SOLUTION MANUAL for Personal Finance, 14th Edition by Thomas Garman, , Fox Jonathan, Raymond E. Forg by StudyGuide

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E, CHAPTER 1: T HINKING LIKE A FINANCIAL P LANNER

TABLE OF CONTENTS Answers to Chapter Concept Checks ........................................................................................................ 2 What Do You Recommend Now? .............................................................................................................. 4 Let’s Talk About It ..................................................................................................................................... 5 Do the Math ................................................................................................................................................. 6 Financial Planning Cases ........................................................................................................................... 8 Extended Learning.................................................................................................................................... 10

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

ANSWERS TO CHAPTER CONCEPT CHECKS LO1.1 Recognize the keys to achieving financial success. 1.

Explain the five steps in the financial planning process. Answer: There are five fundamental steps to the personal financial planning process: (1) evaluate your financial health to your education and career choice; (2) define your financial goals; (3) develop a plan of action to achieve your goals; (4) implement spending and saving plans to monitor and control progress toward your goals; and (5) review your financial progress and make changes as appropriate.

Distinguish among financial success, financial security, and financial happiness. Answer: Financial success is the achievement of financial aspirations that are desired, planned, or attempted. Success is defined by the individual or family that seeks it. Financial success may be defined as being able to live according to one’s standard of living. Financial security is that comfortable feeling that your financial resources will be adequate to fulfill any needs you have as well as your wants. Financial happiness is the experience you have when you are satisfied with money matters. People who are happy about their finances will see a spillover into positive feelings about life in general.

Summarize what you will accomplish studying personal finance. Answer: Several things can be accomplished by studying personal finance. Recognize how to manage unexpected and expected financial events. Pay as little as possible in income taxes. Understand how to effectively comparison shop for vehicles and homes. Protect what we own. Invest wisely. Accumulate and protect the wealth that we may choose to spend during our non-working years (e.g., retirement) or donate.

What are the building blocks to achieving financial success? Answer: The building blocks for achieving financial success include a foundation of regular income that provides the means to support your lifestyle and save for desired goals in the future. The foundation supports a base of various banking accounts, insurance protection, and employee benefits. Then we can establish goals, a recordkeeping system, a budget, and an emergency savings fund. We will also manage various expenses such as housing, transportation, insurance, and the payment of taxes. We will also need to handle credit, savings, and educational costs. Finally, we invest in various investment alternatives such as mutual funds, stocks, and bonds, often for retirement. As a result of all these building blocks, we are more apt to have a financially successful life.

LO1.2 Understand how the economy affects your personal financial success. 1.

Summarize the phases of the business cycle. Answer: The business cycle entails a wavelike pattern of rising and falling economic activity as measured by economic indicators like unemployment rates or the gross domestic product. The phases of the business cycle include expansion (preferred stage—production is high, unemployment low, interest rates low or falling, stock market and consumer demand high), peak, contraction, downturn, trough, and recovery.

Describe two statistics that help predict the future direction of the economy. Answer: Forecasting the state of the economy involves predicting, estimating, or calculating what will happen in advance. We need to be able to forecast the state of the economy, inflation, and interest rates so that we have advance warning of the directions and strength of changes in economic trends since they will affect our personal finances. Two statistics we could watch are the consumer confidence index (how consumers feel about the economy and their personal finances) and the index of leading economic indicators (composite index, averages ten components of economic growth).

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

Give an example of how inflation affects income and consumption. Answer: Inflation reduces the purchasing power of the dollar. This means that our income will not go as far and, thus, in real terms will be lowered by inflation. Because items cost more, we will have to consume less and may cut back on some expenditures to be able to afford those with a higher priority.

LO1.3 Think like an economist when making financial decisions. 1.

Define opportunity cost and give an example of how opportunity costs might affect your financial decision making. Answer: The opportunity cost of a decision is measured as the value of the next-best alternative that must be forgone. If we, for example, put our retirement savings in a regular savings account instead of in a taxsheltered retirement account, we may be forgoing the tax benefits associated with investing in retirement accounts such as IRAs or 401(k) plans. In another example, if we decide to borrow the maximum student loan amount for which we qualify to live a bit more comfortably while in college, we will not be able to live as nicely, save as much for the down payment on a home or save for retirement once we graduate because of the higher loan payments.

Explain and give an example of how marginal utility and marginal cost make some financial decisions easier. Answer: Marginal analysis focuses on the next increment of usefulness or cost when making financial decisions. Marginal utility is the extra satisfaction derived from having one more incremental unit of a product or service. Marginal cost is the additional cost of that unit. When marginal utility exceeds marginal cost, and we compare the two, we can make better financial decisions. As an example, if you must fly to some destination, is the marginal cost of checking a bag using a carry-on worth the marginal utility?

Describe and give an example of how your marginal income tax rate can affect financial decision making. Answer: As our income rises, we will find ourselves in higher and higher tax brackets. One type of decision that is affected by income taxes is how we should invest for retirement. We might want to invest through a 401(k) plan instead of keeping our retirement money in a savings account, which is taxable. Since most types of income are taxable, it is important that we understand the impact of income taxes on financial decisions. Of particular importance is the marginal tax rate (the tax rate at which our last dollar earned is taxed). If we are in the 25 percent marginal tax bracket, we will get to keep 75 percent (100 percent minus 25 percent) of our last taxable dollar earned. If the income is tax-free income, on the other hand, we would get to keep 100 percent of it. Therefore, it is important to know our marginal tax rate as well as what types of income are subject to federal income taxes. It is also important to remember the impact of state income taxes and Social Security taxes.

LO1.4 Perform time value of money calculations in personal financial decision making. 1.

What are the two common questions about money? Answer: The two common questions about money are its future value and present value. Future value is what investment or series of investments will be at a point in the future. Present value is how much we would need to invest today and/or in a series of future investments to provide some amount in the future.

Explain the difference between simple interest and compound interest, and describe why that difference is critical. Answer: Simple interest is money paid on a principal amount for a given number of years. The interest is paid only on the principal (the original amount invested). For example, we might put $1,000 in a bank savings account at 5 percent interest for one year. We would have accumulated $50 in that year.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

Compound interest is interest paid on interest and principal. For example, if we leave your $1,000 on deposit and do not withdraw the $50 interest at the end of the year, we will earn interest on both the deposit and the interest earned during the first year. This difference in the types of interest paid is important as compound interest is the basic principle of accumulating wealth. If we invest regularly over time, our money will grow due to the power of compound interest. 3.

Use Table 1-1 to calculate the future value of (a) $2,000 at 5 percent for four years, (b) $4,500 at 9 percent for eight years, and (c) $10,000 at 6 percent for ten years. Answer: a. $2,000 at 5 percent for four years would equal $2,431 ($2,000 × 1.2155). b. $4,500 at 9 percent for eight years would equal $8,966.70 ($4,500 × 1.9926). c. $10,000 at 6 percent for 10 years would equal $17,908 ($10,000 × 1.7908).

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WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on the importance of personal finance, what do you recommend to Jing Wáng in the case at the beginning of the chapter. 1.

Participating in her employer’s 401(k) retirement plan? Answer: Jing should participate in her employer’s plan because her contributions reduce her taxable income and will grow tax-sheltered until withdrawn at retirement. By doing so, she will qualify for her employer contributions, thereby receiving additional tax-sheltered income that will go directly into her retirement account. If Jing contributed 8 percent of her salary, her employer would match it with 4 percent for a total of 12 percent. Her total contribution would be $9,600 based on her salary of $80,000.

Understanding the effects of her marginal tax rate on her financial decisions? Answer: Jing should use her marginal tax rate to assess how changes in her income and the financial decisions she will make would be affected by taxes. For every extra dollar that she contributes to her retirement plan, for example, she will save $0.25 in taxes if she is in the 25 percent tax bracket. Also, if she earns an extra dollar, it will be taxed at her marginal rate.

Considering the current state of the economy in her personal financial planning? Answer: Jing should stay informed about economic trends as indicated in changes in the gross domestic product, index of leading economic indicators, and consumer price index. She should also keep track of the federal funds rate as an indicator of interest rates in the economy. She should be able to make her own estimate for economic growth, inflation, and interest rates over the next couple of years.

Using time value of money considerations to project what her Roth-IRA might be worth at age 63? Answer: Jing could use Appendix A.1 to calculate how much her IRA fund (currently $2,000) would grow in 40 years. She would need to assume a rate of return on the funds. An 8 to 10 percent rate would be appropriate given the investment opportunities available to her in her IRA. At 8 percent, her account would be worth about $43,449 (21.7245 × $2,000).

Using time value of money considerations to project what her 401(k) plan might be worth at age 63 if she were to participate fully?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

Answer: Jing could use Appendix A.3 to calculate how much her contributions would grow in 40 years. She would need to assume a rate of return on the funds. An 8 percent rate would be appropriate given the investment opportunities available to her in her 401(k). At 8 percent, her account would be worth about $2,486,942 (259.0565 × $9,600; $6,400 of Jing’s money and $3,200 from her employer). 6.

Saving for retirement versus paying off student loans? Answer: At a minimum Jing should contribute 8 percent of her salary to her retirement savings to take advantage of her employer’s match. Jing’s retirement savings capitalizes on compounding and the time value of money. Employer matching for retirement is free money and should not be left on the table. Jing is paying off $35,000 in student loans and paying off any loan does provide a guaranteed rate of return. However, it is unlikely that the return from paying off the student loan will exceed the value of the retirement savings when it is combined with the employer match.

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LET’S TALK ABOUT IT 1.

Economic Growth. How do federal government efforts help stimulate economic growth? How do these efforts affect consumers? Answer: Answers will vary depending on the student’s own financial situation. Tax cuts may help students in the lower tax brackets. Efforts to revive the economy will help students keep or obtain jobs. Educationrelated credits will help college students. Efforts to help people buy their first home will help students who might be so interested.

The Business Cycle. Where do you think the United States is in the economic cycle now, and where does it seem to be heading? List some indicators that suggest in which direction it may move. Answer: At the time this edition was published, the economy was expanding with annual growth of around 2.3 percent. The gross domestic product was edging up, but growth has been an uneven pattern. Consumer spending is up, despite inflation being at a four-decade high. Interest rates were raised by the Fed, so borrowing is more expensive. The unemployment rate is declining slightly and is forecast to continue to decline. Many people are benefiting from rising wages due to tighter labor markets. Along with inflation, supply chain disruptions have been an issue. There has been an exuberant real estate market throughout the pandemic but that is starting to cool due to the rise in interest rates and inflation. Federal infrastructure spending programs were about to kick in and help some of the economic indicators.

Personal Finance Mistakes. What are some common mistakes that people make in personal finance? Name two that might be the worst, and why? Answer: Eleven mistakes that people make in personal finance are failing to (1) engage in long-term personal financial planning, (2) engage in long-term budgeting, (3) engage in short-term budgeting, (4) establish a cash reserve in case of emergencies, (5) save at a rate that is sufficiently high, (6) establish adequate insurance protection, (7) manage income tax liabilities advantageously, (8) limit credit card debt, (9) manage expenditures so as to prevent unexpected expenditures on a credit card, (10) engage in investment planning, and (11) engage in retirement and estate planning. All eleven mistakes are important. The three most important mistakes are saving at a rate that is too low, and inadequate retirement and estate planning. Americans save at a rate that is very low. If you save just 1 percent more of your pay, you will reap a high return at retirement. Also, if you withdraw money from your tax-sheltered retirement plan before retirement, you will have a substantial shortfall when it comes time to retire.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

Federal Reserve. Describe some economic circumstances that might persuade the Federal Reserve to lower short-term interest rates. Answer: This is a potential ―Class Activity exercise related to page 14 in the text. The Federal Reserve Board might be persuaded to lower interest rates if the economy is in a downturn, a trough, or even in the early stages of recovery. The goal would be to make borrowing easier and provide a boost to the economy.

Opportunity Costs. People regularly make decisions in personal finance that have opportunity costs. Share financial decisions you have made recently and identify the opportunity cost for each. Answer: Students’ examples of decisions in personal finance that have opportunity costs will vary. Each should focus not on the direct cost of the decision but on the lost opportunity that resulted from making the decision.

Inherited Money. What would you do if you inherited $3,000 from an aunt? Identify three options. Answer: Students’ options will vary by their financial circumstances. Common options might include paying off debt, paying future schooling costs, or beginning a retirement savings program.

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DO THE MATH 1.

Real Income. Joshua Vermier of Topeka, Kansas, received a raise after his first year on the job to $45,800 from his initial salary of $44,000 (LO2 and LO3). What was Joshua’s raise stated as a percentage? If inflation averaged 2.8 percent for the year, what was his real income after the raise? What was his real raise stated as a percentage? Solution: This is a potential ―Class Activity‖ exercise related to page 12 in the text. Joshua received a $1,800 raise. As a percentage of his pre-raise income that was a raise of 4.1 percent ($1,800/$44,000 × 100). His real inflation-adjusted income after the raise is $45,553 ($45,800/1.028). As a percentage, his real raise was 1.3 percent (4.1% − 2.8%).

Future Value. As a graduating senior, Chun Kumora of Charleston, West Virginia, is eager to enter the job market at an anticipated annual salary of $54,000 (LO3 and LO4). Assuming an average inflation rate of 3 percent and an equal cost-of-living raise, what will his salary possibly become in 10 years? In 20 years? (Hint: Use Appendix A.1.) To make real economic progress, how much of a raise (in dollars) does Chun need to receive next year and the year after? Solution: This is a potential ―Class Activity‖ exercise related to page 21 in the text. Assuming an average inflation rate of 3 percent and an equal cost-of-living raise, Chun’s salary in 10 years will be $72,571 ($54,000 × 1.3439). In 20 years, he could anticipate earning $97,529 ($54,000 × 1.8061). To make real economic progress, Chun must receive raises greater than each year’s rate of inflation. Otherwise, Chun is standing still because his raises will be required to compensate for the inflationary increase in the cost of living.

Present and Future Values. Megan Berry, a freshman horticulture major at the University of Minnesota, has some financial questions for the next three years of school and beyond (LO4). Answers to these questions can be obtained by using Appendix A. a. If Megan’s tuition, fees, and expenditures for books this year total $22,000, what will they be during her senior year (three years from now), assuming costs rise 4 percent annually?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

b. c.

Megan is applying for a scholarship currently valued at $5,000. If she is awarded it at the end of next year, how much is the scholarship worth in today’s dollars, assuming inflation of 3 percent? Megan is already looking ahead to graduation and a job, and she wants to buy a new car not long after her graduation. If after graduation she begins an investment program of $2,400 per year in an investment yielding 4 percent, what will be the value of the fund after three years? Megan’s Aunt Karroll, from Austin, Texas, told her that she would give Megan $1,000 at the end of each year for the next three years to help with her college expenses. Assuming an annual interest rate of 2 percent, what is the present value of that stream of payments?

Solution: a. Assuming a 4 percent increase over the next three years, Megan’s tuition, fees, and books will cost $24,748 ($22,000 × 1.1249). b. Assuming an inflation rate of 3 percent, the scholarship is worth $4,855 in today’s dollars ($5,000 × 0.9709). c. With an annual contribution of $2,400 and an expected return of 4 percent, in three years Megan’s savings will total $7,492 ($2,400 × 3.1216). d. Assuming a 2 percent interest rate, the stream of payments from Megan’s aunt is presently worth $2,884 ($1,000 × 2.8839). 4.

