarely allows her credit card balance to revolve from month to month. Knowing this about Emily, what features should she look for when selecting a new credit card? a. A low interest rate. b. A low minimum payment percentage. c. Cash back and other rewards for card usage. d. Both a low interest rate and a low minimum payment percentage. Answer: c Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a 4. The maximum amount that can be borrowed using a credit card is known as a. the annual percentage rate. b. credit limit. c. minimum payment percentage.
d. balance and penalty amount. Answer: b Section 5.6; LO 5.6; BT: K Diff: E TOT: 2 min AACSB: n/a 5. Assume a college student is having a hard time getting approved for a credit card. What method can the student use to increase the probability of receiving a credit card? a. Borrow money from a pawn shop or payday lender to establish credit. b. Ask a parent to co-sign the credit card application. c. Open a secured credit card with a lending institution. d. Both ask a parent to co-sign the credit card application and open a secured credit card with a lending institution. Answer: d Section 5.6; LO 5.6; BT: C Diff: E TOT: 2 min AACSB: n/a
Chapter 5 End-of-Chapter Summary Assessment Continuing Case: Tarek’s Financial Journey a. Tarek was so pleased with your financial help from previous chapters that he has decided to obtain additional information from you. Tarek has been thinking about getting a credit card, but he is skeptical that a credit card can be a useful spending tool for him. Tarek has always used a debit card. He has never had a credit card nor is he convinced that he needs a credit card. His reasoning is that using a debit card provides protection from overspending; after all, he can only spend what is in his account. Provide Tarek with at least three reasons he should consider adding a credit card as a spending tool rather than relying solely on a debit card. Answer: There are numerous reasons why Tarek should consider obtaining a credit card. The top four reasons are as follows: (1) liability, (2) emergency, (3) liquidity, and (4) protection. Liability: The personal liability limit in case a credit card is lost or stolen is $50 if you report it lost/stolen immediately after the initial fraud. With a debit card, the potential liability is the entire amount in the bank account tied to the debit card. Emergency: A credit card can be used for emergencies when your crisis situation exceeds your checking account balance. Also, if current bills or expenses exceed the balance in your bank account until your next paycheck, your purchases do not have to be paid until the billing cycle ends and the next month’s payment is due. Liquidity: There may be situations when a merchant (e.g., rental car agency, hotel, or airline) makes using a debit card very expensive by putting a hold on assets in the associated checking account, where credit cards will not actually post the charge and only restrict your available credit limit by the merchant’s pending holds.
Protection: Credit cards often provide buyer protection and a way to dispute charges on your behalf while crediting you the disputed amount until a resolution is made. Debit card purchases are immediately paid from your checking account. Section 5.6; LO 5.6; BT: Ap Diff: E TOT: 2 min AACSB: n/a b. Assume Tarek is now convinced that he needs a credit card. Provide him with guidance on choosing between cards with different APRs. Specifically, when does choosing a credit card with a low APR really matter? Answer: Choosing a credit card with a low APR really matters when the cardholder carries a balance from month to month. If Tarek plans to pay off the balance on his credit each month in full, the APR becomes less important. Instead, Tarek should focus on finding a credit card that offers benefits, such as cash back or affiliation rewards. Section 5.6; LO 5.6; BT: Ap Diff: E TOT: 2 min AACSB: n/a
c. Tarek has heard that it is quite difficult to get a credit card. He had a friend whose credit score was 550. The friend applied for a credit card and was denied. This got Tarek scared, so he obtained a free credit report and found out his credit score is 745. Based on this information, how difficult will it be for Tarek to obtain a credit card? What other advice do you have for Tarek if he decided to obtain a credit card? Answer: The reason why Tarek’s friend was denied a credit card is because his credit score was too low. A score of 550 is considered subprime, which is an indication of a high-risk borrower. Tarek’s credit score is excellent, making him an ideal lending customer. He should have very few problems obtaining a credit card. One piece of advice is to use the credit card for emergencies. Just because he has a credit card does not mean he must use it often. Tarek should be counseled that credit cards are not “free money.” If used appropriately, a credit card can be a useful spending tool. The most appropriate way to handle a credit card is to pay the balance due on a credit card in full each month. Section 5.5; LO 5.5; BT: Ap Diff: E TOT: 2 min AACSB: A d. One feature of a credit card that Tarek finds appealing is the ability to carry a balance from month to month. Let’s say that in the future he ends up carrying a $2,000 monthly balance. If the credit card company uses a 4% multiplier to determine the minimum monthly payment, and the card has a 19% APR and a 30-day billing cycle, what will be the minimum monthly payment? How much of the first payment will go toward paying interest?
Answer: $80; $31.26 Solution: The multiplier represents the minimum monthly payment as a percent. 4% multiplier means that his minimum monthly payment is 4% of the outstanding balance: $2,000 balance × 4% (0.40 in decimal form) = $80. The interest cost for the month is calculated by multiplying the daily periodic rate by the number of days in the billing period for a monthly periodic rate, then multiply by the outstanding balance. APR 0.19 = = 0.000521 365 days 365 Interest cost = 0.000521 daily periodic rate × 30 days × $2,000 balance = $31.26 Daily periodic rate =
Section 5.6; LO 5.6; BT: Ap Diff: E TOT: 2 min AACSB: ACalculating the Cost of Life’s Financial Journey Belinda is in the process of choosing a credit card. She has narrowed her choice to two cards. She would like your help in choosing the best card for her situation. 1. • • •
A credit card co-branded with a major airline. The card offers the following features: She can earn 1 mile for every $1 spent on eligible purchases. A $25 per bag fee will be waived for the first bag checked per flight. She will receive priority seating. The card charges an annual $95 fee. The APR varies from 16.50% to 25.50% based on each borrower’s credit score. Other fees, including balance transfer and late fees, apply. Card miles can be redeemed at the rate of $50 for 5,000 miles.
2. A credit card offers a 1% cash-back rebate on all purchases made with the card during the year. The card offers the following features: • The amount of cash earned never expires. • The cash earned may be redeemed or used to pay outstanding charges. The card has no annual fee. The APR varies from 11.75% to 23.75% based on each borrower’s credit score. Other fees, including balance transfer and late fees, apply. Belinda plans to spend approximately $45,000 per year on her credit card. Her plan is to make purchases and then pay the balance in full each month. She is not particularly worried about the APR. She is primarily interested to know if the airline credit card is a good option if she plans to make two trips each year to see her family. When making your calculations, assume that the cost of a flight is $500 for a roundtrip ticket. If she uses the cash-back credit card, assume that she will pay a $25 baggage fee for each leg of her trip. Based on this information, which credit card should she choose? What other factors should she consider when making her choice?
Answer: Airline Miles card Solution: In this case, the co-branded Airline Miles credit card offers Belinda a slight advantage of $4 based on the current scenario. This difference is attributed to the net savings from baggage fees that the Airline Miles card gets waived. Airline Miles Card
Cash-Back Card
Annual purchases1
45,000.00
45,100.00
Value of 2 roundtrips per year 4 Baggage required per year
1,000.00 4
1,000.00 4
Purchase reward2
1%
1%
2
450.00
3
Value of perk (baggage fee)
100.00
-
Annual fee Net benefit
(95.00) $455.00
-
Value of purchase rewards
451.00
$451.00
Note1: Cash-back card purchases include $100 for 4 baggage fees. Note2: Card miles can be redeemed at the rate of $50 for 5,000 miles. Note3: $25 baggage fee for 2 roundtrips is $100. Note4: Value of the 2 roundtrips is inconsequential for comparison, as it is the same for either card option.
If Belinda takes more than two roundtrip flights, the advantage associated with the airline credit card increases. Again, this is primarily due to the ongoing baggage fee that is waived with the card. Other factors to consider include the following: (1) she must fly the same airline in order to obtain the advantage, and (2) she must use the miles for products and services offered by the airline; however, with the cash-back card, she may use the cash anywhere at any time. Another issue to consider is the perk of boarding the plan early. For some passengers, the ability to obtain overhead space for carry-on luggage is worth the fee of the credit card. Section 5.6; LO 5.6; BT: Ap Diff: E TOT: 2 min AACSB: A Planning for the Future The Fair Credit Reporting Act (FCRA) gives each consumer living in the United States the right to obtain his or her credit report from one or more national credit reporting agencies. Under FCRA rules, you may order a free annual credit report each year. If you want a report more than one
report in a 12-month period, the credit reporting companies may charge a fee. Your credit report is a valuable tool you can use to manage your financial affairs. As such, it is important to make sure that the information used by the credit reporting agencies is correct. One way to do this is to get a copy of your report. Instructions Go to www.annualcreditreport.com or call 877-322-8228 to get the reporting process started. You will be asked to provide personal information, such as your address and Social Security number. Generally, you should never disclose this type of information, but in this case, it is okay to share these details. If you prefer to mail your request, visit https://www.consumer.ftc.gov/articles/pdf-0093-annual-report-request-form.pdf, complete and print the form, and send it to the address given: P. O. Box 105281 Atlanta, GA 30348-5281
CHAPTER 6 Learning Objectives 6.1 Identify high-cost consumer loans and how to avoid them. 6.2 Explain the characteristics of a personal loan. 6.3 Discuss the sources of financial aid and loans available to students. 6.4 Develop a vehicle acquisition strategy that uses an auto loan or lease. 6.5 Know the basics of renting a home or an apartment. 6.6 Describe the necessary considerations and benefits associated with purchasing and owning a home. Key to metadata for questions: LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), not applicable (NA) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes For Instructor: Each writing question will have criteria which is specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criteria will be assessed and the associated points for each level of performance are found in columns 2 – 5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criteria (row) is worth up to 4 pts (column 2).
Rubric: (It is suggested the rubric be shared with the students) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking significant incomplete and detail limited
Answer is realistic / relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
Does not represent realistic or relevant understanding of topic.
Organization/clarity of thought (25% of score)
Well organized
Adequate organization
Limited organization
Poor organization
A clear conclusion Appropriate or recommendation recommendations and is presented that is conclusions are appropriate given reached. the content (25% of score) discussed
25% of points (1 out of 4)
Conclusion or recommendation is Conclusion or No conclusion/ mostly clear and recommendation is recommendation appropriate given incomplete provided the content
6.1 Identify high-cost consumer loans and how to avoid them. 6.1 Multiple-Choice Questions 1. a. Money in a savings account. ANSWER: a LO 6.1 BT: C Difficulty: E TOT: 2 min AACSB: n/a 2. a. Banks and credit unions. ANSWER: a LO 6.1 BT: C Difficulty: E TOT: 2 min AACSB: n/a 3. a. Convenience. ANSWER: a LO 6.1 BT: C Difficulty: E TOT: 2 min AACSB: n/a
4. c. 2.4% APR. ANSWER: c LO 6.1 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: 0.2% X 12 = 2.4% OR 0.002 X 12 = 0.024, or 2.4%.
5. c. 120% APR. ANSWER: c LO 6.1 BT: An Difficulty: M TOT: 5 min AACSB: A Solution: Step 1, $100/$1,000 = 0.10; Step 2, 12 months / 1 month = 12; Step 3, 0.10 X 12 = 1.20; Step 4, 100 X 1.20 = 120%.
6. a .$0, because interest on subsidized loans does not accrue until Aman’s stops attending school. ANSWER: a LO 6.1 BT: Ap Difficulty: M TOT: 2 min AACSB: A
7. c. 1.5%. ANSWER: c LO 6.1 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Monthly rate: 0.18/12 = 0.015
8. b. there is a relatively small difference in the total finance charge between mainstream and alternative financial service providers. ANSWER: b LO 6.1 BT: C Difficulty: M TOT: 2 min AACSB: n/a 9. c. 11%. ANSWER: c LO 6.1 BT: K Difficulty: E TOT: 2 min
10. d. all are correct choices. ANSWER: d LO 6.1 BT: Ap Difficulty: M TOT: 2 min
6.1 Adventures in Financial Literacy Short Answer 1. LO 6.1 BT: Ap Difficulty: M TOT: 5 min AACSB: n/a Answer: Discussion should include convenience or alternative financial services, or lack of credit history or a low credit score prevent the borrower from accessing mainstream financial services. This is a lender of last resort because of the high cost.
2. LO 6.1 BT: S Difficulty: E TOT: 5 min AACSB: RT
Answer: First, check savings and other accounts. Second, look for low-cost loans including banks, credit unions, or a student loan through the school. Some might be able to borrow money from family or friends which could be a low-cost option. Next, credit cards could be a very good option for those who can qualify for a credit card, this could also be store credit. The most expensive option would be to use alternative financial services.
Explore 1. Contact several check cashers, payday lenders, or title loan lenders in your community and find out what they charge for a loan and the length of the loan period. Then calculate the APRs using the four-step process shown in this topic. Share with others in class the range of interest rates you found in the community. LO 6.1 BT: S Difficulty: M TOT: 45 min AACSB: A, E 2. Contact a local bank or credit union in your community and ask if it is possible to get a loan (any type, such as auto loan, credit card, or other) if you do not have a credit report or credit history. Also ask what types of loan products are available for those just starting out on their financial journey. What would the interest rate on such a loan be? LO 6.1 BT: S Difficulty: M TOT: 45 min AACSB: C 3. Conduct an internet search to determine if your state has limits on the interest rate that certain types of lenders can charge. Discuss any limits your state imposes on lenders. LO 6.1 BT: S Difficulty: M TOT: 30 min AACSB: E
Expanded Learning Activity More recently, the pawn shop has been replaced by online marketplaces that bring together buyers and sellers from across the globe. Some large online classified providers have emerged to foster greater opportunity for sellers and buyers to connect. Research this type of market place system and prepare a one-page report detailing your findings, including its advantages and disadvantages relative to pawn shops or flea markets. LO 6.1 BT: S Difficulty: H TOT: 60 min AACSB: C
6.1 Concept Checks 1. The number of unbanked or underbanked households in the United States is approximately: a. 5% of all households. b. 10 million households. c. 10% of all households. d. 34 million households. ANSWER: d LO 6.1 BT: K Difficulty: E TOT: 2 min AACSB: n/a
2. Rank the following types of loans from least expensive to most expensive. I. Payday loan. II. Cash advance on a credit card. III. Pawnshop loan. IV. Subsidized student loan a. II, I, III, IV b. IV, I, II, III c. IV, II, III, I d. I, II, III, IV ANSWER: c LO 6.1 BT: C Difficulty: E TOT: 2 min AACSB: n/a 3. All the following are mainstream financial service providers except: a. Credit union. b. Store credit card. c. Ford Motor Finance Company. d. Title Loan lender. ANSWER: d LO 6.1 BT: K Difficulty: M TOT: 2 min AACSB: n/a 4. All of the following are alternative financial service providers except: a. Check cashing services. b. Pawn shop. c. Payday lender. d. Target store card. ANSWER: d LO 6.1 BT: K Difficulty: M TOT: 2 min AACSB: n/a 5. Why to consumer advocates advise against using alternative financial services? a. Because they have a conflict of interest and invest in bank stock. b. Because of the poor customer service provided by alternative financial service providers. c. Because the amount that can be borrowed is too little to get through an emergency. d. Because of the high-cost associated with the loans and other services. ANSWER: d LO 6.1 BT: C Difficulty: M TOT: 2 min AACSB: n/a
6.2 Explain the characteristics of a personal loan. End-of-Topic Assessment 6.2 Multiple-Choice Questions 1. b. young adults just starting out their careers. ANSWER: b LO 6.2 BT: K Difficulty: E TOT: 2 min AACSB: n/a
2. d. property that can be siezed by the lender if a loan is unpaid. ANSWER: d LO 6.2 BT: K Difficulty: E TOT: 2 min AACSB: n/a
3. a. Lower than ANSWER: a LO 6.2 BT: C Difficulty: E TOT: 2 min AACSB: n/a
4. a. receives the full amount of money upfront and then makes regular payments to repay the loan and interest. ANSWER: a LO 6.2 BT: C Difficulty: M TOT: 2 min AACSB: n/a
5. a. if the borrowed funds are repaid, then the credit line is still available for future use without having to apply for another loan. ANSWER: a LO 6.2 BT: C Difficulty: M TOT: 2 min AACSB: n/a
6. d. All of the choices are correct. ANSWER: d LO 6.2 BT: C Difficulty: M TOT: 2 min AACSB: n/a
7. d. 438% APR. ANSWER: d LO 6.2 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Step 1: $12/$100 = 0.12; Step 2: 365 days/10 days = 36.5 periods in the year; Step 3: 0.12*36.5 = 4.38; Step 4: 4.38*100 = 438%.
8. a. 29.2% APR. ANSWER: a LO 6.2 BT: An Difficulty: M TOT: 2 min AACSB: A
Solution: Step 1: 0.024; Step 2: 365 days/30 days = 12.167 periods in the year; Step 3: 0.024*12.167 = 0.292; Step 4: 0.292*100 = 29.2%.
9. d. 217.3% APR. ANSWER: d LO 6.2 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: Step 1: $25/$300 = 0.0833; Step 2: 365 days/14 days = 26.07 periods in the year; Step 3: 0.0833*26.07 = 2.172; Step 4: 2.172*100 = 217.2%. If you do not round your answers in each step, your answer will be 217.3%.
10. a. A line of credit with a 29.9% APR. ANSWER: a LO 6.2 BT: An Difficulty: H TOT: 2 min AACSB: A Solution: Using the steps shown in the “Concepts in Action” section, the payday loan has an APR of 243.3%, the deposit advance has an APR of 52.14%, the installment loan has an APR of 34.8%. The line of credit has the lowest APR.
6.2 Adventures in Financial Literacy Short Answer 1. LO 6.2 BT: C Difficulty: M TOT: 5 min AACSB: n/a Answer: b, a, e, c, d, f. 2. LO 6.2 BT: C Difficulty: M TOT: 10 min AACSB: n/a Answer: Generally car loans, mortgages, and student loans are examples of installment loans. Installment loans are for a set amount of money, which is borrowed at the start of the loan and then repaid over a set period of time generally using equal payments.
3. LO 6.2 BT: K Difficulty: M TOT: 10 min AACSB: A Answer: Student loans, credit cards, line of credit, personal loans, and pay-day loans are unsecured loans. Unsecured loans have higher interest costs (generally) because there is more risk for the lender. If the borrower does not repay the loan, there is no collateral for the lender to seize. 4. LO 6.2 BT: S Difficulty: E TOT: 20 min AACSB: A Answer: The risks are that the borrowers are not good credit risks and do not repay the loans. Banks and other mainstream lenders may have very good cause for not lending people money, thus an individual seeking to lend money to these same individuals should be prepared for higher risk. With higher risk, comes a higher interest rate which compensates the lender for the risk they are taking.
Some peer-to-peer lenders pool the lenders’ money so that all of a particular lender’s money is not going to one person. Lenders’ money is spread across many different borrowers so that if one borrower does not repay the loan, there is a minimal impact on the lenders.
5. Getting a paycheck advance from an employer or borrowing money from friends and family will likely have the lowest amount of interest charge, but what other costs may be incurred because of the loan? LO 6.2 BT: S Difficulty: M TOT: 10 min AACSB: A Answer: The financial costs may be low, however, if the loan puts a strain on the family member or friend who is lending the money, or the money is not repaid, then the relationship could be damaged. A long-term damaged relationship with close friends or family is much more costly in the long run. One should only borrow from friends and family if he or she is confident that the loan will be repaid.
Research 1. Visit three peer-to-peer lending websites. Based on the information provided, compare each site’s lending options by completing the form that follows. Site 1:
Site 2:
Site 3:
Minimum Loan Amount Maximum Loan Amount Minimum Credit Score Loan Duration Average Interest Rate Origination Fee Other Fees
LO 6.2 BT: C Difficulty: M TOT: 20 min AACSB: C 2. Research your city and state usury laws. Are there interest rate caps that all lenders are subject to in your state or are there no caps on interest rates charged on loans? Summarize your findings in three to four paragraphs, including your thoughts on whether this is a good or bad policy for your city or state. LO 6.2 BT: C Difficulty: M TOT: 20 min AACSB: E
3. Do a search in your community to find 4 to 6 of the lenders that make personal loans. Make two columns on a page and list all of the banks and credit unions on one side of the page and on the other side list all of the other lenders. Call a few of the lenders and ask them what their typical APR is for a 1-year personal installment loan, or similar product. Also ask about the application process. What did you find out? What are the differences you observed between the two groups? LO 6.2 BT: C Difficulty: M TOT: 20 min AACSB: A
Expanded Learning Research Contact at least two banks or credit unions in your community. Find out whether they offer deposit advance loans and personal lines of credit. What are the terms of the loans? Is there a minimum credit score required to qualify for one of these loans, or is any credit score required? Share the results of your research with others in class. LO 6.2 BT: S Difficulty: M TOT: 30 min AACSB: C, A
6.2 Concept Checks 1. Which of the following personal loan options would be the most appropriate for use as an emergency source of funds? a. Payday loan. b. Installment loan. c. Line of credit. d. Deposit advance. ANSWER: c LO 6.2 BT: Ap Difficulty: E TOT: 2 min AACSB: n/a 2. A personal loan is a: a. Small dollar loan used to pay bills or make purchases. b. Payday loan. c. Installment loan. d. Line of credit. ANSWER: a LO 6.2 BT: K Difficulty: M TOT: 2 min AACSB: n/a 3. Requesting an advance on a paycheck from an employer a. Is against the law. b. Provides a low-cost loan alternative. c. Must be honored by employers under federal employment laws. d. Provides a low-cost loan alternative and must be honored by employer under federal employment laws are correct. ANSWER: b LO 6.2 BT: C Difficulty: M TOT: 2 min AACSB: n/a 4. What percentage of adults living in the United States have a credit card? a. 25%.
b. 50%. c. 75%. d. 95%. ANSWER: c LO 6.2 BT: K Difficulty: E TOT: 2 min AACSB: n/a 5. Friends and family can be good sources of low-cost loans, except that a. Friends may not have the money to lend. b. Family members may also be struggling financially. c. Interest rates charged by alternative financial service providers are cheaper. d. Only friends may not have the money to lend and family members may also be struggling financially are both correct. ANSWER: d LO 6.2 BT: C Difficulty: E TOT: 2 min AACSB: n/a
6.3 Discuss the sources of financial aid and loans available to students. End-of-Topic Assessment 6.3 Multiple-Choice Questions 1. a. fee is required to submit the FAFSA form. ANSWER: a LO 6.3 BT: C Difficulty: E TOT: 2 min AACSB: n/a 2. b. Students receiving financial aid awards may qualify for all three types of federal financial aid and also receive additional financial aid awards from the state or school. ANSWER: b LO 6.3 BT: C Difficulty: M TOT: 2 min AACSB: n/a
3. d. I, II, and III. ANSWER: d LO 6.3 BT: C Difficulty: M TOT: 2 min AACSB: n/a
4. c. Direct subsidized loan. ANSWER: c LO 6.3 BT: K Difficulty: E TOT: 2 min AACSB: n/a 5. b. Undergraduate students with financial need. ANSWER: b LO 6.3 BT: C Difficulty: M TOT: 2 min AACSB: n/a 5.
6. d. private student loans generally have lower interest rates compared to federal student loans. ANSWER: d LO 6.3 BT: C Difficulty: E TOT: 2 min AACSB: n/a 7. 7. d. Direct subsidized loans. ANSWER: d LO 6.3 BT: C Difficulty: E TOT: 2 min AACSB: n/a 8. d. Both direct unsubsidized and PLUS loans. ANSWER: d LO 6.3 BT: C Difficulty: M TOT: 2 min AACSB: n/a 9. c. consolidated loans can be discharged in bankruptcy. ANSWER: c LO 6.3 BT: C Difficulty: M TOT: 2 min AACSB: n/a 10. d. Both repay them as quickly as possible and limit borrowing to direct subsidized loans. ANSWER: d LO 6.3 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a
6.3 Adventures in Personal Finance Short Answer 1.
1. LO 6.3 BT: Ap Difficulty: M TOT: 2 min AACSB: A Answer: Any repayment option that extends the loan to 20 or 25 years and minimizes the payment amount (i.e. REPAYE, ICRP, etc.) will maximize the benefit received from the loan forgiveness program.
2. LO 6.3 BT: Ap Difficulty: M TOT: 2 min AACSB: A Answer: Standard repayment plan over 10 years.
3. LO 6.3 BT: S Difficulty: M TOT: 2 min AACSB: A, RT Answer: Work part- or full-time when possible while attending school, limit spending to only essentials, take out only subsidized student loans, repay the loans as quickly as possible. Explore 1. Match the following loan repayment plans and terms with their definitions. Use the Federal Student Aid website for help.
a. Standard Repayment Plan
1. Payments start out low and then increase every 2 years. The repayment period is 10 years except for consolidated loans, which may have repayment periods up to 30 years. Payments cannot be less than the periodic interest charge and cannot be greater than 3 times the standard plan payment.
b. Revised Pay As You Earn Repayment Plan
2. Payments are based on the lesser of 20% of discretionary income or a reduced standard payment amount based on income. Repayment period is 25 years, after which the remaining loan balance will be forgiven. Income tax may be due on the forgiven balance.
c. Graduated Repayment Plan
3. The repayment period can be up to 25 years. Must have $30,000 or more direct loans. Payments can be fixed or graduated.
d. Income-Contingent Repayment Plan
4. Payments are based on income and family size, and are 10% of discretionary income. Monthly payment amounts will not exceed the standard repayment plan amount. Repayment period is 20 or 25 years, after which time any remaining balance will be forgiven. Income tax may be due on the forgiven balance.
e. Extended Repayment Plan
5. This is the default repayment plan if no other repayment plan is selected. Loan(s) are repaid over a period of up to 10 years with fixed monthly payments (minimum monthly payment is $50). Consolidation loans are eligible for repayment periods between 10 and 30 years.
LO 6.3 BT: K Difficulty: M TOT: 10 min AACSB: n/a Answer: a-5, b-4, c-1, d-2, e-3 2. Go to the Federal Student Aid website to estimate what your payments will be for any federal student loans you currently have. If you expect to have additional student loans, include these additional loans in a separate estimate. How will you afford these payments after graduation? LO 6.3 BT: C Difficulty: M TOT: 20 min AACSB: A
Expanded Learning Activity Based on your monthly budget previously developed, determine how much money you need each year to attend school. Then determine how much you can earn at your job (or could earn if you were to start working part-time) and what federal or state grants you qualify for based on your FAFSA application. What is the difference between your budgeted required expenses and your income and grants? With this information in hand, contact your school’s financial aid office or student services office, and find out about what scholarships are available to students. If
you’re able to receive a scholarship, would this eliminate your need for student loans? If not, what amount of student loans would you need for the year? LO 6.3 BT: S Difficulty: M TOT: 30 min AACSB: A, RT
6.4 Develop a vehicle acquisition strategy that uses an auto loan or lease. End-of-Topic Assessment 6.4 Multiple-Choice Questions 1. a. As a use asset, car values nearly always decline over time. ANSWER: a LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: n/a
2. c. lowest; highest. ANSWER: c LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: n/a 3. d. All of these answer choices are correct. ANSWER: d LO 6.4 BT: K Difficulty: M TOT: 2 min AACSB: n/a
4. a. Using money from savings to fund the entire purchase. ANSWER: a LO 6.4 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a
4.
5. b. Nicole, who lives in the suburbs but works in a city 35 miles from her home. ANSWER: b LO 6.4 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a
6. d. Inexpensive compact car. ANSWER: d LO 6.4 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a 7. b. $225. ANSWER: b LO 6.4 BT: An Difficulty: M TOT: 2 min AACSB: A
Solution: $380 - $45 - $90 - $20 = $225
8. d. Melba’s credit report showed that other dealers had accessed her credit score before she test drove their cars. ANSWER: d LO 6.4 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a
9. b. increase; decrease. ANSWER: b LO 6.4 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a
10. b. $335.57. ANSWER: b LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: A 𝑖(𝑃𝑉)
0.00375($18,000)
Solution: 𝑃𝑀𝑇 = 1−(1+𝑖)−𝑛 = (1−(1+0.00375)−60 ) = $335.57
6.4 Adventures in Financial Literacy Short Answer 1. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: n/a Answer: a-2, b-1, c-6, d-5, e-4, f-3 2. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: A Answer: Several companies compile owner reviews on used cars to identify cars that are holding up well over time. Publications such as Edmunds, Consumer Reports, and J.D. Power are examples of these types of companies. These are very valuable resources when making decisions about the general quality of a make and model of a used car. 3. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: A Answer: When ownership of a car is not a long term need, or the car will be sold after a short period because of an expected long-distance relocation and the car will not be taken with you. Occasionally lease terms can be more beneficial than outright ownership and should be considered. Always do the math to make sure you are getting the best option possible.
4. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: n/a Answer: Vehicles depreciate most significantly the first year when they are purchased brand new from the dealership. The rate of depreciation slows a bit, but remains relatively steady over the next four years of ownership. Depreciation can be accelerated or slowed based on the care the owner provides for the car. The best time to purchase a vehicle is when it is about 2 to 3 years old. Another good time to purchase is when it is 5 years old. 5. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: A Answer: Purchase price, depreciation rate, loan amount, loan interest rate, and loan payment. Student should discuss these factors and how they relate to each other. 6. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: A Answer: Routine maintenance not only slows depreciation but it also extends the useful life of the vehicle and helps to prevent more costly repairs in the future. 7. LO 6.4 BT: C Difficulty: M TOT: 5 min AACSB: A Answer: Monthly loan payments are dependent upon the interest rate and payment term. The interest rate is the most important loan feature to negotiate, once that the interest rate is negotiated, then the duration of the loan can be negotiated. These two items, along with the amount borrowed, will determine the payment amount and how much interest must be repaid over time.
Research 1. Contact two financial institutions in your community and complete the following table for each of the credit score ranges. Total Lender Credit Score Loan term APR Finance Charge 1. Above 720 36 months 60 months 620 – 720 36 months 60 months Below 620 36 months 60 months 2. Above 720 36 months 60 months 620 – 720 36 months
60 months Below 620 36 months 60 months LO 6.4 BT: C Difficulty: M TOT: 20 - 30 min AACSB: C 2. Rank the following categories of vehicles from least expensive to most expensive from an insurance perspective. Assume that all cars are current year models. (Hint: You will need to research insurance estimates using the Internet.) a. Minivans b. Small or mid-size SUV c. Sports cars d. Full size trucks and SUV e. Sedans f. Luxury imported cars g. Compact cars LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: n/a Answer: a-1, b-2, c-7, d-4, e-3 , f-6, g-5 3. Conduct an internet search to find the fuel efficiency for five different types of vehicles, such as a small truck, sedan, hybrid compact, SUV, and sports car. Be sure to include the exact make, model, and year for each vehicle you select. Summarize the information into a table that can be shared with others in class. Based on your research, which of the vehicles researched would you consider purchasing? Why? LO 6.4 BT: C Difficulty: M TOT: 10 min AACSB: A
Expanded Learning Research According to the Federal Trade Commission, “A service contract is a promise to perform (or pay for) certain repairs or services. Although a service contract is sometimes called an extended warranty, it is not a warranty as defined by federal law. A service contract may be arranged any time and always costs extra; a warranty comes with a new car and is included in the original price. Used cars also may come with some type of warranty coverage included in the sales price. The separate and additional cost distinguishes a service contract from a warranty.” Many consumer advocates argue that service contracts are a consumer rip-off; however, there may be times when a service contract makes sense. Research the difference between a service contract and a new or used car warranty and determine when a service contract may be an appropriate choice for a car owner. Write the results of your research in a brief report. Share the results of your study with your instructor and other students. LO 6.4 BT: S Difficulty: H TOT: 20 min AACSB: C
6.4 Concept Checks 1. The reason automobiles should not be considered an investment is because a. They appreciate in value over time.
b. They provide an essential service in providing household income. c. They depreciate in value over time. d. They help save time and effort. ANSWER: c LO 6.4 BT: K Difficulty: M TOT: 2 min AACSB: n/a 2. All of the following factors combine to help determine whether a vehicle is a value except: a. Low price. b. High quality. c. Level of style and fun. d. Both low price and high quality. ANSWER: d LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: n/a 3. When shopping for a new car, which of the following should be the first step in the buying process? a. Shop for a loan. b. Obtain an estimate for auto insurance. c. Calculate how much you can afford. d. Determine your transportation need. ANSWER: d LO 6.4 BT: K Difficulty: M TOT: 2 min AACSB: n/a 4. Which of the following factors helps determine whether a car is affordable? a. The monthly loan payment. b. The monthly insurance cost. c. The monthly gas and maintenance cost. d. All of these answer choices are correct. ANSWER: d LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: n/a 5. All the following help determine the amount of the loan that you can qualify for when auto shopping except: a. The safety features of the car. b. The maximum payment you can fit into your budget. c. The interest rate of the loan. d. Both the maximum payment you can fit into your budget and the interest rate of the loan. ANSWER: a LO 6.4 BT: Ap Difficulty: M TOT: 2 min AACSB: A
6.5 Know the basics of renting a home or an apartment. End-of-Topic Assessment
6.5 Multiple-Choice Questions 1. b. Application fee. ANSWER: b LO 6.5 BT: C Difficulty: M TOT: 2 min AACSB: n/a 2. d. Safety. ANSWER: d LO 6.5 BT: K Difficulty: M TOT: 2 min AACSB: n/a 3. d. $1,000. ANSWER: d LO 6.5 BT: An Difficulty: M TOT: 2 min AACSB: A Solution: ($40,000 / 12 months)*30% = $1,000 / month 4. a. Cosigner. ANSWER: a LO 6.5 BT: K Difficulty: E TOT: 2 min AACSB: n/a
5. d. All of these answer choices are correct. ANSWER: d LO 6.5 BT: C Difficulty: M TOT: 2 min AACSB: n/a
6. c. Security Deposit ANSWER: c LO 6.5 BT: K Difficulty: M TOT: 2 min AACSB: n/a
7. a. Cat. ANSWER: a LO 6.5 BT: K Difficulty: E TOT: 2 min AACSB: n/a
8. c. Requiring you to pay for normal wear and tear. ANSWER: c LO 6.5 BT: K Difficulty: M TOT: 2 min AACSB: n/a
9. d. All of these answer choices are correct. ANSWER: d LO 6.5 BT: C Difficulty: M TOT: 2 min AACSB: n/a
10. b. All of the answer choices are correct. ANSWER: d LO 6.5 BT: C Difficulty: M TOT: 2 min AACSB: n/a
6.5 Adventures in Financial Literacy Short Answer 1. LO 6.5 BT: K Difficulty: E TOT: 5 min AACSB: n/a
Answer: Landlord owns or manages the property and approves or denies the renters application for rent. The renter is an entity that agrees to pay rent each month for the use of the living space / unit. 2. LO 6.5 BT: C Difficulty: M TOT: 10 min AACSB: n/a Answer: Renter’s insurance is inexpensive and provides coverage for personal belongings in the event of burglary, fire, or other hazard are covered after a deductible is paid. 3. LO 6.5 BT: C Difficulty: K TOT: 5 min AACSB: n/a Answer: Application fee, security deposit, first and last month’s rent, early termination of lease, late payment, parking, or pet fees. 4. LO 6.5 BT: Ap Difficulty: M TOT: 5 min AACSB: n/a Answer: The security deposit is generally much higher if you have pets living in the apartment with you. The security deposit is often in relation to the monthly rent amount, so as the monthly rental amount increases, the amount required for the security deposit will also increase.
Research 1. Contact the agent (either in person or online) from whom you purchase auto insurance. Ask the agent to provide information about renter’s insurance. Write a brief summary of the advantages of such coverage, the cost involved in purchasing the coverage, and any additional responsibilities you might have once you receive coverage. LO 6.5 BT: Ap Difficulty: M TOT: 30 min AACSB: C
2. Imagine that you were going to move to your first (or a new) apartment in the next six months. Evaluate and rank (1 = Most Important and 16 = Least Important) the following list of amenities that you would want to have in your next rental. Next, do a search where you want to live to determine if any dream properties exist, and if yes, what the monthly cost is right now. If the rent is too high, what amenities can you live without? AMENITIES Amenity Laundry in the Apartment Laundry in the Apartment Complex Dishwasher Indoor Parking Pool Fitness Center
Rank
Apartment Complex 1.
COMPARISONS Total Monthly Cost $
2.
$
3.
$
Storage Space Garage Fireplace Cable TV included in Rent Pets Allowed Playground Spa Internet Access Balcony or Patio Other ______________________
4.
$
5.
$
6.
$
7.
$
8.
$
LO 6.5 BT: Ap Difficulty: H TOT: 60 min AACSB: A
3. Visit the Vermont Law Help website to obtain information about actions someone can take to get back a security deposit. Be sure to review your own state’s laws to determine if there are additional options available. Write a brief report and share your findings with others in class. LO 6.5 BT: Ap Difficulty: M TOT: 60 min AACSB: E
4. Sometimes the apartment of your dreams may be unaffordable. Many financial planning experts recommend that in these situations you should find a roommate to help offset rental expenses. Interview two friends to get their opinions on the benefits and disadvantages associated with having a roommate. Write a brief report based on your findings and share your results with your class. LO 6.5 BT: S Difficulty: M TOT: 45 min AACSB: C, RT
Expanded Learning Research Visit the U.S. Department of Housing and Urban Development website. Click on the link to your state and conduct a review of the basic landlord rights and responsibilities under your state laws. Write a brief report and share the findings with others in class.
6.5 Concept Checks 1.
All the following are features of renting, except: a. Provides flexibility over the short-term. b. Requires a security deposit. c. Requires a down payment. d. Provides an environment where you do not need to worry about major repairs. ANSWER: c LO 6.5 BT: K Difficulty: M TOT: 2 min AACSB: n/a
2. When searching for a rental property, what is the most important factor to consider? a. Safety.
b. Appearance of neighborhood. c. Access to work. d. Access to neighborhood amenities. ANSWER: a LO 6.5 BT: K Difficulty: M TOT: 2 min AACSB: n/a 3. Paul makes $2,500 per month as a building maintenance engineer. He is shopping for a new apartment. Using HUD guidelines, what is the maximum amount Paul should spend on rent per month? a. $500. b. $750. c. $1,000. d. $1,250. ANSWER: b LO 6.5 BT: An Difficulty: E TOT: 2 min AACSB: A Solution: $2,500*30% = $750 4. Which of the following are indicators that a landlord is taking adequate care of property? a. The property’s parking lot has been repaved recently. b. The property is well lit. c. The property has high ratings posted online from tenants. d. All of these answer choices are correct. ANSWER: d LO 6.5 BT: C Difficulty: E TOT: 2 min AACSB: n/a 5. All the following are outlined in a lease except: a. What happens if you make a late monthly rental payment. b. What you need to do when you move out. c. When you can turn on your water heater. d. Whether you may or may not have a roommate. ANSWER: c LO 6.5 BT: Ap Difficulty: E TOT: 2 min AACSB: n/a
6.6 Describe the necessary considerations and benefits associated with purchasing and owning a home. End-of-Topic Assessment 6.6 Multiple-Choice Questions 1. b. No, because her ratio is greater than 31%. ANSWER: b LO 6.6 BT: An Difficulty: E TOT: 2 min AACSB: A Solution: $900 / $2,500 = 36%, which greater than the 31% benchmark. 2, d. No, because her ratio is greater than 43%. ANSWER: d LO 6.6 BT: An Difficulty: E TOT: 2 min AACSB: A
Solution: $900 + $75 + $125 + $235 = $1,335 / $2,500 = 53.40%, which is greater than the 43% benchmark. 3. c. Yard maintenance fees. ANSWER: c LO 6.6 BT: K Difficulty: H TOT: 2 min AACSB: n/a 4. b. FHA 30-year mortgage. ANSWER: b LO 6.6 BT: Ap Difficulty: M TOT: 2 min AACSB: n/a 5. d. $7,000. ANSWER: d LO 6.6 BT: An Difficulty: E TOT: 2 min AACSB: A Solution: 0.02 * $350,000 = $7,000 6. c. $2,072. ANSWER: c LO 6.6 BT: M Difficulty: M TOT: 2 min AACSB: A 𝑖(𝑃𝑉)
0.0025($300,000)
Solution: 𝑃𝑀𝑇 = 1−(1+𝑖)−𝑛 = 1−(1+0.0025)−180 = $2,071.74 7. a. Mortgage insurance. ANSWER: a LO 6.6 BT: K Difficulty: M TOT: 2 min AACSB: n/a 8. b. -$18,000. ANSWER: b LO 6.6 BT: An Difficulty: M TOT: 2 min AACSB: A Answer: $175,000 - $193,000 = -$18,000
9. d. Both foreclosure and short sale. ANSWER: d LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: n/a
5.
6.
7.
8.
10. d. All of these answer choices are correct. ANSWER: d LO 6.6 BT: C Difficulty: E TOT: 2 min AACSB: n/a
10.
6.6 Adventures in Financial Literacy Short Answer 1. LO 6.6 BT: K Difficulty: H TOT: 10 min AACSB: n/a Answer: A-2, B-5, C-6, D-8, E-7, F-3, G-1, H-4 2. LO 6.6 BT: S Difficulty: M TOT: 10 min AACSB: A Answer: a. If an individual was planning on being in the home less than 5 to 7 years. The savings on the closing costs would compensate for the higher interest paid over this relatively short time period. b. If an individual plans to stay in the home for the duration of the mortgage then the lower interest rate would be more beneficial and would likely be worth paying higher closing costs to minimize interest expense over the life of the mortgage. 3. LO 6.6 BT: Ap Difficulty: M TOT: 5 min AACSB: n/a Answer: Conventional loans would allow you to borrow more. FHA loans are capped. 4. LO 6.6 BT: C Difficulty: H TOT: 15 min AACSB: n/a Answer: The loan origination fee can be a significant cost. Paying points to get a lower interest rate is also a significant expense. Other significant closing costs that must be paid include prepayment of certain expenses such as property taxes, homeowners insurance, and the first month’s interest. Additional attorney’s fees and record keeping fees are also included.
5. LO 6.6 BT: S Difficulty: M TOT: 15 min AACSB: n/a Answer: 1. Equity is built by paying down principle on the loan. 2. Equity it built by the value of the home increasing in value, while the loan stays constant. 3. Equity is built by putting a larger down payment at the time of purchase. 6. LO 6.6 BT: Ap Difficulty: M TOT: 10 min AACSB: n/a
Answer: Negative equity can be avoided by putting a larger down payment at the time of purchase or paying down the loan more quickly.
Research 1. How much do houses in your community cost? Search real estate websites to see the selling prices for houses available in your community. LO 6.6 BT: Ap Difficulty: M TOT: 30 min AACSB: n/a 2. According to the US Department of Housing and Urban Development (HUD), nearly 75% of homeowners in the United States are White. Homeownership among African-Americans and Hispanics is less than 50%. Visit the HUD website, as well as other Internet sites, to obtain more information describing why there may be a racial/ethnic difference in homeownership and why it is important that everyone have access to home ownership. As part of your research, summarize some of the interventions that have been developed to help first-time, low-income, and minorities gain access to the housing market. LO 6.6 BT: S Difficulty: H TOT: 60 min AACSB: n/a
Expanded Learning Activity Joe wants to borrow $200,000. If he can get a 30-year loan at a 5% rate, how much will his monthly principal and interest payment be? Here is the time value of money formula for calculating a monthly mortgage payment: (𝑖(1 + 𝑖)𝑛 ) 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑃[ ] ((1 + 𝑖)𝑛 − 1) Where P = the amount borrowed (mortgage), i = interest rate, and n = number of payments. Let’s try an example. Assume Joe wants to borrow $200,000. If he can get a 30 year loan at a 5% rate, how much will his monthly principal and interest payment be? In order to answer this question you first need to convert the years to months and the yearly rate of interest to monthly: • •
Number of Periods: 30 years x 12 months = 360 Monthly Interest Rate: 5% / 12 = .004167%
Now, plug these figures into the formula, as follows: (.004167(1 + .004167)360 ) $1,073.69 = $200,000[ ] ((1 + .004167)360 − 1) Or
(.004167(4.4683) $1,073.69 = $200,000[ ] (4.4683 − 1) Help Joe figure out whether he passes the FHA housing payment to income ratio if his monthly income is $6,000 and the monthly hazard insurance premium if $200 and monthly property taxes are $350. Use an online mortgage affordability calculator to verify your answer. LO 6.6 BT: An Difficulty: H TOT: 30 min AACSB: A ANSWER: Yes, Joe passes the FHA housing payment-to-income ratio. Joe’s ratio is 27%, which less than 31%. SOLUTION: ($1,073.69+$200+$350) $6,000
=
$1,623.69 = .27 < .31 $6,000
6.6 Concept Checks (online-only assessment questions) 1. What percent of Americans own their personal residence free-and-clear, without a mortgage? a. 0%. b. 19%. c. 32%. d. 61%. ANSWER: c LO 6.6 BT: K Difficulty: M TOT: 2 min AACSB: n/a 2. PITI stands for: a. Principal Mortgage Insurance. b. Principal, Interest, Tax, and Insurance. c. Payments, Insurance, Tax, and Indemnity. d. Payments, Income, Tax, and Insurance. ANSWER: b LO 6.6 BT: K Difficulty: E TOT: 2 min AACSB: n/a 3. Use the FHA housing payments to income ratio to determine whether Nadine can qualify to purchase a home. Assume that the mortgage payment is $1,200, taxes are $300, and insurance is $150 monthly. Also assume that Nadine earns $4,000 per month. Can she afford the home? a. Yes, because the ratio is less than the benchmark. b. No, because the ratio is greater than the benchmark. c. Yes, because the ratio is greater than the benchmark. d. No, because the ratio is less than the benchmark. ANSWER: b LO 6.6 BT: An Difficulty: E TOT: 2 min AACSB: n/a Solution: ($1,200 + $300 + $150) / $4,000 = 41.25% > 31% 4. Which of the following protects a lender in case another person, at a later date, makes a claim on a piece of real estate? a. Title insurance. b. Property insurance.
c. PITI insurance. d. Mortgage insurance. ANSWER a LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: n/a 5. In order to make the monthly mortgage payment on a new house affordable, Kolton will need to obtain a lower mortgage interest rate. Kolton’s bank has offered to reduce the rate of his mortgage from 5.25% to 4.35% if he pays one point at closing. If the amount of the mortgage is $465,000, how much must Kolton pay to reduce his interest rate? a. $388. b. $1,552. c. $2,328. d. $4,650. ANSWER d LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A Solution: 0.01 * $465,000 = $4,650
Chapter 6 Summary Continuing Case: Tarek’s Financial Journey a. When thinking about purchasing a car, Tarek came up with the following estimates. First, he is confident that he can dedicate a total of $410 per month in cash flow for the purchase and maintenance of a car. Tarek also estimated the following monthly expenses: gas $50; insurance $80; maintenance $40; and repairs $15 (assuming he buys a new car). Based on these estimates, how much can Tarek spend each month on a loan payment, assuming a 4-year 3% annual APR loan? Answer: He can spend $225 per month for the payment. Based on this dollar amount, he can afford a loan of approximately $10,165. Answering this question requires the use of a time value of money calculator: $225 PMT, 3/12 = .25 I/Y, 48 N, CPT PV = $10,165 (rounded). LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: A b. Assuming that Tarek can obtain a car loan, how will making timely payments influence his credit score? What other things can Tarek do to reestablish his credit score? Answer: Making timely payments with an installment loan will provide evidence of his financial management skills and increase his credit score. Other things that improve his score include opening a line of credit, like a credit card and making timely payments on any outstanding balances. He should also keep revolving balances low, avoid holding lots of credit cards, and vary the types of credit used. LO 6.1, 6.4 BT: C Difficulty: M TOT: 2 min AACSB: A
c. Not surprisingly, Tarek still has several thousand dollars in student loans outstanding. When he graduated from college, he had federal loans of $45,000, with an average APR of 6.80%. Six months after graduation he started making payments using the standard repayment plan. How much is his monthly payment? Assuming that all of his student loans were subsidized, what repayment schedule would be best for Tarek if he wants to minimize his monthly payment to increase his financial flexibility? What will be his new maximum monthly payment if his federally calculated discretionary income is $4,500 per month. Answer: A standard repayment plan requires the loan to be repaid over a 10 year period. He currently makes a monthly payment equal to $518: $45,000 PV, 6.80/12 = .5667 I/Y, 10 x 12 = 120 N, CPT PMT = $518 (rounded). A REPAYE plan bases the monthly payment on the borrower’s income and household size. If certain requirements are met, monthly payments are capped at 10% of discretionary income but never more than a standard repayment. If the loan has not been paid in full within 20 years the remaining balance will be forgiven (however, taxes will be due on the forgiven amount). For Tarek, and those just starting their careers, a REPAYE plan generally makes loan payments more manageable. His maximum monthly payment will be $450. LO 6.3 BT: C Difficulty: M TOT: 2 min AACSB: A d. As housing prices in his area have recently dropped, Tarek is insistent that he should buy a home. Given his projected monthly income of $4,500 and other monthly debt repayment expenses of $225 for a car and estimated student loan payments of $500 per month (please use this number rather than the number calculated in for question 3), what is the maximum monthly principal and interest payment he can afford if insurance is $80 per month and property taxes on the home are an additional $200 per month (use HUD guidelines)? What size loan can Tarek afford based on your answer—assume that he can obtain a 5.50% loan for 30 years? Answer: $912; based on HUD guidelines, he should pay no more than 43% for principal, interest, tax, insurance, and other debt payments: $4,500 x . 43 = $1,935 - $80 - $500 $225 - $200 = $930. He can afford a loan in the amount of $179,999: $930 PMT, 5. 50/12 = . 3750 I/Y, 30 x 12 = 360 N, CPT PV = $183,545. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A e. Now that you have helped Tarek, do you think that he should follow the money gurus’ advice and avoid debt at all costs, or should he incorporate credit and debt into his financial management strategy? Why or why not? What other factors might be considered when he makes his final decision? Answer: As the topics in this chapter highlight, debt itself is not bad. The appropriate use of debt can help someone accumulate assets, purchase expensive items, and improve human capital. Tarek needs to use credit and debt to purchase a new car and maintain an emergency source of funds. While Tarek should follow the money gurus’ advice about
building up an emergency savings fund, Tarek should also prudently incorporate credit and debt management techniques into his financial management plan. LO 6.1 – 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A
Calculating the Cost of Life’s Financial Journey
a. Which vehicle should they purchase if they are interested only in the lowest monthly loan payment? Answer: The luxury SUV has the lowest monthly loan payment of $565. LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: A b. What should they choose if they are interested in buying something that has the lowest total monthly cost? Answer: They should choose either the SUV or the luxury SUV because they both have a total monthly cost of $929. LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: A c. If they are interested in a vehicle with the lowest overall cost of ownership, which one should they choose? Answer: Although the 4 door sedan (Car 1) has the highest monthly expense, over the course of the loan, this has the lowest overall cost of ownership at $37,777.30. LO 6.4 BT: C Difficulty: M TOT: 2 min AACSB: A Question Proofs: Type Cost Loan Interest Rate Length of Loan (Years) Monthly Insurance
Car 1 Car 2 Car 3 Car 4 4 Door Sedan 2 Door Luxury Coupe 4 Door Luxury Sedan SUV
Car 5 Luxury SUV
$
$ 4,000 1.90%
$ 42,000 3.50%
5
7
29,000 1.90%
3 $
$
43,000 3.40%
5 125
$
$
45,000 0.00%
6 170
$
175
$
145
$
155
Monthly Gas N
$
95
36
$
150
60
I/Y 0.16% PV $ 29,000 $ Monthly $ 829 $ Payment Total $ 1,049 $ Monthly Expense Total of all Payments $29,857.30 $46,819.25 Overall Cost of $37,777.30 $66,019.25 Ownership
$
165
72 0.28% 43,000 780
$ $
0.00% 45,000 625
1,100
$
965
$
190
$
210
60
84
0.16% $ 34,000 $ 594
0.29% $ 42,000 $ 564
$
$
929
929
$45,000.00
$35,667.46 $47,415.79
$69,480.00
$55,767.46 $78,075.79
Planning for the Future 1. Lini is particularly interested in buying a home. Tucco, on the other hand, likes the flexibility of renting. Given their current financial situation, does it make sense for them to continue renting in their current location? Use the HUD rental expenses guideline to guide your answer. Answer: No, they do not meet the HUD guideline, which states that a household should not spend more than 30% of their income for rent. In their case, they are spending approximately 35% of income on rent ($32,550/$93,023). LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A
2. Lini has been investigating the housing market. She found a wonderful new house priced at $205,000. Given their credit score, she is confident that she and Tucco can qualify for a 30-year fixed-rate 5. 20% mortgage. If they were to purchase this home how much of down payment will they need to have in order to avoid PMI? How much will they need to put down if they use a 5% down payment? Answer: They will need to put down 20% of the purchase price, which is $41,000, in order to avoid PMI. A 5% down payment will be $10,250. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A 3. Given their current financial situation, do they have sufficient assets to make either a 5% or 20% down payment? If they do not have enough, what can they do? Answer: No, they do not have enough cash assets (checking, savings, investments) to make a down payment at this time. They could seek a loan that requires less of a down
payment; however, they will probably pay more in interest. Alternatively, they could postpone purchasing a home and begin saving for a down payment. They may also be able to find someone to co-sign a mortgage loan. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A 4. Lini anticipates receiving a gift from her parents to help offset the expense of a down payment. If a homeowner’s policy will cost $1,400 per year and property taxes will be $4,300 per year what will be their monthly PITI on a loan with a 20% down payment? What will be the monthly PITI with a 5% down payment, assuming private mortgage insurance costs $900 per year? Answer: First, calculate the monthly mortgage payment. If they make a 20% down payment the loan amount will be $164,000, which results in a monthly payment of $901. If they make a 5% down payment the loan amount will be $194,750, which results in a monthly payment of $1,069. Adding in the monthly insurance ($1,400/12 = $117) and monthly taxes ($4,300/12 = $358) results in a PITI of $1,376 for the 20% down payment loan. PITI for the 5% down loan adds in the private mortgage insurance of $75 per month to the standard $1,544 of PITI for a total payment amount of $1,619. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A
5. Do Lini and Tucco meet HUD’s housing payments to income ratio? Do they meet HUD’s total fixed payments to income ratio? Answer: The housing payments to income ratio is 31% or $2,403 per month, based on their income. They easily pass this test using either a 20% or 5% down payment loan: $1,376 < $2,403 and $1,619 < $2,403. HUD’s total payments to income ratio is 43% or $3,333 per month, based on their income. In order to calculate this figure, you must estimate how much they are spending on other debt payments each month. Monthly debt payments include: Car payments of $9,438, student loans of $7,929, and credit cards of $2,400. On a monthly basis they are spending $1,647. 25 on these payments. When added to PITI they will be spending $3,023 per month if they use a 20% down payment and $3,366.67 per month if they use a 5% down payment. With a 20% down payment the monthly payment is less than HUD’s guideline: $3,023 < $3,333, however, with a 5% down payment they are slightly over HUD’s guideline: $3,367 > $3,333. Tucco and Lini should reduce some of their payments or increase income slightly to qualify under the total payments to income ratio. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A 6. Based on your estimates, do you agree or disagree with Lini that they should purchase a home, assuming they have at least a 5% down payment, at this time?
Answer: Lini is correct. Purchasing a home, assuming they will live in the home for at least five years, makes financial sense. The amount they will spend in PITI, assuming a loan with a 5% down payment, will decrease their monthly housing expense by more than $14,500 per year. This extra cash flow can be used to pay down other debt or increase savings for other goals. They exceed or are close enough to the HUD ratios that they can adjust some payments by refinancing the car loans or other measures to fit within the guidelines. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A
7. Should Tucco and Lini request a non-standard student loan repayment plan? Why or why not? Answer: Given their income and payments made to date, switching to another repayment plan may not significantly reduce their monthly student loan payment. A new repayment plan would extend the number of payments, which would result in an increase in the total amount of interest being paid over the course of the loan. While they should certainly look at another repayment plan, they may find that the standard repayment plan will lead to the debt being repaid the quickest. It could be that a new repayment plan would reduce their monthly debt payments (even though it increases the total amount interest to be paid) by making it easier to qualify for a mortgage. LO 6.6 BT: C Difficulty: M TOT: 2 min AACSB: A
Chapter 6 Appendix A: Financing a College Education
End-of-Topic Assessment Solutions Manual Learning Objective 6A Determine how to best plan and finance a college education. Key to metadata for questions:
LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes For Instructor: Each writing question will have criteria which is specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criteria will be assessed and the associated points for each level of performance are found in columns 2 – 5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criteria (row) is worth up to 4 pts (column 2).
Rubric: (It is suggested the rubric be shared with the students) Full points 75% of points 50% of points Criteria (4 out of 4) (3 out of 4) (2 out of 4) Thoroughness of answer to the question
The question is answered thoroughly
25% of points (1 out of 4)
The response is lacking a few details
The response is The response is lacking incomplete and significant detail limited
Amounts and information Answer is realistic / discussed are relevant relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
Does not represent realistic or relevant understanding of topic.
Organization/clarity Well organized of thought
Adequate organization
Limited organization
Poor organization
(25% of score) Appropriate recommendations and conclusions are reached. (25% of score)
A clear conclusion or recommendation is presented that is appropriate given the content discussed
Conclusion or recommendation Conclusion or No conclusion/ is mostly clear recommendation recommendation and appropriate is incomplete provided given the content
Please refer to the sample writing assignment rubric in the solutions manual.
6A End-of-Topic Assessment 6A Multiple Choice Questions 1. c. Approximately 10 years. Answer: c; SECTION 6.3; LO 6.3; BT: An; Difficulty: M; TOT: 40 min; AACSB: A 2. c. Savings bonds. Answer: c; SECTION 6.3; LO 6.3; BT: An; Difficulty: H; TOT: 40 min; AACSB: A 3. d. Because the distribution is not qualified, Maurice will owe federal and state taxes, plus a 10% federal tax penalty. Answer: d; SECTION 6.3; LO 6.3; BT: An; Difficulty: H; TOT: 40 min; AACSB: A
4. b. A Roth IRA. Answer: b; SECTION 6.3; LO 6.3; BT: An; Difficulty: M; TOT: 40 min; AACSB: A 5. a. Grant. Answer: a; SECTION 6.3; LO 6.3; BT: An; Difficulty: E; TOT: 40 min; AACSB: A
6A Adventures in Personal Finance Short Answer 1. ANSWER: The answers will vary based on each student’s unique situation. However, answers should include an evaluation of the monthly loan payment amount, an analysis of future earnings, and the total cost of education (past, current, and future anticipated
expenses until degree completion). Some students may also include lost wages (additional expense) or current wages if working (offset to expenses) in the analysis. SECTION 6.3; LO 6.3; BT: An; Difficulty: H; TOT: 40 min; AACSB: A
2. ANSWER: It is never too late. There are still things a student can do to search for and find financial aid options and funding help. These include talking with employees of the student’s current college or university financial aid office, completing a FAFSA form, applying for scholarships (both internally at the institution as well as externally through local or national organizations), and exploring jobs that will help repay student loans (e.g., certain K-12 teaching positions will help repay student loans, working as a doctor with certain organizations or in certain geographic locations will provide loan repayment assistance). There are many more options as well. SECTION 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A 3. ANSWER: Sometimes good intentions backfire when it comes to applying for and receiving financial aid for college. For example, holding savings in a student’s name will reduce financial aid awards. Colleges and universities assume that money held in a student’s name will be used to help offset tuition expenses. Additionally, certain assets held by a student’s parent(s) may potentially reduce financial aid. A parent who holds assets in traditional bank savings accounts may find the amount of financial aid awarded to her or his child reduced. On the other hand, assets held in Roth IRA accounts, in a parent’s name, are disregarded from financial aid formulas. However, income distributed from a Roth IRA to a student is included in the financial aid formula. So, if using a Roth IRA savings strategy, it is best to use a Roth IRA later in a student’s college career (sophomore or junior year) rather than at the start of college. Doing so will ensure that subsequent FAFSA reporting periods will not be negatively affected. SECTION 7.1; LO 7.1; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: n/a 4. ANSWER: While tuition tends to be the most publicized element of college costs, families also need to take into consideration expenses related to room and board, books and fees, study abroad costs, food purchased off campus, clothing, vehicle and transportation costs, and day-to-day out-of-pocket expenses. These “other” expenses can sometimes be equal to or greater than the cost of tuition. There are, fortunately, ways these expenses can be reduced or managed. One option is for a student to live at home during college. This action will effectively cut ongoing expenses dramatically. If living at home is not an option, a family can apply for additional scholarships or aid. After the first year of college, a student can apply to be a residential assistant (RA) in a dorm. If accepted, being an RA will typically pay for the cost of room and board. Another popular funding option involves finding a part-time job during college. SECTION 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A
Chapter 7—Solutions Manual The Foundation of Savings Introduction to Personal Finance: Beginning Your Financial Journey By John Grable and Lance Palmer
Learning Objectives 7.1 Describe the relationship between investment risk and return. 7.2 Explain why an emergency fund is critical for financial well-being. 7.3 Identify the use and benefits of savings accounts, money market savings accounts, and certificates of deposits. 7.4 Explain how a Roth IRA provides savings and tax benefits. 7.5 Describe the benefits and limitations of U.S. savings bonds. 7.6 Discuss the different types of custodial and beneficiary accounts and their appropriate uses. 7.7 Recognize financial frauds and the strategies to protect against them. Key to metadata for questions: LO: Learning objective number BT: Bloom’s taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H)] TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), Not Applicable (n/a)
Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes for instructor: Each writing question will have criteria which are specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criterion will be assessed and the associated points for each level of performance are found in columns 2–5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criterion (row) is worth up to 4 points (column 2).
Rubric: (It is suggested that the rubric be shared with the students.) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking significant incomplete and details limited
Answer is realistic/relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
The response does not represent realistic or relevant understanding of topic
Organization/clarity of thought (25% of score)
Well organized
Adequate organization
Limited organization
Poor organization
A clear conclusion Appropriate or recommendation recommendations and is presented that is conclusions are appropriate given reached the content (25% of score) discussed
25% of points (1 out of 4)
Conclusion or recommendation is Conclusion or No conclusion or mostly clear and recommendation is recommendation is appropriate given incomplete provided the content
7.1 Describe the relationship between investment risk and return. 7.1 Multiple-Choice Questions 1. c. volatility. Answer: c; Section 7.1; LO: 7.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. c. 4.55%. Answer: a; Section 7.1; LO: 7.1; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: Calculate the real rate of return based on the nominal rate of 7.75%, expected annual rate of return, and 3.06% inflation rate, the average annual increase in the Consumer Price Index (CPI) for the past 35 years as reported by the U.S. Bureau of Labor Statistics (page 7-3 and Illustration 7.1.1)
(1 + Nominal return) ]−1 (1 + Inflation rate) (1 + 0.0775) Real rate of return = [ ]−1 (1 + 0.0306) Real rate of return = [
Real rate of return = [ 1.04551 ] − 1 = 0.0455 ~ 4.55%
3. d. No, because her money will double every 18 years, leaving her short of her goal. Answer: d; Section 7.1; LO: 7.1; BT: Ap; Diff: M; TOT: 2 min; AACSB: A Solution: Her $300,000 will only double to $600,000 in approximately 18 years, when she will be 51 years old. Her money will double to her required $1.2 million in an additional 18 years when she is 69 years old, 7 years past her goal.
Rule of 72 Estimate Number of years to double principal =
72 𝐼
Number of years to double principal =
72 = 18 years 4
4. d. The rate of return on a bank or credit union savings account will increase, and holding cash in an emergency fund is more attractive. Answer: d; Section 7.1; LO: 7.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: A 5. a. $12,700. Answer: a; Section 7.1; LO: 7.1; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: Their take-home pay is $56,555, and they save 10%. The remaining 90% of their take-home pay is used for expenses: $50,899.50. Their monthly expenses are $4,241.63 ($50,899.50 annual expenses/12 months). An emergency fund should be 3 months of expenses: $4,241.63 × 3 months =
$12,724.88 ~ $12,700 rounded. 6. c. Even though there is federal insurance in place, you still face inflation risk. Answer: c; Section 7.1; LO: 7.1; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a 7. d. U.S. savings bonds, certificate of deposits, and Treasury bills. Answer: d; Section 7.1; LO: 7.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. a. High-risk tolerance. Answer: a; Section 7.1; LO: 7.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. c. Mutual fund. Answer: c; Section 7.1; LO: 7.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. d. Savings accounts. Answer: d; Section 7.1; LO: 7.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 7.1 Adventures in Personal Finance Short Answer 1. Answer: At 2%, it will take approximately 36 years; at 5%, it will take approximately 14.4 years; and at 9%, it will take approximately 8 years. Solution: Use the Rule of 72 to estimate the time to double. 72 Number of years to double principal = 𝐼
72 = 36 years 2 72 Number of years to double principal @ 5% APY = = 14.4 years 5 Number of years to double principal @ 2% APY =
Number of years to double principal @ 9% APY =
72 = 8 years 14
Section 7.1; LO: 7.1; BT: An; Diff: M; TOT: 15 min; AACSB: A 2. Answer: Since savings deposits are highly liquid and insured by the U.S. government, an appropriate rate of return would be the rate on the U.S. Treasury bill. It is a direct obligation of the U.S. government and has maturities less than one year. Solution: (1) What can go wrong? It is possible that the bank could go out of business; (2) How likely is it? Not likely at all; and (3) What are the consequences? Although a bank closure would be inconvenient, each deposit under a specific named account is insured up to $250,000. The savings deposit should earn a commensurate rate of return similar to other U.S. short-term government obligations. Section 7.1; LO: 7.1; BT: Ap; Diff: M; TOT: 20 min; AACSB: n/a
3. Answer: Inflation risk is the danger that you will lose purchasing power of the money you have saved. The inflation rate is like the speed of a treadmill, if you cannot keep up with the speed of the treadmill, you can fall behind and eventually fall off. Your savings must have an APY that at least matches the rate of inflation in order to maintain the same purchasing power of your savings. If not, whatever the long-term goal you are saving for will continue to keep getting pushed back. Investment volatility will affect your cumulative savings in the form of reinvestment risk and price risk associated with the timing of distributions. Inflation risk affects your cumulative savings through diminished purchasing power. Section 7.1; LO: 7.1; BT: Ap; Diff: M; TOT: 20 min; AACSB: A 4. Answer: Tip needs at least $11,250 to meet the minimum 3-month emergency fund rule ([$45,000 annual expenses/12 months] × 3 months). Section 7.1; LO: 7.1; BT: An; Diff: M; TOT: 5 min; AACSB: A 5. Answer: The association between risk and return is positive. In order to earn higher returns, a person must be willing to take more risk. The sketch would look like an upward sloping (from left to right) line.