Future Values. Using Table 1-1 calculate the following (LO4): a. The future value of lump-sum investment of $4,000 in four years that earns 5 percent. b. The future value of $1,500 saved each year for three years that earns 6 percent. c. A person who invests $1,200 each year finds one choice that is expected to pay 3 percent per year and another choice that may pay 4 percent. What is the difference in return if the investment is made for four years? d. The amount a person would need to deposit today with a 5 percent interest rate to have $2,000 in three years. Solution: This is a potential ―Class Activity‖ exercise related to page 21 in the text. a. The future value of $4,000 in four years, assuming a 5 percent rate of return, would be $4,862 ($4,000 × 1.2155). b. Assuming a 6 percent return, $1,500 saved each year for three years would be $4,775 ($1,500 × 3.1836). c. The $1,200 would grow to $5,020 ($1,200 × 4.1836) after four years at 3 percent and $5,096 ($1,200 × 4.2465) at 4 percent. The difference is $76. d. One would need to invest $1,728 now to have $2,000 in three years, assuming a 5 percent return ($2,000 × 0.8638).

Using the present and future value tables in Appendix A, or an alternate financial calculator, calculate the following (LO4): a. The amount a person would need to deposit today to be able to withdraw $6,000 each year for 10 years from an account earning 6 percent. b. A person is offered a gift of $5,000 now or $8,000 five years from now. If such funds could be expected to earn 8 percent over the next five years, which is the better choice? c. A person wants to have $3,000 available to spend on an overseas trip four years from now. If such funds could be expected to earn 6 percent, how much should be invested in a lump sum to realize the $3,000 when needed? d. A person invests $50,000 in an investment that earns 6 percent. If $6,000 is withdrawn each year, how many years will it take for the fund to run out? Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

a. b. c. d.

One would need to invest $44,160 now to withdraw $6,000 per year for 10 years, assuming a 6 percent return ($6,000 × 7.3601). $8,000 in five years is the better choice because the future value of $5,000 in five years, assuming an 8 percent return, is $7,347 ($5,000 × 1.4693). One would need to invest $2,376 now to have $3,000 in four years, assuming a 7 percent return ($3,000 × 0.7921). The $50,000 investment will last approximately 12 years if it earns 6 percent and $6,000 is withdrawn annually ($50,000/$6,000 = 8.33—look for the factor 8.33 in the 6 percent column of the present value of a stream of equal payments table; Appendix A-4).

Inflation. Laureen Mauer, from Baton Rouge, Louisiana, earned a salary a year ago of $52,000 (LO2 and LO3). If inflation during the year was 3.5 percent where she lives, how much of a decline in her purchasing power occurred? Also, what would be her purchasing power if deflation of 1 percent occurred? Solution: This is a potential ―Class Activity‖ exercise related to page 12 in the text. The 3.5 percent inflation resulted in a $1,820 reduction in purchasing power for Laureen (1.035 × $52,000) minus $52,000. The 1 percent deflation would result in $420 increase in purchasing power for Lauren (0.01 × $52,000 = $520).

Use the Rule of 72. Using the Rule of 72, calculate how quickly $1,000 will double to $2,000 at interest rates of 2 percent, 4 percent, 6 percent, 8 percent, and 10 percent (LO2). Solution: To calculate the years until an investment would double, divide the rate into seventy-two. For 2 percent it would be 36 years, 4 percent would be 18 years, 6 percent would be 12 years, 8 percent would be 9 years, and 10 percent would be 7.2 years.

Use the Rule of 72. Based on the Rule of 72 determine how long it would take to double an investment of $5,000 if you could invest it at 7 percent. How long would it take to triple the investment (LO4)? Solution: This is a potential ―Class Activity‖ exercise related to page 22 in the text. The investment would double in about 10.3 years (72/7). It would take about 15 years for the investment to triple. For this tripling time use Appendix, A-1, and in the 7 percent, column look for the year that most closely approximates a factor of three.

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FINANCIAL PLANNING CASES CASE 1: Harry and Belinda Johnson Consider Inflation and Children Throughout this book, we will present a continuing narrative about Harry and Belinda Johnson. The following is a brief description of the lives of this couple. Harry is 28 years old and graduated five years ago with a bachelor’s degree in interior design from a large Midwestern university near his hometown in Indiana. Since graduation Harry has been working in a small interior design firm in Kansas City earning a salary of about $50,000. Belinda is 27, has a degree in business administration from a university on the West Coast, and has been employed in a medium-size manufacturing firm in California for about five years. Harry and Belinda both worked on their schools’ student newspapers and met at a conference during their junior year in college. After all these years they met again socially in January in Kansas City, Missouri, where Belinda was visiting relatives and by chance she and Harry were at the same museum. After getting reacquainted they

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

started dating and in only a matter of months Belinda got transferred from California to work in Kansas City and in June they got married. Belinda is now employed as a stockbroker earning about $77,000 annually. After the wedding they moved into his small apartment. They will face many financial challenges over the next few decades as they buy their first home, decide on life insurance needs, begin a family, change jobs, and invest for retirement. a. Annually Harry receives $3,000 in interest income payments from a trust fund set up by his deceased father’s estate. The amount will never change until it runs out in 20 years. What will be the buying power of $3,000 in 10 years if inflation rises at 3 percent a year? (Hint: Use Appendix A.2.) b. Belinda and Harry have discussed starting a family but decided to wait for perhaps five more years in order to get their careers moving along well and getting their personal finances solidly on the road to success. They also know that having children is expensive. The government’s figure is that the extra expense of a child would be about $16,000 a year through high school graduation. How much money will they likely cumulatively spend on a child over 18 years assuming a 3 percent inflation rate? (Hint: Use Appendix A.3.) Solution: a. $2,232 = $3,000 × 0.7441. b. $374,630 = $16,000 × 23.4144. CASE 2: Victor and Maria Hernandez Look at Future Income Throughout this book, we will present a continuing narrative about Victor and Maria Hernandez. The following is a brief description of the lives of this couple. Victor and Maria, both in their late 30s, have two children: Jacob, age 13, and Nicholas, age 15. Victor has had a long sales career with a retail appliance store in Fargo, North Dakota earning $53,000 annually. Maria works as a medical records assistant earning $32,000. a. Victor and Maria regularly buy and sell a number of items on eBay, Craig’s List, and through the free community newspaper, from which they earn about $4,000 each year. What is the accumulated future value of those amounts over 20 years if the annual earnings were invested regularly and provided a 5 percent return each year? (Hint: Use Appendix A.3.) b. What would Victor and Maria’s annual income be after 20 years if they both received an average 3 percent raise over their current $85,000 salary ($53,000 + $32,000) every year? (Hint: Use Appendix A.1.) Solution: a. $132,264 = $4,000 × 33.0660. b. $153,519 = $85,000 × 1.8061. CASE 3: Julia Price Thinks About the Economy Throughout this book, we will present a continuing case about Julia Price. Following is a brief description about her. Six years ago, Julia graduated with a degree in aeronautical engineering and went to work as an engineer in Alabama. Last year she moved to Seattle, Washington, to start a job as a mid-level systems engineer on jet aircraft, and some of her design and coordination responsibilities include Department of Defense projects. Julia thinks that the economy is going to get worse in the next two to three years, perhaps even with prices declining (deflation). Offer your opinions about her thinking. Solution: The response to this question will vary depending upon the state of the economy when the students respond to this question. The student’s response should include valid rationale, such as recent changes in the inflation rate, rising/lowering gross domestic product data, increasing/decreasing unemployment rate, and changes in the consumer confidence index.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 1: Thinking Like a Financial Planner

CASE 4: Reasons to Study Personal Finance Samantha Beliveau of Honolulu, Hawaii, is a senior in college, majoring in nutrition. She anticipates getting married a year or so after graduation. Samantha has only one elective course remaining and is going to choose between an advanced class in sociology and one in personal finance. As Samantha’s friend, you want to persuade her to take personal finance, a course you enjoyed. Give some examples of how Samantha might benefit from the study of personal finance. Solution: Samantha will benefit from acquiring financial knowledge because this knowledge will enable her to make more intelligent decisions about how to spend or invest money and help her to eventually acquire some degree of personal wealth. Samantha will learn about recordkeeping and budgeting, banking, and credit use, saving and borrowing, protecting her income and assets, and planning for retirement and estate transfer. CASE 5: A Closer Look at Financial Success You have been asked to give a brief speech on how to achieve financial success and financial security. Use the five steps in the financial planning process and the building blocks to achieving financial success in your speech. Outline your speech. Solution: Financial success is defined by the individual or family that seeks it. Success is the achievement of financial aspirations that are desired, planned, or attempted. Financial happiness is the experience we have when we are satisfied with money matters. People who are happy about their finances will see a spillover into positive feelings about life in general. A speaker could discuss the financial building blocks including a foundation of a regular income to support our lifestyle and save for desired goals in the future. The foundation supports a base of various banking accounts, insurance protection, and employee benefits. Then we can establish goals, a recordkeeping system, a budget, and an emergency savings fund. We will also manage various expenses such as housing and transportation and the payment of taxes. We will also need to handle credit, savings, and educational costs. Finally, we invest in various investment alternatives such as mutual funds, stocks, and bonds, often for retirement. As a result of all these building blocks, we are more apt to have a financially successful life.

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EXTENDED LEARNING 1.

Opportunity and Marginal Costs. Survey two relatives or friends and ask about their decision-making process when they most recently bought a vehicle. Find out if they thought about the opportunity costs when making the purchase. Also ask if they used marginal costs in their thinking. Make a written summary of your findings. Solution: A written paragraph about each person should include their thoughts about both opportunity costs (could have spent the money on XYZ?) and marginal costs (for X dollars I obtained Y options on the vehicle).

Research Future Direction of the Economy. Survey three people to determine their opinions on the direction of the economy over the next 12 months. Even though they may not know the meaning of these exact terms, ask about their perceptions on such indicators as the (a) gross domestic product, (b) consumer confidence, (c) inflation and deflation, (d) interest rates, and (e) federal fund rate. Make a table that summarizes your findings. Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

Show a table of responses but since people are not likely to know the meaning of each of the five terms utilized the summary may be a bit muddled with misconceptions about the terms.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E, CHAPTER 2: CAREER P LANNING

TABLE OF CONTENTS Answers To Chapter Concept Checks .................................................................................................... 12 What Do You Recommend Now? ............................................................................................................ 14 Let’s Talk About It ................................................................................................................................... 15 Do The Math.............................................................................................................................................. 16 Financial Planning Cases ......................................................................................................................... 17 Extended Learning.................................................................................................................................... 19

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

ANSWERS TO CHAPTER CONCEPT CHECKS LO2.5 Identify the key steps in successful career planning. 1.

What is career planning and why is it important? Answer: Career planning provides a strategic guide for one’s career through short-, medium-, longer-, and long-term goals as well as future education and work-related experiences. We cannot advance very far in planning our financial life without also planning a career that will earn an adequate income.

How do your values and interests impact your lifestyle trade-offs in career planning? Answer: It is impossible to do all things that might be desirable related to our career and balance our personal life, too. Thus, we must assess our values and interests and emphasize those efforts that are most important to us and trade-off those of higher importance for those of lesser importance.

What can be done to enhance your abilities, experiences and education without working in a job situation? Answer: It is important to take advantage of opportunities such as internships, volunteer opportunities, networking in professional associations, and getting the most we can out of our college courses.

Is the gig economy, freelancing, or entrepreneurship for you? Why or why not? Answer: Student answers will vary on this question. Some will like the freedom and opportunities that the gig economy, freelancing, and entrepreneurship can provide. Others will like the security provided by fulltime, consistent employment with one employer.

LO2.6 Analyze the financial and legal aspects of employment. 1.

Is college worth the cost? Why or why not? Answer: College is always worth the cost. Income increases both with education level and age. In addition, those workers with more education find that their highest income years occur later in their careers and see their incomes stay high longer into their working years.

How does one put a market value on an employee benefit? Answer: One method is to place a market value on a benefit by determining how much the worker would have to pay to obtain the benefit on their own. A second method is to calculate the future value of employee benefits. This technique fits well for such benefits as a retirement plan or reimbursement for the costs of additional education.

Give some examples of legal employment rights. Answer: Legal employment rights include worker’s compensation benefits for job-related illness and injuries, personal leave for family and medical problems, a continuation of health insurance for as long as 18 months after leaving an employer, and protection against unfair discrimination and against being harassed on the job.

LO2.3 Practice effective employment search strategies. 1.

Offer suggestions on correctly assembling a résumé and what style formats are available. Answer: Résumés should be developed according to one of three formats (chronological, skills, or functional) according to our assessment of the desires of prospective employers. Use keywords from the job description in a résumé so that they can be picked up by a computer scan.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

Give examples of how to identify specific job opportunities. Answer: Ways to learn about job opportunities include attendance at career fairs, classified ads in the newspaper or trade publications, using an employment agency, and searching the Internet.

Give three suggestions on how to succeed in an interview. Answer: The wording of student answers will vary. The essence should be to do research before the interview, compile personal stories that speak to skills and abilities, be prepared to ask questions, prepare responses to anticipated interviewer questions, and create positive responses to negative questions.

Explain how to compare salary and living costs in different cities. Answer: Salary offers in different cities must be adjusted to reflect the relative living costs in those cities. Several websites are available to provide indexes of the cost of living. To compare City 1 to City 2, multiply the City 1 salary times the result of dividing the index for City 2 by the index for City 1. If the result is higher than City 2, then City 1 has a better-adjusted salary.

Give two career advancement tips. Answer: One career advancement tip would be to volunteer for new assignments. This would show an employer that we are willing to put our own job on the line for the good of the employer. A second tip would be to attend professional meetings and conferences in our field. This would show an employer that we are interested in learning as much as possible about our field and be a good ambassador for our employer. A third tip would be to take advanced college courses and/or complete a graduate degree. This would not only benefit our current employer but would also position us for promotions or better jobs with another employer.

LO2.5 Make good decisions about employee benefits. 9.

What is a flexible spending account and what do pretax dollars have to do with it? Answer: A flexible spending account (FSA), also called a flexible spending arrangement, is a sum of money that the employee sets up at the start of each year that can then be used during the year to pay for health care- and/or dependent-care related items. Such an account relates to pretax dollars because the money put into the account is sheltered from income taxation because it is not included in one’s taxable income for the year.

10. Summarize the benefits of participating in a high-deductible health care plan at work. Answer: A high-deductible health plan would lower your health care premiums. To take advantage of this we would also want to set up and fund a health savings account (HSA) where we can place pretax dollars to await any deductibles or uncovered health care expenses that might occur later. 11. Create a math example of why many employees participate in a tax-sheltered employee benefit plan, such as an HSA or 401(k) plan. Answer: One example could be depositing $4,000 into a 401(k) plan annually. Doing so would reduce our taxes for the year by $1,000 if we were in the 25 percent tax bracket ($4,000 × 0.25). Thus, in effect, we are only contributing $3,000 and the government is providing the other $1,000. 12. List two ways we can maximize the benefits from a tax-sheltered retirement program.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

Answer: The first way would be to tax shelter any funds put into the programs. The second would be a sheltering of the income earned over the years from the interest or dividends earned by the assets invested in the plan. LO2.6 Identify the professional certifications of providers of financial advice. 1. How does a professional financial planner differ from a local lawyer of insurance person in the community? Answer: A professional financial planner differs from a local lawyer or insurance person in that they are professionally trained and certified in all areas of a client’s financial life and develop plans and strategies that take all areas into account. An attorney or an insurance agent has specialized knowledge. 2.