Section 7.1; LO: 7.1; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
Explore 1. Answer: Inflation has caused purchasing power to decrease dramatically over time. Some decades, such as the 1970s and 1980s, had very high inflation, and later decades have had very low inflation. Investing in only low-return accounts will not produce high enough returns to keep up with inflation.
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Consumer Price Index (CPI) data is provided by the U.S. Department of Labor Bureau of Labor Statistics. This monthly pipelined data is the gas powering the always-current inflation calculator. https://www.bls.gov/cpi/home.htm Section 7.1; LO: 7.1; BT: An; Diff: M; TOT: 15 min; AACSB: A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.1; LO: 7.1; BT: Ap; Diff: M; TOT: 45 min; AACSB: C, RT 7.1 Expanded Learning Activity Answer: Depending on the time of year and the current market rates, will effect gasoline price comparisons with inflation. Please refer to the sample writing assignment rubric in the solutions manual. Section 7.1; LO: 7.1; BT: An; Diff: H; TOT: 120 min; AACSB: C, A
7.1 Practice Questions 1. Risk refers to a. your willingness to investing in high return assets. b. the possibility of losing money. c. the chance that an asset will increase in value faster than inflation. d. how quickly you can convert an asset to cash. Answer: b; Section 7.1; LO: 7.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Purchasing an asset designed to help you reach a long-term goal is a form of a. savings. b. investing. c. an emergency fund.
d. both savings and an emergency fund. Answer: b; Section 7.1; LO: 7.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. Rick is petrified at the thought of flying. Whenever he thinks about getting on an airplane, he envisions a disaster. Rick’s assessment of the risks associated with flying is most closely associated with his a. subjective risk evaluation. b. aversion to volatility. c. objective risk evaluation. d. business risk evaluation. Answer: a; Section 7.1; LO: 7.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. Which of the following risk-return statements is true? a. Liquidity and return move up and down together. b. Higher returns mean greater risk. c. Lower risks are associated with less liquid assets. d. Higher risk is associated with higher liquidity. Answer: b; Section 7.1; LO: 7.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. A portfolio of securities that is professionally managed is known as a a. stock. b. mutual fund. c. Treasury security. d. commodity. Answer: b; Section 7.1; LO: 7.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
7.2 Explain why an emergency fund is critical for financial well-being. 7.2 Multiple-Choice Questions 1. d. Between 3 and 6 months of expenses. Answer: d; Section 7.2; LO: 7.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. b. 3. Answer: b; Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 2 min; AACSB: A Monetary assets
Solution: Emergency fund ratio = Monthly living expenses Emergency fund ratio =
$7,500 =3 $2,500
3. b. No, because he has only enough in the account to cover 2.5 months of expenses.
Answer: b; Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 2 min; AACSB: A Monetary assets
Solution: Emergency fund ratio = Monthly living expenses Emergency fund ratio =
$4,500 = 2.5 $1,800
4. a. $22,350. Answer: a; Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 2 min; AACSB: A Monetary assets
Solution: Emergency fund ratio = Monthly living expenses Monetary assets needed $3,725 6 × $3,725 = Monetary assets needed = $22,350 6=
5. c. 0.4479. Answer: c; Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: Emergency fund ratio =
Monetary assets Monthly living expenses
Emergency fund ratio =
$4,300 = 0.4479 $9,600
6. a. $10,000. Answer: a; Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: A Solution: A stable income and profession suggests that 3 months of emergency funds are sufficient. Monthly expenses multiplied by 3 months is about $10,000 rounded ($3,300 monthly expenses × 3 months = $9,900). 7. d. Buying Christmas gifts. Answer: d; Section 7.2; LO: 7.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a Solution: The best answer choice is buying Christmas gifts. Because gift giving associated with holidays can be planned many months in advance and separate savings goals can be set up so that it is not an emergency. 8. a. Taking money from your savings account. Answer: a; Section 7.2; LO: 7.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. d. A savings account held at the local bank or an online checking account.
Answer: d; Section 7.2; LO: 7.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
10. d. you may not have access to credit, the means to repay the debt, and it may lead to bigger problems. Answer: d; Section 7.2; LO: 7.2; BT: Ap; Diff: E; TOT: 2 min; AACSB: A
7.2 Adventures in Personal Finance Short Answer 1. Answer: Pros: It reduces the amount of money that needs to be set aside for emergencies. Access to low-interest credit is a good source for a backup emergency source, as it can finance emergencies until savings can be accumulated. Cons: Utilizing the backstop credit will create larger barriers to saving for future emergencies, as the debt needs to be repaid and an emergency fund has to be reestablished. Credit may not be available for other needs. The discipline of saving may not be developed. If the emergency results in reduced free cash flow because debt payments are added to monthly expenses, it may be difficult or impossible to repay the money in a timely manner unless new sources of income are developed. Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 15 min; AACSB: A 2. Answer: Individuals, as we learned from Chapter 2, have many different sources of earnings, depending on the type of profession, experience, rank, and industry. Individuals may have W-4 earnings or 1099 self-employed income. The income source of an individual will most likely have the greatest impact on the commensurate size of an emergency fund. Professionals with salaried earnings will have the most predictable pattern of income, and 3–6 months of an emergency fund is very appropriate. Sales professionals, typically on commissions and self-employed individuals, should have at least a 6-month emergency fund and maybe larger depending on the volatility of their business. Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 15 min; AACSB: A 3. Answer: The best way to build an emergency fund is through regular deposits into a savings account (not a checking account because of easier access to this account). It would be best if these deposits occurred automatically each time you were paid or at set intervals of time, such as the first of each month. Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 15 min; AACSB: n/a
4. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 20 min; AACSB: n/a Explore
1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Answers will vary based on students’ findings. Section 7.2; LO: 7.2; BT: S; Diff: H; TOT: 60 min; AACSB: C, A, RT 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Answers will vary based on students’ findings. Section 7.2; LO: 7.2; BT: S; Diff: H; TOT: 60 min; AACSB: C, A, RT 3. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Answers will vary based on students’ findings. Section 7.2; LO: 7.2; BT: S; Diff: H; TOT: 60 min; AACSB: C, A, RT
7.2 Expanded Learning Activity Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.2; LO: 7.2; BT: An; Diff: H; TOT: 120 min; AACSB: C, A, RT
7.2 Practice Questions 1. Liquidity can be described as a. having access to your money whenever you need it. b. being prepared for unforeseen events. c. having access to affordable credit. d. small amounts of money in a savings account. Answer: a; Section 7.2; LO: 7.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Which of the following is not a common financial emergency? a. Major car repairs. b. Vacation travel. c. Job loss. d. Major medical expenses. Answer: b; Section 7.2; LO: 7.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3
A pure risk is one that results a. only in a financial loss. b. in an outcome that can include a gain or loss. c. in an outcome that has both gains and losses at the same time. d. in a gamble that has equal odds of winning or losing. Answer: a; Section 7.2; LO: 7.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
4
Nell has a steady job earning of $65,000 per year. She has looked at her fixed expenses and other financial obligations and determined that in the event of a major financial emergency she would need to replace approximately $40,000 per year in income. Based on the 3-month emergency fund ratio rule, how much should Nell have in an emergency fund today? a. $10,000. b. $12,500. c. $16,250.
d. $20,000. Answer: a; Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 2 min; AACSB: n/a Solution: Nell’s emergency fund consists of 3 months of expenses. $40,000 annual expenses on a monthly basis are $3,333.33 ($40,000/12 months), and 3 months of expenses are $10,000 ($3,333.33 × 3) 5
Which of the following would be an appropriate tool, if necessary, for someone who has not yet accumulated any savings and is just starting to build an emergency fund? a. A savings account. b. Credit cards. c. Collectible coins. d. A savings account and/or credit card. Answer: b; Section 7.2; LO: 7.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
7.3 Identify the use and benefits of savings accounts, money market savings accounts, and certificates of deposits. 7.3 Multiple-Choice Questions 1. c. the opportunity cost. Answer: c; Section 7.3; LO: 7.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 2. c. Automatically have money deposited into a restricted account each month. Answer: c; Section 7.3; LO: 7.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. a. consider how other people you love would be affected if you could not pay for an emergency. Answer: a; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. a. visualizing where you want to be in the future. Answer: a; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. d. Loss of interest, possible theft, and/or no protection against impulse purchases. Answer: d; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 6. b. money market savings account. Answer: b; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 7. d. Dedicated savings account. Answer: d; Section 7.3; LO: 7.3; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: They already have $5,000 in a savings account that represents 10 months of savings ($500/month savings). Since they have enough liquidity, they should seek to earn a higher return in an equally safe (FDIC deposit) but less liquid access, such as the dedicated savings account.
8. c. certificate of deposit. Answer: c; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. a. money market savings account. Answer: a; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 10. c. The money is earning a higher rate of return than a savings account. Answer: c; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
7.3 Adventures in Personal Finance Short Answer 1. Answer: a—3, b—5, c—6, d—4, e—1, f—2 Solution: a. Opportunity cost b. Money market account
c. National Credit Union Insurance Fund
d. Certificate of deposit
3. The foregone benefit that you would get from doing the next best thing. 5. An account that pays higher interest rates than a savings account, with a restricted number of monthly withdrawals. 6. Insures deposit accounts at credit unions against loss if the credit union becomes insolvent. 4. A savings account that restricts withdrawals from the account until a specific date; in exchange, the depositor receives a higher interest rate.
e. Federal Deposit Insurance Corporation
1. Insures deposit accounts at banks against loss if the bank becomes insolvent. f. Savings account 2. An interest-bearing account providing depositors a safe and secure place for money. Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 10 min; AACSB: n/a 2. Answer: If the bank were to go bankrupt, Scotty will receive $250,000 from the FDIC. Solution: Scotty has $255,000 in deposits at the bank ($100,000 in a savings account, $85,000 in a 3-year CD, $30,000 in a money market account, and $40,000 in a 5-year CD). FDIC insurance covers up to $250,000 per account holder. As such, he will receive $250,000. This means that he may lose $5,000. Section 7.3; LO: 7.3; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual.
Section 7.3; LO: 7.3; BT: An; Diff: M; TOT: 45 min; AACSB: A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.3; LO: 7.3; BT: An; Diff: M; TOT: 20 min; AACSB: A 3. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.3; LO: 7.3; BT: An; Diff: M; TOT: 20 min; AACSB: A 4. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.3; LO: 7.3; BT: S; Diff: H; TOT: 60 min; AACSB: C, A 7.3 Expanded Learning Activity Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.3; LO: 7.3; BT: C; Diff: M; TOT: 75 min; AACSB: C, A
7.3 Practice Questions 1. An effective way to manage temptation and impulse spending involves a. managing your environment. b. going on a diet. c. always looking for an opportunity to spend savings on something else. d. being as flexible as possible with the way you save money. Answer: a; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. When someone says that he or she purchased something but could have bought something else, he or she is referring to a. the temptation to spend on impulse. b. the opportunity cost of their purchase. c. the management of their environment. d. his or her intention to save. Answer: b; Section 7.3; LO: 7.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. Which of the following bank products provides high liquidity with a limited ability to make penaltyfree withdrawals? a. Savings account. b. Money market savings account. c. Certificate of deposit. d. Dedicated savings account. Answer: b; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. If you withdraw money from a CD prior to maturity, what can happen?
a. b. c. d.
You can be penalized through the lost interest earned. You can lose a portion of your original investment. You can roll over the money penalty free into a money market savings account. You can lose access to other banking products, including low-interest loans and advanced savings products. Answer: a; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Which of the following bank products are insured by FDIC? I. Savings account. II. Certificate of deposit. III. Dedicated savings account. a. I only. b. II only. c. I and II only. d. I, II, and III. Answer: d; Section 7.3; LO: 7.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 7.4 Explain how a Roth IRA provides savings and tax benefits. 7.4 Multiple-Choice Questions 1. a. contributions to a Roth IRA are made with pretax dollars. Answer: a; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. d. Earnings within an account are not taxed as income until the earnings are withdrawn from the account, which could be many years after the earnings were first credited to the account. Answer: d; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. d. set money aside for emergencies, reduce the opportunity costs of an emergency fund, and receive potential tax-free growth. Answer: d; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. b. investment earnings receive unique tax treatment. Answer: b; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. b. $5,500. Answer: b; Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: A Solution: James can withdraw the principal at any time without penalty. He funded the Roth IRA with $5,500. Any amount in excess of his principal ($5,500) will be assessed a 10% penalty and subject to ordinary income tax if withdrawn within 5 years of opening the Roth IRA and prior to reaching age 59½. 6. a. Today.
Answer: a; Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Lannie can withdraw her principal at any time without penalty. Since Lannie is withdrawing her “contribution,” it is solely principal. 7. d. when you reach 59½ years of age and the Roth IRA has been open for at least 5 years. Answer: d; Section 7.4; LO: 7.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. a. they are appropriate accounts to hold emergency funds. Answer: a; Section 7.4; LO: 7.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. d. Bank, credit union, and/or mutual fund companies. Answer: d; Section 7.4; LO: 7.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. c. Nelda who is still in college and has a part-time job as a sales clerk. Answer: c; Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: You must have earned income that is equal to or greater than the amount you contribute to the Roth IRA. (A nonworking spouse may use the earned income of the working spouse to open an IRA.) Only Nelda has earned income (“part-time job as sales clerk”). Lamar’s scholarship is not earned income. Mary is retired and taking distributions from her account, and Shelby is only receiving interest income; both are forms of unearned income.
7.4 Adventures in Personal Finance Short Answer 1. Answer: Advantages associated with establishing an emergency fund using a savings account include the following: • They are insured against loss by the federal government (FDIC). • They are highly liquid accounts. • They are easy to access and manage. Disadvantages include the following: • The interest rate is very low. • There are no investment options with a savings account, just the one way to earn interest on the account. Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 20 min; AACSB: A
2.
Answer: Roth IRAs minimize the opportunity cost associated with traditional savings accounts. You can still put money into an insured savings account within Roth IRAs, but the interest earned will be tax-free and will help you save for retirement. Additionally,
other low risk, but higher yielding investments, can also be purchased with Roth IRAs. These can generate a higher return to help you reach future goals, and your principal (contributions to the account) is still available to be withdrawn from the Roth IRA without penalty or tax at any time. Additionally, Roth IRAs are separate accounts typically established at an investment company. The funds are not accessible through an ATM but are easily accessed if necessary. These small barriers to access funds help reduce the temptation to pull money out of a Roth IRA for nonemergency expenditures. Roth IRAs provide accessibility combined with tax-deferral. Section 7.4; LO: 7.4; BT: An; Diff: M; TOT: 20 min; AACSB: A 3.
Answer: If you never use your Roth IRA for emergencies, and you wait to withdraw the interest earned in the account until you reach 59½ years of age, then all of the account earnings will be tax-free. Additionally, you will have never paid tax on the interests, dividends, or gains as it accumulated in the account because it grew tax-deferred. Section 7.4; LO: 7.4; BT: C; Diff: E; TOT: 5 min; AACSB: n/a 4.
Answer: Pros: If insured accounts are preferred within the Roth IRA, CDs provide the highest insured rates of return. A CD provides another barrier to accessing the money for nonemergency use. Cons: A CD limits liquidity in the event of an emergency (small interest penalty). Higher rates of return can be earned by using different investments that are uninsured but relatively at a higher risk.
Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 20 min; AACSB: n/a Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.4; LO: 7.4; BT: K; Diff: M; TOT: 20 min; AACSB: C, A, RT 2. Answer: a. He can withdraw up to $3,600 in his Roth IRA without penalty or tax since it represents all his contributions ($100 per month for 36 months). b. John could use a credit card, and if he can’t pay the balance within the billing period, he will have essentially obtained a short-term loan from the bank. He could also approach a family member or friend for a short-term loan. Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 20 min; AACSB: A 3. Answer: a. Their cash holdings are insufficient for an emergency. b. The traditional IRA and 401(k) are not efficient for use in an emergency. Their $500 per month savings rate seems adequate (without knowing what their budget looks like). The 401(k) should be left alone; however, the $500/month contribution to their traditional IRA should be directed toward a Roth IRA. Although the Roth IRA doesn’t receive a current income tax benefit, the potential tax penalty and reversal of the tax deduction from a distribution of the traditional IRA will be larger than the initial pretax contribution benefit. All distributions of Roth IRA contributions are penalty-free. Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 15 min; AACSB: A
7.4 Expanded Learning Activity Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.4; LO: 7.4; BT: Ap; Diff: M; TOT: 40 min; AACSB: n/a 7.4 Practice Questions 1. You can make tax-free withdrawals from Roth IRAs a. when you withdraw your principal. b. when you withdraw your principal or after reaching age 59½ and the account has been open for 5 years. c. after reaching age 59½. d. after the account has been open for 5 years. Answer: b; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. The cost of going without an emergency fund can be a. a minor inconvenience. b. catastrophic. c. significant. d. a nonissue. Answer: b; Section 7.4; LO: 7.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. Traditional IRAs provide for a. pretax contributions. b. tax-free distributions. c. taxable distributions. d. pretax contributions and taxable distributions. Answer: d; Section 7.4; LO: 7.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. A Roth IRA can be established at a(n) a. investment company. b. credit union. c. bank. d. credit union, a bank, and/or an investment company. Answer: d; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Roth IRAs were created by a. investment companies. b. mutual fund companies. c. Congress. d. presidential executive order. Answer: c; Section 7.4; LO: 7.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
7.5 Describe the benefits and limitations of U.S. savings bonds. 7.5 Multiple-Choice Questions 1. a. Interest earned is always received on a tax-free basis at the federal level. Answer: a; Section 7.5; LO: 7.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. b. Interest on I bonds and EE bonds is taxed by the federal government when the bonds are redeemed. Answer: b; Section 7.5; LO: 7.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. b. $24. Answer: b; Section 7.5; LO: 7.5; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: Mike has $200 of interest income (sold @ $300 less purchase @ $100). Because the interest income is from U.S. savings bonds, the interest is not taxable at the state level. The federal tax is $24 ($200 interest × 0.12 federal tax rate). 4. c. Because he is younger than age 24, he will need to pay taxes on the interest earned when the bonds are redeemed. Answer: c; Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Tax on the interest earned from Series EE and I bonds can be avoided altogether if the proceeds from the redemption of the bonds are used to pay tuition and fees for college. So long as the taxpayer’s adjusted gross income (AGI) is below a certain level, no tax needs to be paid. There are two important caveats: (a) If the bonds are being used to fund a child’s education, the bonds cannot be owned by the child. This is a strange rule, but it means that if a student’s parent, guardian, or relative owns the bond, cashes it in, and then uses the money to help the student, neither the student nor the original bondholder will owe tax. (b) Students using the bonds for their own education must be at least 24 years old when the bonds are issued. 5. d. $0. Answer: d; Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: U.S. savings bond interest is reported when the bonds are redeemed; thus, interest accruing to the bond each year is not taxed. 6. b. $10. Answer: b; Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: The penalty for redeeming the bond within 5 years of purchase is the loss of 3 months’ interest. Annual interest rate is 2%, so the monthly rate is 0.16667%. Therefore, 3 months of interest would be 0.5% (0.005 × $2,000 value) or $10. 7. b. III only. Answer: b; Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: You can use your federal income tax refund to automatically purchase Series I bonds (minimum investment is $50). The process is as follows: (1) use Form 8888 when you file your federal tax return and (2) you will receive the actual paper Series I bonds in the mail 4–6 weeks after
filing your tax return.
8. b. $1,049. Answer: b; Section 7.5; LO: 7.5; BT: An; Diff: M; TOT: 2 min; AACSB: A Solution: The future value of the $500 Series EE bond 30 years from now at 2.5% APY is $1,049. When using a financial calculator or Excel spreadsheet TVM function, either the PV or the FV must be expressed as a negative number representing a cash outflow, typically an initial investment. Financial Calculator I (2.5); N (30); PV (−500); CPT FV (1,048.78) Excel Spreadsheet =FV(rate, nper, 0, pv) =FV(0.025, 30, 0, −500) => $1,048.78 TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM.
TVM Formula The future value of a lump-sum formula: FV = PV (1 + i)n FV = $500 (1 + 0.025)30 FV = $500 (2.09757) FV = $1,048.78 9. c. 22 years is closest answer choice. Answer: c; Section 7.5; LO: 7.5; BT: An; Diff: E; TOT: 2 min; AACSB: A Solution: Solve for N of a $100 current bond value and a $200 future value @ 3.3% APY. When using a financial calculator or Excel spreadsheet TVM function, either the PV or the FV must be expressed as a negative number representing a cash outflow, typically an initial investment.
Financial Calculator I (3.3); PV (−100); FV (200); CPT N (21.35) Excel Spreadsheet =NPER(rate, pmt, pv, fv) =NPER(0.033, 0, −100, 200) => 21.35 TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM.
TVM Formula The future value of a lump-sum formula: FV = PV (1 + i)n 200 = 100 (1 + 0.033)n 200 = (1.033)𝑛 100 2 = (1.033)n The next step is to eliminate exponent n. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 2) = n × (natural logarithm 1.033) 0.69315 = 0.03247n 0.69315 = 𝑛 = 21.35 0.03247 Rule of 70 Estimate (Rule 70 is best to use when a variable is less than 4%) 70 Number of years = (APY) 70 = 21.21 years 3.3
10. a. Cash in the bond at a local bank or credit union. Answer: a; Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Before 2012, you could purchase a U.S. savings bond from participating banks or credit unions. This is no longer possible, which helps explain why savings bonds are not as popular as they used to be. Today, there are now basically three ways to buy a U.S. savings bond: (1) directly from the U.S. Treasury Department, (2) directly with your federal income tax return, and (3) through payroll deductions. As such, when you are ready to cash in the bond, you may redeem it in one of two ways: (1) log into your Treasury Direct account and follow the redemption procedure, and (2) mail the paper bonds to the Treasury Securities Sales location in Minneapolis. However, some financial institutions may offer to assist in redeeming older savings bonds (i.e., Series E and H), as well as current Series E bonds as a courtesy.
7.5 Adventures in Personal Finance Short Answer 1. Answer: Advantages: no risk of principal loss, interest accrues tax-deferred, state income taxfree, relatively ease of purchase and redemption, and potentially tax-free distribution if used for education. Disadvantages: relatively low return (Series EE bonds may not exceed the rate of inflation), limited flexibility relative to securities, and significant opportunity cost compared with other investments. Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 5 min; AACSB: n/a 2. Answer: No. Solution: Series EE bonds cease paying interest at 30 years. For an investor to double his or her investment before the bond stops earning interest, the rate on the Series EE bond must be at least
2.34%. You can either estimate the APY required to double your money with the Rule of 70 (if rates <4%) or Rule of 72 (if rates >4%), or you can calculate the APY using TVM methods with any PV and FV doubling (i.e., $100–$200). Thus, any interest rate <2.34% will NOT allow the investor to double his or her money, where any interest rate >2.34% will allow at least a 100% return at some point before 30 years. When using a financial calculator or Excel spreadsheet TVM function, either the PV or the FV must be expressed as a negative number representing a cash outflow, typically an initial investment. Financial Calculator N (30); PV (−100); FV (200); CPT I (2.34) Excel Spreadsheet =RATE(nper, pmt, pv, fv) => =RATE(30, 0, −100, 200) => 2.34 TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM. TVM Formula 1
𝐹𝑉 𝑛 𝑖 =( ) −1 𝑃𝑉 1
$200 30
𝑖 = ($100) − 1 = 0.0234 ~ 2.34%
Rule of 70 Estimate (Rule 70 is best to use when a variable is less than 4%) 70 APY = ( ) Number of years 70 APY = = 2.33% 30
Section 7.5; LO: 7.5; BT: An; Diff: M; TOT: 8 min; AACSB: A 3. Answer: While the yield on savings bonds is relatively low, these investments do provide a very safe place to hold money that is earmarked for a specific goal over 5 years. There is no possibility of losing money with a savings bond. Savings bonds allow individuals to own U.S. government bonds without the typical minimum ($1,000 face value), transaction costs (broker/dealer fees), volatility of bond prices (potential to sell U.S. Treasury bonds and notes at a loss prior to maturity), and price fluctuations as interest rates change. Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 10 min; AACSB: A 4. Answer: Please refer to the sample writing assignment rubric in the solutions manual.
Section 7.5; LO: 7.5; BT: An; Diff: M; TOT: 15 min; AACSB: A, RT Solution: Benefit of a Series I bond is that the total return of the bond includes adjustment for inflation (as calculated by the CPI). If inflation is higher over an extended period of time, then the return on the bond would also be higher, thus protecting your purchasing power. However, during periods of low inflation, the bond return would be lower. EE savings bonds earn a fixed rate of return; this is a positive attribute during periods of falling interest rates, often associated with lower levels of inflation; however, a fixed interest rate is less attractive during periods of rising inflation, often associated with rising interest rates. Explore 1. Answer: As of April 2018, new Series EE bonds had a 0.10% fixed interest rate, and new Series I bonds had a 2.58% variable interest rate. Section 7.5; LO: 7.5; BT: Ap; Diff: E; TOT: 10 min; AACSB: n/a 2. Answer: Bonds must be registered in the parents’ name to claim the exclusion. Bonds can be registered in the child’s name, but the exclusion only applies if the child was over 24 when they bought the bonds. If bonds are registered in the child’s name, no exclusion applies, but the interest will be taxed at the child’s tax rate. Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 15 min; AACSB: A
7.5 Expanded Learning Activity Answer: Series EE savings bonds had an average yield of 1.34% over the period. Series I bonds provided a yield of 0.56%. The reason why the Series I bond yield was so low was that inflation was also very low during the period. In the future, if inflation were to increase to historical rates, then investors should expect yields for Series I bonds to be greater than Series EE bond yields. Section 7.5; LO: 7.5; BT: Ap; Diff: M; TOT: 20 min; AACSB: A 7.5 Practice Questions 1. Which of the following benefits do U.S. savings bonds provide? a. are very safe. b. are tax-advantaged. c. do not require a bank account. d. are very safe, are tax-advantaged, and do not require a bank account. Answer: d; Section 7.5; LO: 7.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Jerry is thinking about buying a U.S. savings bond. What is the minimum investment that he needs to make if he opens a Treasury Direct account and purchases the bond online? a. $1. b. $25. c. $50. d. $100.
Answer: b; Section 7.5; LO: 7.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. For which of the following savings goals would a U.S. savings bond be most useful? a. Starting an emergency fund. b. Building a child’s college education fund. c. Funding a short-term goal. d. Both starting an emergency fund and funding a short-term goal. Answer: b; Section 7.5; LO: 7.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. Graham would prefer to own a U.S. savings bond directly, rather than through an account with Treasury Direct. What method should he use to make the purchase? a. Through a payroll deduction. b. Directly through a bank. c. Using Form 8888 when he files his federal income tax return. d. Either through a payroll deduction or using Form 8888 when he files his federal income tax return. Answer: c; Section 7.5; LO: 7.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Who should consider buying an I bond today? a. Someone who thinks inflation will be lower in the future. b. Someone who believes yields on EE bonds will be greater than the yield on I bonds in the future. c. Someone who believes that inflation will remain at approximately 1% over the next 15– 30 years. d. Someone who thinks inflation will be higher in the future. Answer: d; Section 7.5; LO: 7.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
7.6 Discuss the different types of custodial and beneficiary accounts and their appropriate uses. 7.6 Multiple-Choice Questions 1. a. Minors cannot legally contract. Answer: a; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. a. custodial accounts represent a way parents can indefinitely control money they give to children. Answer: a; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. c. II and III only. Answer: c; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. d. I, II, and III.
Answer: d; Section 7.6; LO: 7.6; BT: K; Diff: M; TOT: 2 min; AACSB: n/a 5. b. UTMA. Answer: b; Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Assets can be owned by a minor using the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) custodial account, depending on individual state laws. UGMAs are used for bank accounts, investments, and insurance policies. UTMAs can be used to hold any type of property, including real estate. 6. c. the tax rate on the investment earnings could be as low as 0%. Answer: c; Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Earnings from investments in UGMA and UTMA accounts are taxable in the year earned. The minor who owns the account is responsible for paying the tax on those earnings. (In some cases, the child may be very young and obviously the parents will be responsible for filing the child’s tax return to report the earnings.) Unearned income of less than $2,100 (2018, adjusted annually for inflation) from dividends or long-term capital gains are taxed the special rate of 0%. 7. d. begin saving for retirement prior to reaching age 16, invest in long-term assets, and/or invest in bank CDs. Answer: d; Section 7.6; LO: 7.6; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. d. It offers tax-deferred growth on investment earnings, allows minors to build long-term savings, and/or gives minors control of assets in the IRA once they reach the age of majority. Answer: d; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. d. establish a 529 plan to maintain control of the funds gifted. Answer: d; Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: A 529 plan offers tax-deferred growth on interest and earnings in the plan. Distributions from 529 plans used for qualified higher education expenses are also tax-free. Additionally, the parent maintains ownership of the account and the child is simply the beneficiary of the account. The owner (parent) can change the beneficiary (child) at any time, so if the child chooses not to attend college, the money is not irrevocably given to the child, but rather the beneficiary can be changed to a different family member. These tax and ownership benefits are not available with regular custodial accounts. 10. d. A Qualified Tuition Plan. Answer: d; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
7.6 Adventures in Personal Finance Short Answer
1. Answer: Many transfers to minors are given with the intent of providing financial support for a child’s college education. However, with an UGMA or UTMA account, if the child decides not to attend college, he or she still gets the money to use for whatever purpose he or she chooses. To address this risk, at least from a parent’s point of view, and to encourage parents and other family members to save for a child’s education, Congress passed legislation introducing college savings plans. A 529 plan offers tax-deferred growth on interest and earnings in the plan. Distributions from 529 plans used for qualified higher education expenses are also tax-free. Additionally, the parent maintains ownership of the account and the child is simply the beneficiary of the account. The owner (parent) can change the beneficiary (child) at any time, so if the child chooses not to attend college, the money is not irrevocably given to the child, but rather the beneficiary can be changed to a different family member. These tax and ownership benefits are not available with regular custodial accounts. Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 15 min; AACSB: A 2. Answer: Financial institutions, such as banks and brokerages, are reluctant to open accounts for those who are considered a minor. The reason is because a minor is generally exempt from binding clauses in contracts; thus, lenders have no recourse. This means that anyone who has yet to reach the age of majority (18 years in most cases) can change his or her mind on a transaction or trade after the deal is done, despite signing a contract. Hence, financial institutions are very averse to doing business in any significant manner with minors. Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 5 min; AACSB: A 3. Answer: A minor who owns an account is responsible for paying the tax on those earnings. (In some cases, the child may be very young, and obviously the parents will be responsible for filing the child’s tax return to report the earnings.) Unearned income of less than $2,100 (kiddie tax hurdle in 2018, adjusted annually for inflation) from dividends or long-term capital gains are taxed the special rate of 0%. Any unearned income above $2,100 is assessed for the parent’s marginal tax rate. The IRS enforces the kiddie tax rule to make sure parents are not trying to avoid their higher income tax rates on unearned income. Hence, parents should look to build assets to the child in different ways (i.e., 529 plans) or transfer to the child different types of assets which do not generate current income but rather simply appreciate in value over time. Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 20 min; AACSB: A Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.6; LO: 7.6; BT: Ap; Diff: H; TOT: 120 min; AACSB: C, A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.6; LO: 7.6; BT: Ap; Diff: M; TOT: 20 min; AACSB: RT 7.6 Expanded Learning Activity Answer: •
Donor: An individual who transfers money or property to a custodian on behalf of a minor.