What are the four different ways financial planners may be compensated? Answer: Financial planners can be compensated solely for the commissions from the sale of financial products. They can be compensated by an up-front fee plus commissions from financial products they might sell. They can be compensated by an annual or hourly fee that might be offset if the client purchases financial products from the planner. Finally, they can be compensated solely for the fee they charge their clients for the services provided.

Describe two professional certification programs for financial planners. Answer: Two professional certification programs for financial planners are the Certified Financial Planner (CFP) and NAPFA Registered Financial Advisor (NRFA) programs. Both require passage of an exam or exams, a minimum number of years of experience, continuing education in the field, and adherence to a code of ethics.

List three questions that every person should ask a financial planner. Answer: Answers may vary, but three of the most important questions are the professional experiences of the planner, how the planner is compensated, and the planner’s qualifications to practice financial planning.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on the importance of career planning, what do you recommend to Nicole Linkletter in the case at the beginning of the chapter regarding: 1.

Clarifying her values and lifestyle trade-offs in career planning? Answer: Nicole might make two lists to clarify her thinking. (1) Her top five list of values and (2) the lifestyle options that are most important.

Enhancing her career-related experiences before graduation? Answer: Nicole could have a discussion with her academic adviser seeking suggestions for her to obtain additional opportunities for career-related experiences before graduation. Nicole could visit her college and/or university career center in her college to take advantage of their services and resources.

Creating career plans and goals? Answer: To begin the process of creating her career plans and goals, Nicole could review the occupations in Table 2.1 identify some careers of interest, communicate with friends who graduated in previous years

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

about their jobs and avocations, and do some thinking about how an avocation might be related to a future career path. 4.

Understanding her work-style personality? Answer: Nicole should fill out the work-style personality worksheet

Identifying job opportunities? Answer: To identify job opportunities, Nicole might review the occupations in Table 2.1 as well as search for useful information using careers fairs, classified advertisements, employment agencies, and the Internet.

LET’S TALK ABOUT IT 1.

Interviewing Tips. List three interviewing tips for new college graduates looking for employment when in many parts of the country a growing job market exists. Answer: During all types of economic times, employers will want to make especially sure that a new hire will be a successful addition to the team. To beat the other applicants for the job we must communicate that we are genuinely interested in the job and want to move up the ladder at the company. We need to also let them know that we are a person with a positive attitude and a team player. Demonstrate that we have a thorough knowledge of the company and the challenges it is facing as well as the skills we have that can help the company meet those challenges.

Interview Mistakes. Thinking about some common mistakes that people make in job interviews, which three are the worst? Make a short list of things people should do to improve success in an interview. Answer: Common interview mistakes include not knowing enough about the prospective employing organization; being unprepared to sell us through our abilities, skills, and experience; not having clear career plans and goals; a lack of enthusiasm; and not making eye contact. Ten things people could do to enhance interview success include (1) researching the company history, (2) knowing its profitability and place among its competitors, (3) being able to ask the interviewer questions, (4) telling specific stories that illustrate our abilities and experiences, (5) being able to identify our strengths, (6) being able to tell about a particularly difficult problem on a previous job and how we handled it, (7) acknowledging weaknesses but explaining how we have taken steps to overcome them, (8) making a good positive impression with a firm handshake and confident tone of voice, (9) practicing our interview skills in advance, and, finally, (10) sending a warm thank-you note after the interview. We also want to display enthusiasm and look the interviewers in the eye.

Career Trade-offs. People regularly make decisions in career planning that have trade-offs. Identify some benefits and costs people are faced with as well as two lifestyle trade-offs. Answer: Three trade-offs include urban/rural settings, near/far from relatives, and warm/cold climates. For the first, we will have higher transportation costs for fuel if we live in the country but lower costs for parking and insurance. Psychic and lifestyle trade-offs will depend on whether we prefer open spaces and natural surroundings or the hustle and bustle and richness of city life. For the second, the economic aspects might relate to travel to family events. Psychic and lifestyle trade-offs will depend upon the size and closeness of our family relationships. For the third, the economic trade-offs will include the cost of appropriate clothing and heating and cooling costs. Lifestyle tradeoffs will depend on our preference for leisure and physical recreation options specific to each climate.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

Keeping Track Topics. Review the task areas in the Decision-Making Worksheet ―Keeping Track of Your Job Search‖ on page 53 and identify what you think are the three that are likely the most difficult for people to accomplish. For each of the three, offer a suggestion that might help people accomplish the task. Answer: The items that are most difficult to accomplish will vary from student to student. While the question asks for the ones that are the most difficult for people in general, the students will be revealing what they feel are the most difficult when they make their selections. Having them offer suggestions provides a way for them to begin their own self-improvement.

Assessing the Benefits of a Second Income. Adding a second part-time income to a family either by having another person work or by working two jobs often seems to be a good way to add financial resources. But the impact is not always as large as people hope. Review the example given in the ―Run the Numbers‖ box on page 47 and discuss the pros and cons of a second income in that example. Answer: This is a potential ―Class Activity‖ exercise related to page 47 in the text. The most obvious benefits of a second income are the salary and employee benefits that the second worker receives. But these are offset by taxes, additional transportation, and commuting costs, work-related meals, clothing, and other expenses.

Interviewing Mistakes. Recall an interview for a job you did not get. What happened to cause it to go wrong? Was there anything you could have done differently/better to prepare? Answer: Student responses will vary.

DO THE MATH 1.

Economic Trade-off of Graduate School. Jessica Sotomajor, of Bangor, Maine, works for a military contractor and hopes to earn an extra $1,000,000 over her remaining 30-year working career by going back to school to obtain a doctoral degree. If her income projection is correct, that’s an average of over $33,000 more income a year. Jessica’s employer is willing to pay half, or $45,000, toward the $90,000 cost of the annual Ph.D. program, so she must pay $45,000 of her own money. Jessica wonders if the expected extra income would warrant spending the money to get the Ph.D. Jessica's decision demonstrates that earlier work clarifying her values and lifestyle landed her in a career she finds so rewarding that she wants to continue to invest in it through advanced education (LO1). This decision also demonstrates that creating career plans and goals doesn't end after graduation, it is ongoing throughout one's career (LO2 and LO3). a. What is the forgone lost future value of her $45,000 over the 30 years at 6 percent? (Hint: See Appendix A.1.) b. What would be the forgone lost future value of $90,000 over 30 years if Jessica had to pay all the costs for her doctoral degree? (Hint: See Appendix A.1.) c. Advise Jessica as to what she should do. Solution: This is a potential ―Class Activity‖ exercise related to page 34in the text. a. The forgone lost future value of the $45,000 is $258,458 ($45,000 × 5.7435). b. The forgone lost future value of the $90,000 is $516,915 ($90,000 × 5.7435). c. Jessica would be wise to take the opportunity to obtain a Ph.D. degree. She would also need to consider the impact of any potential reduction of income while obtaining the degree. However, this reduction is still unlikely to make the decision financially unsound. With all decisions, the opportunity costs should also be considered.

Comparing Salary Offers. Using Equations (2.1) or (2.2), if the cost-of-living index was 132 for Chicago and 114 for San Antonio, compare the buying power a $50,000 salary in Chicago with a $47,000

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

offer in San Antonio. This cost-of-living exercise helps a person clarify their values and lifestyle trade-offs (LO1). Solution: This is a potential ―Class Activity‖ exercise related to page 60 in the text. $50,000 × (114 ÷ 132) = $43,182. Thus, the Chicago salary as adjusted falls below the San Antonio salary, and the San Antonio salary is the better offer. 3.

Future Value of Employer’s Match. Future Value of Employer’s Match. Tyler Winkle’s employer in Pittsburgh makes a matching contribution of $2,000 a year to his 401(k) retirement account at work. If the dollar amount of the employer’s contribution increases 4 percent annually, how much will the employer contribute to the plan in the twentieth year from now? (Hint: See Appendix A.1) An employer-sponsored retirement account, and especially when there is a matching contribution, should be a part of evaluating our job opportunities (LO2 and LO5). Solution: The employer match in 20 years would be $4,382 ($2,000 × 2.1911).

Cashing Out 401(k) Plan. Emily Amarrada of Sioux City, South Dakota has accepted a new job and is thinking about cashing out the $30,000 she has built up in her employer’s 401(k) plan to buy a new car. If, instead, she left the funds in the plan and they are projected to earn 6 percent annually for the next 30 years, how much would Emily have in her plan? (LO2) (Hint: See Appendix A.1.) Solution: This is a potential ―Class Activity‖ exercise related to page 68in the text. Her $30,000 would grow to $172,305 ($30,000 × 5.7435) if she left the money in the plan. Employee Benefits Decision. Ramon Alvarez, of Juneau, Alaska, signed up for his employer’s flexible spending account plan primarily because he can use the money to pay for unreimbursed medical expenses for himself and his disabled son. Ramon is in the 15 percent marginal tax bracket, pays Social Security payroll taxes of 7.65 percent, and pays a 4 percent state income tax rate. How much will he save in income taxes by participating in the program this year in the amount of $3,000? How much would Ramon save if he was in the 22 percent federal marginal tax bracket (LO4)? Solution: This is a potential ―Class Activity‖ exercise related to page 68 in the text. Ramon will save $570 ($3,000 × 0.19) if he is in the 15 percent federal income tax bracket and with a state income tax of 4 percent. He would save $580($2,000 × 0.29) if he were in the 25 percent federal income tax bracket. Note that there are no savings related to the Social Security payroll taxes when one tax-shelters income.

FINANCIAL PLANNING CASES CASE 1: Harry and Belinda Johnson’s Family Might Have a Career Change Harry has started out fine in his career as his responsibilities have increased since he began working there about five years ago. Belinda recently attended a conference for those in her stock brokerage field and by chance she dropped in at the ―career search‖ room. She saw job opportunities there that fit her skill set that offered salaries of $78,000 to $80,000 in nearby Parkville, Missouri, only about a 30-minute commute away. a. If a new employer offered Belinda $80,000 to move and the relative cost index for the new community was 122, how does that compare to her current salary of $77,000 in Kansas City assuming the index in the latter is 116? b. Do you think she should take the new job? Give three reasons why or why not? Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

a. b.

$80,000 × (116 ÷ 122) = $76,066. Thus, the Parkville salary as adjusted falls below the Kansas City salary and she would take a pay cut to move. The Parkville salary as adjusted falls below the Kansas City salary and she would take a pay cut to move. She would only move if there were other nonfinancial reasons for moving.

CASE 2: Victor and Maria Hernandez Consider a Career Change Victor is somewhat satisfied with his sales career and has always wondered about a career as a teacher in a public school. He would have to take a year off work to go back to college to obtain his teaching certificate, and that would mean giving up his $53,000 salary for a year. Victor expects that he could earn about the same income as a teacher. a. What would his annual income be after 10 years as a teacher if he received an average 3 percent raise every year? (Hint: Use Appendix A.1.) b. Victor also could earn $4,000 each year teaching during the summers. What is the accumulated future value of earning those annual amounts over 10 years assuming a 5 percent raise every year? (Hint: Use Appendix A.3.) Solution: a. $71,227 ($53,000 × 1.3439) b. $50,311 ($4,000 × 12.5779) CASE 3: Julia Price’s Career Plans Change Julia has recently undergone a severe career crisis. After nearly ten years as a professional engineer, her position was phased out by her company due to a loss of government contracts, and she has been offered a position in the marketing department. The new job will require that she interact with purchasing agents for various companies that are current and potential customers of her company. The job pays more but will require considerable travel. She will be using her engineering background, but the primary tasks all will relate to presenting herself and her company in the best possible light to these other firms. Julia thinks she should take the new job and make a personal commitment to doing it for one year and, if she does not truly enjoy the work, seek a new engineering job within her company or at another employer. Offer your opinions about her thinking. Solution: Julia is wise not to prematurely rule out the career change. The new job will be challenging but it will also allow Julia to broaden her experience. The days of being able to work the same job and maintain a direct career path from graduation through to retirement are long gone. Taking the time to see what comes of the new job will provide Julia with the perspective to reevaluate the change in one year. CASE 4: Matching Yourself with a Job After completing his associate of arts degree four months ago from a community college in Oklahoma City, Oklahoma, Juan Ramirez has answered more than three dozen advertisements and interviewed three times in his effort to get a sales job, but he has had no success. Juan has never done sales work before, but he did take some business classes in college, including ―Personal Selling.‖ After some of the interviews, Juan telephoned some of those potential employers only to find that even though they liked him, they said they typically hired only those people with previous sales experience or who seemed to possess terrific potential. a. If Juan actually were well suited for sales, which work values and work-style factors do you think he would rate as ―very important‖? b. What would you recommend to Juan regarding how to find out about the depth of his interest in a sales career? c. Assuming Juan has appropriate personal qualities and academic strengths to be successful in a sales career, what additional strategies should he consider to better market himself?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

Solution: a. A review of the work-style personality worksheet, particularly with the help of a career adviser, might show Juan that those well suited for a career in sales would mark as ―very important‖ factors such as material gain, achievement and recognition, public contact, group membership, and helping others. b. In addition to filling out the work-style personality worksheet to see if he rates key sales-related factors highly, Juan also could interview people who are currently employed in sales, make a list of his abilities and experiences, list his most important values, visit the career center on his college campus, and take an interest inventory. c. Juan could begin by aligning himself with tomorrow’s employment trends in the field of sales, and then take steps to network with people who might help him secure a position. It also would be smart for him to research certain employers and target those of the most interest. CASE 5. Career Promotion Opportunity Nina and Ting Guo of Lima, Ohio, have been together for eight years, having married five years after completing college. Nina has been working as an insurance agent ever since. Ting began working as a family counselor for the state of Ohio last year after completing his master’s degree in counseling. Recently Nina’s supervisor commented confidentially that he was going to recommend Nina to be the next person promoted, given a raise of about $15,000, and relocated to the home office in Portland, Oregon. Nina thinks that if offered the opportunity she would like to take it, even if it means that Ting will have to resign from his new job. a. What suggestions can you offer Nina when she gets home from work and wants to discuss with her husband her likely career promotion? b. What lifestyle factors and benefits and costs issues should Nina and Ting probably discuss? Solution: This is a potential ―Class Activity‖ exercise related to page 37 in the text. a. Nina and Ting are dual-earner households, and such couples are especially challenged when one person’s career opportunity conflicts with the other persons. Nina might suggest that the two of them take 30 minutes to have an initial discussion of her forthcoming career opportunity and what it might mean to their family. Being honest and respecting the feelings and opinions of the other person. Subsequent planned conversations to review the pluses and minuses of the opportunity will help. b. This would be a good time for them to reexamine their values and the costs and benefits and lifestyle trade-offs of moving to Portland, Oregon.

EXTENDED LEARNING 1.

Interview a Human Resource Manager. Use the Internet and/or Yellow Pages to find a local company that employs people in your prospective career field. Request a brief interview with the human resource manager. Ask about salary levels, employee benefits, and the career ladder. Make a written summary of your findings.

Solution: Students should prepare a summary of the interview with a human resource manager with responses to the questions listed in this exercise. Students should also provide contact information about the manager and his/her business card. 2.

Prepare a Résumé. Using the Monster. com find a job listing for a position in your career field. Prepare a resume for the job. Review Figures 2-3, 2-4, and 2-5 on pages 49, 50 and 51 and create or update your

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 2: Career Planning

resume accordingly. Take the job listing and documents to your faculty advisor or campus career center and ask for feedback. Solution: This is a potential ―Class Activity‖ exercise related to page 49 in the text. The résumé should be in one of the styles described in the text and conform to standard requirements for grammar, spelling, and clarity. 3.