• •
• • • •
Custodian: An adult designated by nomination to receive, maintain, and manage custodial property on behalf of a minor beneficiary. Custodial property: Any interest in property transferred to a custodian on behalf of a minor beneficiary under the UTMA, including any income or proceeds resulting from that transferred property. Minor: An individual who has not yet attained the legal age of majority as established by state law. Adult: An individual who has attained the legal age of majority as established by state law. Transfer: A transaction that creates custodial property. Irrevocable transfer: A transfer in which the donor relinquishes all control of the custodial property and retains no legal authority to revoke his or her release of the custodial property.
Source: https://secure.ssa.gov/poms.nsf/lnx/0501120205 Section 7.6; LO: 7.6; BT: Ap; Diff: H; TOT: 30 min; AACSB: A
7.6 Practice Questions 1. An emancipated minor may I. buy property. II. sell property. III. not open a financial account until he or she turns 21years old. a. I only. b. III only. c. I and II only. d. II and III only. Answer: c; Section 7.6; LO: 7.6; BT: K; Diff: M; TOT: 2 min; AACSB: n/a 2. Which type of account can hold any type of investment or real estate property? a. UTMA. b. UGMA. c. 529 plan. d. Either UTMA or UGMA. Answer: a; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. If a parent establishes a UGMA or UTMA to fund their child’s college education and the child—now age 22—decides to forgo college, the parent can do what to ensure that the child does not use the money in the account for an unwise purchase? a. Change the beneficiary to someone else. b. Use the funds to open a Roth IRA. c. Pay the child’s own higher education costs. d. Nothing, because the child is legally entitled to the assets held in the account. Answer: d; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
4. Up to what amount, the kiddie tax rules, partially or fully, shelter income on custodial accounts for the 2018 tax year? a. $1,050. b. $2,500. c. $2,100. d. $1,500. Answer: c; Section 7.6; LO: 7.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Which of the following types of accounts could be subject to taxation? a. UTMA. b. 529 plans. c. Qualified Tuition Programs. d. UTMA, 529 plan, and/or Qualified Tuition Program. Answer: d; Section 7.6; LO: 7.6; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 7.7 Recognize financial frauds and the strategies to protect against them. 7.7 Multiple-Choice Questions 1. c. Fraud. Answer: c; Section 7.7; LO: 7.7; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. b. Ponzi scheme. Answer: b; Section 7.7; LO: 7.7; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. a. Hearing an investment advisor claim that he or she has consistently earned 15% annually for his or her clients over the past 10 years. Answer: a; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. c. pyramid scheme. Answer: c; Section 7.7; LO: 7.7; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
5. c. II and III only. Answer: c; Section 7.7; LO: 7.7; BT: C; Diff: M; TOT: 2 min; AACSB: n/a 6. d. never pay anything to receive a free prize and never give your credit card number out over the phone unless you initiated the phone call. Answer: d; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
7. b. The occurrence of identity theft has decreased dramatically since it was designated as a federal crime. Answer: b; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. d. Never use credit cards online since nearly all identity theft occurs online. Answer: d; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. d. I, II, and III. Answer: d; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. c. credit freeze; new accounts. Answer: c; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
7.7 Adventures in Personal Finance Short Answer 1. Answer: It will take about 9 cycles. After the 9th cycle, the 350 million population will cause the Ponzi scheme to break. Solution: Start with 7 individuals, and then multiply every new “recruit” by 7 (each “new recruit”) recruiting 7 more, and so on. 0 7 (original individuals). 1 Each individual “recruits” 7 more individuals (7 × 7) = 49 individuals. 2 Each individual “recruits” 7 more individuals (49 × 7) = 343 individuals. 3 Each individual “recruits” 7 more individuals (343 × 7) = 2,401 individuals. 4 Each individual “recruits” 7 more individuals (2,401 × 7) = 16,807 individuals. 5 Each individual “recruits” 7 more individuals (16,807 × 7) = 17,649 individuals. 6 Each individual “recruits” 7 more individuals (117,649 × 7) = 823,543 individuals. 7 Each individual “recruits” 7 more individuals (823,543 × 7) = 5,764,801 individuals. 8 Each individual “recruits” 7 more individuals (5,764,801 × 7) = 40,353,607 individuals. 9 Each individual “recruits” 7 more individuals (40,353,607 × 7) = 282,475,249 individuals. 10 Each individual “recruits” 7 more individuals (282,475,249 × 7) = 1,977,326,743 individuals. Section 7.7; LO: 7.7; BT: Ap; Diff: M; TOT: 15 min; AACSB: A 2. Answer: There are numerous reasons, but some of the most common are greed (“deal” too good to pass up), the desire to fit in (“keeping up with the Jones”), the fear of losing out on an opportunity (behavioral finance), and sympathy for or attracted to the person committing the fraud (deception). Section 7.7; LO: 7.7; BT: Ap; Diff: M; TOT: 5 min; AACSB: n/a 3. Answer: Freeze your credit with the major credit rating agencies. This will keep any source from pulling your credit report or score.
Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 15 min; AACSB: n/a 4. Answer: Each of these statements indicates that the offer may be fraudulent. Section 7.7; LO: 7.7; BT: Ap; Diff: E; TOT: 5 min; AACSB: n/a Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section 7.7; LO: 7.7; BT: Ap; Diff: H; TOT: 60 min; AACSB: C 2. Answer: High-quality papers should discuss key issues those over age 65 face in relation to financial scams, rip-offs, and fraud, and include tips, tools, and techniques that seniors can use to avoid being a victim of a financial crime. Please refer to the sample writing assignment rubric in the solutions manual. Section 7.7; LO: 7.7; BT: Ap; Diff: H; TOT: 75 min; AACSB: C, E 3. Answer: High-quality papers should discuss why and how Charles Ponzi enacted his fraudulent scheme and include references. Please refer to the sample writing assignment rubric in the solutions manual. Section 7.7; LO: 7.7; BT: Ap; Diff: M; TOT: 60 min; AACSB: C, E 7.7 Expanded Learning Activity Answer: High-quality papers should discuss current IRS-related scams and also discuss how the IRS does contact individuals if there is a problem with the tax return. Please refer to the sample writing assignment rubric in the solutions manual. Section 7.7; LO: 7.7; BT: Ap; Diff: M; TOT: 75 min; AACSB: C, E
7.7 Practice Questions 1. Bernie Madoff ran the world’s largest a. telemarketing fraud. b. pyramid scheme. c. Ponzi scheme. d. identity theft ring. Answer: c; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 2. A Ponzi scheme represents a. inflation risk. b. business risk. c. fraud risk. d. identity risk. Answer: c; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. Which of the following is a warning sign of fraud? a. An unsolicited phone call asking for personal information. b. A promise of high investment return with very low risk.
c. A limited time offer that must be purchased now. d. An unsolicited phone call asking for personal information, promises of high returns with very low risk, and/or limited time offers that must be purchased now. Answer: d; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. If you become a victim of identity theft, you should report the crime to a. the FBI. b. the FDIC. c. your local police or sheriff department. d. the chairperson of the local city commission. Answer: c; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. Tammy is going on a 2-week vacation overseas. She is planning on taking two credit cards and has notified her credit card issuers that she will be traveling with those credit cards. What should she do with her other credit cards while she is gone? a. Keep them in a safe deposit box. b. Give them to her neighbor for safe keeping. c. Cancel the cards. d. Be preemptive and report the cards stolen. Answer: a; Section 7.7; LO: 7.7; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
Chapter 7 End-of-Chapter Summary Assessment Continuing Case: Tarek’s Financial Journey a. Answer: They have a projected surplus of $125 per month. Solution: $6,740 total income − $6,615 total expenses = $125 surplus LO: 2.5; BT: An; Diff: M; TOT: 5 min; AACSB: A
b. Answer: Their net worth position is $7,550. Solution: $95,050 assets − $87,500 liabilities = $7,550 net worth LO: 2.4; BT: An; Diff: M; TOT: 10 min; AACSB: A c. Answer: 1. Current ratio is 0.32 or 32%, which is below the benchmark of 1.0. 2. Debt ratio is 0.92, which is above the recommended benchmark of 0.40. 3. Combined savings ratio is 4%, which is below the minimum recommended guideline of 10%. Solution: 1. Current assets = $800 checking + $3,300 savings = $4,100 Current liabilities = $13,000 credit cards Current ratio = Current assets/Current liabilities $4,100 current assets/$13,000 current liabilities = 0.3154 ~ 31.54% 2. Total debt (liabilities) = $87,500 Total assets = $95,050 Debt ratio = Total debt (liabilities)/Total assets $87,500/$95,050 = 0.9206 ~ 92.06%
3. Savings ratio = Savings/Total income $266 retirement savings/$6,740 total income = 0.0394 ~ 3.94% LO: 2.4, 2.5, 2.6; BT: An; Diff: M; TOT: 10 min; AACSB: A d. Answer: Based on the emergency fund need assumptions, their emergency fund savings ratio is 0.99. Solution: Monetary assets Emergency fund ratio = Monthly living expenses Monetary assets = $800 checking + $3,300 savings = $4,100 Monthly required living expenses = $850 rent + $420 vehicle insurance + $450 food + $790 car + 783 student loan payment + $200 household + $650 credit cards = $4,143 $4,100 Emergency fund ratio = = 0.9896 ~ 99% $4,143 If income has been lost, then taxes will be eliminated; additionally, sports and hobbies, retirement savings, and vacations are not required expenses. Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 5 min; AACSB: A e. Answer: At a minimum, the ratio should be 3.0 or 3 months of living expenses. In their case, they have enough savings to cover one month of living expenses. This is below the benchmark. As a couple, they should focus on efforts to increase monetary assets to increase their immediate emergency funds. Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 15 min; AACSB: A f.
Answer: Until they reach at least 3 months of living expenses, they should focus on holding monetary assets in insured bank and/or credit union savings accounts. The most liquid assets should be used as immediate emergency funds. Once they reach their 3-month goal, they can begin to use other assets, such as certificates of deposit, U.S. savings bonds, and possibly Roth IRAs, to fund the remainder of their emergency fund. Section 7.2; LO: 7.2; BT: Ap; Diff: M; TOT: 10 min; AACSB: A Calculating the Cost of Life’s Financial Journey 1. Answer: Noel estimates that he needs to replace 45% of his gross income in the event of a severe emergency. His annual gross income is $65,000 and 45% of that is $29,250 ($65,000 × 0.45%). Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 5 min; AACSB: A 2. Answer: Based on his estimate that $29,000 can meet all his necessary annual expenses, Noel’s 6month emergency fund goal is $14,500 ($29,000 annual expenses/2). A 3-month emergency goal would be $7,250 ($29,000/4). Section 7.2; LO: 7.2; BT: An; Diff: M; TOT: 8 min; AACSB: A 3. Answer: It will take nearly 24 months to reach his 3-month emergency fund goal of $7,250 and a little over 46 months to reach his 6-month emergency fund goal of $14,500. Solution: (1) Compute the number of months (N) to reach $7,250 based on $300 monthly savings at 2% APY (0.16667% monthly periodic rate). When using financial calculators and Excel spreadsheet TVM functions, annuity payments are expressed as negative numbers because payments are technically cash outflows, and the FV
represents your aggregate savings. Financial Calculator PMT (−300); I (2/12); FV (7,250); CPT N (23.71) Excel Spreadsheet =NPER(rate, pmt, pv, fv) =NPER(0.00167, −300, 0, 7,250) => 23.71 TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM. TVM Formula 𝑃𝑀𝑇 [(1 + 𝑖)𝑛 − 1] 𝐹𝑉𝐴 = 𝑖 $300 [(1 + 0.00167)𝑛 − 1] $7,250 = 0.00167 $7,250 = $179,640.72 [(1.00167)𝑛 − 1] $7,250 = [(1.00167)𝑛 − 1] $179,640.72 0.04036 = (1.00167)𝑛 − 1 1.04036 = 1.00167n The next step is to eliminate exponent N. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 1.04036) = n × (natural logarithm 1.00167) 0.03957 = 0.00167n 0.03957 = 𝑛 = 23.69 0.00167 (2) Compute the number of months (N) to reach $14,500 based on $300 monthly savings at 2% APY (0.16667% monthly periodic rate). When using financial calculators and Excel spreadsheet TVM functions, annuity payments are expressed as negative numbers because payments are technically cash outflows, and the FV represents your aggregate savings. Financial Calculator PMT (−300); I (2/12); FV (14,500); CPT N (46.52) Excel Spreadsheet =NPER(rate, −pmt, pv, fv) =NPER(0.00167, −300, 0, 14,500) => 46.52
TVM Factor Table TVM factor table is not the best choice solution method for this problem. Conventional factor tables (PV/FV of $1) typically use N (periods) in rows of whole numbers and % (rates) in columns of whole numbers. When a problem involves periods in excess of 20, or rates in excess of 15%, or rates in a fractional denomination, the table method would NOT be the most efficient method to calculate the TVM. TVM Formula 𝑃𝑀𝑇 [(1 + 𝑖)𝑛 − 1] 𝐹𝑉𝐴 = 𝑖 $300 [(1 + 0.00167)𝑛 − 1] $14,500 = 0.00167 $14,500 = $179,640.72 [(1.00167)𝑛 − 1] $14,500 = [(1.00167)𝑛 − 1] $179,640.72 0.08072 = (1.00167)𝑛 − 1 1.08072 = 1.00167n The next step is to eliminate exponent n. Take the natural logarithm (ln) of each number, using a calculator, to eliminate the exponent: (natural logarithm 1.08072) = n × (natural logarithm 1.00167) 0.07762 = 0.00167n 0.07762 = 𝑛 = 46.48 0.00167 Section 7.2; LO: 2.3, 7.2; BT: An; Diff: M; TOT: 10 min; AACSB: A 4. Answer: Initially, Noel should focus on using low-risk or high liquidity assets, such as bank savings accounts. Then after building a 3-month emergency fund, the next 3 months of funds can be less liquid and higher yielding, such as CDs, for a total of 6 months of expenses in reserve. Section 7.1; LO: 7.1; BT: S; Diff: H; TOT: 5 min; AACSB: n/a 5. Answer: Although expensive, he could use a credit card to finance expenses in an emergency. Other sources of emergency income include borrowing money from family and friends, selling assets, or obtaining a short-term loan using his assets as collateral. LO: 7.1, 7.3; BT: Ap; Diff: E; TOT: 5 min; AACSB: A
Planning for the Future Answer: High-quality papers should complete and discuss the grid provided to compare online banking alternatives to one or more local banks and/or credit unions and make a recommendation as to where emergency funds should be held. Please refer to the sample writing assignment rubric in the solutions manual. Section 7.3; LO: 7.3; BT: Ap; Diff: M; TOT: 60 min; AACSB: C, A
Chapter 8 – Solutions Manual Investments Introduction to Personal Finance: Beginning Your Financial Journey By John Grable and Lance Palmer
Learning Objectives 8.1 Explain what a stock represents and how it can create wealth. 8.2 Discuss how stocks are traded and valued. 8.3 Describe a bond and how it differs from a stock. 8.4 Identify the benefits and options that mutual funds provide to investors. 8.5 Described the advantages and use of exchange-traded funds compared with mutual funds. 8.6 recognize the opportunities, benefits, and risks of investing internationally. 8.7 Discuss the expected relationships among risk, return, and marketability. 8.8 Describe brokerage accounts and the different types of brokerage firms. 8.9 Explain why some investors prefer to hold and invest their wealth in real estate. 8.10 Identify how supply and demand, spreads, and level of specialization affect the value of alternative investments. 8.11 List ways to protect your investments from losses and frauds. Key to metadata for questions: LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT)
Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes For Instructor: Each writing question will have criteria which is specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criteria will be assessed and the associated points for each level of performance are found in columns 2 – 5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criteria (row) is worth up to 4 pts (column 2).
Rubric: (It is suggested the rubric be shared with the students) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking significant incomplete and detail limited
Answer is realistic / relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
Does not represent realistic or relevant understanding of topic.
Organization/clarity of thought (25% of score)
Well organized
Adequate organization
Limited organization
Poor organization
A clear conclusion Appropriate or recommendation recommendations and is presented that is conclusions are appropriate given reached. the content (25% of score) discussed
25% of points (1 out of 4)
Conclusion or recommendation is Conclusion or No conclusion/ mostly clear and recommendation is recommendation appropriate given incomplete provided the content
Please refer to the sample writing assignment rubric in the solutions manual. Chapter 8 Solutions 8.1 End-of-Topic Assessment 8.1 Multiple-Choice Questions 1.a To raise money for expansion. Answer: a; LO 8.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. $222,000,000. Solution: To determine how much capital is raised, multiply the IPO issue share price by the outstanding shares and then subtract the underwriter’s fee. $22.50 x 10,000,000 = $225,000,000 $3,000,000 = $222,000.000. Answer: d; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A
3.c. $110. Solution: The bid price ($108) indicates how much another investor will pay a current shareholder for stock. The ask price indicates the price an investor will sell stock to another investor. The ask price is always higher than the bid price. In this case, add $2 to the bid price to arrive at $110 ($108 + $2 = $110). Answer: c; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.b. $1.5 million profit. Solution: Net Profit equals sales less expenses or $13,000,000 - $11,500,000 = $1,500,000 Answer: b; LO 8.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 5.d. 75 cents. Solution: First, calculate net profit ($13,000,000 - $11,500,000), which is $1,500,000. Next, divide $1,500,000 by the 2,000,000 million shares to arrive at the earnings per share estimated: $1,500,000/2,000,000 = 75 cents. Answer: d; LO 8.1; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 6.c. I and II only. Answer: c; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.c. She will have a $500 capital gain. Solution: First, determine Nicki’s profit or loss per share: $40 - $35 = $5 profit. Multiply the profit by the number of shares sold to arrive at the amount of the capital gain: $5 x 100 = $500 capital gain. Answer: c; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 8.d. 3.75 percent. Solution: The dividend yield is based on dividing the current dividend ($3.50) by the share price ($93.25). In this case, the dividend yield is $3.50/$93.25 = 3.75%. Answer: d; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 9.b. 4 percent. Solution: The dividend yield is based on dividing the current dividend ($1.00) by the share price ($25.00). In this case, the dividend yield is $1.00/$25.00 = 4.00%.
Answer: b; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 10.d. II and III only. Answer: d; LO 8.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
8.1 Adventures in Personal Finance Short Answer 1. Answer: An investor is someone who is primarily interested in generating investment income through the capital gains. A saver prefers lower risk alternatives that generate interest. LO 8.1; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a 2. Answer: Some business owners are content owning a small business. Others do not generate enough sales to warrant a large expansion. Still others want to maintain total control over their firm LO 8.1; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a 3. Answer: The value of a stock is primarily driven by investors’ expectations of how profitable the company is or is going to be. A firm’s stock may drop dramatically in value if profits are too low or negative. Additionally, changing attitudes and opinions about a company’s future prospects can negatively influence a stock’s price. LO 8.1; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a 4. Answer: Note: numbers for current AAPL quotes will be different. (a) $532.50 (b) $44.15 per share (c) $10.60 (d) 1.99% ($10.60/$532.50) LO 8.1; BT: An; Difficulty: M; TOT: 20 min; AACSB: A
Explore 1. Answer: High quality responses should include how the individual’s wealth was generated, what businesses or other investments they own. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.1; BT: Ap; Difficulty: M; TOT: 60 min; AACSB: C
2. Answer: Depending on the year this answer will vary. High quality responses should include the company, line of business, and the home country of the company. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.1; BT: Ap; Difficulty: H; TOT: 75 min; AACSB: C, A 3. Answer: Depending on the year this answer will vary. High quality responses should include the company, line of business, whether the company has a direct stock purchase plan. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.1; BT: Ap; Difficulty: M; TOT: 75 min; AACSB: C, A
8.1 Expanded Learning Activity Answer: High quality responses will include a chart of the stock price, dividend yield, and discussion of each stock. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.1; BT: Ap; Difficulty: M; TOT: 75 min; AACSB: C, A
8.1 Practice Questions 1. When you own stock in a company, you are: a. Entitled to earn interest on your investment. b. Entitled to a share of the firm’s profits. c. Liable for any losses the firm may incur. d. All of these answer choices are correct. Answer: b; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Duncan would like to buy shares in Chevron, which is an oil and gas company that trades on the New York Stock Exchange. What price will he pay when he makes his purchase? a. The ask price. b. The bid price. c. The spread price. d. The yield price. Answer: a; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Who generally makes more money over time? a. Someone who lends money to a business. b. Someone who owns assets that generate a profit. c. Someone who buys stock with a low spread price. d. Someone who obtains the highest dividend yield. Answer: b; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. When can investors begin to buy and sell shares in a new company? a. When the company employs an underwriter. b. After the initial public offering. c. At the initial public offering. d. During the equity conversion offering. Answer: c; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Once a stock trades as an IPO, it moves to: a. The NLSY. b. The public market. c. The third market. d. The NASD Answer: b; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.2 End-of-Topic Assessment 8.2 Multiple-Choice Questions 1.d. All of the choices are correct. Answer: d; LO 8.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Edward Jones. Answer: d; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.a. pay lower commission Answer: a; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.d. I, II, and III. Answer: d; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5.b. Have a lower P/E ratio. Answer: b; LO 8.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 6.c. II and III only. Answer: c; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.c. $4.78 Answer: c; LO 8.2; BT: An; Difficulty: M; TOT: 2 min; AACSB: A Solution: You can use a time value of money calculation to solve for the future value of this dividend. Financial Calculator: PV = -$4.25 (negative cash flow) I/Y = 6 N=2 CPT FV = $4.78. Excel Spreadsheet =FV(rate, nper, pmt, pv) =FV(0.06, 2, 0, -4.25) FV = 4.78 Future Value Formula: 𝐹𝑉 = 𝑃𝑉 (1 + 𝐼)𝑁
𝐹𝑉 = $4.25 (1 + 0.06)2 𝐹𝑉 = $4.25 (1.06)2 𝐹𝑉 = $4.25(1.1236) 𝐹𝑉 = $4.78
8.a. $27.83. Solution: Discounted Dividend Valuation Model: 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × (1 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒) (𝑌𝑜𝑢𝑟 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒)
𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 =
$1.06×(1+0.05) ($1.06)(1.05) $1.1130 = 0.04 = 0.04 = $𝟐𝟕. 𝟖𝟐𝟓 or $27.83 (0.09−0.05)
Answer: a; LO 8.2; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 9.b. $4.58. Solution: Discounted Dividend Valuation Model: 𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × (1 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒) (𝑌𝑜𝑢𝑟 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒)
𝑆𝑡𝑜𝑐𝑘 𝑉𝑎𝑙𝑢𝑒 =
$0.40×(1+0.03) ($0.40)(1.03) $0.4120 = = 0.09 = $4.57778 or $4.58 (0.12−0.03) 0.09
Answer: b; LO 8.2; BT: An; Difficulty: M; TOT: 2 min; AACSB: A
10.d. Sometimes the best investment strategies and the best investments are made by combining basic analysis with intuition. Answer: d; LO 8.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.2 Adventures in Personal Finance Short Answer 1. Answer: Answers will vary based on when the assignment is given. High quality answers will contain the relevant information and comparisons.
LO 8.2; BT: An; Difficulty: M; TOT: 10 min; AACSB: A 2. Answer: Because Tesla has no current earnings, it has no P/E ratio (at the time of writing this). The reason investors are buying shares is that they believe Tesla will eventually begin making money, at which point the value of Tesla shares will rise. LO 8.2; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 3. Answer: Many rapidly growing companies do not pay dividends because they can generate a higher rate of return for investors by reinvesting free cash flow back into expanding the business. LO 8.2; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a Explore 1. Answer: High quality responses will include a clear classification of the companies. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.2; BT: An; Difficulty: M; TOT: 10 min; AACSB: A 2. Answer: $24,000; $3,600 Solution: Carroll’s long-term capital gain is $24,000 (500 shares x $48 profit per share). The longterm capital gains tax is $3,600 ($24,000 gain x 0.15 tax rate). The after-tax gain is $20, 400 ($24,000 gain - $3,600) LO 8.2; BT: S; Difficulty: H; TOT: 20 min; AACSB: A 8.2 Expanded Learning Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.2; BT: S; Difficulty: H; TOT: 60 min; AACSB: C, A
8.2 Practice Questions 1. You can gain access to the stock market by: a. Visiting Wall Street in New York City. b. Opening a brokerage account. c. Obtaining a seat at the New York Stock Exchange. d. Establishing your own stock exchange. Answer: b; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. In what ways are full-service brokerage firms and discount brokerage firms the same?
a. b. c. d.
Both may charge commissions. Both provide investors with access to the stock exchanges in the U. S. Both provide investors with a record of transactions. All of these answer choices are correct.
Answer: d; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. A great way to pick stocks is to: a. Research them using trustworthy, reliable finance websites. b. Select the stocks with the highest price growth in the previous year. c. Follow stocks your friends invest in. d. Use the stock pages in the newspaper and a dart board. Answer: a; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. The discounted dividend valuation model uses: a. An investor’s required return. b. A company’s current dividend. c. A company’s dividend growth rate. d. All of these answer choices are correct. Answer: d; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Researching, selecting, and managing a portfolio of stocks and other investments: a. Is relatively simple and uncomplicated. b. Is not for new investors. c. Can be done in many ways. d. Helps classify different companies. Answer: c; LO 8.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.3 End-of-Topic Assessment 8.3 Multiple-Choice Questions 1.c. I and II only. Answer: c; LO 8.3; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 2.c. $1,000. Solution: Bonds typically return the face value of the bond to the owner of the bond at the time of maturity. In this case, the bond was issued with a face value of $1,000. At the time of maturity, you will receive the $1,000 back.
Answer: c; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 3.a. $60. Solution: The coupon rate (payment) is based on the terms of the bond when issued. In this case, the coupon rate is 6%, thus the coupon payment is $60 ($1,000 x .06). Answer: a; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 4.c. 4.55%; $1,000. Solution: The coupon rate (payment) is based on the par value of the bond when its issued (par value is also known as face value). In this case, the coupon rate is 5%, and thus the coupon payment is $50 ($1,000 x .05). However, Griffin paid $1,100 for the bond, making the current-interest rate earned 4.55% ($50/$1,100). When the bond matures, Griffin will receive the face value of the bond, which is $1,000. Answer: c; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 5.a. Tax-free at the federal level. Answer: a; LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.c. 4.00%. Solution: Equivalent Taxable Bond Interest Rate Formula: 𝑇𝑎𝑥 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =
𝑀𝑢𝑛𝑖𝑐𝑖𝑝𝑎𝑙 𝐵𝑜𝑛𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 1 − 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒
𝑇𝑎𝑥 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =
0.03 1 − 0.25
𝑇𝑎𝑥 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =
0.03 0.75
𝑇𝑎𝑥 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 = 𝟎. 𝟎𝟒 𝑜𝑟 𝟒%
Answer: c; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 7.c. The value of their bonds to decrease. Answer: c; LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.b. $1,000.00. Answer: b; LO 8.3; BT: K; Difficulty: M; TOT: 2 min; AACSB: n/a Solution: In this case, the bond is selling at par value. Calculate the present value of $1,000 bond that matures in 10 years with a $80 coupon, at the current yield of 8% Financial Calculator Inputs: (PV of bond computes as a negative number because it is a negative cash-flow representing a purchase, as compared to positive cash-flow of FV representing a redemption received at maturity and positive coupon payments representing interest payments received periodically) F/V = $1,000 PMT = $80 N = 10 I/Y = 8 CPT PV = -$1,000. Excel Spreadsheet: =PV(rate, nper, pmt, fv) =PV(0.08,10, 80, 1000) (PV expressed as outgoing cash flow because FV and PMT are expressed as receiving cash flow) PV = -1000.00 Excel Solution (a .xls file), and Solution Video are also available showing how to set this problem up as a model in Excel. Combine the PV of the $1,000 bond that matures in 10 years and the PV of the $80 annuity payments of the $1,000 bond over 10 years at the current yield of 8%. TVM Equation
[𝐶𝑜𝑢𝑝𝑜𝑛𝐼 𝑃𝑚𝑡 (1 − (1+𝐼)1 )] $1,000 $80 1 ((1+0.08) ) + [0.08 (1 − (1+0.08) )] = $463.19 + $536.81= $𝟏, 𝟎𝟎𝟎. 𝟎𝟎 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 )+ (1+𝐼)𝑁
PV of Bond = ( 10
𝑁
10
9.a. $932.90. Answer: a; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A Solution: In this case, the bond is selling at less than par value. Calculate the present value of $1,000 bond that matures in 10 years with a $70 annual coupon at the current yield of 8% Financial Calculator Inputs: (PV of bond computes as a negative number because it is a negative cash-flow representing a purchase, as compared to positive cash-flow of FV representing a redemption received at maturity and positive coupon payments representing interest payments received periodically) F/V = $1,000 PMT = $70 N = 10 I/Y = 8 CPT PV = -$932.90.
Excel Spreadsheet: =PV(rate, nper, pmt, fv) =PV(0.08, 10, 70, 1000) PV = -932.90 (PV expressed as outgoing cash flow because FV and PMT are expressed as receiving cash flow) Excel Solution (a .xls file), and Solution Video are also available showing how to set this problem up as a model in Excel. TVM Equation Combine the PV of the $1,000 bond that matures in 10 years and the PV of the $70 annuity payments of the $1,000 bond over 10 years at the current yield of 8%.
[𝐶𝑜𝑢𝑝𝑜𝑛𝐼 𝑃𝑚𝑡 (1 − (1+𝐼)1 )] $1,000 $70 1 ((1+0.08) ) + [ (1 − (1+0.08) )] = $463.19 + $469.71= $𝟗𝟑𝟐. 𝟗𝟎 0.08 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 )+ (1+𝐼)𝑁
PV of Bond = ( 10
𝑁
10
10.c. $1,085.30. Answer: c; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A Solution: Calculate the present value of $1,000 bond that matures in 10 years with a $40 annual coupon at the current yield of 3% Financial Calculator Inputs: (PV of bond computes as a negative number because it is a negative cash-flow representing a purchase, as compared to positive cash-flow of FV representing a redemption received at maturity and positive coupon payments representing interest payments received periodically) F/V = $1,000 PMT = $40 N = 10 I/Y = 3 CPT PV = -$1,085.30. (PV expressed as outgoing cash flow because FV and PMT are expressed as receiving cash flow) Excel Spreadsheet: =PV(rate, nper, pmt, fv) =PV(0.03, 10, 40, 1000) PV = -1085.30 (PV expressed as outgoing cash flow because FV and PMT are expressed as receiving cash flow) Excel Solution (a .xls file), and Solution Video are also available showing how to set this problem up as a model in Excel. TVM Equation
Combine the PV of the $1,000 bond that matures in 10 years and the PV of the $40 annuity payments of the $1,000 bond over 10 years at current yields of 3%. 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 )+ (1+𝐼)𝑁
PV of Bond = (
[𝐶𝑜𝑢𝑝𝑜𝑛𝐼 𝑃𝑚𝑡 (1 − (1+𝐼)1 )] 𝑁
$1,000
PV of Bond = ((1+0.03)10 ) +
$40 1 [0.03 (1 − (1+0.03) )] 10
PV of Bond = = $744.09 + $341.21= $𝟏, 𝟎𝟖𝟓. 𝟑𝟎
8.3 Adventures in Personal Finance Short Answer 1. Answer: A-6, B-7, C-4, D-2, E-3, F-1, G-5. LO 8.3; BT: C; Difficulty: M; TOT: 10 min; AACSB: n/a 2. Answer: A. $50, B. $25. LO 8.3; BT: An; Difficulty: M; TOT: 10 min; AACSB: A Solution: The total annual coupon payment is the coupon rate times the face value (0.05 x $1,000 = $50). The semiannual coupon payment is the coupon rate divided by two times the face value (0.05/2 x $1,000 = 0.025 x $1,000 = $25). 3. Answer: The improved credit score would result in the fair market value of the bonds increasing. Since the coupon rate would be higher than other similarly rated bonds (“AA”) investors would bid up the price of the bond until the effective interest rate earned was decreased to the level of other “AA” rated bonds. LO 8.3; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a Explore 1. Answer: The instructor will need to look up current rates to grade this assignment. LO 8.3; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: n/a 2. Answer: Answer will vary by residence of student and latest publication date of the Census Bureau document. Here is a link to an Excel file containing the 2010 document for state bond ratings: https://www2.census.gov/library/publications/2011/compendia/statab/131ed/tables/12s0445.xls LO 8.3; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: A 3. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.3; BT: An; Difficulty: M; TOT: 60 min; AACSB: C, A, RT
8.3 Expanded Learning Activity Answer: $1,242.67; $1,188.54; $1,137.39; $1,089.04; $1,043.29; $1,000.00; $959.00; $920.15; $883.31; $848.37.