Cover Letter. Review Figure 2-6 and create or update a sample cover letter to accompany your resume when applying for a job. Solution: This is a potential ―Class Activity‖ exercise related to page 55 in the text. The cover letter should address the specifics of the job listing for which the student has developed the letter.

Where Do You Want to Live? It is highly likely that one of the best job opportunities for you at graduation will require that you move away from your hometown and/ or where you went to college. While that new location is unknown now, it is not too early to begin thinking of where you might need and/or want to live. Use the list of websites on page 00 to compare housing costs, quality of life issues, and moving costs for three cities of interest to you. Solution: This is a potential ―Class Activity‖ exercise related to page 60 in the text. Student responses should address the cost of housing, quality of life issues, quality of schools, and moving costs for the five cities chosen.

Clarify Your Values. To help you clarify your values, review the section titled ―Clarify Your Values and Interests‖ on pages 34 and 35 and make a list of your 10 most important ones. Solution: This is a potential ―Class Activity‖ exercise related to page 35 in the text. Student responses will vary.

Trade-Offs. To clarify your lifestyle trade-offs, review the section titled ―Lifestyle Trade-offs‖ on page 00 and given the list make a list of your choices for trade-offs. Solution: This is a potential ―Class Activity‖ exercise related to page 37 in the text. Student responses will vary.

Anticipated Interview Questions. Review the questions in the section on ―Prepare Responses for Anticipated Interview Questions‖ on page 58 and write out concise sample responses to each question. Solution: This is a potential ―Class Activity‖ exercise related to page 58 in the text. Student answers will vary.

Name Some Possible Mistakes. Stanford University professors Bill Burnett and Dave Evans bring a fresh perspective to career advice. Their book, Designing Your Life: How to Build a Well-Lived, Joyful Life, offers a series of self-evaluation exercises about treating life in a more improvisational way. You can make mistakes. Failure is good. List two mistakes that you might make soon after graduation, and then record what potential solutions might result.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Solution: Student answers will vary.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E, CHAPTER 3: FINANCIAL S TATEMENTS , GOALS, AND BUDGETS

TABLE OF CONTENTS Answers To Chapter Concept Checks .................................................................................................... 22 What Do You Recommend Now? ............................................................................................................ 24 Let’s Talk About It ................................................................................................................................... 25 Do The Math.............................................................................................................................................. 27 Financial Planning Cases ......................................................................................................................... 32 Extended Learning.................................................................................................................................... 37

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

ANSWERS TO CHAPTER CONCEPT CHECKS LO3.1 Identify your financial values, goals, and strategies. 5.

Summarize the content in Figure 3-1, the overview of effective personal financial planning. Answer: Financial planning is the process of developing and implementing a coordinated series of financial plans to achieve financial success. It does not produce a single plan; rather, it produces a coordinated series of plans covering various parts of a person’s overall financial affairs. Financial planning is unique to each individual and family because it takes into consideration all aspects of financial activity. Financial planning is an ongoing process where changing goals and circumstances require constant reevaluation.

What is the biggest financial worry of most individuals, and what can they do about it? Answer: The biggest financial worry for most people is spending beyond their means. Solutions to this problem are to keep planned monthly spending below income and to have an emergency fund to cover from three to six months so that unexpected expenses do not cause overspending.

Summarize how financial goals follow from one’s values. Answer: Values are the starting point for guiding financial objectives and goals. Goals should be specific in terms of topic, dollar amounts, and time frames. Financial strategies are the financial activities such as the details of budgeting and investing that lead to the achievement of goals.

Pick two wealth-building principles for life and explain what they mean to you. Answer: Student answers will vary among the ten wealth-building principles.

LO3.2 Use balance sheets and cash-flow statements to measure your financial health and progress. 9.

Define the balance sheet and give two examples of how to increase one’s net worth. Answer: The balance sheet shows the financial condition at a point in time and identifies the net worth of the individual or family. Net worth can be increased by saving or by paying off debts.

10. Define the cash-flow statement and explain what it does. Answer: The cash-flow statement is a record of income and expenditures for a period such as a month or a year. It provides information on where income is coming from and where money is spent. 11. How should assets and liabilities be valued for the balance sheet, and why? Answer: Assets should be valued at their fair market value. In other words, at the value that could be received if they were sold or cashed in today. Liabilities should be valued at what it would take to pay them completely today. Future interest need not be included; only the current loan pay off amount.

12. Distinguish between fixed and variable expenses and give two examples of each. Answer: Fixed expenses change little or not at all from month to month. They are often contractual obligations such as rent or debt payments. Variable expenses can change from month to month and are subject to much greater control by the personal financial planner. 13. Which two financial ratios for evaluating financial progress do you think will help you the most, and why?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Answer: Student answers will vary among the financial ratios; however, the liquidity ratio and the need for emergency savings are universal.

LO3.3 Collect and organize the financial records necessary for managing your personal finances. 14. List some advantages of keeping good financial records. Answer: Having good records helps one have a clearer understanding of one’s financial life, is a way for loved ones to understand the situation in the event of an emergency and allows one to take advantage of ways to reduce taxes. 15. Name three records that might be best kept in a safe-deposit box instead of stored digitally on the cloud. Answer: An original copy of your birth certificate, marriage certificate, legal documents verifying ownership of real estate and personal assets, and copies of income-tax filings are three important types of records that are best kept in a safe-deposit box.

LO3.4 List a number of money topics to discuss with a partner. 16. Identify two money topics you think might be valuable to discuss with a partner. Answer: Student answers will vary, the key is that the couple is talking. 17. Identify two money topics that you think might present some challenges when discussing them with a partner. Answer: Student answers will vary, but differences in spending and saving habits will be common answers.

LO3.5 Achieve your financial goals through budgeting. 18. Explain why setting financial goals is an important step in budgeting. Answer: Financial goals should set the parameters for budgeting. Reaching financial goals requires saving and setting aside amounts to save in one’s budget and is the only way to reach one’s goal. A budget should be a spending and saving plan that is driven by personal financial goals, not just a spending plan. 19. What are budget estimates? Offer some suggestions on how to go about making budget estimates for various types of expenses. Answer: Budget estimates are planned amounts of income and expenditures for the upcoming budget period. One particularly good source of information for making estimates is one’s recent cash-flow statements.

20. How might one go about revising budget estimates to create a balanced budget? Answer: Creating a balanced budget rarely occurs on the first pass. When making a balanced budget, one must revise estimates in the spending and saving categories until the total spending and saving equals income. Revising estimates will require looking at past spending patterns for the various categories and looking ahead to where certain categories may allow for reductions and others may require increases. 21. Explain what a cash-flow calendar accomplishes. Name three techniques to control spending. Answer: A cash-flow calendar plots out projected income and spending totals for future months to forecast when there might be overage and underage situations due to fluctuations in income and spending. Three

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

effective budget controls are the envelope tracking spending and using a subordinate budget. Answers will vary and any method listed in the chapter is appropriate. 22. Describe different ways to handle budget variances. Answer: Student answers will vary. There are several ways to handle budget variances. If overspending has occurred in a category, one could resolve to spend less in that category in the future or increase the budgeted amount in future budgets by reducing planned spending in other categories. If spending is lower in a category, one could decide to spend more in that category in the future, or to decrease the budgeted amount in future budgets and allocate the planned spending to other categories including saving. Or one could simply continue to allocate the same amounts to the over- or underspent categories if the one-month overage or underage is just an aberration.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on financial statements, goal setting, and budgeting, what do you recommend to Austin Patterson for his talk with Emily regarding: 23. Setting financial goals? Answer: Austin and Emily have several financial goals. Each goal should be made specific by determining the dollar amount of the goal, its target date, and the amount needed to be saved each budget period to reach the goal. The goals should then be prioritized so that there is an understanding as to which should be addressed first, second, and so on. On a regular basis, they should sit down and go over their balance sheet and cash-flow statements to ensure that they are making progress on reaching their financial goals. Only by monitoring these statements over time will they be able to know what is working, and what is not, to improve their financial health. 24. Determining what they own and owe? Answer: Austin should first develop a balance sheet. He can use their most recent bank and other account statements for any monetary and investment assets they might own. He will need to make estimates of the fair market value of their personal property and tangible assets. Some assets, like stocks and mutual funds are easy to value at any given point in time, others, like works of art or antiques, require more work to value, having to find and pay for the services of a specialized appraisal professional. They can use a recent account statement or consult the lenders to determine the dollar amount of their liabilities. As a result, he will know his family’s net worth as of the date that he prepares the statement. 25. Using the information in Austin’s newly prepared financial statements to summarize the family’s financial situation? Answer: Because Austin keeps documents, he should be able to go back and reconstruct their income and expenditures over the past month or year. Then he can prepare a cash-flow statement to determine if they have been running a surplus or deficit over that time. Austin should calculate the financial ratios outlined in the text. They could even calculate other ratios that help them monitor areas of particular interest, like growing a specific type of investment asset. Of particular importance will be the basic liquidity ratio (which will show if they have enough monetary assets to weather a financial emergency) and the assets-to-debt ratio (to see if they are solvent). He should calculate a debt payment-to-disposable-income ratio for both before and after going back to school to see if the change in income and expenditures will affect their ability to handle their debts. In the future, he might wish to organize the receipts by category to allow quicker development of this statement. Emily and he could also carry a small notebook to record expenditures by category.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

26. Evaluating their financial progress? Answer: Austin and Emily can use their monthly cash-flow statements to assess their ability to keep their spending in line with their income each month. Then at least once per year they can update their balance sheet to assess progress toward increasing their net worth. Most important of all, they need to commit to reviewing financial statements and ratios periodically and then evaluating any changes in their financial health. 27. Setting up a record-keeping system to better serve their needs? Answer: Fortunately, Austin and Emily have complete records, but they are not well organized. While a time-period system works well for simply storing documents, they will need to organize them better. He can use the information in Table 3.4 on pages 88 and 89 to set up a system. This will enable them to stay abreast of their financial situation as they go through their financial lives. 28. Starting a budgeting process to guide saving and spending? Answer: Austin and Emily can use the cash-flow statement that Austin prepared to begin working on their budget. They need to discuss how the records will be kept and who will do the day-to-day record-keeping. They may find it useful to computerize their budgeting and/or use one of many available apps on their phones. The Patterson’s would benefit from a monthly family meeting to discuss their budget for the previous month and to prepare a new budget. This meeting would be a good opportunity to do some analysis so they can keep their budget in line with what they really want to accomplish in life.

LET’S TALK ABOUT IT 29. Families. During slow economic times, the federal government’s budgeting priority often is to borrow so it can spend more money than it takes in. What happens to families that try that, and why? Answer: The government spends more than it takes in by borrowing; just as families do. The government hopes that the economic growth that results will fuel higher tax revenues and thus provide funds to repay the loans. When families spend more than they take in they often do so in ways that will not result in additional income later for use in repaying the borrowed funds. Thus, only spending more than income in ways that provide future income such as for investments or education makes sense for families in the long run. 30. Your Values. What are two of your most important personal values? Give an example of how each of those values might influence your financial plans. Answer: Student answers will vary. Three important personal values could be valuing education, using credit wisely, and valuing experiences with family and friends over material goods. If you value education, you might start a college savings fund for your child. If you want to use credit wisely, you will minimize your credit card debt. If you value your family and social life, you might want to invest your money in educational or entrepreneurial experiences. 31. Cash Flow. College students often have little income and many expenses. Does this reduce or increase the importance of completing a cash-flow statement on a monthly basis? Answer: College students, even if they do not have much income or many expenses, should keep track of their finances by completing a cash-flow statement monthly. This will instill good financial habits and allow the student to have a complete picture of their financial position upon graduation. Moreover, early in life financial statements tend to be less lengthy and complicated so they are easier to build.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

32. Financial Ratios. Of the financial ratios described in this chapter, which two might be most useful for the typical college student to track over time? Answer: The two most useful financial ratios for the typical college student would be the basic liquidity ratio and the asset-to-debt ratio. By contrast, the two most revealing for a retiree might be the basic liquidity ratio and the investment assets-to-total assets ratio. 33. Budgets. Do you have a budget or spending plan? Why or why not? What do you think are the two major reasons why people do not make formal written budgets? Answer: One reason that people do not make formal budgets is inertia. Couples, individuals, and families see making a formal budget as a big job they do not have time for. Often, they do not keep a formal checkbook register, particularly if they have online banking. Also, some families do not make formal budgets because it can cause friction within the family.

34. Control Spending. What can a person try to do to genuinely control spending to better achieve financial success? Answer: There are several things people can do to control spending. Recording the purpose of all expenditures can be helpful as can setting a budget for shopping trips and subordinate budgets for such things as vacations. Keeping track of credit card spending can help keep that type of spending under control. The envelope system can be an especially effective way of controlling spending for categories where purchases are primarily made in cash. 35. Financial Mistakes. Evaluate the biggest three financial mistakes you made over the past seven years. Are there any patterns in the mistakes? Answer: Student answers will vary. A common example of a financial mistake typical for college students is to let credit card and student debt get out of control, not follow a budget, and not have specific, measurable, attainable, realistic, and time bound (S.M.A.R.T.) financial goals. 36. Budgeting Mistake. What is the biggest budget-related mistake that you have made? What would you do differently now? Answer: Student answers will vary. Many students do not budget at all, certainly a mistake. For those who do budget, common examples of budgeting mistakes are overestimating income and underestimating expenses in the ―other‖ or ―miscellaneous‖ category. 37. Personal Finances Over the Life Cycle. Areas of financial decision-making change over one’s life-cycle. Based on the information provided in Figure 3-3 on page 94 justify the appropriate use of debt and/or deficit spending. Answer: This is a potential ―Class Activity‖ exercise related to Figure 3-3 in the text. Student answers will vary depending on their general attitude toward the use of debt within lifetime financial planning. Typically, college students are focused on meeting their expenses and managing their money effectively. Spending more than income early in life is justified by large investments in human capital. Spending more than income later in life is justified by adequate savings from higher-earning years where the plan was to retire and use income deferred through retirement plans.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

DO THE MATH 1.