Solution: Calculate the present value of $1,000 bond that matures in 5 years with a 6% coupon rate, at current yields ranging from 1% to 10%. Financial Calculator Inputs (PV of bond computes as a negative number because it is a negative cash-flow representing a purchase, as compared to positive cash-flow of FV representing a redemption received at maturity and positive coupon payments representing interest payments received periodically) FV = $1,000; I/Y = 1; PMT = 60; N = 5; CPT PV = -1,242.67 ~ $1,242.67 FV = $1,000; I/Y = 2; PMT = 60; N = 5; CPT PV = -1,188.54 ~ $1,188.54 FV = $1,000; I/Y = 3; PMT = 60; N = 5; CPT PV = -1,137.39 ~ $1,137.39 FV = $1,000; I/Y = 4; PMT = 60; N = 5; CPT PV = -1,089.04 ~ $1,089.04 FV = $1,000; I/Y = 5; PMT = 60; N = 5; CPT PV = -1,043.29 ~ $1,043.29 FV = $1,000; I/Y = 6; PMT = 60; N = 5; CPT PV = -1,000.00 ~ $1,000.00 FV = $1,000; I/Y = 7; PMT = 60; N = 5; CPT PV = -959.00 ~ $959.00 FV = $1,000; I/Y = 8; PMT = 60; N = 5; CPT PV = -920.15 ~ $920.15 FV = $1,000; I/Y = 9; PMT = 60; N = 5; CPT PV = -883.31 ~ $883.31 FV = $1,000; I/Y = 10; PMT = 60; N = 5; CPT PV = -848.37 ~ $848.37 Excel Spreadseet Excel Macro formula is =PV(rate, nper, pmt, fv) =PV(0.01, 5, 60, 1000) = -1242.67 ~ 1,242.67 =PV(0.02, 5, 60, 1000) = -1188.54 ~ 1,188.54 =PV(0.03, 5, 60, 1000) = -1137.39 ~ 1,137.39 =PV(0.04, 5, 60, 1000) = -1089.04 ~ 1,089.04 =PV(0.05, 5, 60, 1000) = -1043.29 ~ 1,043.29 =PV(0.06, 5, 60, 1000) = -1000.00 ~ 1,000.00 =PV(0.07, 5, 60, 1000) = -959.00 ~ 959.00 =PV(0.08, 5, 60, 1000) = -920.15 ~ 920.15 =PV(0.09, 5, 60, 1000) = -883.31 ~ 883.31 =PV(0.10, 5, 60, 1000) = -848.37 ~ 848.37 Excel Solution (a .xls file), and Solution Video are also available showing how to set this problem up as a model in Excel.
TVM Formula Combine the PV of the $1,000 bond that matures in 5 years and the PV of the $60 annuity payments of the $1,000 bond over 5 years at current yields from 1% to 10%.
[𝐶𝑜𝑢𝑝𝑜𝑛𝐼 𝑃𝑚𝑡 (1 − (1+𝐼)1 )] $1,000 $60 1 ((1+0.01) ) + [0.01 (1 − (1+0.01) )] = $951.47 + $291.21= $𝟏, 𝟐𝟒𝟐. 𝟔𝟖 $1,000 $60 1 ((1+0.02) ) + [0.02 (1 − (1+0.02) )] = $905.73 + $282.81= $𝟏, 𝟏𝟖𝟖. 𝟓𝟑 $1,000 $60 1 ((1+0.03) ) + [0.03 (1 − (1+0.03) )] = $862.61 + $274.78 = $𝟏𝟏𝟑𝟕. 𝟑𝟗 $1,000 $60 1 ((1+0.04) ) + [0.04 (1 − (1+0.04) )] = $821.93 + $267.11= $𝟏, 𝟎𝟖𝟗. 𝟎𝟒 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 )+ (1+𝐼)𝑁
PV of Bond = (
𝑁
5
5
5
5
5
5
5
5
$60 1 [0.05 (1 − (1+0.05) )] = $783.53 + $59.77 = $𝟏, 𝟎𝟒𝟑. 𝟑𝟎 $1,000 $60 1 ((1+0.06) ) + [0.06 (1 − (1+0.06) )] = $747.26 + $252.74 = $𝟏, 𝟎𝟎𝟎. 𝟎𝟎 $1,000 $60 1 ((1+0.07) ) + [0.07 (1 − (1+0.07) )] = $712.99 + $246.01= $𝟗𝟓𝟗. 𝟎𝟎 $1,000 $60 1 ((1+0.08) ) + [0.08 (1 − (1+0.08) )] = $680.58 + $239.56 = $𝟗𝟐𝟎. 𝟏𝟒 $1,000 $60 1 ((1+0.09) ) + [ (1 − (1+0.09) )] = $649.93 + $233.38= $𝟖𝟖𝟑. 𝟑𝟏 0.09 $1,000 $60 1 ((1+0.10) ) + [0.10 (1 − (1+0.10) )] = $620.92 + $227.45= $𝟖𝟒𝟖. 𝟑𝟕 $1,000
((1+0.05)5 ) +
5
5
5
5
5
5
5
5
5
5
5
As interest rates increase, the value of bonds declines, whereas when interest rates decline, bond values increase. LO 8.3; BT: An; Difficulty: M; TOT: 30 min; AACSB: A 8.3 Practice Questions 1. A person who lends money to a corporation is known as: a. A bondholder. b. A shareholder. c. A contractual interest holder. d. A municipal bondholder. Answer: a; LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. When a bond matures the bond issuer typically pays the bondholder $1,000. The $1,000 is known as the: a. Face value. b. Par value. c. Coupon value. d. Both face value and par value. Answer: d; LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. To raise money to build a new school, the city of Akron is considering whether to issue a new bond. This bond is called a: a. Treasury note. b. Municipal bond. c. T-bill. d. AAA Corporate bond. Answer: b; LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. A bond rated BB or below is called a: a. T-bill. b. Marginal security.
c. Junk bond. d. Low-probability bond. Answer: c; LO 8.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Mack owns a bond with a coupon rate of 4%. The market interest rate for bonds of equal quality, risk, and maturity date just increased to 6%. Which of the following aspects of Mack’s bond changed as a result of the change in the market interest rate? a. The bond’s coupon rate. b. The bond’s coupon payment. c. The bond’s face value. d. The bond’s fair market value. Answer: d; LO 8.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 8.4 End-of-Topic Assessment 8.4 Multiple-Choice Questions 1.a. Thousands. Answer: a; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Diversification, professional management, and to pool capital with other investors. Answer: d; LO 8.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3.b. The risk that always remains in a portfolio. Answer: b; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.c. I and III only. Answer: c; LO 8.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.a. Passively managed funds designed to mimic a specific market. Answer: a; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. It consists of a small number of stocks of the largest US companies from a variety of sectors of the economy.
Answer: d; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.d. Dow Jones Industrial Average, Standard & Poor’s 500 Composite Stock Price Index, and Russell 2000 Index are all common stock market indices.
Answer: d; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.a. 0.94 percentage points Answer: a; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.d. A sales load is a one-time commission paid to an investment salesperson when the mutual fund is bought or sold.
Answer: d; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.c. Mutual Fund C with an expense ratio of .07%. Answer: c; LO 8.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A
8.4 Adventures in Personal Finance Short Answer 1. Answer: Mutual fund benefits include being able to pool money with other investors so that a complete portfolio with dozens, and perhaps hundreds or thousands, of different stocks are owned. By investing in a mutual fund, investors also gain access to professional investment management. Without a mutual fund, the cost to invest in a diversified portfolio of stocks and hire a professional investment manager are cost prohibitive for investors just getting started. LO 8.4; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A 2. Answer: Actively managed mutual funds seek to outperform the stock market by choosing to invest in only those securities and strategies that they believe will result in higher gains than the market as a whole; however, in pursuing this objective, actively managed mutual funds incur higher management expenses relative to passively managed mutual funds. Passively managed mutual funds simply seek to replicate the performance of the stock market and can keep costs to a minimum by pursuing this strategy. LO 8.4; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 3. Answer: When comparing different index funds and ETFs, all of which track the same index, the most important fund feature to compare is the expense ratio. However, the liquidity of the ETF is very important. The average trading volume and tracking error are characteristics of the ETF that must be considered when comparing similar ETFs. A large investor or a short-term investor will require high liquidity (very high volume, bid/ask tightness, and tracking correlation to actual index) over cheapest expense ratio.
LO 8.4; BT: Ap; Difficulty: E; TOT: 10 min; AACSB: A Explore 1. Answer: a. The riskiest is the Life Strategy Growth Fund, the least risky is the Life Strategy Income Fund. b. Life Strategy Income Fund: 20% stocks, 80% bonds; Life Strategy Conservative Growth Fund: 40% stocks, 60% bonds; Life Strategy Moderate Growth Fund: 60% stocks, 40% bonds; Life Strategy Growth Fund: 80% stocks, 20% bonds. c. Each Life Strategy Fund invests in four mutual funds. LO 8.4; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.4; BT: An; Difficulty: H; TOT: 60 min; AACSB: C, A 3. Answer: Answers will vary based on when the material is retrieved. LO 8.4; BT: An; Difficulty: M; TOT: 20 min; AACSB: A
8.4 Expanded Learning Answer: High quality responses address parts a), b), and c). Please refer to the sample writing assignment rubric in the solutions manual. LO 8.4; BT: An; Difficulty: H; TOT: 90 min; AACSB: C, A
8.4. Practice Questions 1. A mutual fund is: a. A brokerage firm that gives you access to buying individual stocks. b. A way to invest in stocks or bonds indirectly. c. A strategically managed fund out of reach of the average investor. d. Difficult to invest in. Answer: b; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Which of the following statements about passively managed mutual funds is correct? a. Passively managed mutual funds attempt to earn rates of return higher than the stock market return for a given level of risk. b. Passively managed mutual funds generally have lower fees than actively managed mutual funds. c. Passively managed mutual funds spend a great deal of time investigating individual stocks to determine whether that stock will outperform the market.
d. The mutual fund manager is an important consideration when choosing a passively management mutual fund. Answer: b; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. A mutual fund’s expense ratio is: a. A measure of the total management fees and expenses charged to the mutual fund annually. b. A back-end sales load paid when a mutual fund is sold. c. A one-time commission paid to an investment salesperson when the mutual fund is purchased or sold. d. A measurement of the total management fees and expenses charged to the mutual fund quarterly. Answer: a; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Mutual funds can invest in: a. stocks. b. bonds. c. stocks and bonds. d. stocks, bonds, and other mutual funds. Answer: d; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. A target date fund glide path: a. Is relatively simple and uncomplicated. b. Is the rate and pattern at which the asset allocation shifts from more risk to less risk. c. An asset allocation that is maintained by the fund. d. A predetermined ratio of stocks and bonds within the target date fund. Answer: b; LO 8.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.5 End-of-Topic Assessment 8.5 Multiple-Choice Questions 1.a. II only. Answer: a; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Both diversified portfolio and the ability to buy and sell at any time curing the trading day. Answer: d; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3.c. Many stocks from many industries. Answer: c; LO 8.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.c. Professional active management. Answer: c; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
5.b. Funds can be traded throughout the day. Answer: b; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. Both index mutual funds and exchange-traded funds. Answer: d; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 7.c. Exchange-traded funds Answer: c; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. Buy an actively managed mutual fund. Answer: d; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.d. SPY. Answer: d; LO 8.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 10.a. Index-based ETFs. Answer: a; LO 8.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.5 Adventures in Personal Finance Short Answer 1. Answer: Solution: Portfolio 2 is the most diversified. Although Portfolio 3 holds stock in different firms in different industries, only owning five stocks does not provide enough diversification. Portfolio 1 is not appropriate because it is comprised almost entirely of technology investments. LO 8.5; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 2. Answer: Some of the advantages include diversification, low annual expenses, and a wide variety of investment choices. Disadvantages include the lack of professional management with most ETFs and the inability to outperform the broader market over time. LO 8.5; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a 3. Answer: The actively-managed fund may be the best option. While the ETF is an okay option, Jared’s limited dollar investment makes the fund a better choice. Also, Jared’s need for professional oversight rules out most ETFs.
LO 8.5; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.5; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.5; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A 8.5 Expanded Learning Activity Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.5; BT: An; Difficulty: H; TOT: 60 min; AACSB: A 8.5 Practice Questions 1. Diversification refers to: a. Allocating your money among stocks and bonds from firms operating in a single industry. b. Spreading your money among various investments to reduce the impact of losses on a few investments. c. Spreading your money among a small number of investments in hopes of maximizing the returns of those with high returns. d. Allocating your money among stocks, bonds, and commodities in a strategic way to anticipate changes in the markets. Answer: b; LO 8.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Which of the following investment strategies offers investors with the greatest diversification? a. Build a portfolio with individual stocks. b. Purchase bonds. c. Purchase a market index ETF. d. Purchasing bonds, individual stocks, or a market ETF all provide the same amount of diversification. Answer: c; LO 8.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. What is the earliest time of day that an ETF that is traded on the NYSE can be purchased? a. 8:00 am Eastern time. b. 9:30 am Eastern time. c. 4:00 pm Eastern time.
d. 4:30 pm Eastern time. Answer: b; LO 8.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. While ETFs are available to meet the needs of almost every investor, the majority of ETF assets are invested in: a. Large company stock. b. Small company stock. c. Commodities. d. Bonds. Answer: a; LO 8.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. How much must Jane’s portfolio increase in value to break even if she invests $3,000 in a portfolio of securities but pays $210 in commissions in addition to her $3,000 investment? a. 3.5 percent. b. 6.0 percent. c. 7.0 percent. d. 8.5 percent. Answer: c; LO 8.5; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: Jane’s initial cost is her $3,000 investment plus the $210 commission, that is, $3,000 + $210 = $3,210. In order to break even, her portfolio must increase ($3,210 / $3,000 = 1.07; 1.07 – 1 = 0.07 or 7.0%. 8.6 End-of-Topic Assessment 8.6 Multiple-Choice Questions 1.b. II and III only Answer: b; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.c. United States and China Answer: c; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.a. familiarity bias. Answer: a; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.a. Low correlation between U.S. stocks and international stock which reduces investment risk. Answer: a; LO 8.6; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.a. Currency exchange rate risk, less regulation, and reduced marketability are all risks inherent in international investing.
Answer: d; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. Countries with strong GDP growth, oversight, and legal structure. Answer: d; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.b. I, II, and IV. Answer: b; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. Exchange-traded funds, American Depositary Receipts, and mutual funds. Answer: d; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.b. Global Fund. Answer: b; LO 8.6; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 10.a. invests in specific markets, such as Europe, Asia, or Pacific Rim. Answer: a; LO 8.6; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
8.6 Adventures in Personal Finance Short Answer 1. Answer: Amanda could purchase a regional ETF or mutual fund that focuses on Mexico. She could probably find an ETF or mutual fund that focuses especially on manufacturing in Mexico. LO 8.6; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a 2. Answer: Global funds include US companies, international funds exclude US based companies, regional funds invest in specific regions of the world, and county funds invest only in companies based in a specific country. The best fund would be an international fund because it would have the broadest exposure to international markets. LO 8.6; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a 3. Answer: John could invest in individual companies with American Depository Receipts. He could invest in dozens or even hundreds of foreign companies simultaneously with international or global ETFs or mutual funds. LO 8.6; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a
Explore 1. Answer: a. While some BRIC economies are very large now, such as China, these countries are still emerging markets and subject to higher levels of political and economic volatility. Risks include typical investment risk plus exchange rate risk and geopolitical risk. b. Dean could purchase a “BRIC” mutual fund or ETF. He could also allocate only a small percentage of his portfolio to the BRIC investment, perhaps less than 5 to 10 percent. LO 8.6; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: A 2. Answer: Company Name
Stock Symbol US Exchange Home Country
HSBC Holdings plc HSBC
NYSE
United Kingdom
BP plc
BP
NYSE
United Kingdom
Total SA
TOT
NYSE
France
Petrobras
PBR
NYSE
Brazil
BHP Billiton
BHP
NYSE
Australia
LO 8.6; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: n/a 8.6 Expanded Learning Activity Answer: High quality answers will include the table and discussion of the findings. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.6; BT: S; Difficulty: H; TOT: 60 min; AACSB: A, C 8.6 Practice Questions 1. GDP is: a. Useless in evaluating an economy. b. A measure of an economy’s size. c. Is only useful when comparing economies. d. Difficult to understand. Answer: b; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. The tendency for Americans to prefer American investments and American markets is known as __________. a. Familiarity bias. b. Nationalism.
c. Defensiveness. d. Risk aversion. Answer: a; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Using international investments to diversify a portfolio reduces __________ risk. a. Investment. b. Pure. c. Systemic. d. Global. Answer: a; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. ADRs are: a. American Depositary Receipts. b. American Debt Receipts. c. American Diversification Receipts. d. American Depository Remittances. Answer: a; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. International ETF’s are ______________ ways to invest in international markets. a. easy. b. effective. c. efficient. d. easy, effective, and efficient. Answer: d; LO 8.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.7 End-of-Topic Assessment 8.7 Multiple-Choice Questions 1.d. I, II, and III. Answer: d; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
2.a. Stocks traded on the New York Stock Exchange. Answer: a; LO 8.7; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3.d. I, II, and III. Answer: d; LO 8.7; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 4.b. How wildly returns fluctuate over time. Answer: b; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5.b. -19%.
Solution: Because Wookjae wants to know, with 95% confidence, the worst possible loss amount. The solution requires the standard deviation to be subtracted from the average (mean) twice: 9% 14% - 14% = -19%. Answer: b; LO 8.7; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 6.d. 51%. Solution: Because Wookjae wants to know, with 99% confidence, the best possible gain amount. The solution requires the standard deviation to be added to the average (mean) three times: 9% + 14% + 14% + 14% = 51%. Answer: d; LO 8.7; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 7.a. II only. Answer: a; LO 8.7; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.c. less than the average return of the investment. Answer: c; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.a. 2.86%. Answer: a; LO 8.7; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A Solution: Use TVM calculation to solve for the inflation rate. Financial Calculator Inputs: PV = -$90,000 FV = $210,000 N = 30 PMT = 0 CPT I/Y = 2.86%. (Either the PV or FV must be a negative-cash-flow/purchase) TVM Equation: 1
𝐹𝑉 𝑛 𝑖 =( ) −1 𝑃𝑉 1
$210,000 30 𝑖=( ) −1 $90,000 1
𝑖 = (2.3333)30 − 1 𝑖 = 1.0286 − 1 = 𝟎. 𝟎𝟐𝟖𝟔 𝑜𝑟 𝟐. 𝟖𝟔% Excel Spreadsheet: =RATE(nper, pmt, pv, fv)
=RATE(30, 0, -90000, 210000) (Either the PV or FV must be a negative-cash-flow/purchase) Rate = 2.86% Excel Solution (a .xls file), and Solution Video are also available showing how to set this problem up as a model in Excel. 10.b. No, because he should have closer to $50,000 to keep pace with inflation. Answer: b; LO 8.7; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: The FV of the $25,000 investment over 20 years at 3.5% inflation rate is $49,745, and the tax-deferred growth of the investment is only $45,000. Financial Calculator Inputs: PV = -$25,000 (negative because cash-flow out represents investment) N = 20 I/Y = 3.5% PMT = 0 CPT FV = $49,745 Future Value Formula: 𝐹𝑉 = 𝑃𝑉(1 + 𝐼)𝑁 20
𝐹𝑉 = $25,000(1 + 0.035) 𝐹𝑉 = $25,000(1.035)20 𝐹𝑉 = $25,000(1.9898) 𝐹𝑉 = $𝟒𝟗, 𝟕𝟒𝟓 Excel Spreadsheet: =FV(rate, nper, pmt, -pv) =FV(0.035, 20, 0, -25000)
(PV expressed as outgoing cash flow because FV is expressed as receiving cash flow)
FV = 49745 Excel Solution (a .xls file), and Solution Video are also available showing how to set this problem up as a model in Excel.
8.7 Adventures in Personal Finance Short Answer 1. Answer: Liquidity refers to how quickly you can convert an asset to cash. Marketability refers to how quickly you can sell an asset. Marketability risk is tied to the size and activity of a market in which buyers and sellers meet to exchange products, services, and assets. LO 8.7; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a 2. Answer: While volatility is an important form of risk, individual investors need to worry more about inflation over the long run. The loss of purchasing power should be a primary concern among
all savers and investors. Supposedly ‘safe’ options like savings accounts can backfire on investors as they gradually lose value in real, inflation-adjusted dollars. In contrast, more volatile assets like stocks tend to keep up with or surpass inflation. Consequently, in the long run, investors utilizing these more volatile assets tend to see their purchasing power grow in real dollars. LO 8.7; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a 3. Answer: Risk tolerance refers to an individual investor’s willingness to take a financial risk in which the outcome of the behavior is both unknown and potentially negative. LO 8.7; BT: C; Difficulty: E; TOT: 5 min; AACSB: n/a 4. Answer: As liquidity declines it becomes more difficult to convert an asset to cash. This means that assets with less liquidity should not be used for emergency savings funds or other short-term needs. To entice someone to tie up his or her money, it is then necessary for a less liquid investment to offer a higher potential return. LO 8.7; BT: C; Difficulty: E; TOT: 5 min; AACSB: n/a 5. Answer: He should focus on safe, liquid, and marketable assets, such as savings account, money market savings accounts, and short-term certificates of deposit. LO 8.7; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a 6. Answer: a = 2; b = 1; c = 5; d = 3; e = 4 LO 8.7; BT: C; Difficulty: E; TOT: 5 min; AACSB: n/a Explore 1. Answer: Answers will vary based on products selected. High quality responses will utilize the calculator provided, or a similar type of analysis, and discuss their findings. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.7; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: A, C 2. Answer: Answers will vary based on products selected. High quality responses will quantify price changes in absolute and relative terms and present findings in a organized way, such as with a table. The brief discussion should include a reasonable, evidence-based conclusion based on the information provided. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.7; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: A, C
8.7 Expanded Learning Activity
Answer: A good place to start is by reading a review published by the Federal Reserve Bank of Dallas. The full PDF can be found at: http://www.dallasfed.org/assets/documents/institute/annual/2011/annual11b.pdf. High quality responses will discuss government inability to address hyper-inflation, loss of confidence in government issued money, and other economic factors. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.7; BT: Ap; Difficulty: M; TOT: 60 min; AACSB: C, A 8.7 Practice Questions 1. An investor who wants and needs to earn a higher rate of return could attempt to do so by: a. Taking more financial risk. b. Increasing the liquidity of the asset. c. Requiring a high degree of marketability. d. Both taking more financial risk and increasing the liquidity of the asset. Answer: a; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Someone who strongly agrees that, in terms of investing, safety is more important than returns is likely a person who has: a. A low-risk tolerance. b. A moderate-risk tolerance. c. A high-risk tolerance. d. A very high-risk tolerance. Answer: a; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. What is the most liquid asset the average saver or investor owns? a. Real estate. b. S&P ETF. c. Certificate of deposit. d. Savings account. Answer: d; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Risk tolerance can refer to: a. Your willingness to make a risky investment. b. Your willingness to forego liquidity when making an investment. c. Your willingness to buy an investment asset with low marketability. d. All of these answer choices are correct. Answer: d; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Lindsey is what some people call a gold bug. She loves the allure of owning gold. What are some of the investment characteristics of gold? a. High liquidity. b. High marketability. c. High risk. d. Both high liquidity and high marketability.
Answer: c; LO 8.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.8 End-of-Topic Assessment 8.8 Multiple-Choice Questions 1.d. Borrow money from their brokerage firm to buy stocks, bonds, and mutual funds. Answer: d; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.c. I, II, III and IV. Answer: c; LO 8.8; BT: C; Difficulty: M; TOT: 2 min; AACSB: n/a 3.a. Requires investors to have money in the account before buying investments. Answer: a; LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 4.d. All of these answer choices are correct. Answer: d; LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.b. II and IV only. Answer: b; LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. Both cash in customer accounts up to $250,000 and securities in customer accounts up to $500,000. Answer: d; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.a. The fastest way to transact a stock market trade. Answer: a; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. A limit order. Answer: d; LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.d. Place a market order, stop order, or utilize the guidance of a registered representative. Answer: d; LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 10.d. In “street name.” Answer: d; LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
8.8 Adventures in Personal Finance Short Answer
1. Answer: Market order. LO 8.8; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Answer: Morgan Stanley offer full-service brokerage services; E*Trade provide self-directed accounts. Charles Schwab, Merrill Lynch and Fidelity provides both options. LO 8.8; BT: C; Difficulty: E; TOT: 10 min; AACSB: n/a 3. Answer: Limit orders set the price you are willing to pay. If the price of the stock never trades within the limit range set by you, your trade will not be executed. For stocks that fluctuate significantly over the course of the day, a limit order is especially important to ensure that you purchase the stock for the intended price. LO 8.8; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A
Explore 1. Answer: Answers will vary based on the firms chosen. High quality responses will address the questions posed. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.8; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: n/a 2. Answer: High quality responses will include a discussion of the fiduciary standard and a thoughtful discussion of pros and cons. For example, because of the higher legal requirements, fiduciaries may charge higher fees, making it harder for low-wealth or low-income investors to work with a financial advisor. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.8; BT: An; Difficulty: H; TOT: 40 min; AACSB: C, A, E
8.8 Expanded Learning Answer: In general, full service brokerage firms will have the highest account minimum requirements and the highest fees and commission rates. These firms also provide the broadest array of services and customer interactions. Fees and commissions tend to be high in order to compensate brokers for their services. Self-directed brokerage firms can charge lower fees and commissions because the level of services provided is lower. LO 8.8; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: n/a
8.8 Practice Questions 1. Borrowing money to purchase stocks: a. Is relatively difficult and complicated. b. Costs money and increases risk. c. Reduces potential returns on stock purchases. d. Is appropriate for all types of investors. Answer: b; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
2. Stocks can only be purchased through a: a. Broker-dealer. b. Local bank or credit union. c. Credit card account. d. None of these answer choices are correct. Answer: a; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Full-service brokerage accounts are __________ for investors as compared to self-directed brokerage accounts. a. More expensive. b. Less expensive. c. About equally as expensive. d. Less risky. Answer: a; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. SIPC insurance protects against losses: a. From illegal, unethical, or bad brokerage firm behavior. b. In the market. c. As a result of investing in fraudulent companies. d. Due to illegal and unethical investor behavior. Answer: a; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. A limit order is: a. A way to set a limit on the number of shares of stock an investor wishes to purchase. b. A way to instruct a brokerage firm to buy (or sell) at a specific price or better. c. The most common type of stock purchase order. d. All of these answers are correct. Answer: b; LO 8.8; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.9 End-of-Topic Assessment 8.9 Multiple-Choice Questions 1.d. I, II, and III. Answer: d; LO 8.9; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 2.b. U.S. residential real estate. Answer: b; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.c. Mutual fund. Answer: c; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
4.b. -$275.00 Solution: First, add all expenses. Second, subtract the expenses from the income Jamal can earn: (1) $900 + $500 + $300 + $75 = $1,775; (2) $1,500 - $1,775 = -$275.00 Answer: b; LO 8.9; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 5.d. A real estate investment trust. Answer: d; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.b. I and II only. Answer: b; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.b. $70,000. Solution: Mabel’s beginning equity balance was $30,000 ($300,000 x 10%) while her mortgage was initially $270,000. Over time, she has added $25,000 in principal, meaning she now owes $270,000 $25,000 = $245,000. Because her home is now worth $315,000 Mabel’s equity is $70,000 ($315,000 - $245,000). Answer: b; LO 8.9; BT: An; Difficulty: M; TOT: 2 min; AACSB: A 8.d. Underwater. Answer: d; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.c. The mortgage lender eliminates the remaining mortgage balance. Answer: c; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.b. Landlords are responsible for the maintenance and upkeep of the property. Answer: b; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.9 Adventures in Personal Finance Short Answer 1. Answer: Real estate that is owned as both a use and investment asset provides the homeowner with a place to live, while renting a portion of the home out provides income to pay the mortgage. There may also be additional tax benefits that allow homeowners to deduct certain expenses from their taxes associated with maintaining the home.
LO 8.9; BT: C; Difficulty: M; TOT: 10 min; AACSB: n/a 2. Answer: Commercial real estate is almost always owned as an investment designed to generate income for the landlord by renting to business, organizations, and other entities. Residential real estate is individually owned and used for housing purposes. LO 8.9; BT: C; Difficulty: M; TOT: 10 min; AACSB: n/a 3. Answer: $75; 0.9% Solution: Her monthly expenses equal $1,125 ($750 mortgage + $100 condo fee + $150 taxes + $75 insurance + $50 misc). Given the rent income of $1,200, she can expect to make $75 per month ($1,200 income - $1,125 expenses), or $900 annual profit ($75 x 12 months). Based on a $100,000 investment, her rate of return is 0.9% ($900 income / $100,000 investment = 0.009 = 0.9%). LO 8.9; BT: An; Difficulty: M; TOT: 15 min; AACSB: A 4. Answer: Most real estate investors hope that the value of the properties they own will increase in value. As the price goes up, their equity position in the property will increase. Additionally, as the property values increase they will be able to charge a higher rent in the future. As this example illustrates, real estate investing is not a short-term strategy. LO 8.9; BT: An; Difficulty: M; TOT: 10 min; AACSB: A Explore 1. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.9; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: A 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.9; BT: Ap; Difficulty: H; TOT: 90 min; AACSB: C, A 8.9 Expanded Learning Activity Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.9; BT: An; Difficulty: H; TOT: 120 min; AACSB: C, A, RT 8.9 Practice Questions 1. Land, buildings, and other structures permanently attached to the land is known as: a. A use asset. b. REIT. c. Real estate. d. Rental property.
Answer: c; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Why do most people purchase real estate? a. As a place to live. b. As a way to generate capital gains. c. As rental property. d. Both as a way to generate capital gains and as rental property. Answer: a; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. An asset purchased primarily to generate income is called: a. An investment asset. b. A use asset. c. A fund asset. d. An equity. Answer: a; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Equity represents: a. Your ownership position in a property. b. How much you owe to the mortgage lender. c. The amount you sell a home for in the market. d. The amount owed when your home is foreclosed. Answer: a; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. Why might someone choose to become a landlord? a. They want to avoid foreclosure. b. They want to avoid a short sale. c. They want to increase their monthly cash flow. d. All of these answers are correct. Answer: d; LO 8.9; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.10 End-of-Topic Assessment 8.10 Multiple-Choice Questions 1.a. Collectibles and hard assets. Answer: a; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Hold, buy, and sell. Answer: d; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.d. REITs.
Answer: d; LO 8.10; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 4.c. Both an automobile and baseball card. Answer: c; LO 8.10; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.c. I, II, III and IV. Answer: c; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. Consistently buy items at low prices and resell them at higher prices. Answer: d; LO 8.10; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 7.c. I, II, III, and IV. Answer: c; LO 8.10; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. Impose costs that reduce the spread that can be made buying and selling tangible assets. Answer: d; LO 8.10; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.c. Is where demand of an asset equals the supply for an asset. Answer: c; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.a. Gold market. Answer: a; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.10 Adventures in Personal Finance Short Answer 1. Answer: a = 5; b = 4; c = 3; d = 2; e = 1 LO 8.10; BT: K; Difficulty: E; TOT: 5 min; AACSB: n/a 2. Answer: Bid price LO 8.10; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Answer: There are two reasons this is misleading. The first is that the annualized gain is really only 4.43%, which is less than what someone could have earned in the stock market. Second, the advertisement does not indicate how much it would cost to sell the stamp. At auction, a seller would pay between 15% and 35% of the total amount received from a buyer. A dealer would likely only pay about 50% of the market value, or $5,000. In either case, the gross and annual rate of return would be much lower than advertised. LO 8.10; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A
Explore 1. Answer: (a) $600; (b) $400; (c) 20%; (d) $8 Solution: (a) $3,000 sales proceeds x 20% commission rate = $600 commission (b) ($3,000 sales proceeds - $2,000 cost of acquisitions - $600 sales commission = $400 net profit (c) $400 net profit / $2,000 cost of acquisitions = 0.20 ~ 20% rate of return (d) $400 net profit / 50 hours worked = $8 per hour (e) Kristy’s 20% return on her initial investment was excellent; however, given the amount of time involved (50 hours), she barely made a minimum wage. If Kristy can consistently buy low and sell high enough, this type of investment strategy may be worthwhile. It is important to note that if she were to realize less at a future auction both her rate of return and wage would decline. LO 8.10; BT: An; Difficulty: M; TOT: 20 min; AACSB: A 2. Answer: The tax rate applicable to long-term capital gains on collectibles is a maximum of 28% (i.e., the lesser of the marginal ordinary tax rate or 28%). This rate only provides tax savings to individuals subject to high marginal tax rates. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.10; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A 8.10 Expanded Learning Answer: High qualify responses will address each question presented. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.10; BT: Ap; Difficulty: M; TOT: 60 min; AACSB: A, C, RT
8.10 Practice Questions 1. An investor in tangible assets: a. Wants to create new assets. b. Is looking to achieve capital gains. c. Receives enjoyment simply from owning the asset. d. Shouldn’t think about making money from the asset. Answer: b; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. The phrase _________ investing describes the world of collectibles and other hard assets. a. Collectible. b. Garage sale. c. Dollar cost. d. Tangible. Answer: d; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. What is the “spread?” a. A dealer’s primary way to profit on the sale of an item. b. The difference between the bid price for an asset and the ask price for an asset.
c. The difference between what a dealer buys an item for and what he or she ultimately sells it for. d. All of these answer choices are correct. Answer: d; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. The point where demand meets supply is called: a. Equilibrium. b. Status quo. c. Shortage. d. Consumer well-being. Answer: a; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. The size of a market can provide an indication of overall _________ for an asset. a. Demand. b. Supply. c. Volume. d. Price. Answer: a; LO 8.10; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
8.11 End-of-Topic Assessment 8.11 Multiple-Choice Questions 1.d. Bonds. Answer: d; LO 8.11; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A 2.d. Money Market Savings Accounts. Answer: d; LO 8.11; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3.d. Larry will get back $40,000 in cash and $1,000 in stock from SIPC. Answer: d; LO 8.11; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A Solution: Securities Investor Protection Corporation (SIPC) insurance protects your account up to $500,000 per customer, per firm, with up to a $250,000 limit for cash. SIPC covers you in the event that the brokerage firm goes out of business or experiences theft. SIPC does not insure against losses in the markets, only the value of securities held at the insured firm. Larry will get back $40,000 in cash and $1,000 market value of the stock he owns. 4.c. A Ponzi scheme. Answer: c; LO 8.11; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
5.a. The advisor tells you that she has earned approximately 10% per year over the last 15 years without a losing year. Answer: a; LO 8.11; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 6.c. $500. Answer: c; LO 8.11; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A Solution: The advisor’s commission will be $10,000 x 5% = $500. 7.a. $9,500 Answer: a; LO 8.11; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: A Solution: After commission, Emily will have 95% of her contribution left to be invested in the mutual fund ($10,000 x 95% = $9,500). 8.a. II only. Answer: a; LO 8.11; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.a. A CFP® professional only works with accredited investors. Answer: a; LO 8.11; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.c. II and III only. Answer: c; LO 8.11; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.11 Adventures in Personal Finance Short Answers 1. Answer: In general, the more risk you take the more you should expect to receive in terms of return. Stated another way, the more return you demand from an investment, the more risk you must take. LO 8.11; BT: C; Difficulty: E; TOT: 5 min; AACSB: n/a 2. Answer: The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash. SIPC insurance also does not cover market losses; rather, it protects consumers from the risk of a broker going out of business. LO 8.11; BT: K; Difficulty: E; TOT: 5 min; AACSB: n/a 3. Answer: Always be skeptical of unrealistic promises, never rely solely on reputation or word-ofmouth referrals, and verify details of investment proposals. Most importantly, you should diversify your assets, accounts, and advisers.
LO 8.11; BT: Ap; Difficulty: E; TOT: 5 min; AACSB: A Explore 1. Answer: As a reminder, stockbrokers are paid fully or in part by commission. Fee-Only financial advisers and those who receive a fee for service are required to be registered with either the Securities and Exchange Commission or their state securities regulator. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.11; BT: Ap; Difficulty: M; TOT: 40 min; AACSB: C, E 2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. LO 8.11; BT: C; Difficulty: E; TOT: 40 min; AACSB: n/a 3. Answer: Please refer to the sample writing assignment rubric in the solutions manual. http://cfp.net/utility/find-a-cfp-professional?utm_source=findcfp&utm_medium=header&utm_content=homepage&utm_campaign=header LO 8.11; BT: Ap; Difficulty: M; TOT: 40 min; AACSB: A 8.11 Expanded Learning Activity Answer and Solution: Information about marijuana scams can be found at: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/FraudsAndScams/P325352; it is worth noting that many of these scams are promoted by inmates in prison. Please refer to the sample writing assignment rubric in the solutions manual. LO 8.11; BT: Ap; Difficulty: M; TOT: 60 min; AACSB: A 8.11 Practice Questions 1. As investment risk increases, the amount of return demanded by investors: a. Decreases. b. Increases. c. Stays constant. d. Gets reduced by insurance premiums to either FDIC or SIPC. Answer: b; LO 8.11; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Which of the following investment assets provides the greatest level of diversification? a. Bonds. b. Stocks. c. Real estate. d. Mutual funds. Answer: d; LO 8.11; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
3. Bernie Madoff is famous for: a. Running the biggest investment fraud in history. b. Hedging his investor’s money using SIPC-insured accounts. c. Being the “Investing Wizard” of Wall Street. d. Both running the biggest investment fraud in history and being the “Investing Wizard” of Wall Street. Answer: d; LO 8.11; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Eleanor Blayney recommends the consumers interview __________ financial advisor(s) before hiring one. a. 1. b. 3. c. 10. d. At least 10. Answer: b; LO 8.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. The “C” in “I COME FIRST” stands for: a. Capitalization. b. Credentials. c. Credit. d. Confidentiality. Answer: b; LO 8.11; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a Chapter 8 Summary Continuing Case: Tarek’s Financial Journey a. Answer: While Samantha would prefer to stick with insured bank products and highly rated bonds, they will need to expand their investment alternatives to include a variety of bonds and stocks. They should focus on identifying balanced mutual funds that own a combination of stocks and bonds. When thinking about individual stocks they should focus on high-quality blue-chip equities that pay and grow their dividends (large-cap value stocks). This asset class serves as a compromise for the investors’ risk tolerances, as well as, contribute towards their 8% required rate of return. Owning a home should also be a priority. As a dual-purpose asset, it is possible that their home, as a real estate asset, will appreciate in value over time. LO 8.1, 8.4, 8.5, 8.8; BT: S; Difficulty: H; TOT: 10 min; AACSB: A b. Answer: Stock B and Stock C Solution: Use the Discounted Dividend Valuation Model to calculate each stock’s fair market value based on the investors’ 8% required rate of return. Based on the discounted dividend valuation model from Topic 8.2, stocks B and C are bargains (the current estimated value is greater than the current price of share of stock. Dividend Discount Valuation Formula: 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒙 (𝟏 + 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆) 𝑺𝒕𝒐𝒄𝒌 𝑽𝒂𝒍𝒖𝒆 = (𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 − 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆)
Stock A
Stock B
Stock C
Stock D
Dividend Dividend Growth Rate
$
$
0.95
$2.45
$
2.00%
3.30%
Current Price Required Rate of Return
$
Calculation Value Is the Stock a Bargain?
0.50 4.50% 19.50
$
15.00
$
45.00
3.60 1.50%
$
73.25
8.00%
8.00%
8.00%
8.00%
(0.05 𝑥 1.045)
(0.95 𝑥 1.02)
(2.45 𝑥 1.033)
(3.60 𝑥 1.05)
(0.08−0.045) = 0.0523/0.035
(0.08−0.02) = 0.969/0.06
(0.08−0.033) = 2.5309/0.047
(0.08−0.05) = 3.78/0.03
$
14.93 No
$
16.15 Yes
$
53.85 Yes
$
56.22 No
Excel Solution (a .xls file), and Solution Video are also available showing how to set up part b of this problem as a model in Excel.
LO 8.2; BT: An; Difficulty: M; TOT: 20 min; AACSB: A c. Answer: Fund C Solution: Passive management strategies out-perform the majority of active management strategies for mutual funds in the long-run, therefore only fund B and C should be considered. Since both Fund B and C track the S&P 500, the most important factor to examine is the fees. Neither fund charges a sales load, so it is just the expense ratio that matter. Fund C has a slightly lower expense ratio and therefore is the fund that should be selected. LO 8.4, 8.5; BT: Ap; Difficulty: E; TOT: 10 min; AACSB: A
d. Answer: $842,343 Solution: Calculate the present value of $3,000 annual investments over 41 years at 8% APY. Financial Calculator: PV = 0 PMT = -$3,000 (negative number because it is a cash-flow out) I/Y = 8 N = 41 (future age of 67 minus current age of 26) CPT FV = 842,343.12 Excel Spreadsheet: =FV(rate, nper, pmt, -pv) =FV(0.08, 41, -3000, 0) (Payments are negative because it is expressed as outgoing cash flow) FV = 842343.12 TVM Formula: 𝑃𝑀𝑇 [(1 + 𝐼)𝑁 − 1] 𝐹𝑉𝐴 = 𝐼
$3,000 [(1 + 0.08)41 − 1] 0.08 𝐹𝑉𝐴 = $37,500[23.46248 − 1] = $𝟖𝟒𝟐, 𝟑𝟒𝟑. 𝟏𝟐 𝐹𝑉𝐴 =
LO 8.7; BT: An; Difficulty: E; TOT: 5 min; AACSB: A e. Answer: Either a mutual fund or an exchange traded fund could be used to reduce unsystematic risk through diversification. Individual stocks and bonds would not be appropriate. If she were interested in investing in real estate, she could also use a real estate investment trust. LO 7.1; BT: Ap; Difficulty: E; TOT: 5 min; AACSB: n/a
Calculating the Cost of Life’s Financial Journey a. Answer: $82,402.83 Solution: Calculate each year’s respective earnings based on the new annual $3,000 investment, as well as the new year’s rate of return. Most efficient to approach as a table.
Beginning Additional Ending Year Balance Investment Rate Earnings1 Balance2 1 $0.00 $3,000.00 9.50% $ 285.00 $ 3,285.00 2 $ 3,285.00 $3,000.00 9.00% $ 565.65 $ 6,850.65 3 $ 6,850.65 $3,000.00 8.60% $ 847.16 $ 10,697.81 4 $ 10,697.81 $3,000.00 8.10% $ 1,109.52 $ 14,807.33 5 $ 14,807.33 $3,000.00 7.60% $ 1,353.36 $ 19,160.69 6 $ 19,160.69 $3,000.00 7.10% $ 1,573.41 $ 23,734.09 7 $ 23,734.09 $3,000.00 6.70% $ 1,791.18 $ 28,525.28 8 $ 28,525.28 $3,000.00 6.20% $ 1,954.57 $ 33,479.85 9 $ 33,479.85 $3,000.00 5.70% $ 2,079.35 $ 38,559.20 10 $ 38,559.20 $3,000.00 5.20% $ 2,161.08 $ 43,720.27 11 $ 43,720.27 $3,000.00 4.80% $ 2,242.57 $ 48,962.85 12 $ 48,962.85 $3,000.00 4.30% $ 2,234.40 $ 54,197.25 13 $ 54,197.25 $3,000.00 3.80% $ 2,173.50 $ 59,370.75 14 $ 59,370.75 $3,000.00 3.30% $ 2,058.23 $ 64,428.98 15 $ 64,428.98 $3,000.00 2.90% $ 1,955.44 $ 69,384.42 16 $ 69,384.42 $3,000.00 2.40% $ 1,737.23 $ 74,121.65 17 $ 74,121.65 $3,000.00 1.90% $ 1,465.31 $ 78,586.96 18 $ 78,586.96 $3,000.00 1.00% $ 815.87 $ 82,402.83 1 *Note : Earnings = (Beginning year’s balance + Additional investment) x Rate of return *Note2: Ending balance = Beginning balance + Additional investment + Earnings
LO 8.7; BT: Ap; Difficulty: H; TOT: 10 min; AACSB: A b. Answer: $55,074.55
Solution: Calculate each year’s respective earnings based on the new annual $3,000 investment, as well as the new year’s rate of return. Most efficient to approach as a table. Beginning Year
Balance
Additional Investment
Ending Rate
Earnings
1
Balance2
1 2 3 4 5 $ $3,000.00 7.60% $ 228.00 $ 3,228.00 6 $ 3,228.00 $3,000.00 7.10% $ 442.19 $ 6,670.19 7 $ 6,670.19 $3,000.00 6.70% $ 647.90 $ 10,318.09 8 $ 10,318.09 $3,000.00 6.20% $ 825.72 $ 14,143.81 9 $ 14,143.81 $3,000.00 5.70% $ 977.20 $ 18,121.01 10 $ 18,121.01 $3,000.00 5.20% $ 1,098.29 $ 22,219.30 11 $ 22,219.30 $3,000.00 4.80% $ 1,210.53 $ 26,429.83 12 $ 26,429.83 $3,000.00 4.30% $ 1,265.48 $ 30,695.31 13 $ 30,695.31 $3,000.00 3.80% $ 1,280.42 $ 34,975.73 14 $ 34,975.73 $3,000.00 3.30% $ 1,253.20 $ 39,228.93 15 $ 39,228.93 $3,000.00 2.90% $ 1,224.64 $ 43,453.57 16 $ 43,453.57 $3,000.00 2.40% $ 1,114.89 $ 47,568.46 17 $ 47,568.46 $3,000.00 1.90% $ 960.80 $ 51,529.26 18 $ 51,529.26 $3,000.00 1.00% $ 545.29 $ 55,074.55 *Note1: Earnings = (Beginning year’s balance + Additional investment) x Rate of return *Note2: Ending balance = Beginning balance + Additional investment + Earnings LO 8.7; BT: Ap; Difficulty: H; TOT: 10 min; AACSB: A c. Answer: $30,844.61. Solution: Solution: Calculate each year’s respective earnings based on the new annual $3,000 investment, as well as the new year’s rate of return. Most efficient to approach as a table.
Year 1 2 3 4 5 6 7
Beginning Balance
Additional Investment
Rate
Earnings1
Ending Balance2
8 9 10 $ $3,000.00 5.20% $ 156.00 $ 11 $ 3,156.00 $3,000.00 4.80% $ 295.49 $ 12 $ 6,451.49 $3,000.00 4.30% $ 406.41 $ 13 $ 9,857.90 $3,000.00 3.80% $ 488.60 $ 14 $ 13,346.50 $3,000.00 3.30% $ 539.43 $ 15 $ 16,885.94 $3,000.00 2.90% $ 576.69 $ 16 $ 20,462.63 $3,000.00 2.40% $ 563.10 $ 17 $ 24,025.73 $3,000.00 1.90% $ 513.49 $ 18 $ 27,539.22 $3,000.00 1.00% $ 305.39 $ *Note1: Earnings = (Beginning year’s balance + Additional investment) x Rate of return *Note2: Ending balance = Beginning balance + Additional investment + Earnings
3,156.00 6,451.49 9,857.90 13,346.50 16,885.94 20,462.63 24,025.73 27,539.22 30,844.61
LO 8.7; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A d. Answer: To accumulate the maximum amount, they must begin saving as early as possible. The combination of a long-time horizon, a higher rate of return early in the savings process, and more years of contribution work to generate the largest expected balance at education time. LO 8.7; BT: An; Difficulty: M; TOT: 10 min; AACSB: A Excel Solution (a .xls file), and Solution Video are also available showing how to set up this problem as a model in Excel. Planning for the Future a. Answer: Portfolio 1 is 7.30%; Portfolio 2 is 6.30%; Portfolio 3 is 5.45% Solution: These weighted returns can be calculated by multiplying each asset’s respective portfolio weight by its associated rate of return and then summing the asset class weights. After the asset class weights are computed, add them up to arrive at the average weighted return of the portfolio. Portfolio 1 Asset Class
Rate of Return
Cash 2% Bonds 4% Stocks 9% Portfolio Return2
Asset Allocation
Weighted Return1
Portfolio 2 Asset Allocation
10% 20% 70%
Weighted Return1
0.200% 10% 0.200% 0.800% 40% 1.600% 6.300% 50% 4.500% 7.300% 6.300% 1 * Note : Weighted Return = Asset Class Rate of Return x Asset Allocation
Portfolio 3 Asset Allocation
Weighted Return1
15% 50% 35%
0.300% 2.000% 3.150% 5.450%
* Note2: Portfolio Return = Sum of Portfolio's Weighted Return Excel Solution (a .xls file), and Solution Video are also available showing how to set up part a of this problem as a model in Excel.
LO 8.7; BT: An; Difficulty: H; TOT: 30 min; AACSB: A
b. Answer: Portfolio 1 offers the greatest level of uncertainty or risk. You know this because the portfolio has the largest allocation to stocks. Stock returns are less certain over time. Because the allocation to bonds and cash assets is highest in Portfolio 3, this portfolio’s returns are the most certain and least risky. LO 8.7; BT: C; Difficulty: M; TOT: 10 min; AACSB: n/a c. Answer: Given her time horizon, Portfolio 1 would be appropriate. This portfolio, while riskier that the other portfolios, offers a higher rate of return. She has enough time to recoup any short-term losses that might arise while she is investing. LO 8.7; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A d. Answer: Portfolio 3 would be most appropriate if she has a short time horizon. The reason is that she will not have enough time remaining to recoup losses if she were to lose money in the portfolio. LO 8.7; BT: Ap; Difficulty: E; TOT: 5 min; AACSB: A e. Answer: Although Portfolio 3 may appeal to someone with a below-average or low risk tolerance, the portfolio is relatively vulnerable to inflation risk. As general prices increase in the future, Ayasha’s real rate of return in this portfolio would be lower than it would be had she invested in the other portfolios. Inflation risk is one reason long-term investors prefer holding stocks rather than bonds or cash. LO 7.1; BT: C; Difficulty: E; TOT: 10 min; AACSB: A
Chapter 9 – Solutions Manual Learning Objectives 9.1 Describe the importance of health management and general insurance. 9.2 Explain the options, costs, and requirements associated with health insurance. 9.3 Discuss the need for disability insurance and the key features of disability insurance policies. 9.4 Describe the types of life insurance policies and how to develop a plan for optimal life insurance coverage. 9.5 Identify the need for automobile insurance and the key coverage elements to include as part of an automobile insurance policy. 9.6 Describe the benefits of insurance to protect the personal and real property of renters and homeowners. 9.7 List different strategies and available insurance for meeting long-term care needs. Key to metadata for questions: LO: Learning objective number BT: Bloom’s Taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H) TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), not applicable (NA) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes For Instructor: Each writing question will have criteria which is specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criteria will be assessed and the associated points for each level of performance are found in columns 2 – 5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criteria (row) is worth up to 4 pts (column 2).
Rubric: (It is suggested the rubric be shared with the students) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking significant incomplete and detail limited
Answer is realistic / relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
Does not represent realistic or relevant understanding of topic.
Organization/clarity of thought (25% of score)
Well organized
Adequate organization
Limited organization
Poor organization
A clear conclusion Appropriate or recommendation recommendations and is presented that is conclusions are appropriate given reached. the content (25% of score) discussed
25% of points (1 out of 4)
Conclusion or recommendation is Conclusion or No conclusion/ mostly clear and recommendation is recommendation appropriate given incomplete provided the content
9.1 End-of-Topic Assessment 9.1 Multiple-choice 1.a. Human capital. ANSWER: a; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.b. Go back to college and / or engage in health behavior. ANSWER: b; LO 9.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3.a. High. ANSWER: a; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.c. Avoid the risk. ANSWER: c; LO 9.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 5.b. Managing the risk. ANSWER: b; LO 9.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: A
6.d. The severity and frequency of future risks increases over time. ANSWER: d; LO 9.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 7.b. Transference. ANSWER: b; LO 9.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. Health Behavior; Genetic Disposition. ANSWER: d; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.d. Eat right, exercise, and get enough sleep. ANSWER: d; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.a. Transferring the risk of high health related expenses to an insurance company. ANSWER: a; LO 9.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.1 Adventures in Financial Literacy Short Answer 1. ANSWER: In this case, the person should purchase insurance to transfer the risk to an insurance company. LO 9.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: n/a 2. ANSWER: Insurance works by transferring the risk associated with an event to a secondary party, most often an insurance company. The insurance company pools premiums from many different insured consumers, investment the premiums, and pays premiums from earnings and other insurance company assets. LO 9.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: n/a 3. ANSWER: High quality responses should clearly identify a health habit to change and a strategy to change it. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.1; BT: Ap; Difficulty: M; TOT: 25 min; AACSB: C, RT 4. ANSWER: From most to least important: (1) Health Behavior, (2) Genetic Disposition, (3) Social Circumstance, (4) Medical Care, and (5) Environmental Exposures. LO 9.1; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a Explore 1. ANSWER: High quality responses should address point (a) – (d). Please refer to the sample writing assignment rubric in the solutions manual. LO 9.1; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a
2. ANSWER: High quality responses will address points (a) – (c). Please refer to the sample writing assignment rubric in the solutions manual. LO 9.1; BT: An; Difficulty: M; TOT: 30 min; AACSB: C, RT 9.1 Expanded Learning Research ANSWER: High quality responses should address each of the four bullet points listed. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.1; BT: An; Difficulty: M; TOT: 30 min; AACSB: C, RT 9.1 Concept Checks 1. Human capital refers to: a. Your ability to work. b. Your ability to learn. c. Your ability to form connections with other people. d. Your ability to work and / or learn. ANSWER: d; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Some of the outcomes associated with obesity include all of the following, except: a. High blood pressure. b. Strokes. c. Reduction in human capital due to reduced social interactions. d. Type 2 diabetes. ANSWER: c; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. Lamar is faced with a high frequency high severity risk. According to the risk matrix, Lamar should: a. Accept the risk. b. Manage the risk. c. Transfer the risk. d. Avoid the risk. ANSWER: d; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. All of the following are considered good health habits, except: a. Wearing a seatbelt. b. Exercising. c. Eating fruits and vegetables. d. Staying focused by working long stress filled hours. ANSWER: d; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. The cost of insurance increases as: a. The severity of a loss increases. b. The frequency of a loss increases. c. The retention of the loss increases.
d. The severity and frequency of a loss increases. ANSWER: d; LO 9.1; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.2 End-of-Topic Assessment 9.2 Multiple-choice 1.b. Health risks are very uncommon for young people. ANSWER: b; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Visiting a doctor or emergency room due to an injury or accident, and / or getting a prescription for medicine. ANSWER: d; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.b. I and III only. ANSWER: b; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.a. Medicaid. ANSWER: a; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5.d. I, II, and III. ANSWER: d; LO 9.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. An insurance deductible is the amount that the insured individual must pay before the health insurance company will pay any money. ANSWER: d; LO 9.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 7.b. Receiving healthcare services is more affordable if you have health insurance. ANSWER: b; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8. c. $1,040. ANSWER: c, LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: n/a Solution: $3,000 - $500 - $50 = $2,450 x 20% = $490; $500 + $50 + $490 = $1,040 9.a. HSAs are great tools for health-care expenses and retirement goals. ANSWER: a; LO 9.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 10.d Long-term care premiums. ANSWER: d; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
9.2 Adventures in Financial Literacy Short Answer
1. ANSWER: The insurance company will pay $15,300. Logan must pay $2,700. Solution: The insurance company will pay $15,300 ($18,000 - $1,000 = $17,000 x .10 = $1,700; $17,000 - $1,700 = $15,300); Logan’s out-of-pocket expense is the difference or $2,700 ($18,000 - $15,300). LO 9.2; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A 2. ANSWER: Jonny could use the money for retirement savings. Once he turns 65, he can use the money for whatever he wants without a penalty, he will still need to pay tax on that money if not used for health care. LO 9.2; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a
3. ANSWER: Solutions: A-6, B-4, C-5, D-1, E-2, F-3, G-7. LO 9.2; BT: K; Difficulty: M; TOT: 5 min; AACSB: n/a Explore 1. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.1; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a 2. ANSWER: James will be responsible for his $250 copay and $500-dollar deductible. The remaining hospital bill is $16,800 ($17,550 - $750). James’ share of the coinsurance is $3,360 (20% X $16,800); however, James has an out-of-pocket maximum of $2,500 of which he has already paid $750, leaving only $1,750 left to pay before he reaches his out-of-pocket limit. So, James will only have to pay $1,750 of his share of the coinsurance, and the insurance company will pay for the rest. LO 9.2; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 3. ANSWER: High quality responses should including information on at least 2 different health insurance plans and a discussion of the advantages and disadvantages of each. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.2; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: C, RT
9.2 Expanded Learning ANSWER: High quality responses should include a discussion of the plans available, which plan the student would choose and why, and a discussion of subsidies available through the Advance Premium Tax Credit. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.2; BT: An; Difficulty: M; TOT: 40 min; AACSB: C, A, RT 9.2 Concept Check 1. The cost of health insurance is: a. Prohibitive.
b. Usually a monthly premium. c. Too expensive for most people to get adequate coverage. d. The out-of-pocket costs for health care services. ANSWER: b; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. An individual can be exempt from fines proscribed by the Affordable Care Act for which of the following reasons? a. Their income is too low. b. Their income is too high. c. They are a student. d. They do not have dependents. ANSWER: a; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. The reason you need health insurance is because risks to your health may be: a. Financially catastrophic. b. Infrequent. c. Inconsequential. d. Unlikely for young people. ANSWER: a; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. The copayment an individual needs to pay is: a. The cost incurred after paying a deductible. b. A fee paid as a percent of the total medical bill. c. A flat fee. d. The total amount paid, including coinsurance and a deductible. ANSWER: c; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. The best strategy for dealing with health risks is: a. Transferring all costs to someone else. b. Self-insuring against sickness. c. Avoiding and managing health risks. d. Saving or using an emergency fund for any unforeseen health episode. ANSWER: c; LO 9.2; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.3 End-of-Topic Assessment 9.3 Multiple-choice 1.b. You are unable to do the work you did before your illness or accident and it is expected to last on year or longer. ANSWER: b; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.a. Any Occupation. ANSWER: a; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
4.d. At no age is the probability of death greater than disability. ANSWER: d; LO 9.3; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 3.b. Men are more likely to become disabled. ANSWER: b; LO 9.3; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
5.c. 20 in the last ten years. ANSWER: c; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.d. 12. ANSWER: d; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.b. Someone with high debt. ANSWER: b; LO 9.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a 8.c. $1,050. ANSWER: c; LO 9.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A Solution: For individuals working in hazardous occupations, annual long-term disability premiums cost approximately 3% of the annual benefit. The answer is $35,000 X 0.03 = $1,050 9.a. $100.00. ANSWER: a; LO 9.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A Solution: Annual benefit is 12 X $5,000 = $60,000. Cost for a low-risk occupation and a smoker is 2% of the annual benefit, or $60,000 X 0.02 = $1,200. Monthly premiums = $1,200 / 12 = $100 per month 10.b. III only. ANSWER: b; LO 9.3; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a
9.3 Adventures in Financial Literacy Short Answer 1.
ANSWER: You should attempt to obtain an own occupation or modified own occupation policy. You should avoid an any occupation policy because the definition of disability is often difficult to meet. LO 9.3; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a
2.
ANSWER: Someone who implements the recommendations made in this book will already have built an emergency savings fund. This fund can be used to cover short-term disability needs. LO 9.3; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a
3.
ANSWER: She needs approximately $31,850 in yearly benefits [$49,000 x 65%]. LO 9.3; BT: An; Difficulty: M; TOT: 5 min; AACSB: A
4.
ANSWER: An inflation protection rider ensures that the monthly or yearly benefits promised within a disability plan keep pace with future pay raises. Without this rider, the benefit will be fixed at the amount purchased. With the rider, the benefit will increase with inflation. LO 9.3; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a
5.
ANSWER: No, she will not be covered under workers’ compensation. Workers’ compensation only pays benefits in situations where a disability or injury is the direct result of work related action. Your relative may be eligible for Social Security disability coverage, however. LO 9.3; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: n/a
Explore 1. ANSWER: This should be added. Answers should include topics such as regular childhood vaccines, injury prevention, and keeping away from high noise levels. LO 9.3; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: n/a
2. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.3; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: C
3. ANSWER: This person should purchase an own occupation disability policy that, at a minimum, provides residual benefit coverage in the case that she is only partially disabled. The policy should have a short waiting period before benefits begin. The policy should also include both a guaranteed renewable and inflation protection rider. LO 9.3; BT: An; Difficulty: M; TOT: 40 min; AACSB: C, A
Expanded Research ANSWER: High quality responses should include a discussion of the type of disability and the prevalence of the disability in the chosen state. Please refer to the sample rubric at the front of the solutions manual. LO 9.3; BT: Ap; Difficulty: M; TOT: 30 min; AACSB: C, A
9.3 Concept Checks 1. Which of the following statements is true? a. Social Security disability benefits are designed to replace more than 100% of a person’s pre-disability income. b. Social Security disability benefits max out after one year. c. You are more likely to obtain Social Security disability insurance benefits than to receive benefit from a modified own occupation policy. d. It is difficult to qualify for Social Security benefits. ANSWER: d; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. A disability policy that provides benefits when you are unable to perform the material and substantial duties of your job is called: a. Any Occupation. b. Own Occupation. c. Modified Any Occupation. d. Comprehensive Occupation. ANSWER: b; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. What helps explain why few adult Americans currently have a disability policy? a. Disability policies are relatively new, which means few consumers know about them. b. Disability policies are very expensive. c. Disability policies require people to envision themselves becoming injured. d. Disability policies are difficult to obtain because few insurance companies offer the product. ANSWER: c; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Laural earns $85,000 per year as a professional tuba player in a local symphony. If she is in good health, how much disability insurance should she purchase? a. $15,250. b. $42,500. c. $55,250. d. $76,500. ANSWER: c; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: The maximum amount of disability insurance coverage that Laural can purchase is 65% of her income, or 0.65 X $85,000 = $55,250. It is best to purchase the maximum coverage unless there is another source of income independent of earnings. 5. Over the past weekend, Javier injured himself waterskiing. While he did not go to the emergency room, he was in so much pain that he could hardly work. On Monday, he made it to work but collapsed on the job. His job foreman rushed him to the hospital where he was diagnosed with severe internal injuries. The doctor indicated that Javier would be out of work for at least 9 months. Given this scenario, Javier can: a. Make a claim against his employer’s workers’ compensation insurance. b. Claim benefits against his personal long-term modified own occupation disability policy.
c. Claim disability benefits from Social Security. d. Make a claim against his personal short-term own occupation disability policy. ANSWER: d; LO 9.3; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
9.4 End-of-Topic Assessment 9.4 Multiple-choice 1. b. Beneficiary; Policy Owner. ANSWER: b; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.a. Will receive the death benefit if the primary beneficiary dies before the policy owner. ANSWER: a; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.a. Term Life Insurance. ANSWER: a; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4.d. Universal, Variable, and Variable Universal. ANSWER: d; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5.d. Only provides pure insurance against unexpected death. ANSWER: d; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.a. Variable Universal Life Insurance. ANSWER: a; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.c. II and III only. ANSWER: c; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. You and your fiancee to be are getting married in 1 year and both of you work full time. ANSWER: d; LO 9.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.b. Calculating present values of future cash flows. ANSWER: b; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.c. $450,000. ANSWER: c; LO 9.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: Income Multiplier Method multiplies current income by 10, or $45,000 X 10 = $450,000 9.4 Adventures in Financial Literacy
Short Answer 1. ANSWER: First, the life insurance policy that Max owns must be a cash value policy (which is probably not the best type of policy for Max to own to begin with), otherwise, cash could not be taken from a term policy. Max has two options to pull money from a cash policy. First, Max could cancel or surrender the life insurance policy, but in doing so he would pay some pretty significant costs known as surrender charges, these are penalties charged to the life insurance owner and deducted from the cash value. These penalties decrease over time so that after 7 to 10 years they are entirely eliminated. Second, Max could borrow money from his own life insurance policy. Then, over time Max would repay the loan to the life insurance policy. LO 9.4; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a 2. ANSWER: Shannon probably does not need life insurance. No one is currently dependent on her or her income and she does not have debts that would go to another in the event of her passing. If Shannon were to purchase life insurance, term insurance would be the most affordable for the coverage amount she might desire. LO 9.4; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A 3. ANSWER: Jenny should purchase $450,000 of life insurance based on the multiplier method. LO 9.4; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A Explore 1. ANSWER: High quality responses should discuss what happens to the price of the policy as the term period changes. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.4; BT: An; Difficulty: M; TOT: 40 min; AACSB: A 2. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.4; BT: C; Difficulty: M; TOT: 30 min; AACSB: n/a 9.4 Expanded Learning ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: n/a 9.4 Concept Check 1. Life insurance provides a tax-free lump sum payoff that can be used to: a. Pay burial costs. b. Pay off final debts. c. Pay final expenses. d. Pay burial costs, final debts, and final expenses. ANSWER: d; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. For tax reasons, it is generally best to have _____ of the three parties involved in a life insurance policy be the same people.
a. 1. b. 2. c. 3. d. It does not matter, the tax treatment is the same. ANSWER: b; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. For someone with a limited budget, which type of policy makes most sense? a. Whole Life Policy. b. Term Life Policy. c. Variable Universal Life Policy. d. Universal Life Policy. ANSWER: b; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Which of the following statements regarding term life insurance is INCORRECT? a. Annual renewable term needs to be purchased yearly. b. Level term is purchased for periods ranging from 5 to 30 or more years. c. Term life insurance is much less expensive than cash value life insurance. d. Term life insurance is intended to provide life-time insurance protection. ANSWER: d; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. For cash value policies, the death benefit: a. Equals the face value of the policy. b. Is the initial dollar amount of insurance selected by the policy owner. c. Grows as premiums are paid. d. Offers no savings aspect. ANSWER: c; LO 9.4; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
9.5 End-of-Topic Assessment 9.5. Multiple-choice 1.b. Pay for the liability you may cause to others if you are involved in an accident in which you are at fault. ANSWER: b; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.a. Car; Driver. ANSWER: a; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.b. No, because her insurance company will claim that the boyfriend should have been listed as a regular driver of the car. ANSWER: b; LO 9.5; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a
4.d. medical coverage for one person in the other car. ANSWER: d; LO 9.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.c. $50,000. ANSWER: c; LO 9.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: A 6.b. $25,000. ANSWER: b; LO 9.5; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A
7.b. An underinsured motorist. ANSWER: b; LO 9.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 8.c. I and II only. ANSWER: c; LO 9.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 9.c. $500. ANSWER: c; LO 9.5; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: The deductible for liability coverage on Melba’s policy is $500 and that is her out-of-pocket cost for this accident. 10.d. Both comprehensive and underinsured coverage. ANSWER: d; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
9.5 Adventures in Financial Literacy Short Answer 1. ANSWER: All of the following will count against a good driving record: being involved in accidents, getting moving violation tickets, committing manslaughter, driving while under the influence of alcohol or drugs, criminally negligent driving, driving without a license, and previously driving without insurance. Low credit scores are also used to determine who will be classified as a high-risk driver. LO 9.5; BT: C; Difficulty: M; TOT: 10 min; AACSB: A 2. ANSWER: Given his split limit coverage, Nigel’s insurance company will pay up to $10,000 in damage to someone else’s property. In this case, the other car owner or the insurance company for the other driver can sue Nigel for $20,000, which is the difference between the car’s value and what Nigel’s policy paid.