Ratio Analyses for Victor and Maria. Review the financial statements of Victor and Maria Hernandez

(Table 3-2 and Table 3-3) and the financial ratios on page 96 and respond to the following questions (LO 3-1): a. How would you interpret their investment assets to total assets ratio? b. The Hernandez family appears to have too few monetary assets compared with tangible and investment assets. How would you suggest that they remedy that situation over the next few years? c. What are your thoughts on the Hernandez’s liquidity ratio? How might they address any issues you see? d. Comment on the couple’s diversification of their investment assets. e. The Hernandez’s seem to receive most of their income from employment rather than investments. What actions would you recommend for them to remedy that imbalance over the next few years? f. The Hernandez’s have just been invited by friends to join on a two-week vacation next summer, and they have only eight months to save the necessary $3,400. What reasonable changes in expenses might they consider increasing net surplus and make the needed $425 per month ($3,400/8)? Solution: The investment assets to total assets ratio for the Hernandez family is 43.2 percent. The ratio suggests that 43.2 percent of the Hernandez’s total assets are attributable to their investment assets. This is an acceptable ratio for a couple with children. As a family approaches retirement age this ratio should continue to grow. The Hernandez’s do seem to have too few monetary assets, which should be readily available for meeting daily expenses as well as emergency expenses. Monetary assets are only 3.2 percent of total assets ($12,750/$393,250). Such a small portion is good in terms of putting their money to work in investments but might be an issue as unexpected or emergency expenses are incurred. Using any surplus in a given month or year is an effective way to build monetary assets. They also have the option to move funds from the nonretirement investment assets. The Hernandez family has a liquidity ratio of 1.58. Again, they have too few monetary assets, which should be readily available for meeting daily expenses as well as emergency expenses. Additional emergency funds would be recommended. Victor and Maria could use the net gain from their cashflow statement to increase the amount in savings. Victor and Maria own a wide variety of investments. However, 67 percent of their investments ($114,000/$170,000) are in real estate. For now, they can refrain from investing in more real estate to achieve a better balance in their investment portfolio. Victor and Maria could make investments that pay higher dividends and interest. They currently have a large amount of labor income, but investment income could be increased once their investments are more diversified. This is also to be expected based on where they are in the lifecycle. As they enter retirement a much higher portion of their income will come from investments. There are also important tax implications to the form of income. Interest and dividends will be taxed in the year received, but any price appreciation will only be taxed when the investment is sold. Much more will be said on this in the next chapter. The Hernandez’s have no net surplus each month. So, they need to cut expenses by $425 more per month to save for the vacation. They could save the money for their vacation by cutting their clothing spending by $90 per month, their food spending by $100 per month, utilities by $30 per month by being more careful with heating and cooling, both Victor’s and Maria’s personal allowances by $50 a month each and each child’s personal allowance $20 per month, by reducing their emergency savings into the credit union by $30 per month and by reducing their miscellaneous expenses by $10 per month. Those cuts totaled up to $400 per month ($90 + $100 + $30 + $50 + $50 + $20 + $20 + $30 +

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

$10) for the vacation. Even with these cuts, they would need to cut $25 more. There are infinite options available to the family in terms of cutting spending, students should be creative in finding combinations that net around $425 per month in savings. The best combinations require the least amount of effort on the part of the family. 2.

Calculating Net Worth and Net Surplus. Jennifer Pontesso, from Lincoln, Nebraska, wants to better understand her financial situation. Use the following balance sheet and cash flow statement information to determine her net worth and her net surplus for a recent month. Liquid assets: $10,000; home value: $210,000; monthly mortgage payment: $1,300 on $170,000 mortgage; investment assets: $90,000; personal property: $20,000; total assets: $330,000; other than mortgage long-term debt: $5,500 ($250 a month); total debt: $175,500; monthly gross income: $9,000; monthly disposable income: $6,800; monthly expenses (not including employer withholdings for items like taxes, retirement savings, insurance, and union dues): $6,000. Solution: This is a potential ―Class Activity‖ exercise related to pages 89 and 92 in the text. Net worth; $154,500 = ($330,000  $175,500) Net surplus; $800 = ($6,800  $6,000)

Ratio Analyses. Now that Jennifer better understands her situation, she wants to do some analysis of what she has found. Given the information above in item 2 that comes from her balance sheet and cash-flow statements, calculate the following ratios: a. Liquidity ratio b. Asset-to-debt ratio c. Debt-to-income ratio d. Debt payments-to-disposable income ratio e. Investment assets-to-total assets ratio Solution: This is a potential ―Class Activity‖ exercise related to the ratios illustrated on page 96 in the text. Liquidity ratio; $10,000/$6,000 = 1.667 or 1 2/3 months Asset-to-debt ratio; 1.88 = ($330,000/$175,500) Debt-to-income ratio; 17.22% = [($250  12 = $3,000) + ($1,300  12)] = $18,600/$108,000 Debt payments-to-disposable income ratio; 3.68 percent = ($250/$6,800) Investment assets-to-total assets ratio; $90,000/$330,000 = 27.2%

Cash-Flow Surplus/Deficit. Cody Sebastian, of Lubbock, Texas, earns $60,000 a year. He pays 30 percent of

his gross income in federal, state, and local taxes. He has fixed expenses in addition to taxes of $1,800 per month and variable expenses that average $1,400 per month. What is his net cash flow (surplus or deficit) for the year? Solution: $3,600 surplus = $60,000 – [($60,000  0.30) + ($1,800  12) + ($1,400  12)] 5.

Construct Financial Statements. Thomas Green, of Laramie, Wyoming, has been a retail salesclerk for six

years. At age 35, he is divorced with one child, Amanda, age 7. Thomas’s salary is $46,000 per year. He regularly receives $400 per month for child support from Amanda’s mother. Thomas invests $100 each month ($50 in his mutual fund and $50 in U.S. savings bonds). Using the following information, construct a balance sheet and a cash-flow statement for Thomas. Assets

Amount

Vested retirement benefits (no employee contribution)

$6,000

Money market account (includes $150 of interest earned last year)

5,000

Mutual fund (includes $200 of reinvested dividend income from last year)

5,000

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Checking account

1,000

Personal property

5,000

Automobile

12,000

U.S. savings bonds

3,000 Outstanding Balance

Liabilities Dental bill (pays $25 per month and is included in uninsured medical/dental)

$450

Visa (pays $100 per month)

3,500

Student loan (pays $100 per month)

7,500

Annual Fixed Expenses

Amount

Auto insurance

$780

Rent

12,000

Utilities

2,400

iPhone

980

Cable

1,400

Internet

800

Food

3,000

Uninsured medical/dental

1,000

Annual Variable Expenses

Amount

Dry cleaning

$480

Personal care

420

Gas, maintenance, license

2,120

Clothes

500

Entertainment

2,700

Vacations/visitation/travel

3,300

Childcare

5,000

Gifts

400

Miscellaneous

300

Federal income tax

5,600

Social Security taxes

3,500

Health insurance

2,440

Solution: This is a potential ―Class Activity‖ exercise related to pages 89 and 92 in the text. Based on the information provided, the balance sheet and a cash-flow statement for Thomas Green would be as follows: Balance Sheet for Thomas Green ASSETS

Dollars

Percent

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Monetary assets Checking account Money market account EE savings bonds Total

$1,000 5,000 3,000

Tangible assets Personal property Automobile Total

$5,000 12,000

Investment assets Mutual fund Vested pension benefits Total TOTAL ASSETS LIABILITIES Short-term liabilities Dental bill Visa Total Long-term liabilities Student loan Total TOTAL LIABILITIES

2.70 13.51 8.11 $9,000

13.51 32.43 17,000

$5,000 6,000

13,51 16.22

$450 3,500

29.73 100.00

1.22 9.46 $3,950

$7,500

10.68

20.27 7,500 $11,450

20.27 30.95

$25,550

69.05

$37,000 TOTAL LIABILITIES AND NET WORTH Cash-Flow Statement for Thomas Green Dollars INCOME Thomas’s salary $46,000 Child support 4,800 Interest and dividends 350 $51,150 TOTAL INCOME

Variable expenses Food

45.95

11,000 $37,000

NET WORTH

EXPENSES Fixed expenses Rent Mutual fund EE savings bond Childcare Health insurance Auto insurance Taxes Debt payments Total fixed expenses

24.32

$12,000 600 600 5,000 2,440 780 9,100 2,400

100

Percent 89.93 9.38 0.69 100.00

23.46 1.17 1.17 9.78 4.77 1.52 17.79 4.69 32,920

$3,000

64.35

5,87

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Utilities Phone Cable Gas, maintenance, license Dry cleaning Uninsured medical/dental Personal care Clothes Entertainment Vacation/visitation travel Gifts Miscellaneous Total variable expenses TOTAL EXPENSES NET SURPLUS/DEFICIT 6.

1,200 980 1,400 2,120 480 1,000 420 500 2,700 3,300 400 300

2.35 1.92 2.74 4,41 0.94 1.96 0.82 0.98 5.28 6.45 0.78 0.59 17,800 $50,720

34.80 99.15

$430

0.85

Budgeting and Income Projections. Leyia and Larry Hartley of Columbus, Ohio have decided to start a family next year, so they are looking over their budget (illustrated in Table 3-5 as the ―young married couple‖). Leyia thinks that she can go on half-salary ($2,400 instead of $4,800 per month) in her job as a college textbook sales representative for about 18 months after the baby’s birth; she will then return to fulltime work. a. Looking at the Hartley’s current monthly budget, identify categories and amounts in their budget where they realistically might cut back $2,400. (Hint: Federal and state taxes should drop about $600 a month ($7,200 annually) as their income drops.) b. Assume that Leyia and Larry could be persuaded not to begin a family for another five years. What specific budgeting recommendations would you give them for handling (i) their fixed expenses and (ii) their variable expenses to prepare financially for an anticipated $2,400 loss of income for 18 months as well as the expenses for the new baby? c. If the Hartley’s gross income of $8,830 rises 3 percent per year in the future, what will their income be after five years? (Hint: See Appendix A.1) Solution: For Leyia and Larry, starting a family next year will require strict budget cutbacks. Their federal and state tax payments will drop a projected $600 because of lower income, but they will need to reduce other expenditures an additional $1,800 plus allow for expenses to meet the new baby’s needs. If they have enough monetary assets, Leyia and Larry should pay off their personal loan (savings of $220). They could cut personal allowances, entertainment, gifts, vacations, and miscellaneous in half (savings of $565). Vehicle costs can go down; perhaps 25 percent (savings of $90). Food and clothing will be difficult to cut with a third family member. They could stop contributing to the individual retirement account for now (savings of $360) and make up the remaining $565 as well as additional baby expenses from investments or other savings. The bottom line is that dealing with the combination of less income and more expenses will be anything but easy. If the Hartley’s decided to postpone having a family for five years, they could reduce their fixed expenses with less expensive housing, cheaper insurance policies, and debt reduction. Regarding variable expenses, they could cut back on food and entertainment. Increased savings and a higher amount in the revolving savings fund would cushion their anticipated future loss of income. In five years, the Hartley’s’ income would equal $10,237 ($8,830  1.1593) per month.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

FINANCIAL PLANNING CASES CASE 1: The Johnsons’ Financial Statements Suggest Budget Problems Harry has worked at a medium-size interior design firm for five years and earns a salary of $4,080 per month. He also receives $3,000 in interest income once a year from a trust fund set up by his deceased father’s estate. Belinda earns a salary of $6,400 per month, and she has many job-related benefits including flexible benefits program, life insurance, health insurance, a 401(k)-retirement program, workplace financial education, and a credit union. The Johnsons live in an old apartment located halfway between their places of employment. However, their rent will increase by $100 a month in July. Harry drives about ten minutes to his job, and Belinda travels about 15 minutes via public transportation to reach her downtown job. Harry and Belinda’s apartment is nice, but small, and it is furnished primarily with furniture given to them by some of his friends. Soon after getting married, Harry and Belinda decided to begin their financial planning. Fortunately, each had taken a college course in personal finance. After initial discussion, they worked together for three evenings to develop the financial statements presented below. Note that the cash-flow statement covered the first six months of their marriage. a. Briefly describe how Harry and Belinda determined the fair market prices for each of their tangible and investment assets. b. Using the data from the cash-flow statement developed by Harry and Belinda, calculate a liquidity ratio, asset-to-debt ratio, debt-to-income ratio, debt payments-to-disposable income ratio, and investment assets-to-total assets ratio. What do these ratios tell you about the Johnsons’ financial situation? Should Harry and Belinda incur more debt, such as credit cards or a new vehicle loan? c. The Johnsons enjoy a high income because both work at well-paying jobs. They have spent parts of three evenings over the past several days discussing their financial values and goals together. As shown in the upper portion of Figure 3-5, they have established three long-term goals: $6,000 for a European vacation to be taken in 2026, $5,000 needed in October 2027 for a down payment on a new automobile, and $30,000 for a down payment on a home to be purchased in December 2029. As shown in the lower portion of the figure, the Johnsons did some calculations to determine how much they had to save for each goal—over the near term—to stay on schedule to reach their long-term goals as well as pay for two vacations and an anniversary party. After developing their balance sheet and cash-flow statement (shown below), the Johnsons made a budget for the year (shown in Table 3-6 on page 99). They then reconciled various conflicting needs and wants until they found that total annual income was close to the total of planned expenses. Next, they created a revolving savings fund (Table 3-8 on page 101) in which they were careful to include enough money each month to meet all their short-term goals. When developing their cash-flow calendar for the year (Table 3-7 on page 100), they noticed a problem: substantial cash deficits in November and December. Make specific recommendations to the Johnsons on how they could make reductions in their budget estimates. Do not offer suggestions that would alter their new lifestyle drastically, as the couple would more than likely reject such ideas. Balance Sheet for Harry and Belinda Johnson January 1, 2024 Assets Monetary Assets Cash on hand

$ 1,100

3.8%

Savings (First Credit Union)

1,200

4.1%

Savings (Far West Savings Bank)

4,000

13.7%

Savings (Homestead Credit Union)

2,260

7.7%

Checking (First Credit Union)

2,100

7.2%

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Total Monetary Assets

$10,660

36.5%

$11,000

37.6%

Personal property

2,300

7.9%

Furniture

1,700

5.8%

$15,000

51.3%

Harry’s retirement account

$ 1,170

4.0%

Belinda’s retirement account

2,400

8.2%

Total Investment Assets

$ 3,570

12.2%

Total Assets

$29,230

100.0%

Tangible Assets Automobile (3-year-old Toyota)

Total Tangible Assets Investment Assets

Liabilities Short-Term Liabilities Visa credit card

390

1.3%

Target credit card

0.2%

Dental bill

400

1.4%

835

2.9%

$13,800

47.2%

8,200

28.1%

Total Long-Term Liabilities

$22,000

75.3%

Total Liabilities

$22,835

78.1%

Net Worth

$ 6,395

21.9%

Total Liabilities and Net Worth

$29,230

100.0%

Total Short-Term Liabilities

Long-Term Liabilities Vehicle loan (First Credit Union) Student loan (Belinda)

Cash-Flow Statement for Harry and Belinda Johnson July 1–December 31, 2023 (First Six Months of Marriage) Cash Flow

Dollars

Percent

Harry’s gross income

$24,000

37.6%

Belinda’s gross income

36,600

57.4%

180

0.3%

3,000

4.7%

$63,780

100.0%

$ 9,600

15.1%

1,800

2.8%

Income

Interest Harry’s trust fund Total Income Expenditures Fixed Expenses Rent Health insurance

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

Life insurance

120

0.2%

Renter’s insurance

220

0.3%

Automobile insurance

600

6.3%

Auto loan payments

2,940

4.6%

Student loan payments

1,800

2.8%

Cable TV and Internet

960

1.5%

Savings/emergencies

960

1.5%

Harry’s retirement plan

1,170

1.8%

Belinda’s retirement plan

2,400

3.8%

Federal income taxes

10,200

16.0%

State income taxes

3,000

4.7%

Social Security taxes

4,640

7.3%

Automobile registration

300

0.5%

Total Fixed Expenses

$40,710

63.8%

$ 3,000

4.7%

Food (home)

3,800

6.0%

Food (out)

1,860

2.9%

Utilities

1,320

2.1%

660

1.0%

Auto gas/maintenance/repairs

1,150

1.8%

Doctor’s and dentist’s bills

1,140

1.8%

350

0.5%

Clothing and upkeep

1,200

1.9%

Church and charity

550

0.9%

1,070

1.7%

Public transportation

940

1.5%

Personal allowances

2,400

3.8%

Entertainment

960

1.5%

Family holiday trip

780

1.2%

Summer vacation

1,200

1.9%

Miscellaneous

560

0.9%

Total Variable Expenses

$22,940

36.0%

Total Expenses

$63,650

99.8%

Surplus (Deficit)