LO 9.5; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 3. ANSWER: Most cars that are seven years or older have a low market value, whereas the premium for comprehensive coverage can be quite high. If you are involved in an accident and the car is deemed to be “totaled”, the insurance company will generally pay you the market value and scrap the car. The exception to the rule is when you own a collector or high value car that would be too expensive to replace without insurance. LO 9.5; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A 4. ANSWER: The reason you should never admit guilt is that even if you feel you may be at fault, there may be other factors that you are not aware of that led to the accident. The other driver, for example, may have been impaired or the road may have been unsafe. Basically, when you admit guilt you limit your future legal alternatives. LO 9.5; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a
Explore 1. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: C 2. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: An; Difficulty: M; TOT: 30 min; AACSB: A, C 3. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: An; Difficulty: M; TOT: 20 min; AACSB: A, C 4. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: An; Difficulty: M; TOT: 30 min; AACSB: A, RT
9.5 Expanded Learning Research ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: Ap; Difficulty: M; TOT: 40 min; AACSB: C, A 9.5 Concept Checks 1. The amount you must pay before your insurance company makes a payment on a claim is called: a. The premium. b. The loss waiver. c. The deductible. d. The collision waiver. ANSWER: c; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. What type of coverage pays for things like broken glass and vandalism to your car? a. Uninsured motorist coverage. b. Collision coverage. c. Liability coverage.
d. Comprehensive coverage. ANSWER: d; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. What are your options if you are hit by a driver who is underinsured and the damage to your vehicle exceeds the other driver’s insurance limits? a. Unfortunately, you have no options. b. You may sue the other driver in court for damages. c. You may make a claim against your own PAP coverage but this may increase your premium. d. Either you may sue the other driver in court for damages or you may make a claim against your own PAP coverage but this may increase your premium. ANSWER: d; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. When you sign a ticket issued by a police officer or sheriff you are: a. Pleading guilty. b. Accepting some fault in the accident. c. Agreeing to appear in court. d. Both accepting some fault in the accident and agreeing to appear in court. ANSWER: c; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. One day, while Barbara was parking her car at the mall, she backed into another car. She got out of her car to see what happened. The other driver was not there at the time. Barbara could not see any damage, so she continued on her way. Which of the following statements is true about this situation? a. Because there was no obvious damage, Barbara has no liability. b. Barbara should have left a note for the other driver. c. Barbara’s action is an example of a hit and run. d. Both Barbara should have left a note for the other driver and Barbara’s action is an example of a hit and run. ANSWER: d; LO 9.5; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.6 End-of-Topic Assessment 9.6. Multiple-choice 1.b. Morale hazard. ANSWER: b; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. Filing false insurance claims. ANSWER: d; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3.a. Throwing a block party at your house. ANSWER: a; LO 9.6; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: A 4.a. Self-Insure.
ANSWER: a; LO 9.6; BT: C; Difficulty: E; TOT: 2 min; AACSB: n/a 5.a. II only. ANSWER: a; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 6.b. Fire, windstorm, and floods. ANSWER: b; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 7.c. Part E. ANSWER: c; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 8.d. A basketball court, swimming pool, and / or a swing set. ANSWER: d; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.d. I, II, and III. ANSWER: d; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.d. Loss of personal property, loss of use of property, and personal liability. ANSWER: d; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
9.6 Adventures in Financial Literacy Short Answer 1. ANSWER: Brent could increase his liability coverage on his homeowner’s policy, and he could also purchase a separate umbrella policy to provide additional liability protection. LO 9.6; BT: C; Difficulty: M; TOT: 10 min; AACSB: n/a 2. ANSWER: Gary can keep the basketball court if he wants to. The basketball court represents an attractive nuisance on Gary’s property, which could lead to additional losses (injuries resulting from kids playing basketball on the court). Gary should have a fence around his court and he should also consider increasing his liability coverage and carrying an umbrella policy. LO 9.6; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: n/a 3. ANSWER: They have risk exposure due to their house and vehicles. Their house should be insured because of the value it represents. Their vehicles should be insured against the damage/harm that they could cause to others (liability coverage). The couple can self-insure against the replacement cost of the vehicles. Additionally, the couple should consider an umbrella policy to protect their other assets from unanticipated litigation or loss. LO 9.6; BT: An; Difficulty: M; TOT: 20 min; AACSB: A 4. ANSWER: A. III; B. VI; C. IV; D. V; E. I; F. II. LO 9.6; BT: C; Difficulty: M; TOT: 5 min; AACSB: n/a Explore
1. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.6; BT: An; Difficulty: M; TOT: 40 min; AACSB: A, C 2. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.6; BT: An; Difficulty: M; TOT: 40 min; AACSB: A, C 9.6 Expanded Learning ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.6; BT: An; Difficulty: M; TOT: 60 min; AACSB: n/a 9.6 Concept Check 1. A ________ is a situation or condition that makes the probability or loss more likely. a. Peril. b. Hazard. c. Risk. d. Catastrophe. ANSWER: b; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. A __________ is anything that causes you to lose something. a. Peril. b. Hazard. c. Risk. d. Rider. ANSWER: a; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. If you live in a flood zone, you should purchase: a. Homeowner’s insurance. b. Flood insurance. c. Umbrella policy. d. Catastrophic loss policy. ANSWER: b; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. When you buy an HO policy, you should purchase enough insurance to pay for ______ of the cost of replacing your dwelling and your personal property. a. 50%. b. 80%. c. 100%. d. 120%. ANSWER: c; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 5. What does replacement coverage ensure? a. The full replacement cost of items will be paid. b. The cash value of items will be paid. c. Both the full replacement cost and the cash value of items will be paid.
d. Neither the full replacement cost of items will be paid or the cash value of items will be paid. ANSWER: a; LO 9.6; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9.7 End-of-Topic Assessment 9.7 Multiple-choice 1.b. Two or more. ANSWER: b; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2.d. The amount of time you must wait for long-term care insurance benefits to begin. ANSWER: d; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. b. $63,000. ANSWER: b; LO 9.7; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: $350 daily charge X 180 days = $63,000 4. c. $216,000. ANSWER: c; LO 9.7; BT: A[; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: $200 per day X 360 days X 3 years = $216,000, this is the minimum amount of coverage he would want. 5. d. $13,500.$27,000 ANSWER: d; LO 9.7; BT: Ap; Difficulty: E; TOT: 5 min; AACSB: n/a Solution: Daily cost of care is $81,000 / 360 days = $225 / day. First multiply this by 60 days, $225 X 60 = $13,500. Then look at the maximum daily benefit covered, higher of $175 or 80% of $225 ($225 X 0.80 = $180), use $180 for the insurance coverage for each day. Uncovered daily cost of care is $225 - $180 = $45 per day. Cost for the first 60 days is $13,500. Cost for the next 300 days is $45 X 300 = $13,500. Cost for the whole year (360 days) is $13,500 + $13,500 = $27,000. 6.a. $175. ANSWER: c; LO 9.7; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: Annual cost of $63,000 divided by 360 days, $63,000 / 360 = $175 / day. This is the same amount as the maximum insurance daily benefit. So the insurance will pay the daily cost of $175. 7.
b. $19,444. ANSWER: b; LO 9.7; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: Daily cost is the annual cost divided by 360 days, or $70,000 / 360 = $194.44 per day. Cost of the 100 day elimination period is 100 days X $194.44 per day = $19,444.44 rounded to $19,444 8. c. If she needs care beyond two years, she will need to fund these costs from her own savings or investments. ANSWER: c; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 9. b. No, because the risk of needing long-term care insurance benefits is very low now. ANSWER: b; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 10.c. $400. ANSWER: a; LO 9.7; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: n/a Solution: Using the future value of a lump sum input the following variables: N = 28, I = 3, PV = 175, CPT > FV. The answer is $400.39 (it will have the opposite sign of the PV). Round to $400.
9.7 Adventures in Financial Literacy Short Answer 1. ANSWER: Bathing, continence, dressing, eating, toileting, and transferring. LO 9.7; BT: C; Difficulty: M; TOT: 2 min; AACSB: n/a 2. ANSWER: The daily cost is $225 ($81,000 / 360). LO 9.7; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: n/a 3. ANSWER: They will pay approximately $34,500 as an elimination period cost (($69,000 / 360) x 180). LO 9.7; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: n/a Explore 1. ANSWER: High quality responses will include a description of at least to people’s long-term care plans, if any, and how they hope to implement their plans. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.7; BT: An; Difficulty: M; TOT: 60 min; AACSB: C, A 2. ANSWER: High quality answers should address each of the cost questions outlined above. Please refer to the sample writing assignment rubric in the solutions manual. LO 9.7; BT: An; Difficulty: M; TOT: 30 min; AACSB: A
9.7 Expanded Learning Research ANSWER: The “oldest old,” those 85 and older are expected to triple in number over the coming decades. The working population will also increase, but at a much slower growth rate. The ratio between oldest old and working people LO 9.7; BT: Ap; Difficulty: M; TOT: 20 min; AACSB: A, C
9.7 Concept Checks 1. A key element within long-term care insurance policies is defining activities of daily living. Which of the following lists represents the primary six activities of daily living most commonly used by insurance companies as benefits triggers under long-term care insurance policies? a. Dressing, walking 50 feet, telephone use, medicine management, bathing, and eating. b. Bathing, continence, dressing, eating, toileting, and transferring. c. Medicine management, continence, dressing, eating, paying bills, toileting. d. Memory loss, toileting, transferring, dressing, vision, and telephone use. ANSWER: b; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 2. Those in need of long-term care assistance are provided for in a variety of different ways. Which of the following best describes the breakdown of service providers? a. 78% receive care from family and friends. b. 14% receive all care from family and friends. c. 22% receive care in nursing homes. d. 8% receive care from family and friends. ANSWER: a; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 3. All of the following statement are true, except: a. Most long-term care insurance policies provide benefits for home health-care services. b. Few long-term care insurance policies have elimination periods shorter than one month. c. Nearly all long-term care insurance policies have a limited benefit limit. d. Most long-term care insurance policies provide lifetime coverage. ANSWER: d; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a 4. Latrice just turned 65. During her life’s financial journey she has accumulated a sizable nest egg. At this time she does not have a long-term care insurance policy. Which of the following governmental programs can she enroll in to cover her long-term care needs? a. Medicare. b. Medicaid. c. Obamacare. d. There is not a government program that Latrice can enroll in that will cover all of her long-term care needs. ANSWER: d; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a
5. Who would be most likely to help a consumer when searching for a long-term care insurance policy? a. Doctor. b. Financial Planner. c. Home Health Aide. d. Both doctor and home health aide. ANSWER: b; LO 9.7; BT: K; Difficulty: E; TOT: 2 min; AACSB: n/a Chapter 9 Summary
Continuing Case: Tarek’s Financial Journey a. ANSWER: Their out-of-pocket expense will be $2,000; the insurance company will pay the remainder or $6,000: Cost $ 8,000.00 Deductible $ 500.00 Balance Subject to Insurance $ 7,500.00 Co-Insurance $ 1,500.00 [Out of Pocket Max] $ 2,500.00 Tarek & Samantha Expense $ 2,000.00 Insurance $ 6,000.00 Since Tarek and Samantha’s total expenses have not exceeded $2,500, they will pay their share, $2,000, of the expenses. LO 9.2; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A b. ANSWER: Based on the chapter guideline, he should look for a policy that will replace 65% of his income or $31,850. If he buys this amount of coverage, he can expect to pay between $319 and $956 per year based on the hazards associated with his occupation (1% for low-risk occupations and 3% for high-risk occupations). LO 9.3; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A c. ANSWER: The income multiplier approach recommends that her income be multiplied by 10. This is gross insurance need. From this she should subtract her current policy to arrive at the need, which is $280,000 ($330,000 - $50,000). LO 9.4; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A d. ANSWER: The only life insurance product that provides a guaranteed cash value is a whole life insurance policy. Compared to a term policy, the premiums can be expensive. Compared to other cash value policies, the rate of return earned on the cash value in the policy will be relatively low. LO 9.4; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A e. ANSWER: They should each purchase a 30-year term life insurance policy. Optional provisions to consider include a disability premium waiver and a guaranteed renewability provision. LO 9.4; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: A
f. ANSWER: No, he does not need a personal property rider (floater) until the value of the collection reaches $2,500. When the collection is valued at $3,000 he should purchase a rider by documenting what he owns. The approximate annual premium will be $30 ($3,000 x .01). LO 9.6; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A
Calculating the Cost of Life’s Financial Journey a. ANSWER: Estimates for each elimination period are as follows: 180 Day Elimination Period $ 36,000.00 90 Day Elimination Period
$ 18,000.00
30 Day Elimination Period
$
6,000.00
SOLUTION: 180 Day Elimination Period
$ 36,000.00 based on $200 per day for 180 days ($200 x 180)
90 Day Elimination Period
$ 18,000.00 based on $200 per day for 90 days ($200 x 90)
30 Day Elimination Period
$
6,000.00 based on $200 per day for 30 days ($200 x 30)
LO 9.7; BT: An; Difficulty: M; TOT: 10 min; AACSB: A b. ANSWER: They will pay the least amount of premiums with the policy that has a 180-day elimination period. Policy Annual Premium Total Premiums 180 Day Elimination Period
$ 2,900.00
$ 34,800.00
90 Day Elimination Period
$ 3,300.00
$ 39,600.00
30 Day Elimination Period
$ 3,800.00
$ 45,600.00
SOLUTION: Policy
Annual Premium Total Premiums Calculation
180 Day Elimination Period
$ 2,900.00
$ 34,800.00
12 years of payments @ $2,900 per year (12 x $2,000)
90 Day Elimination Period
$ 3,300.00
$ 39,600.00
12 years of payments @ $3,300 per year (12 x $3,300)
30 Day Elimination Period
$ 3,800.00
$ 45,600.00
12 years of payments @ $3,800 per year (12 x $3,800)
LO 9.7; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A
c. ANSWER: $21,600; The maximum reimbursement will be $57,600, which is 80% of $72,000. He will pay $36,000 during the elimination period, which leaves a difference of $21,600. During the second year he will receive $57,600. LO 9.7; BT: Ap; Difficulty: M; TOT: 10 min; AACSB: A d. ANSWER: They need to save $12,075 per year. The future value in this case is $216,000 ($72,000 x 3 years). The interest rate is 7%, and the number of compounding periods is 12. LO 9.7; BT: S; Difficulty: M; TOT: 15 min; AACSB: A e. ANSWER: Given the fact that they have a limited budget, they should consider purchasing a longterm care policy. The policy with the 180-day elimination period is attractive because they have money currently saved that can be used to fund the need. Also, the premium is the lowest of those shown. LO 9.7; BT: An; Difficulty: M; TOT: 10 min; AACSB: A Planning for the Future a. ANSWER: Responses to this question will vary based on each student’s research. Please refer to the sample rubric. High quality response should include a completed rubric from above. LO 9.5; BT: An; Difficulty: M; TOT: 35 min; AACSB: A
b. ANSWER: They may qualify for a premium reduction if they choose to insure the car with the same company that insures their home. Other potential discounts include: (1) a safe driving discount, (2) a low mileage discount, and (3) a car alarm discount LO 9.5; BT: An; Difficulty: M; TOT: 10 min; AACSB: A c. ANSWER: Responses to this question will vary based on each student’s research. LO 9.5; BT: An; Difficulty: M; TOT: 10 min; AACSB: A d. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: An; Difficulty: M; TOT: 20 min; AACSB: A, C e. ANSWER: Please refer to the sample writing assignment rubric in the solutions manual. LO 9.5; BT: An; Difficulty: M; TOT: 45 min; AACSB: A
Chapter 10—Solutions Manual Planning for the Future: Retirement and Estate Planning Introduction to Personal Finance: Beginning Your Financial Journey By John Grable and Lance Palmer
Learning Objectives 10.1 Discuss the need and responsibility for retirement planning. 10.2 Explain how to use individual retirement accounts (IRAs) to save for the future. 10.3 Identify the multiple ways property can be held and transferred. 10.4 Explain the use of wills as a tool to transfer property after death. 10.5 Describe the purpose of living wills, advanced directives, and powers of attorney. 10.6 Explain how professionals can help you navigate your financial journey. Key to metadata for questions: LO: Learning objective number BT: Bloom’s taxonomy [Knowledge (K), Comprehension (C), Application (Ap), Analysis (An), Synthesis (S), Evaluation (E)] Diff: Difficulty level [Easy (E), Medium (M), Hard (H)] TOT: Expected time for student to complete AACSB: Communication (C), Ethics (E), Analytic (A), Technology (T), Diversity (D), Reflective Thinking (RT), Not Applicable (n/a) Sample rubric for writing questions: Note: It is generally recommended that the rubric be shared with students, so it should be sufficiently general to not give away answers. Notes for instructor: Each writing question will have criteria which are specific to the question. The instructor may want to add or delete grading criteria (rows) depending on the topic and assignment. How each grading criterion will be assessed and the associated points for each level of performance are found in columns 2–5. In the sample rubric, a total of 16 points are possible for this assignment. Each grading criterion (row) is worth up to 4 points (column 2).
Rubric: (It is suggested that the rubric be shared with the students.) Criteria
Full points (4 out of 4)
75% of points (3 out of 4)
50% of points (2 out of 4)
Thoroughness of answer to the question
The question is answered thoroughly
The response is lacking a few details
The response is The response is lacking significant incomplete and details limited
Answer is realistic/relevant
Amounts and information discussed are relevant and pertinent to the question
Some of the response is irrelevant to the question
Much of the response is irrelevant, unrealistic, or overly simplistic
The response does not represent realistic or relevant understanding of topic
Adequate organization
Limited organization
Poor organization
Organization/clarity of thought Well organized (25% of score) Appropriate recommendations and conclusions are reached (25% of score)
A clear conclusion Conclusion or or recommendation recommendation is Conclusion or is presented that is mostly clear and recommendation appropriate given appropriate given is incomplete the content the content discussed
25% of points (1 out of 4)
No conclusion or recommendation is provided
10.1 Discuss the need and responsibility for retirement planning. 10.1 Multiple-Choice Questions 1. d. the number of years in retirement is about the same as it was in 1930. Answer: d; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. b. Defined benefit plans guarantee payments to retirees, whereas defined contribution plans make contributions to retiree account without making guarantees. Answer: b; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. c. defined benefit; defined contribution.
Answer: c; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. d. It’s always important, regardless of age. Answer: d; Section: 10.1; LO: 10.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. d. 457 plans, 403(b) plans, and 401(k) plans. Answer: d; Section: 10.1; LO: 10.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 6. d. You will outlive your savings. Answer: d; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 7. a. II and III only. Answer: a; Section: 10.1; LO: 10.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. c. I, III, and IV only. Answer: c; Section: 10.1; LO: 10.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. b. 403(b) plan. Answer: b; Section: 10.1; LO: 10.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. d. They each provide employees tax-advantaged opportunities to save for retirement. Answer: d; Section: 10.1; LO: 10.1; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
10.1 Adventures in Personal Finance Short Answer 1. Answer: 12.6–14.7% Solution: Using Illustration 10.1.3 (see the table next), Lennox’s current income is between $50,000 and $78,000, but he did not have very high consistent income before this job; however, his potential income going forward could be closer to the $78,000. He is also just starting to save at age 33, which is very close to age 35. For these reasons, Lennox’s total retirement savings rate should be between 17.6% and 19.7%. Lennox’s employer matches up to 5% of his compensation, which means he can reduce his savings rate by 5%. So, 12.6–14.7% of his income annually should be saved for retirement until he reaches age 65.
Required Retirement Savings Rate to Reach Retirement Goala
Amount Needed at Retirement $178,250 537,500 936,000 1,620,000
Average Career Income $23,000 50,000 78,000 120,000
Start Saving at Age 25
Start Saving at Age 35
Start Saving at Age 45
7.20% 10.00 11.20 12.60
12.70% 17.60 19.70 22.10
24.70% 34.30 38.30 43.00
Notea Assumes that the individual has not yet saved any money for retirement, plans to retire at age 65, and will realize a real rate of return on investments of 4.5%. Section: 10.1; LO: 10.1; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
2. Answer: 17.6–19.7% Solution: Sue should be saving approximately 17.6–19.7% of her income for retirement to reach her goal. Sue expects average earnings of $65,000, approximately midway between $50,000 and $78,000. She wants to retire 10 years earlier, so it is like she is starting to save at age 35 instead of 25 (30 years to retirement). Sue should be saving approximately 17.6–19.7% of her income for retirement to reach her goal.
Amount Needed at Retirement
Average Career Income
Required Retirement Savings Rate to Reach Retirement Goala Start Saving at Age 25
Start Saving at Age 35b
Start Saving at Age 45
$178,250 $23,000 7.20% 12.70% 24.70% 537,500 50,000 10.00 17.60 34.30 936,000 78,000 11.20 19.70 38.30 1,620,000 120,000 12.60 22.10 43.00 Notea Assumes that the individual has not yet saved any money for retirement, plans to retire at age 65, and will realize a real rate of return on investments of 4.5%. Noteb Although 25-year-old, retirement goal is age 55 rather than 65 so need to treat the savings rate as if 10 years older to adjust for the 10-year reduction in time horizon. Section: 10.1; LO: 10.1; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
3.
Answer: IRA Solution: Jeff’s best option is an IRA. He can do this on his own without sponsorship from his employer. The other options require employer sponsorship. Section: 10.1; LO: 10.1; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
4.
Answer: Yes Solution: Maria can establish a 401(k) for her business. She can make contributions as an employee AND match contributions as an employer.
Section: 10.1; LO: 10.1; BT: Ap; Diff: M; TOT: 5 min; AACSB: n/a
Explore Answer: $749,692; $1,858,354. Solution: Investing $5,500 per year at 9% APY for 30 years (until age 55) will result in $749,692, and for 40 years (until age 65), it will result in $1,858,354.
1.
When using financial calculators and Excel spreadsheet TVM functions, annuity payments are expressed as negative numbers because payments are technically cash outflows, and the FV represents your aggregate savings. Financial Calculator 30 years: PMT (−5,500); I (9); N (30); PV (0); CPT FV (749,692) 40 years: PMT (−5,500); I (9); N (40); PV (0); CPT FV (1,858,354) Excel Spreadsheet =FV(rate, nper, pmt, pv) 30 years: = FV(0.09, 30,−5,500, 0) => $749,692 40 years: = FV(0.09, 40, −5,500, 0) => $1,858,354 TVM Factor Table Future value of annuity of investing $1 at the end of each period—see table. 30 years: Period 30 versus 9% intersects at 136.30754, and then multiply by $5,500 payment = $749,692 40 years: Period 40 versus 9% intersects at 337.88245, and then multiply by $5,500 payment = $1,858,354 TVM Equation 𝑃𝑀𝑇 [(1 + 𝑖)𝑛 − 1] 𝐹𝑉𝐴 = 𝑖 $5,500 [(1 + 0.09)30 − 1] 0.09 𝐹𝑉𝐴30 yrs = $61,111.11[13.26768 − 1] 𝐹𝑉𝐴30 yrs = $61,111.11(12.26768) = $𝟕𝟒𝟗, 𝟔𝟗𝟐 𝐹𝑉𝐴30 yrs =
$5,500 [(1 + 0.09)40 − 1] 0.09 𝐹𝑉𝐴40 yrs = $61,111.11[31.40942 − 1] 𝐹𝑉𝐴40 yrs =
𝐹𝑉𝐴40 yrs = $61,111.11(30.40942) = $𝟏, 𝟖𝟓𝟖, 𝟑𝟓𝟑
Section: 10.1; LO: 10.1; BT: An; Diff: M; TOT: 15 min; AACSB: A
2.
Answer: High-quality responses should compare findings from IRA providers with 401(k) plans. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.1; LO: 10.1; BT: An; Diff: M; TOT: 60 min; AACSB: A
10.1 Expanded Learning Activity Answer: High-quality responses should compare three companies’ 401(k) plans. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.1; LO: 10.1; BT: An; Diff: M; TOT: 60 min; AACSB: A, C 10.1 Practice Questions 1. Life expectancies have increased over the years. What is the current life expectancy for those living today? a. 69 years. b. 72 years. c. 75 years. d. 80 years. Answer: d; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. When you graduate from college, you should start thinking about preparing for retirement a. immediately. b. after you purchase a home. c. after you pay off your student loan debt. d. both after you purchase a home and after you pay off your student loan debt. Answer: a; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. Defined benefit plans a. guarantee payments to retirees for life. b. are still widely available. c. are plans most people can rely on without worry. d. increase a retiree’s need to save outside of the plan. Answer: a; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. A defined benefit plan is a. a defined contribution plan. b. a pension plan. c. no longer available to employees. d. typically offered to only younger workers.
Answer: b; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. If your employer provides a retirement plan, a. your primary investment option will be company stock. b. you should consider participating in the plan to prepare for retirement. c. wait to get a raise to participate in the plan. d. insist that the employer contribute to the plan, so you won’t have to. Answer: b; Section: 10.1; LO: 10.1; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
10.2 Explain how to use individual retirement accounts (IRAs) to save for the future. 10.2 Multiple-Choice Questions
1. a. traditional IRA. Answer: a; Section: 10.2; LO: 10.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
2. d. He never needs to take a distribution. Answer: d; Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: If certain conditions are met, all the money distributed from the Roth IRA (earnings and contributions) will be tax-exempt. This means that money you pull from a Roth IRA in retirement is tax-free to you. Qualifying distributions from Roth IRAs are tax-free if both of the following conditions are met: 1. The account has been open longer than 5 years. 2. The account owner is older than age 59½ when the distribution is made, or the owner of the account has become disabled or died. Provided the above conditions have been met, there is no need for the IRS to ever care about collecting taxes from the Roth IRA, so no required distribution exists. 3. d. 100%. Answer: d; Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Traditional IRAs allow you to claim a tax deduction, if you qualify, on your federal tax return for the amount of the contribution. When you take money out of the account during retirement, all (100%) the distribution will be taxed as ordinary income in that year (if you claimed a tax deduction when you made the original contribution). That is, traditional IRA owners often get a tax deduction in the year they contribute to the account, but they end up paying taxes on that money in the future when it is pulled out in retirement. However, as long as the money is left in the IRA, none of the investment income is taxable. This is what is meant by the term tax-deferral. 4. b. As long as he only takes out his contributions—not the account earnings—the distribution will be tax- and penalty-free. Answer: b; Section: 10.2; LO: 10.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
5. a. Miguel who works part-time at a pretzel shop in the mall. Answer: a; Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: You need to have earned income to contribute to an IRA or a retirement plan. The IRS defines earned income as money received from working or operating your own business. Examples of earned income include wages, salaries, tips, and net earnings from self-employment. Unearned income includes interest, dividends, Social Security, child support, and capital gains. Only Miguel has earned income. 6. c. $205,584. Answer: c; Section: 10.2; LO: 10.2; BT: An; Diff: M; TOT: 5 min; AACSB: A Solution: Contributing $3,000 per year for 28 years at 6% APY will result in $205,584. When using financial calculators and Excel spreadsheet TVM functions, annuity payments are expressed as negative numbers because payments are technically cash outflows and the FV represents your aggregate savings. Financial Calculator N = 28 (started at age 25 and ended at age 53; 53–25=28) PMT = −$3,000 I=6 PV = 0 CPT FV = $205,584 Excel Spreadsheet =FV(rate, nper, pmt, pv) =FV(0.06, 28, -3,000, 0, 0) =>$205,584 TVM Factor Table Future value of annuity of investing $1 at the end of each period—see table. Period 28 versus 6% intersects at 68.52811. Multiply the factor (68.52811) by the payment $3,000 = $205,584. TVM Equation 𝑃𝑀𝑇 [(1 + 𝑖)𝑛 − 1] 𝐹𝑉𝐴 = 𝑖 $3,000 [(1 + 0.06)28 − 1] 𝐹𝑉𝐴 = 0.06 𝐹𝑉𝐴 = $50,000[5.11169 − 1] 𝐹𝑉𝐴 = $50,000(4.11169) = $205,584
7. a. make it automatic. Answer: a; Section: 10.2; LO: 10.2; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
8. c. A Roth IRA. Answer: c; Section: 10.2; LO: 10.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a Solution: Since Xavier expects to pay higher taxes in the future, today he should choose the Roth IRA. Contributions to a Roth IRA are after-tax, so it will be taxed at his current (lower) tax rate. Distributions from a Roth IRA are tax-free. Contributions to a traditional IRA are pretax, with taxes paid at distribution, which is not advantageous for him in this case since he expects to be subject to a higher tax rate at that point.
9. d. $6,500; $0. Answer: d; Section: 10.2; LO: 10.2; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a Solution: For the tax year 2018, individuals aged 50 or older may contribute a total combined amount of $6,500 to any IRA. So if Ruby contributes $6,500 to the traditional IRA, she will have reached the total allowable amount for that tax year and would be able to contribute $0 to the Roth IRA. 10. d. target date funds. Answer: d; Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Target-dated funds provide an automatic guided approach to retirement investing that matches the term to retirement to the amount of risk that is appropriate for the time horizon. While ETFs and index funds provide allocation portfolios and may have lower expense ratios, target-dated funds are the most intricate form of allocation management that essentially takes the timeconsuming management of risk or return in a declining time horizon off your hands. Target date mutual funds manage investment assets based on a set date that is intended to coincide with your retirement date. If you hope to retire around the year 2045, you would then purchase a 2045 target date mutual fund. Target date mutual funds invest in many different types of other mutual funds. Thus, with each investment into a target date fund, you get immediate diversification into stocks, bonds, international securities, other assets, and the peace of mind that you are making progress toward retirement. Target date funds adjust the amount held in stocks, bonds, and cash over time. When you are younger, the fund holds more stock. As you age, the fund automatically reduces the amount held in stocks and increases holdings in bonds and cash. This is what you would do if you were actively managing the money. It is also what would happen if you hired a financial advisor to manage your accounts. Target date funds just do it with less hassle and cost.