$130

0.2%

Variable Expenses Savings money market fund

Cell phones

Medicines

Gifts

Solution: Harry and Belinda consulted a variety of sources to determine the fair market value for each of their tangible assets. The lender who financed the Johnsons’ automobile (or any lender) could provide an

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

appropriate fair market price for the auto. Harry and Belinda could have used personal and bank records to determine the value of their personal property and furniture, and they might have consulted professional appraisers. The Johnsons own no investment assets. If they did, they could determine prices for such assets from investment publications, financial publications, online investment sites, and investment brokers. Some of the personal property and furniture is difficult to value. They may be valuing these items at a level near what was paid, this would be a mistake as most personal property and furnishing depreciate quickly. Liquidity ratio: $10,660/$10,608 = 1.05, note on a monthly basis we have ($63,650/6) in total expenditures Assets-to-debt ratio; $29,230/$22,835 = 1.28 Debt-to-income ratio; $9,480/$124,560 = 7.6%; the annual debt payments are the auto and student loan payments for the year Debt payments-to-disposable income ratio; $790 monthly/$7,126 = 11.09%; note the $7,126 is monthly disposable earned income calculated as (24,000 + 36,600 – 10,200 – 3,000 – 4,640)/6. Investment assets-to-total assets ratio; $3,570/$29,230 = 12.21% The basic liquidity ratio suggests that Harry and Belinda could live only one month if they faced a loss of income, considerably less than the three to six months suggested by financial experts. The asset-todebt ratio shows that the couple own over 1 ¼ times what they owe. Their debt-to-income ratio is 7.6 percent, considerably less than the 36 percent benchmark for potential debt problems. Their debt payments-to-disposable-income ratio is within the manageable range at about 11 percent. Their investment assets-to-total assets ratio is 12.21 percent, which is acceptable for a young couple. Based on these ratios, the Johnsons should use their monthly net gain to build an emergency fund thus accumulating more monetary assets. Their debt-to-income ratio indicates they should be able to manage more debt if desired. However, higher debt payments would require other adjustments in their budget and lifestyle. The Johnsons could reduce their budget estimates without seriously altering their lifestyle. They could cut back 15 to 20 percent of costs on food, telephone, clothing, gifts, entertainment, and church and charity donations. Even if church and charity donations are strongly liked to their values, they might plan to make larger contributions in the future when both income and assets have grown. Their personal monthly allowances of $250 each could also be revised. For example, $100 saved monthly from their allowances, combined with the savings from the other categories, would help reduce their expenses and could be saved for short- and long-term goals.

CASE 2: Victor and Maria Hernandez Think About Their Financial Statements and Budgets Victor and Maria, both in their late thirties, have two children: John, age 13, and Joseph, age 15. Victor has had a long sales career with a retail appliance store. Maria works part-time as a medical records assistant. The Hernandez’s own two vehicles and their home, on which they have a mortgage. They will face many financial challenges over the next 20 years, as their children drive, go to college, and leave home and go out in the world on their own. Victor and Maria also recognize the need to further prepare for their retirement and the challenges of paying for increasing healthcare costs. Victor and Maria spent some time making up their first balance sheet, which is shown in Table 3-2. Victor and Maria are a bit confused about how various financial activities can affect their net worth. a. Assume that their home is now appraised at $200,000 and the value of their automobile has dropped to $8,500. Calculate and characterize the effects of these changes on their net worth and on their asset-todebt ratio. b. If Victor and Maria take out a bank loan for $1,600 and pay off their credit card debts totaling $1,600, what effects would these changes have on their net worth?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e, Chapter 3: Financial Statements, Goals, and Budgets

If Victor and Maria sell their New York 2038 bond and put the cash into the savings account, what effects would this have on their net worth and liquidity ratio? Solution: The net effect of the appreciation of the home and the depreciation of the car is an increase of $7,000 in the Hernandez’s net worth. Their net worth would increase because the value of the real estate rose more than the value of the car declined. This change would change their asset-to-debt ratio. Prior to the increase in assets, their asset-to-debt ratio was 3.87. It would now be 3.94 ($400,250 ÷ $101,520). Taking out a bank loan to pay off the credit card liability would not affect the Hernandez’s net worth. Although they pay off one liability with the bank loan, they are assuming another liability of equal value. The only reason to do so is to lower the monthly interest expense. Over time this might improve financial health, but now it’s only substituting one liability for another of equal value. Selling the New York bond will have no effect on their net worth, but it will increase their basic liquidity ratio to 2.1 ($16,750 ÷ $7,977). As with item b, we are just substituting one for another, but this time it is an asset swapped for an asset instead of a liability for a liability.

CASE 3: Julia Price Thinks About Financial Statements, Goals, and Budgets Julia graduated over six years ago in aeronautical engineering and changed job once. Her income is more than sufficient for her needs. Julia contributes the maximum into her employer’s retirement account and additionally saves about $400 a month. She has only about $1,000 in credit card debt and makes a monthly car payment of $520. With such a strong financial position, she thinks it would be a waste of time to prepare financial statements and create a budget. Offer your opinions about her thinking. Solution: Julia needs to create some financial statements to begin the process of determining how well off she is financially and make some plans for the future. Just as every visit to the doctor starts with a basic measure of health, she needs to use statements, goals, and budgets to measure her overall financial health. While she earns a good income and is saving a lot of money, she lacks key financial information on her financial goals and how she may be progressing in terms of achieve them.

CASE 4: Budget Control for a Recent Graduate Stephen Bailey, a political scientist from McPherson, Kansas, graduated from college eight months ago and is having a terrible time with his budget. Stephen has a regular monthly income from his job and no large bills, but he likes to spend. He exceeds his budget every month, and his credit card balances are increasing. Choose three budget control methods that you could recommend to Stephen and explain how each one could help him gain control of his finances. Solution: This is a potential ―Class Activity‖ exercise related to page 113 in the text. Since Stephen is losing control of his credit, a listing of all his debts and the amounts he must pay each month would be a helpful first step toward a more successful budget. His credit bills are growing because he is overspending. Second, to control overspending, Stephen needs to be constantly aware of unexpended amounts in each budget category. Third, Stephen should carefully and thoroughly justify any budget exceptions so that he will be less inclined to go over budget.

CASE 5: A Couple Creates an Educational Saving Plan Stanley Marsh and Wendy Testaburger of South Park, Colorado, have two young children. They both work and earn a substantial income, over $100,000 annually. Their monthly budget is illustrated in Table 3-5 on page 97 as the ―married couple with two young children.‖ Every month they save quite a bit of money for retirement, and they are paying off their student loans ahead of schedule. They live well but Wendy and

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

Stanley are nervous about not having started an educational savings plan for their children. They have decided that they want to save $200 per month for the children’s education. a. Review the family’s budget and make suggestions about how to modify various budget estimates so that they could save $200 per month for the education fund. b. Briefly describe the effect of your recommended changes on the Marsh-Testaburgers’ lifestyle. Solution: Stanley and Wendy’s budget is tight, but cuts could be made in several variable expenses. Cutting entertainment and gifts by one-fourth would be a good start and would free $95 for the education fund. They could also cut personal allowances by $50 per month and food by $30. Once they get their emergency savings balance up to about four times their monthly expenses, they could cut that savings amount by $25 to make up the remaining needed to reach the $200 a month the family needs to start an education fund. Stanley and Wendy’s lifestyle will feel a little strained with cutbacks in food, personal allowances, and entertainment.

EXTENDED LEARNING 1.

Money Discussion Topics. Use ―Topics to Discuss with a Partner‖ as a guide to interview two married couples. Ask them which of the topics they discussed with their partners within the first year of marriage. Make a table that summarizes your findings. Solution: A simple table (two couples and their topics) showing the responses of the two couples will summarize the survey results.

Financial Mistakes. Interview two people to learn about their financial mistakes in life. Ask each person to cite two financial mistakes they have made. Make a table that summarizes your findings. Solution: A simple table (two people and two financial mistakes) will summarize the survey results.

Short-Term Financial Goals. Interview two people to ascertain their financial goals. Ask each person, ―What are your top two short-term financial goals?‖ Make a table that summarizes your findings. Are their goals specific, measurable, attainable, realistic, and time bound (S.M.A.R.T.)? Solution: A simple table (two people and two financial goals) will summarize the survey results.

Long-Term Financial Goals. Interview two people to ascertain their financial goals. Ask each person, ―What are your top three long-term financial goals?‖ Make a table that summarizes your findings. Are their goals specific, measurable, attainable, realistic, and time bound (S.M.A.R.T.)? Solution: A simple table (two people and three long-term goals) will summarize the survey results.

Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 4: MANAGING INCOME T AXES

TABLE OF CONTENTS Answers to Chapter Concept Checks ...................................................................................................... 39

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

What Do You Recommend Now? ............................................................................................................ 41 Let’s Talk About It ................................................................................................................................... 42 Do the Math ............................................................................................................................................... 44 Financial Planning Cases ......................................................................................................................... 46 Extended Learning.................................................................................................................................... 49

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

ANSWERS TO CHAPTER CONCEPT CHECKS LO4.1 Explain the nature of progressive income taxes and the marginal tax rate. 1.

Distinguish between a progressive and a regressive tax.

Answer: A progressive tax is one that takes a higher percentage of income as income goes up. A regressive tax does the opposite. The federal income tax is a progressive tax. State sales taxes are often regressive as a higher percentage of income is paid by those with lower levels of income. 2.

What is a marginal tax bracket, and how does it impact taxpayers making tax-advantaged contributions to their retirement plans?

Answer: The marginal tax bracket reflects the tax rate applied to the highest (or last) dollar of income earned. Since any additional income earned becomes the highest dollar of income, it is taxed at that marginal rate. If we contribute to a tax-sheltered retirement plan, our marginal tax rate multiplied by the amount contributed is how much we save in taxes. In effect, the government is helping us save for retirement by not having to pay those taxes now and deferring them to the future. The rate of deferral is set by the marginal rate. Those in a higher tax bracket benefit more from deferring income to a time when they may be in a lower bracket. 3.

Explain why many taxpayers have an effective marginal tax rate as high as 40 percent.

Answer: Adding the typical middle-income federal income tax bracket rate of 22 percent (remember, this is higher than one’s average rate) to the Social Security rate of 7.65 percent and a state income tax rate of 6 percent and a potential local income tax rate of 2 percent, we have a possible combined marginal tax rate of 37.65 percent. The U.S. average tax burden is about 26 percent, much lower than this marginal rate.

LO4.2 Differentiate among the seven steps involved in calculating federal income taxes. 1.

Give five examples of income that must be included in income reported to the IRS.

Answer: Five examples of income that must be included in gross income are (1) employment income from wages, salaries, commissions, and tips; (2) gambling winnings; (3) business income; (4) interest and dividends from investments (unless in a qualified retirement account); and (5) capital gains from investments sold. The simple rule is that all income is taxable unless the tax code stipulates otherwise. 2.

How are long-term and short-term capital gains treated differently for income tax purposes?

Answer: Short-term capital gains are taxed at the normal marginal tax rate. Long-term capital gains are taxed at 0 percent if we are in the ten or 15 percent income-tax brackets and 15 percent if we are in one of the next four higher tax brackets. Those in the highest tax brackets pay a 20 percent long-term capital gains rate. The key takeaway is that long-term gains (property held for at least a year and a day) are taxed at lower rates. 3.

Give three examples of income that is excluded from IRS reporting.

Answer: Three examples of exclusions from gross income are (1) interest income received on most municipal bonds; (2) scholarship and fellowship income spent on course-required tuition, fees, books, and supplies; and (3)

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

and gifts and inheritances. All these types of excluded income are specifically referenced in the tax code with statements supporting the conditions where they can be excluded from income. 4.

List three examples of adjustments to income.

Answer: Student loan interest payments, contributions to a traditional retirement account, and certain taxes paid by the self-employed are examples of adjustments to income. Schedule 1 of Form 1040 lists all the possible adjustments to income. 5.

What advice on filing a Form 1040X can be offered to someone who did not file a federal income tax return last year or in any one of the past four years?

Answer: Form 1040X is used to correct or amend a previously filed tax return. Use Form 1040 for any previous year that one did not file a return. A Form 1040 for a prior year can be found on the Internal Revenue Service web site or by using an older version of tax preparation software. 6.

List five examples of tax credits. Why are credits more valuable than deductions?

Answer: Tax credits include the American Opportunity and Lifetime Learning credits for education expenses, a child and dependent care credit, a retirement savings contribution credit for certain lower-income taxpayers, an adoption credit, and the earned income credit. They are more valuable because they reduce the tax liability dollar-for-dollar as opposed to a deduction that only lowers the tax bill by the amount of the deduction times the marginal tax rate.

LO4.3 Use appropriate strategies to avoid overpayment of income taxes. 1.

Distinguish between two major types of tax-sheltered investment returns.

Answer: One type of tax-sheltered investment return is the earnings accrued each year within a qualified retirement plan. These returns do not have to be reported each year as they accrue. For some plans (plans with ―Roth‖ in the name), these returns are forever tax-free when withdrawn during retirement. A second form of taxsheltered investment returns are the returns from qualified 529 college savings plans. They are sheltered in a similar way as retirement account returns are sheltered, and if the funds are used for qualifying educational expenses, they can be withdrawn tax-free.

Explain how to reduce income taxes via an employer, and name three employer-sponsored plans to do so.

Answer: The basic premise is to have portions of our income be used in a pretax mechanism and thus not be reported to the IRS. Flexible spending accounts defined contribution retirement plans, and premium-only plans are three examples of these pretax mechanisms. 3.

Summarize the differences between a traditional IRA and a Roth IRA.

Answer: The basic (traditional) individual retirement account (IRA) allows one to take any contributions made each year as an adjustment to income when we file our tax return. As a result, our taxable income and resulting tax owed is reduced. Then as the investments made with these contributions earn investment returns over

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

the years, we can continue to defer the taxes until we withdraw the funds during retirement at which time ordinary income taxes are owed on the withdrawals. Roth IRAs do not have the deductible contributions feature. They do have a tax-free feature for the investment returns off the deposited funds. The big attraction of the Roth IRA is that withdrawals of any funds from the account during retirement are forever tax-free, meaning the growth on the investment is never taxed, an opportunity that should not be missed— especially for young investors. 4.

Identify three strategies to avoid overpayment of income taxes and summarize the essence of each.

Answer: One strategy is called accelerating deductions. This involves making deductible expenditures in such a way that we prepay them in a particular year to reach the threshold where it is advantageous to itemize deductions. Another technique is to buy municipal bonds as an investment since the interest off these bonds is free from the federal income tax. A third technique is to postpone income into a future year where the marginal tax rate might be lower. Other popular strategies are outlined in section 4.3.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on managing income taxes, what advice can you offer Ace and Florence in the case at the beginning of the chapter regarding: 1.

Using tax credits to help pay for Ace’s college expenses?

Answer: Tax regulations permit money spent on Ace’s tuition and related college expenses to be claimed for a credit of up to $2,000 under the regulations of the Lifetime Learning credit.

Determining how much money Florence will receive if she sells the stocks?

Answer: Florence’s long-term capital gains tax rate will be 15 percent if she sells the stock. At $130 a share, she will realize a profit of $12,000 [($130 − $90) × 300], and after taxes, she will net $10,200 [$12,000 − ($12,000 × 0.15)]. 3.

Buying a home?

Answer: When Florence and Ace buy a home, they can record the interest and property taxes as itemized tax deductions along with many previously nondeductible expenses, plus later when they sell the home, they can reap the enormous benefit of the capital gains exclusion for the sale of a personal residence. 4.

Increasing contributions to their employer-sponsored retirement plans?

Answer: Neither Florence nor Ace is currently saving much for retirement. For every additional $100 of savings, up to their employers’ plan limits, each will save $22 in income taxes if these saved funds fall into the 22 percent bracket, which is given their incomes. By contributing so few dollars now, they also are giving up matching contributions from their employers. Therefore, each should check into their employer’s

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

retirement plan rules and begin saving for retirement in earnest. This will not only save taxes now but also better prepare them for retirement. 5.

Establishing a sideline business for Ace’s jewelry operation?

Answer: Ace could deduct all his business expenses to offset income from his sideline jewelry business. If his business lost money, all or a portion of the losses may be used to offset his salary income.

LET’S TALK ABOUT IT 1.

During Slow Economic Times. Congress often reduces taxes on middle- and low-income taxpayers with the expectation that consumers will spend most of that money and help create more economic growth. Is this idea good or not, and why?

Answer: Student answers will vary. Many students will understand the tax cuts as being a stimulus to the economy and will approve. Some students may perceive that these cuts will add to the national budget deficit and be concerned about how the deficit can be covered. The concept of permanent income may arise. If the cuts are viewed as temporary, then consumption may not go up and the tax cuts may be saved instead of spent, thus not stimulating the economy as expected. Differentiation between a permanent and temporary tax cut is important. 2.

Filing a Tax Return. Many college students choose not to file a federal income tax return, if the income taxes withheld by employers ―probably‖ will cover their tax liability. Is such an assumption, correct? What are the negatives of this practice if the employers withheld too much in income taxes? What are the negatives if the employers did not withhold enough in income taxes? Will any tax credits be lost?

Answer: Commonly the withholding by an employer is enough to cover the taxes owed. However, in most such cases, there is more than enough deducted, and those excess funds can and should be refunded. But this can occur only if the person files a tax return. If the employer did not withhold enough, the taxpayer must make up the difference by April 15. If the shortfall is more than 10 percent of the total amount owed, there may also be a penalty. This can be avoided by making sure that our tax status (single, married, etc.) is correct with our employer. Over or under withholding does not affect one’s tax credits, but the only way to claim and use tax credits is to file a return. 3.

Fairness of Capital Gains. The long-term capital gains tax rates are 0 percent for singles earning up to $44,625, 15 percent for those earning $44,626 to $492,300 and 20 percent for those earning above $492,300. What is your opinion on the fairness of these lower capital gains tax rates as compared with the marginal rates applied to income earned from employment that range as high as 37 percent?

Answer: Opinions will vary on this question. Some students will see higher-wealth people getting a break. Others will see that capital gains accrue over many years, and it may be unfair to tax them as if they all occurred during the year in question. They may also see the positive motivation to invest those results from the lower capital gains rates. Americans are optimistic, many students will expect themselves to soon be in the higher tax bracket, benefiting from the lower capital gains rates. These optimists are likely to be in favor of the lower taxes on long-term capital gains. 4.

Reporting Cash Income. Some college students earn money that is paid to them in cash and then do not include this as income when they file their tax returns. What are the pros and cons of this practice?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

Answer: The pro is obvious. No taxes will be paid. The cons are numerous. First, this is an illegal act—tax evasion. Second, by not reporting this income, one fails to add to their Social Security earnings history. This may mean lower Social Security benefits in the future. And third, eventually the IRS may catch up with the person and significant penalties and interest will be owed on top of the taxes themselves. 5.

Sideline Business. Identify one sideline business that you might engage in to reduce your income tax liability.

Answer: Answers will vary among students. Many have hobbies that could be turned into a business. Driving for Uber or Lyft may be common. Most important is the realization that necessary expenses related to the business reduce the profit from the activity. So, if they are driving, then gas and car expenses are taken against any revenue.

Tax Credits. Name three tax credits that a college student might take advantage of while still in school or during the first few years after graduation.

Answer: The American Opportunity credit, the Hope Scholarship credit, and the Lifetime Learning credit are ones for which many college students and/or their parents might qualify. Students who are or become parents soon after graduation will qualify for the child credit and childcare tax credit. 7.

Eliminate Tax Credits. Review the list of tax credits in Table 4-3 and select two you think ought to be eliminated and explain your reasoning.

Answer: Student answers will vary based on their perceptions of the various credits. There will be some discussion as to why some credits are refundable and the whole idea of having any refundable credit. 8.

Strategies to Reduce Income Taxes. Review the list of strategies to reduce your income taxes in section 4.3 and select two you think you might use in the future, explain your reasoning.

Answer: Student answers will vary about which tax reduction strategies they might use in the future. Most will choose reducing taxes via a tax-sheltered retirement plan. Also, common will be flexible spending accounts. Both primarily rely on programs linked to an employer. 9.

How Is Income Taxed? Review Figure 4-1 and comment on the logic of how different segments of Victoria Bassett’s income are taxed.

Answer: Victoria’s income is not taxed at a uniform rate. Due to the progressive nature of the federal income tax various brackets of her income is taxed at progressively higher rates. The first $13,850 of her income is not taxed at all. The next $11,000 is taxed at 10 percent. The next $33,725 of income is taxed at 12 percent. The remainder above $44,725 or $1,425 of her income is taxes at 22 percent. 10. Take All Tax Deductions. People often are worried that taking too many deductions on their income tax return will risk an audit, so they sometimes do not take deductions they deserve. Reject this tendency and take your deductions because the odds of an audit for most of us are 0.6 percent. What do you think of this conclusion?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

Answer: Taking all one’s tax deductions is the wise move. The odds of being audited are extremely small. In addition, correctly taken deductions will go through an audit unchanged. Tax planning is about using the tax law to our advantage. Following the rules is the only expectation. The tax code is filled with incentives for taxpayers to behave in certain ways. As examples, there are numerous incentives to save for retirement, invest in a business, and own a home.

DO THE MATH 1.

Calculate Tax Liability. What would be the tax liability for a single taxpayer who has a gross income of $55,300? (Hint: Use Table 4-2, and don’t forget to subtract the value of a standard deduction.) (LO 4-1) Solution: $55,300 − $13,850 (standard deduction) = $41,450 Using Table 4-2, the tax on $41,450 is $4,754. calculated as 1,100 + .12(41,450 − 11,000) = $4,754

Marginal Tax Rate. What would be the marginal tax rate for a single person who has a taxable income of (a) $31, 560, (b) $58,150, (c) $66,450, and (d) $100,580? [Hint: Use Table 4-2. (LO 4-1) Solution: a. 12% b. 22% c. 22% d. 24%

Use Tax Rate Schedule. Find the tax liabilities based on the taxable income of the following people: (a) married couple, $92,225; (b) married couple, $74,170; (c) single person, $30,925; (d) single person, $56,060. (Hint: Use Table 4-2.) (LO 4-1) Solution: This is a potential ―Class Activity‖ exercise related to Table 4-2 in the text. a. $10,905, calculated as $10,294 + .22(92,225 − 89,450); note that $10,904.50 is rounded to $10,905 b. $8,460, calculated as $2,200 + .12(74,170 − 22,000) c. $3,491, calculated as $1,100 + .12(30,925 − 11,000) d. $7,641, calculated as $5,147 + .22(56,060 − 44,725)

Determine Tax Liability. Jared Goff, of Detroit, determined the following tax information: gross salary, $160,000; interest earned, $2,000; IRA contribution, $5,000; and standard deduction, $13,850. Filing single, calculate Jared’s taxable income and tax liability. (Hint: Use Table 4-2.) (LO 4-2) Solution: This is a potential ―Class Activity‖ exercise related to page 128 in the text. Jared Goff’s tax liability: Gross income is $162,000 = $160,000 + $2,000. Adjustments to income are $5,000 for the IRA contribution. Adjusted gross income is $157,000 = $162,000 − $5,000. Jared can take the $13,850 standard deduction. Jared’s taxable income is $143,150 = $157,000 − $13,850. Jared’s tax liability is $27,756 = $16,290 + .24($143,150 − $95,375).

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

Determine Tax Liability. Carson Wentz, of Washington, DC, determined the following tax information: salary, $144,000; interest earned, $2,000; qualified retirement plan contribution, $6,000; itemized deductions, $14,000. Filing jointly with a spouse, calculate Carson’s taxable income and tax liability. (Hint: Use Table 4-2.) (LO 4-2) Solution: Carson Wentz’s tax liability: Gross income is $146,000 = $144,000 + $2,000. Adjustments to income are $6,000 for the retirement plan contribution. Adjusted gross income is $140,000 = $146,000 − $6,000. Jared can take the $13,850 standard deduction, but the itemized deductions are slightly higher, so he uses them. Jared’s taxable income is $126,000 = $140,000 − $14,000. Jared’s tax liability is $18,335 = $10,294 + .22($126,000 − 89,450).

Refund or Pay? A person has had $3,790 withheld for income taxes and a final tax liability of $3,600. Would this be a refund or an additional amount due and for what amount? (LO 4-2) Solution: This would be a refund of $190 ($3,790 − $3,600).

Taxable Income. Based on the following information, what is the amount of taxable income or a single tax filer? (LO 4-2) Gross salary: $60,000 Dividend income: $190 Charitable donations: $12,400 Mortgage interest: $8,400 Property taxes: $2,000 Interest earnings: $400 Solution: $37,790 = $60,000 + $190 + $400 = $60,590 in gross income − $22,800 in itemized deductions (which exceeds the standard deduction of $13,850).

Average Tax Rate. Jonas Salky, a single taxpayer taking the standard deduction and no adjustments, earned $50,140 taxable income last year. What is his marginal tax bracket and his average tax rate based on gross income? (LO 4-1) Solution: Jonas is in the 22 percent marginal tax bracket (from Table 4-1). Using Table 4-2, his taxes for the year are $6,338 based on a taxable income of $50,140; calculated as $5,147 + .22(50,140 − 44,725). So, assuming his gross income is $63,990 ($50,140 + $13,850 standard deduction) his average tax rate is 9.9% = $6,338/$63,990.

Using Federal Income Tax Forms. Which tax form(s), if any, should each of the following individuals use? (LO 4-2) a. A high school student with earnings of $900 and no income tax withheld. b. A worker who has $14,000 in tax deductions they overlooked in the previous year. c. A young worker who has no dependents and income only from salary. Solution: a. Form 1040 if any. No return is required in this case so long as the employer filed and withheld Social Security taxes on the $900 in income. b. Form 1040 and Schedule 1040X is the form to use to amend a pervious year return.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

Form 1040.

10. Capital Gains. Marylou Jackson makes $80,000 and she made two investments, the first was 18 months ago and the second was 9 months ago. She just sold both investments and has a capital gain of $3,000 on each. If Marylou is in the 22 percent tax bracket, what will be the amount of capital gain tax on each investment? (LO 4-1) Solution: For the investment Marylou made 18 months ago her tax is $450 = 15% × $3,000. For the investment made 9 months ago her tax is $660 = 22% × $3,000.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Calculate Their Income Taxes Several years have gone by since Harry and Belinda graduated from college and started their working careers. They both earn good salaries. They believe that they are paying too much in federal income taxes. The Johnsons’ total income included Harry’s salary of $73,000 and Belinda’s salary of $94,000. She contributed $3,000 to her 401(k) for retirement. They earned $400 in interest on savings and checking and $3,000 interest income from the trust that is taxed in the same way as interest income from checking and savings accounts. Harry contributed $3,000 into a traditional IRA. a. What are the Johnsons’ reportable gross income on their joint tax return? b. What is their adjusted gross income? c. How much is the standard deduction for the Johnsons? d. The Johnsons are buying a home that has monthly mortgage payments of $3,000, or $36,000 a year. Of this amount, $32,800 goes for interest and real estate property taxes. The couple has $14,000 in other itemized deductions. Using these numbers and Table 4-2, calculate their taxable income and tax liability. e. Assuming they had a combined $24,000 in federal income taxes withheld, how much will be their refund or amount due? f. What is their marginal tax rate? g. List three additional ways that the Johnsons might reduce their tax liability next year. Solution: a. The Johnsons’ income is $73,000 for Harry plus $94,000 in salary for Belinda and $3,400 in interest, for a total reportable gross income of $170,400. b. The Johnson’s AGI is $164,400 ($170,400 − $3,000 − $3,000). c. The Johnsons’ tax status is that of a married couple filing jointly. They are entitled to a $27,700 standard deduction. d. Since they have $46,800 in itemized deductions, the Johnsons should take the itemized deduction. This leaves a taxable income of $117,600 ($164,400 − $46,800). Using Table 4-2, they calculated a tax liability of $16,487; calculated as $10,294 + .22(117,600 − 89,450) e. Since they had $24,000 in federal taxes withheld, the Johnsons’ refund will be $7,513 ($24,000 − $16,487). f. The Johnsons’ marginal tax rate is 22 percent. g. The Johnsons could reduce their tax liability next year by depositing more money in qualified retirement plans, participating in employer-sponsored programs such as premium conversions and flexible spending arrangements, or deferring income into the following year.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

CASE 2: Victor and Maria Reduce Their Income Tax Liability The year before last, Victor earned $85,000 from his retail management position, and Maria began working full-time and earned $62,000 as a medical technician. After they took the standard deduction, their federal income tax liability was about $18,689. After being convinced by friends that they were paying too much in taxes, the couple vowed to try to never again pay that much. Therefore, the Hernandezes embarked on a yearlong effort to reduce their income tax liability. This year they tracked all their possible itemized deductions, and both made contributions to retirement plans at their places of employment. a. Calculate the Hernandez’s income tax liability for this year as a joint return (using Table 4-2) given the following information: gross salary income(Victor, $85,000; Maria, $62,000), state income tax refund ($400), interest on checking and savings accounts ($250), holiday bonus from Maria’s employer ($1,000), and contributions to qualified retirement accounts ($5,500). b. List five additional strategies that Victor and Maria might consider for next year’s tax planning to reduce next year’s tax liability. Solution: This is a potential ―Class Activity‖ exercise related to page 128 in the text. a. Hernandez’s tax liability: Gross income is $148,250 = $85,000 + $62,000 + $250 + $1,000. The state income tax refund is not taxable because they did not itemize deductions last year. Adjustments to income are $5,500 for the IRA contribution. Adjusted gross income is $142,750 = $148,250 − $5,500. Victor and Maria can take the standard deduction of $27,700. Their taxable income is $115,050 = $142,750 − $27,700. Victor and Maria’s tax liability is $15,926 = $10,294 + .22($115,050 − $89,450). This amount is lower for two reasons. One, the contributions to the IRA reduce taxable income and thus the tax liability. Two, the income from previous years was applied to tax tables that were not yet adjusted for inflation thus more of the Hernandez’s income fell into the higher tax brackets, also the standard deduction was lower in previous years. The figures used here are for 2023. With inflation, the brackets move up as does the standard deduction. b. Other strategies that the Hernandez family could try that would reduce their tax liability include increasing their contributions to qualified retirement plans; participating in employer-sponsored programs such as premium conversions and flexible spending arrangements; increasing their charitable contributions; deducting certain medical and dental expenses not covered by insurance, in excess of 7.5 percent of their AGI; deducting taxes on personal property; deducting any local, and foreign income taxes; deducting qualified job expenses; taking any tax credits for which they may qualify (American Opportunity credit, child tax credit, etc.); and taking advantage of tax-sheltered investments such as municipal bonds.