10.2 Adventures in Personal Finance Short Answer 1. Answer: Contributions to a traditional IRA may be tax-deductible, whereas contributions to a Roth IRA are never tax-deductible. Additionally, while both IRAs provide tax-deferral of earnings, only the Roth IRA allows distributions to be taken in the future as tax-free. Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 10 min; AACSB: A Answer: $276,474 Solution: Contributing $2,000 per year from age 30 to 65 (35 years) at 7% APY will result in $276,474. All of the distributions will be tax-free at age 65. When using financial calculators and Excel spreadsheet TVM functions, annuity payments are expressed as negative numbers because payments are technically cash outflows, and the FV represents your aggregate savings. Financial Calculator PMT (−2,000); I (7); N (35); PV (0); CPT FV (276,474) Excel Spreadsheet =FV(rate, nper, pmt, pv) =FV(0.07, 35, −2,000, 0) = $276,474 TVM Factor Table Future value of annuity of investing $1 at the end of each period—see table. Period 35 versus 7% intersects at 138.23688. Multiply the factor (138.23688) by the payment $2,000 = $276,474. TVM Equation 𝑃𝑀𝑇 [(1 + 𝑖)𝑛 − 1] 𝐹𝑉𝐴 = 𝑖 $2,000 [(1 + 0.07)35 − 1] 𝐹𝑉𝐴 = 0.07 𝐹𝑉𝐴 = $28,571.43[10.67658 − 1] 𝐹𝑉𝐴 = $28,571.43(9.67658) = $𝟐𝟕𝟔, 𝟒𝟕𝟒 Section: 10.2; LO: 10.2; BT: An; Diff: M; TOT: 10 min; AACSB: A
2. Answer: Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.2; LO: 10.2; BT: An; Diff: M; TOT: 20 min; AACSB: C, A
3. Answer: Typically, when someone under the age of 59½ takes an IRA distribution, he or she will pay a 10% penalty, in addition to taxes on the entire distribution. However, in this case, Tom can
avoid the penalty because the distribution will be used to pay for college expenses. He will, however, need to pay taxes on the distribution. Section: 10.2; LO: 10.2; BT: C; Diff: M; TOT: 20 min; AACSB: A
Explore
1.Answer: High-quality responses should include information about who the survey was sent to, a summary of survey responses, and a discussion of those responses. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 120 min; AACSB: A
2.Answer: High-quality responses should address items a—d. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.2; LO: 10.2; BT: An; Diff: M; TOT: 60 min; AACSB: A, C
10.2 Expanded Learning Activity Answer: High-quality responses should address each of the bullet points above for at least five firms. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.2; LO: 10.2; BT: An; Diff: M; TOT: 60 min; AACSB: A, C 10.2 Practice Questions 1. The key to reaching your financial goals through investing is to a. be faster than other investors. b. invest consistently. c. invest only in stocks. d. avoid taking more than moderate investment risk. Answer: b; Section: 10.2; LO: 10.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. A retirement plan that provides the possibility for a tax-free distribution and tax-deferral of earnings until they are distributed is called a a. Roth IRA. b. 529 plan. c. MyRA plan. d. traditional IRA. Answer: a; Section: 10.2; LO: 10.2; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. One of the best tax-advantaged ways to save for retirement if you are in your 20s and your employer does not offer a retirement plan is to a. buy real estate. b. contribute to a Roth IRA. c. contribute to a traditional IRA.
d. sign up for a 401(k) retirement plan. Answer: b; Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Roth IRAs are similar to traditional IRAs (you get to choose the investments in the account, and the earnings within the Roth IRA are tax-deferred, like a traditional IRA). The difference is that Roth IRAs provide you with a different tax outcome. If certain conditions are met, all the money distributed from the account (earnings and contributions) will be tax-exempt. This means that money you pull from a Roth IRA in retirement is tax-free to you. When you’re in your 20s just starting out in your career, your earnings are typically at the lowest in your adult life. Hence, it would be advantageous to pay taxes (when earnings are at the lowest marginal tax rates). 4. Kim and Chris have been married for 18 years. Over that time, they have been saving aggressively for their future retirement. Kim has a fully taxable brokerage account with an online broker, whereas Chris has his own taxable brokerage account with a major Wall Street firm. They both also have a 401(k) plan. Kim has a Roth IRA, and Chris has a traditional IRA. They are wondering the best place to hold certain assets. In general, Kim and Chris should hold assets that produce ordinary income in the _________ and assets that have the highest potential for growth in the __________ to take advantage of the tax benefits of certain accounts. a. brokerage account; Roth IRA b. Roth IRA; traditional IRA c. traditional IRA; Roth IRA d. traditional IRA; brokerage account Answer: c; Section: 10.2; LO: 10.2; BT: Ap; Diff: Hard; TOT: 5 min; AACSB: A Solution: When allocating all your assets (qualified retirement accounts like IRAs and nonqualified accounts like brokerage accounts and bank accounts), certain asset classes have various tax advantages and a particular placement has its tax efficiencies. Kim and Chris have been saving aggressively for their future retirement and thus will most likely have a significant portion of their overall savings available for tax-advantaged accounts like IRAs. Roth IRAs provide tax-free growth. Assets that are going to appreciate substantially should be in Roth IRAs to be tax-free rather than taxable (even if at a slightly lower marginal tax rate or long-term capital gain rate). Assets that produce ordinary income, such as CDs and bonds, should be placed in traditional IRAs to take advantage of tax-deferral of ordinary income (interest).In traditional IRAs, all the earnings in the account will not be taxed until you retire or begin taking distributions. Roth IRAs are similar, but since income taxes have been paid on the contributions, all earnings are tax-free when you take distributions (after 59½ years old), so the assets that have the greatest expectation for appreciation should be placed here to avoid taxation.
5. Wayne and May, who are both in their early 40s, have been happily married for nearly 20 years. While they have been saving some money for their eventual retirement, they know they are well short of what they need. Given their age, what percent of their income should they devote to retirement savings in order to make sure that they reach their retirement income goal? a. 10–15%. b. 15–25%. c. 25–40%.
d. More than 50%. Answer: c; Section: 10.2; LO: 10.2; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: If you are in your 20s, save between 10% and 15% of your paycheck for retirement. If you don’t start saving until you are in your 30s, then the amount you will need to save is between 15% and 25%. If you wait to start saving until you are in your 40s, you will need to save between 25% and 40% of your income each year for retirement. 10.3 Identify the multiple ways property can be held and transferred. 10.3 Multiple-Choice Questions 1. b. When you own an asset with another person or persons. Answer: b; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. c. II and III only. Answer: c; Section: 10.3; LO: 10.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. d. They should title the home as JTWROS as a way to accomplish their goals. Answer: d; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. b. Tenancy in common. Answer: b; Section: 10.3; LO: 10.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. c. JTWROS. Answer: c; Section: 10.3; LO: 10.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 6. a. II only. Answer: a; Section: 10.3; LO: 10.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a Solution: Titling their business holdings as JTWROS will automatically transfer ownership to survivors outside the probate process upon their death. Tenancy by the entirety does not apply to them because they are not married. Tenancy in common does not allow probate to be avoided. 7. c. grantor; beneficiary. Answer: c; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 8. b. testamentary trust. Answer: b; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. c. Your parent or guardian until you reach age 18. Answer: c; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
10. b. No, the gift is not taxable to Fan, but because it exceeds the annual gift tax exclusion amount, it is taxable to Fan’s great uncle. Answer: b; Section: 10.3; LO: 10.3; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
10.3 Adventures in Personal Finance Short Answer 1. Answer: JTWROS. Solution: Joint tenancy with right of survivorship (JTWROS) is a very simple method to title property and avoid the publicity from probate. You own the property equally with another person, and each of you has rights of survivorship. That is, when one owner dies, the other owner receives that person’s interest in the property. Titling your assets as JTWROS automatically transfers ownership to another person outside the probate process upon your death. Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 5 min; AACSB: A 2. Answer: Gifts occur only when the donor is alive. In this case, Kim’s uncle had died leaving her with an inheritance. Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 10 min; AACSB: n/a
3.Answer: According to the Internal Revenue Service, a gift of property only occurs if the giver has no expectations to receive something in return. Additionally, the transfer of the property must be irrevocable, which means that the giver cannot ask for or demand that the property be returned. Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 5 min; AACSB: n/a
4.Answer: Revocable living trust. Solution: A revocable trust does not need to be part of a will and bypasses the probate process. A testamentary trust is formed by the will and thus requires the assets to be made public through the probate process. Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 5 min; AACSB: n/a
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1.Answer: Each of these child actors could have been protected had an irrevocable trust been established using a nonfamily member as the trustee. The trust document could have been written to provide the actor access to assets at, say, age 21. Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 20 min; AACSB: n/a
2.Answer: Rather than using a transfer on death (TOD) registration, Pete can also use something called a payable on death (POD) registration to accomplish the same goal with FDIC-insured bank accounts. Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 10 min; AACSB: n/a
10.3 Expanded Learning Activity Answer: High-quality responses should include a discussion regarding the historical development of the gift and estate tax system and the student’s views on the tax. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 60 min; AACSB: C 10.3 Practice Questions 1. All of the following assets require a title as proof of ownership, except a. life insurance. b. vehicle. c. boat. d. home Answer: a; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Everyone owns things outright. Rather than having a title, these assets are owed fee simple. Which of the following is an example of a fee simple asset? a. Boat. b. Home furnishings. c. Motorcycle. d. All of these answer choices are correct. Answer: b; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. James and Elaine are married and live in California. They decide to purchase a home. How will the house most likely be titled? a. Fee simple. b. Tenancy in common. c. JTWROS. d. Community property. Answer: d; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. Dale and Dominic have a strong desire to keep their financial affairs private. They have been married for 10 years and are just now beginning to think about their estate plan. Which of the following strategies can they use to ensure that they can avoid probate? a. Own assets separately and rely on wills to transfer property at the first death. b. Establish a revocable living trust. c. Title all assets as tenancy by the entirety. d. Title all assets as tenancy in common. Answer: b; Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: Probate is the court supervised process of distributing assets by will or intestate laws, and paying debts after someone’s death. Probate can be a time-consuming, public process that many people would like to avoid. The two most common ways to avoid probate include titling property appropriately and using trusts. Titling your assets as JTWROS automatically transfers ownership to another person outside the probate process upon your death. Tenancy by the entirety is where you own the property with your spouse, and each spouse owns the undivided whole. If one spouse passes away, the surviving spouse already owns the property. This method of titling property is not available in most states and is typically only for real estate (cannot title all assets with this method).
Tenancy in common is where you own a divided interest in property with any other person. With tenancy in common, your level of ownership can be different and sold or given away at any time. In the case of death, the ownership interest can be transferred by will or intestate laws in probate. A trust is a legal entity that holds property and assets for someone or some group. By transferring assets to a trust, the death of the grantor does not have any impact in the ownership or beneficiary interests of the assets. 5. Assume that a gift tax is applicable. Who is liable for the tax payment? a. The person who received the gift. b. The person who gave the gift. c. Both the receiver and the giver in equal amounts (50/50). d. This is a trick question because no gift tax is payable. Answer: b; Section: 10.3; LO: 10.3; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
10.4 Explain the use of wills as a tool to transfer property after death. 10.4 Multiple-Choice Questions 1. d. will. Answer: d; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. c. Whomever Mark listed as the account beneficiary. Answer: c; Section: 10.4; LO: 10.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 3. d. Whomever the state where he died indicates through probate statute. Answer: d; Section: 10.4; LO: 10.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. b. Used a transfer on death title on the bank account. Answer: b; Section: 10.4; LO: 10.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 5. a. The gifting of an asset is irrevocable. Answer: a; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 6. b. $44,000. Answer: b; Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 2 min; AACSB: n/a Solution: After Melinda’s death, she can only pass her car and collectible coins to her beneficiaries through her will. The retirement account and insurance policies have beneficiary designations that bypass will and probate. Therefore, the correct answer = $32,000 car + $12,000 coin collection = $44,000 assets distributed by will. 7. b. may disclaim the property.
Answer: b; Section: 10.4; LO: 10.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 8. a. Because probate is public and difficult to maintain privacy for the deceased person and his or her heirs. Answer: a; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 9. d. The wills for Kimberly and Derek should include a guardian clause for any current or future children who are minors. Answer: d; Section: 10.4; LO: 10.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. c. Add a codicil. Answer: c; Section: 10.4; LO: 10.4; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
10.4 Adventures in Personal Finance Short Answer
1.Answer: $85,000; Tyler’s Porsche car. Solution: Tyler’s $85,000 Porsche will pass according to his will. The home and Nell’s car will pass based on the title of the property (JTROS). The retirement plan and life insurance will pass directly to the named beneficiaries (i.e., Nell) outside of the will. Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
2.Answer: Yes. Solution: The fact that two heirs to Nigel’s new will witnessed the signature could be grounds to contest the will. The children could argue that Nigel was unduly influenced when the will was drafted and that the will was not legally executed. The ultimate determination of the will’s validity will fall to the probate court’s ruling. Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a
3.Answer: The executor is not required to follow the letter of last instructors if the requests are unrealistic or too expensive. In this case, the executor can determine that the request is not affordable and elect another option. The executor may also resign, in which case the probate court would appoint a new executor. Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a Explore
1. Answer: High-quality responses should include a description of the probate court’s mission and duties as well as the pros and cons. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.4; LO: 10.4; BT: An; Diff: M; TOT: 40 min; AACSB: A, C 2. Answer: High-quality responses should include a discussion of Elvis’ will and any unique bequests of instructions. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.4; LO: 10.4; BT: An; Diff: M; TOT: 60 min; AACSB: A, C 3. Answer: Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska has an opt-in titling option. Section: 10.4; LO: 10.4; BT: C; Diff: M; TOT: 20 min; AACSB: A
10.4 Expanded Learning Activity Answer: High-quality responses should include a discussion of the student’s thoughts and feelings that they felt while considering writing a will and whether they feel they should have a will. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.4; LO: 10.4; BT: An; Diff: M; TOT: 60 min; AACSB: A, C, RT
10.4 Practice Questions 1. All of the following are the ways property can be transferred at death, except by a. will. b. contract. c. disclaimer. d. title. Answer: c; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. Luke and Mable have been married for 7 years. Last week, Mable gave Luke an expensive gold ring. Luke was stunned and very happy. Legally, the a. ring is considered a bequest by Mable. b. transaction is considered a testate transfer. c. ring is considered a gift. d. transaction, because of the relationship, is considered a charitable gift. Answer: c; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. The person tasked with the responsibility of carrying out a will’s directions and disposing of the deceased’s property is known as a. the heir. b. an attorney. c. the executor. d. a relative. Answer: c; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
4. When it comes to drafting a will, which of the following statements is true in most jurisdictions? a. The will must be written not recorded on video. b. The will must be witnessed. c. The will must be recorded in the probate court prior to death. d. The will must include a letter of last instructions. Answer: b; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. All of the following statements about drafting a will are true, except that: a. In most states, you must use an attorney to draft a will. b. An executor need not follow a letter of last instructions. c. Someone may complete his or her own will using an online legal form. d. Although unusual, a handwritten will is considered valid in most states. Answer: a; Section: 10.4; LO: 10.4; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
10.5 Describe the purpose of living wills, advanced directives, and powers of attorney. 10.5 Multiple-Choice Questions 1. a. a person is in a persistent comatose condition. Answer: a; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. d. both instruct your physician to continue food and water indefinitely and ask that no life support be used if you are diagnosed as being in a prolonged vegetative state. Answer: d; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. c. The court in the district where she is being cared for. Answer: c; Section: 10.5; LO: 10.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 4. c. Age 18 or older. Answer: c; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
5. c. your state office of the attorney general. Answer: c; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 6. b. Do-not-resuscitate declaration. Answer: b; Section: 10.5; LO: 10.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 7. d. agent. Answer: d; Section: 10.5; LO: 10.5; BT: C; Diff: E; TOT: 2 min; AACSB: n/a
8. b. Give her mother a limited power of attorney. Answer: b; Section: 10.5; LO: 10.5; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a 9. b. springing power of attorney. Answer: b; Section: 10.5; LO: 10.5; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a 10. a. durable power of attorney. Answer: a; Section: 10.5; LO: 10.5; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a
10.5 Adventures in Personal Finance Short Answer
1. Answer: A terminal condition occurs when someone’s medical disease, illness, or injury is incurable, and without artificial means, death would result. Section: 10.5; LO: 10.5; BT: C; Diff: M; TOT: 10 min; AACSB: n/a
2. Answer: A will is a legal document that dictates someone’s desires regarding the distribution of property after death. A living will (or advanced directive) is a legal document that is used to inform and direct a physician or hospital about the types of medical treatment someone wants or does not want in case the person becomes incapacitated. In simple terms, a living will states whether or not medical procedures should be used that will artificially prolong life, where a will deals with property after death. Section: 10.5; LO: 10.5; BT: C; Diff: M; TOT: 5 min; AACSB: n/a
3. Answer: The patient must either be in a persistent coma or be in a persistent vegetative state. Section: 10.5; LO: 10.5; BT: C; Diff: M; TOT: 5 min; AACSB: n/a
4. Answer: A springing POA would be ideal. This POA only comes into effect if Torrey becomes incapacitated. Section: 10.5; LO: 10.5; BT: C; Diff: M; TOT: 5 min; AACSB: n/a Explore
1. Answer: High-quality responses should address points a—f. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.5; LO: 10.5; BT: Ap; Diff: H; TOT: 75 min; AACSB: A, C, RT
10.5 Expanded Learning Activity Answer: High-quality responses should include a discussion of how the student would complete a living will and who they would name as a healthcare proxy. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.5; LO: 10.5; BT: Ap; Diff: H; TOT: 60 min; AACSB: A, C, RT 10.5 Practice Questions 1. A document that is used to direct a physician about the types of medical treatment someone wants or does not want should he or she become incapacitated is known as a(n) a. living will. b. will. c. advanced directive. d. both living will and advanced directive. Answer: d; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. When you draft a living will, you need to have the document witnessed. Who may witness the living will? a. Your doctor. b. Your spouse. c. A neighbor. d. All of these answer choices are correct. Answer: c; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. A document that appoints another person to make non-life-ending medical decisions for you is called a a. healthcare proxy. b. living will. c. medical directive. d. do-not-resuscitate declaration. Answer: a; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. Thomas is an elderly gentleman who has lived a long and rewarding life. He is currently faced with a terminal illness. He has weighed his medical choices and has decided that he would like to live out the remainder of his days as comfortable as possible. He has decided, however, that if his heart were to stop beating or if he were to stop breathing, he would not want CPR performed. What form should Thomas complete in order to make his wishes known? a. Limited medical POA. b. Healthcare proxy. c. Do-not-resuscitate declaration. d. Living will. Answer: c; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Which of the following must a doctor certify in order for a living will to take effect? a. The patient must be in a persistent coma. b. The patient must be in a persistent vegetative state.
c. Both the patient must be in a persistent coma and the patient must be in a persistent vegetative state. d. Either the patient must be in a persistent coma or the patient must be in a persistent vegetative state. Answer: d; Section: 10.5; LO: 10.5; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 10.6 Explain how professionals can help you navigate your financial journey. 10.6 Multiple-Choice Questions 1. d. I, II, and III. Answer: d; Section: 10.6; LO: 10.6; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 2. c. past; future Answer: c; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. d. Accredited financial counselor. Answer: d; Section: 10.6; LO: 10.6; BT: Ap; Diff: E; TOT: 2 min; AACSB: n/a 4. b. The second advisor because the total first-year cost is $5,000. Answer: b; Section: 10.6; LO: 10.6; BT: Ap; Diff: E; TOT: 2 min; AACSB: A Solution: We will need to compare the fee charged by each advisor. First advisor fee = 4.5% × $250,000 = $11,250 Second advisor fee = $2,500 + (1% × $250,000) Therefore, second advisor fee = $2,500 + $2,500 = $5,000 It makes sense to go with second advisor, because the fee is lower at $5,000. 5. d. Commission. Answer: d; Section: 10.6; LO: 10.6; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 6. a. Fee-only. Answer: a; Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 2 min; AACSB: A Solution: Erika’s proposed financial advisor is proposing a flat fee for a financial plan and an assetbased fee for her ongoing advice. There is no commission involved, and the arrangement does not imply a fee that is an offset or a supplement for direct compensation the advisor may receive from the product companies that are used in Erika’s portfolio. Thus, the arrangement is fee-only. 7. b. The first advisor because his income goes up as he sells more mutual funds. Answer: b; Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 2 min; AACSB: A Solution: Both advisors’ compensation structure has some conflict of interest, but the first advisor that charges an upfront commission has a negative conflict of interest. The first advisor is strongly incentivized to actively sell different funds to earn 5% every time. The second advisor has a bias toward growing the value of assets as the compensation grows in proportion. While this is a positive conflict of interest, it may skew the asset allocation to more risky investments.
8. b. The first advisor because she does not charge a commission. Answer: b; Section: 10.6; LO: 10.6; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 9. c. I and II only. Answer: c; Section: 10.6; LO: 10.6; BT: C; Diff: E; TOT: 2 min; AACSB: n/a 10. c. A registered investment advisor. Answer: c; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 10.6 Adventures in Personal Finance Short Answer
1. Answer: a—3; b—1; c—4; d—5; e—2. Solution: CFP®: Certified Financial Planner Board of Standards, Inc. Registered representative: Financial Industry Regulatory Authority (FINRA). Registered investment adviser: U.S. Securities and Exchange Commission or statesecurities office. AFC©: Association for Financial Counseling and Planning Education (AFCPE). Certified counselor: National Foundation for Credit Counseling (NFCC).
Section: 10.6; LO: 10.6; BT: K; Diff: M; TOT: 2 min; AACSB: n/a
2. Answer: What consumers can do to get the best advice possible is simply get educated, understand what you are trying to accomplish, and be realistic in what you are able to do. The best advice is not cheap, but understanding what you wish to accomplish and how much you are willing to work at it can save you time, money, and effort. Ideally, the best relationship to find is where your advisor is a fiduciary. Some financial professionals follow a fiduciary standard of advice, which requires a financial professional to act in the best interest of the client at all times and fully disclose any and all conflicts of interest. The following is a list of financial professionals who must follow the fiduciary standard of advice: • Any financial professional who provides advice regarding retirement plans—such as a 401(k), a 403(b), or an IRA rollover—must follow a fiduciary standard when making retirement plan recommendations. • Anyone who markets their practice as fee-only must act as a fiduciary at all times. • Attorneys must follow a fiduciary standard. • Some credentialing organizations also require certificants to follow a fiduciary standard. For example, all AFC® and CFP practitioners are required to disclose any conflicts of interest to their clients and disclose how they are compensated. A conflict of interest occurs when professionals benefit financially to an extent that exceeds the value provided to the client. Stated another way, a conflict of interest exists any time an advisor makes money based on a recommendation that is not in the best interest of his or her client. Financial advisors and
registered representatives, for instance, face conflicts of interest on a daily basis. When professionals earn their compensation based on commissions, the choice to sell new investments or investments that carry higher fees will always be at issue. Whether the advice merits the fee, only the investor can measure the value. High expense doesn’t necessarily mean that the consumer is unsophisticated or being taken advantage of. The most egregious fees in the market are for hedge funds (2% annual management fee + 20% of annual profits), but these investments typically are exclusive for private investors with very high minimums (typically $5–10 million), unregulated by the U.S. government, with assets held overseas and have very restrictive withdrawal rules. But the most sophisticated, most highly educated, and wealthiest consumers in the world happily purchase these investments. Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 10 min; AACSB: n/a
3. Answer: High-quality responses should include a discussion of the students’ thoughts and feelings and information that should be known when working with commission-based salespeople. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 20 min; AACSB: C, RT
Explore
1. Answer: High-quality responses should identify and discuss any credentials that a person has. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.6; LO: 10.6; BT: C; Diff: M; TOT: 20 min; AACSB: n/a
2. Answer: High-quality responses should identify five financial planners and disciplinary information on each one. Please refer to the sample writing assignment rubric in the solutions manual. Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 40 min; AACSB: T, E, C
10.6 Expanded Learning Activity Answer: (1) 15% growth (much faster than average). (2) $90,640 per year, $43.58 per hour, and total of all other occupations is $37,690. (3) Personal financial advisors typically work in offices. Some also travel to attend conferences, teach finance seminars in the evening, and attend networking events to bring in more clients. (4) Personal financial advisors typically need a bachelor’s degree. Although employers usually do not require personal financial advisors to have completed a specific course of study, a degree in finance, economics, accounting, business, mathematics, or law is good preparation for this occupation. Courses in investments, taxes, estate planning, and risk management are also helpful. Programs in financial planning are becoming more available in colleges and universities.
Once they are hired, personal financial advisors often enter an on-the-job training period. During this time, new advisors work under the supervision of senior advisors and learn how to perform their duties, including building a client network and developing investment portfolios. This training usually lasts for more than a year. Personal financial advisors who directly buy or sell stocks, bonds, or insurance policies, or who provide specific investment advice need a combination of licenses that varies with the products they sell. In addition to being required to have those licenses, advisors in smaller firms that manage clients’ investments must be registered with state regulators and those in larger firms must be registered with the Securities and Exchange Commission. Personal financial advisors who choose to sell insurance need licenses issued by state boards. Information on state licensing board requirements for registered investment advisors is available from the North American Securities Administrators Association. Certifications can enhance a personal financial advisor’s reputation and can help bring in new clients. The Certified Financial Planner Board of Standards offers the Certified Financial Planner (CFP) certification. For this certification, advisors must have a bachelor’s degree, complete at least 3 years of relevant work experience, pass an exam, and agree to adhere to a code of ethics. The CFP exam covers the general principles of financial planning, insurance planning, risk management, employee benefits planning, income taxes and retirement planning, investment and real estate planning, debt management, planning liability, emergency fund reserves, and statistical modeling.” Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 40 min; AACSB: T, E, C
10.6 Practice Questions 1. Which of the following financial service professionals is least likely to engage with a client over a long period of time? a. Certified Financial Planner. b. Registered representative. c. Financial counselor. d. Stockbroker. Answer: c; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 2. An advisor who charges commissions on the sale of products when giving financial advice is known as a(n) a. accredited financial counselor. b. registered representative. c. registered investment advisor. d. certified counselor. Answer: b; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 3. A credit counselor can help with all of the following, except a. developing a spending plan. b. negotiating with creditors. c. managing a retirement portfolio. d. creating a debt repayment plan.
Answer: c; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 4. A process that is designed to address long-term issues before the issues become a crisis is known as a. financial counseling. b. financial planning. c. debt management. d. credit forbearance. Answer: b; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a 5. Maurice is a cautious investor. He wants to make sure that any financial advice that he pays for is as free of conflicts of interest as possible. Given this objective, Maurice should seek out a financial advisor who provides advice and products based on a ______________________ standard. a. fiduciary b. suitability c. contractual d. contingency Answer: a; Section: 10.6; LO: 10.6; BT: K; Diff: E; TOT: 2 min; AACSB: n/a
Chapter 10 End-of-Chapter Summary Assessment Continuing Case: Tarek’s Financial Journey
1. Answer: Without a will, the laws of the state where Tarek and Samantha live will dictate the distribution of assets. This is called the probate process. Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
2. Answer: Tarek’s burial wish should be documented in a letter of last instruction. While Samantha will likely follow Tarek’s wish, she is not legally obligated to follow through on any requests made in a letter of last instructions. Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
3. Answer: For ease of administration, Tarek can name Samantha as his executor. He may choose to name someone else, such as an attorney, trust company, or other relative. Section: 10.4; LO: 10.4; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
4. Answer: In most states, they can title the new car as JTWROS or as tenancy by the entirety. If they live in Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin, they may also title the car as community property. Given their goal of joint ownership, they should not use a fee simple title. Given their marital status, they should not use a tenancy in common title. Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
5. Answer: Because the motorcycle is owned fee simple by Tarek, Samantha will not automatically receive ownership of the bike. Instead, Tarek needs to indicate to whom he wishes to transfer ownership to in his will. Note that in some states Samantha may be entitled to an ownership interest in the motorcycle, regardless of Tarek’s instructions in his will. Section: 10.3; LO: 10.3; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
6. Answer: He should draft a living will, which in some states is known as an advanced directive. Section: 10.5; LO: 10.5; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
7. Answer: The powers of someone who holds a healthcare proxy are limited. A healthcare proxy cannot be used to make life-ending decisions. This is the reason Tarek needs a living will (or advanced directive). Section: 10.5; LO: 10.5; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
Calculating the Cost of Life’s Financial Journey a. Answer: Advisor 1: $14,000; Advisor 2: $3,500; Advisor 3: $14,500 Solution: Advisor 1: $350,000 assets × 0.04 upfront asset-based fee = $14,000 total fees Advisor 2: $350,000 assets × 0.01 upfront asset-based fee = $3,500 total fees Advisor 3: $7,500 planning fee + ($350,000 assets × 0.02 asset-based fee) = $14,500 total fees Section: 10.6; LO: 10.6; BT: Ap; Diff: M; TOT: 10 min; AACSB: A
b. Answer: Advisor 1: $364,560; Advisor 2: $374,220; Advisor 3: $360,663 Solution: Cheyenne and Scott wish to pay for their fees with the funds in their account, so the fees are taken from the value of assets prior to the year’s return. Calculate the value of their assets after paying the first year’s fees (value after fees) and then apply the respective expected rate of return. Expected value of the account at the end of the year = cost basis × (1 + r) *r = the expected return as expressed in decimal form Advisor 1: $350,000 assets × 0.04 upfront asset-based fee = $14,000 total fees $350,000 assets − $14,000 total fees = $336,000 value after fees $336,000 value after fees × 1.085 return = $364,560 year-end value Advisor 2: $350,000 assets × 0.01 upfront asset-based fee = $3,500 total fees $350,000 assets − $3,500 total fees = $346,500 value after fees $346,500 value after fees × 1.08 return = $374,220 year-end value
Advisor 3: $7,500 planning fee + ($350,000 assets × 0.02 asset-based fee) = $14,500 total fees $350,000 assets − $14,500 total fees = $335,500 value after fees $335,500 value after fees × 1.075 return = $360,663 year-end value Section: 10.6; LO: 10.6; BT: An; Diff: M; TOT: 10 min; AACSB: A
c. Answer: Advisor 1: $1,823; Advisor 2: $3,742; Advisor 3: $361 Solution: Second-year fees will be based on the previous year-end value. Advisor 1: $364,560 year-end value × 0.005 annual asset-based fee = $1,823 fees Advisor 2: $374,220 year-end value × 0.01 annual asset-based fee = $3,742 fees Advisor 3: $360,663 year-end value × 0.001 annual asset-based fee = $361 fees Section: 10.6; LO: 10.6; BT: An; Diff: M; TOT: 10 min; AACSB: A
d. Answer: Advisor 1 has the highest net return (earnings less expense) over a 7-year period. While Advisors 1 and 3 have the largest upfront fees and Advisor 3 the lowest annual fee, Advisor 1 generated the best overall returns. This scenario is a good example of how various forms of fees and commissions impact long-term returns. Having the highest upfront cost or lowest annual expense ratio does not define the overall success of long-term goals. Many factors, especially the forecast of expected returns, have just as much impact to long-term growth than just fees.
Advisor 1
Advisor 2
Advisor 3
Upfront cost
4.0%
1.0%
2% + $7,500
Annual cost after year 1
0.5
1.0
0.1
Expected annual return
8.5
8.0
7.5
Opening balance
$350,000
$350,000
$350,000
First-year expenses
14,000
3,500
14,500
Net amount invested in year 1
336,000
346,500
335,500
End-of-year 1 value1
364,560
374,220
360,663
End-of-year 2 value2
395,548
404,158
387,712
End-of-year 3 value2
429,169
436,490
416,791
End-of-year 4 value2
465,649
471,409
448,050
End-of-year 5 value2
505,229
509,122
481,654
End-of-year 6 value2
548,173
549,852
517,778
End-of-year 7 value2
594,768
593,840
556,611
*Note1: (Opening balance − initial year’s fees) × expected annual return *Note2: (Prior year-end value − annual asset-based fee) × expected annual return Section: 10.6; LO: 10.6; BT: An; Diff: M; TOT: 20 min; AACSB: A
Planning for the Future
a. Answer: Yes, his property would need to go through the probate system of each state. For property that is not transferred through a title, contract, or will, the laws of the state where the deceased person lived will determine who receives his or her assets. Each state has its own laws, as administered through the probate court. Since he is single and property is not being held in a trust or titled JTWROS, it will go through the probate process. Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 2 min; AACSB: n/a
b. Answer: An advantage would be that the property would transfer directly to his sister at his death, thus avoiding probate. A disadvantage is that he may owe a gift tax immediately. Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 2 min; AACSB: n/a
c. Answer: He should transfer ownership of each piece of property to a trust. He can establish a revocable living trust. This type of trust allows Raul to maintain total control over both pieces of property while avoiding probate. Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 2 min; AACSB: n/a
d. Answer: The first is the grantor, which, in this case, is Raul. He will transfer his ownership of the property to the trust. Second is the beneficiary. Raul can name himself the primary beneficiary. In this case, he retains full interest in the property. He should, however, name a secondary beneficiary, such as his sister. The secondary beneficiary will receive the proceeds of the trust should Raul pass away. Third, he needs to name a trustee. If he establishes a living trust, he will most likely name himself as the trustee. This gives him the power to sell the property in the future and to make adjustments to the trust over time.
Section: 10.3; LO: 10.3; BT: C; Diff: M; TOT: 10 min; AACSB: n/a