CASE 3: Julia Price Thinks About Reducing Her Income Taxes Julia does well financially because she earns a good salary as an engineer, is frugal, and is making the maximum contribution to her employer-sponsored retirement plan. After reading about ways to decrease her income tax liability, she has some thoughts. Buying a home is an option, but Julia is worried about the high prices of housing. As an accomplished sculptural artist, she is thinking about creating a sideline business to sell some of her work and convert some everyday expenses into business expenses. Also, on her possibilities list is to start a master’s degree program in engineering or a master’s in business administration to enhance her skills. Finally, Julia figures she could contribute $300 a month to a Roth IRA account. Offer your opinions about her thinking. Solution: While Julia has ruled out buying a home to reduce income taxes, she may want to revisit her thinking when real estate prices have eased in her community because there will be some excellent opportunities at that

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

time. While she may be able to itemize deductions and benefit from mortgage interest and real estate taxes paid, the big benefit may come later when and if she sells the property for a tax-free capital gain. Opening a sideline business should give her lots of new deductions against her business income. To succeed in reducing income taxes she should keep excellent business records. Stretching out a job-hunting trip is a legitimate deduction at least once a year. Getting a master’s degree is excellent and Julia should review the tax rules to make certain her schooling expenses will be deductible against business income, or at least use available education credits. In addition to her retirement plan at work, contributing to a Roth IRA is a good idea. Even though it does not reduce income taxes in the current period, it can provide a source of tax-free income in the future.

CASE 4: A New Family Determines if All Income Is Taxable Kate Beckett and her two children, Austin, and Alexandra, moved into the home of her new husband, Richard Castle, in New York City. Kate is a novelist, and her husband is a police detective. The family income consists of the following: $60,000 from Kate’s book royalties, $90,000 from Richard’s salary, $10,000 in life insurance proceeds from a deceased aunt, $140 in interest from savings, $15,000 in child support from her ex-husband, $500 cash as a Christmas gift from Richard’s parents; and a $1,600 tuitionand-books scholarship Kate received to continue her college degree last year. a. What is the total of their reportable gross income? b. Which items are not taxable income? c. After Richard put $5,600 into a tax-deferred retirement plan accounts last year, what is their adjusted gross income? d. How much is the allowable standard deduction for the household? e. What is their taxable income on a joint return? f. What is their final federal income tax liability, and what is their marginal tax rate? (Hint: Use Table 42.) g. If Richard’s employer withheld $25,000 for income taxes, does the couple owe money to the government or do they get a refund? How much? Solution: a. Kate and Richard’s income that must be included as total income for the IRS is the $90,000 for Richard’s salary, $60,000 for Kate’s royalties, and $140 interest on savings. Kate and Richard’s total reportable gross income is $150,140. b. The life insurance proceeds, Christmas gifts, scholarship, and child support are not considered taxable income. c. Accounting for their $5,600 contribution to a qualified pension plan, their adjusted gross income is $144,540. d. Assuming they will file jointly, their standard deduction is $27,700. e. The Beckett-Castles gross income is $150,140 and adjusted gross income (AGI) is $144,540. The AGI minus the standard deduction yields a taxable income of $116,840. f. Using Table 4-2 yields a tax liability of $16,320 = $10,294 + .22($116,840 − $89,450) on a taxable income of $116,840. g. If Richard’s employers withheld $25,000 from his paychecks for income taxes and their tax liability is $16,320, they will receive a refund of $8,680. They should have less withheld from their pay for federal income taxes.

CASE 5: New Immigrants File Their Income Taxes Marco Francisco Vasquez and his wife Fatima and their two children emigrated from Tegucigalpa, Honduras, two summers ago, and this past February, Marco started a position as a market research senior analyst for a university in Illinois. He earned $95,400 in salary over the year and must pay federal income taxes for the first time.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 4: Managing Income Taxes

a. b. c. d. e. f. g.

If Marco contributed $5,000 to his employer-qualified retirement plan, what impact does that have on his income taxes? If he bought and sold some stocks during the year and profited $4,000, what impact does it have on his income taxes? How much is their standard deduction amount? What is their taxable income? How much is their tax liability? (Hint: Use Table 4-2) What is their marginal tax rate? What is their average tax rate?

Solution:

a. Contributing $5,000 to the retirement plan will reduce their taxable income by that amount since employer-qualified retirement plan contributions are not subject to current income taxes. b. Capital gains on investments held for less than one year are taxed at the taxpayer’s marginal rate. Thus, this $4,000 must be included in taxable income and taxed at ordinary rates. c. Assuming they will file jointly, their standard deduction is $27,700. d. The Vasquez family has a taxable income of $66,700 = $95,400 − $5,000 + $4,000 − $27,700. e. Using Table 4-2 yields a tax liability of $7,564; calculated as $2,200 + .12(66,700 − 22,000). f. The Vasquez marginal tax rate is 12 percent. g. The Vasquez average tax rate is 7.6 percent = $7,564/($95,400 + $4,000).

EXTENDED LEARNING 1.

Telephone the Internal Revenue Service. Dial 1 (800) TAX-1040 (or 1 (800) 829-3676) to pose a question for an IRS spokesperson. Think of a question before you call. It deals with whether you qualify for a specific education tax credit, can deduct expenses for a sideline business, or can make Roth IRA contributions. Be patient. Write a summary of your findings and the quality of service you received by the IRS associate. Solution: Students should provide a summary of the question they posed to the IRS spokesperson and the response given by the spokesperson. Ask about the quality of the service and how long they had to wait to speak to a representative.

Tax Reform Proposals. Type ―tax reform‖ into your browser and skim read what you find of interest on three websites. Write a summary of your findings and include your views of what reform(s) you might prefer as the income tax code continues to evolve. Solution: Students should provide a summary of their findings as well as a statement indicating what type of reform the student might prefer. Discussion of a flat tax or other simplified system is appropriate.

Who Pays Income Taxes? Type ―income taxes, who pays‖ into your browser and skim read what you find of interest on three websites. Does what you find cause concern over equity and fairness within the U.S. income tax system? Write a summary of your findings and cite your sources. Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

Students should provide a written summary of their findings regarding who in America pays federal income taxes. Their findings will show that many pay little or nothing and top earners pay a large share of the total tax bill. Discussions of fairness and equity are appropriate. The philosophy behind a progressive tax structure can be discussed.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 5: MANAGING CHECKING AND S AVINGS ACCOUNTS

TABLE OF CONTENTS Answers to Chapter Concept Checks ...................................................................................................... 51 What Do You Recommend Now? ............................................................................................................ 54 Let’s Talk About It ................................................................................................................................... 55 Do The Math.............................................................................................................................................. 56 Financial Planning Cases ......................................................................................................................... 59 Extended Learning.................................................................................................................................... 63

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

ANSWERS TO CHAPTER CONCEPT CHECKS LO5.1 Identify the goals of monetary asset management and sources of such financial services. 1.

Identify the primary goals of monetary asset management.

Answer: The primary goals of monetary asset management are liquidity, safety, and earning as high an interest rate as possible on all funds. Monetary asset management is also critical in the practice of investment and insurance planning. 2.

Explain the circumstances when it would be appropriate to have funds in a checking account.

Answer: Checking accounts are appropriate for funds you will need to access in the next three to six months or so. Savings accounts are best for funds that will not be needed until six months to five years in the future. Investments are best for goals and purposes to be achieved in five years or more in the future. 3.

Give three examples of depository institutions where one could open a checking account.

Answer: Examples of depository institutions where one can open a checking account are commercial banks, community banks, credit unions, savings and loan associations, and online banks. 4.

Summarize your insurance protections when you have funds on deposit in a depository institution as opposed to other financial services.

Answer: You have up to $250,000 in total protection for all your individual accounts combined at any one institution. You have up to another $250,000 in total protection for all your joint accounts combined at any one institution. Finally, you have up to $250,000 in total protection for any retirement accounts combined at any one institution. Stocks, bonds, mutual funds, and other investments are not covered by the FDIC or NCUSIF.

LO5.2 Understand and employ the various types of accounts available to meet the goals of monetary asset management. 1.

Explain why opening a checking account and a money market account are appropriate actions for most people and tell how each will be used.

Answer: A checking account is the place to keep funds for day-to-day spending up to three to six months in advance. It is the safest and easiest way to pay your monthly expenses. The drawback is that checking accounts earn little or no interest, and account expenses and fees often exceed any interest earned. Therefore, once a large enough balance is attained and maintained over time, it is wise to open a money market account to maximize interest on these highly liquid resources. 2.

Summarize what happens when you write a check.

Answer:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

When you write a check and use it to make a payment to another person or entity, that person or entity will either attempt to cash it or deposit it into an account they own at a depository institution. That institution will then request the funds from your checking account institution. Years ago, this process included the actual transfer of the paper check as a means for completing the process and it took several days. Today, this process often occurs electronically (often in a matter of seconds) and is aided by the creation of substitute electronic checks and the paper check simply remains on file with the receiving institution. With electronic deposits of paper checks, often these checks remain in the possession of the payee once the check has been photographed and transmitted to the depositing institution. 3.

Distinguish between a money market account and a money market mutual fund account.

Answer: A money market account (MMA) is any of a variety of interest-earning accounts that pays slightly higher interest rates (compared with regular savings accounts), and they offer some check-writing privileges. MMAs are offered by depository institutions and others. The investments in money market accounts must mature in less than one year. The funds on deposit are not loaned out to consumers but instead are invested in the ―money markets‖ for short-term loans to businesses. Money market mutual funds (MMMFs) are money market accounts opened at mutual fund companies. An important difference comes with insurance, deposit accounts are federally insured for up to $250,000 while fund accounts are not. 4.

Explain the benefits and drawbacks of certificates of deposit.

Answer: Certificates of deposit are fixed-time deposits, and the rules of the account require that the money stays on deposit for a specified period. Otherwise, a penalty is assessed for early withdrawal. The penalty comes in the form of forgone interest that has already been earned. Typically, if you want to add more money, you must open another CD offered at current rates. Laddering can be used to always get the higher long-term rate while retaining liquidity as the portion invested in shorter-term term CDs matures.

LO5.3 Establish ownership of assets wisely. 1.

Explain why correctly owning assets is important to the personal finances of people, especially couples.

Answer: Correct ownership of assets is especially important in one’s finances for two major reasons. The first is that ownership designates who controls the asset and has the right to use it or dispose of it. The second reason is that the type of ownership also regulates what happens to the asset when the owner dies. Couples need to think clearly about how their individual and mutual assets are owned, especially in the case of blended families. 2.

Differentiate between ownership via joint tenancy with right of survivorship and tenancy in common.

Answer: Owning an asset via joint tenancy with rights of survivorship means that each owner has full control and access to the entire asset without the approval of the other(s). Furthermore, the entire asset immediately transfers to the other owner(s) upon the death of one of the owners. Tenancy in common means that two or more parties own the asset, but each only has control of a designated portion of the asset, such as 50 percent each in the case of two-person ownership. At the death of one of the owners, that person’s share of the asset will go to the decedent’s heirs and not to the other owner(s).

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

LO5.4 Describe your legal protections when conducting monetary asset management electronically. 1.

Distinguish among credit cards, debit cards, and stored-value cards.

Answer: Credit cards are a mechanism to borrow money. Debit cards provide direct access to checking accounts. A stored value card works like a small checking account. You (or someone paying you money) ―deposit‖ funds into the card and you can withdraw them electronically when you make purchases on the card. All three are commonly used in transactions and can help consumers track spending by creating an ongoing record of purchases. 2.

What is the first thing you should do if you find an error in your monthly statement regarding an electronic transaction?

Answer: You should immediately inform your financial institution of the error. 3.

Summarize the rules that apply if you lose your ATM or debit card and it is used without your authorization.

Answer: Notifying your institution of the lost card within two days will limit your losses to $50. If you wait up to 60 days, you could lose $500, and beyond that, you could lose all the money in your account. Notification before any unauthorized use protects the consumer from any loss. 4.

Is a cryptocurrency like Bitcoin a good investment?

Answer: Bitcoin is a decentralized digital cash currency based on an open-source cryptographic protocol. It is a medium of exchange that has proven to be highly volatile in price relative to U.S. currency, therefore it is not typically considered an investment asset by financial planners. However, the IRS will treat transactions in cryptocurrency like security transactions.

LO5.5 Discuss your money and personal finances effectively with loved ones. 1.

Explain why it is difficult for many people in relationships to talk about money matters.

Answer: Many people have trouble talking about money because they ascribe significant emotional connections to money. The meanings we attach to money are formed early in life based on what we learned in our family of origin. People also have different money management habits and change is not easy. 2.

Identify three ways you might more effectively communicate about money matters.

Answer: Ways to communicate better about money include (1) knowing your own approaches to money, (2) focusing on what you have in common with the other person, (3) using ―I‖ statements, and (4) talking about money frequently and honestly.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on managing checking and savings accounts, what would you recommend to Nathan Rosenberg and Avigail Abramovitz in the case at the beginning of the chapter regarding: 1.

Where they can obtain the monetary asset management services that they need?

Answer: Nathan and Avigail will have to decide whether to combine their accounts and, if so, where they should do so. They would need to look at the fees and balance requirements to determine the best option. They may wish to keep their existing accounts and open a new joint account. Their primary choices are depository institutions such as commercial banks, savings banks, and credit unions. 2.

Their best use of checking accounts and savings accounts as they begin saving for a home?

Answer: It might be good for the couple to consolidate their savings accounts for convenience. One of their existing accounts could be used as their new home savings fund. They would want to maximize the APY on that account as the goal of home ownership is still four or five years away.

The use of a money market account for their monetary asset management?

Answer: Once Nathan’s CD matures, they will have a substantial cash reserve that they could use to set up an emergency fund. They should consider an asset management account to consolidate all their cash management accounts. It will take several years for Nathan and Avigail to save for the down payment on their home. As the savings account they use for this savings goal builds, an asset management account will provide with flexibility and the ability to maximize the interest earned on their funds. 4.

Their use of electronic banking in the future?

Answer: Electronic banking will come in very handy for Nathan and Avigail. One thing they will have to do, however, is keep good records of their electronic transactions. With each having debit cards and access to the same accounts, it will be quite easy for one of them to make transactions unknown to the other. They will have to communicate daily about their banking transactions. Using budgeting and bank apps that instantly record and share transaction information with both account holders will help with communication and transparency over their joint finances. 5.

How they can best discuss the management of their money and finances?

Answer: Open communication is a key for Nathan and Avigail. They should plan together and keep each other informed. When disputes arise, they should be handled openly. They might start down this road by understanding their own approaches to money and talk about how they each differ and are similar. This can lead to some decisions about who might handle which monetary management tasks they will need to undertake. The conversations should stick to the big financial goals in life—not sweating the small stuff.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

LET’S TALK ABOUT IT 1.

Bank Account Fees. List two examples of checking account transactions that result in assessment of fees that are avoidable?

Answer: Examples could include writing checks or making debit transactions with insufficient funds in the account, making excess withdrawals from a savings account, and letting account balances drop below the required minimum for the month. All three of these are avoidable and the first is most crucial because of the large dollar amount of the possible fee. 2.

Avoiding Overdraft Fees. Your friend recently had $90 in overdraft fees for two small debit card transactions. Explain to them why such high fees resulted from such small transactions and the relative benefits of having an automatic funds transfer agreement versus an automatic overdraft loan agreement versus overdraft protection.

Answer: Many accounts offer overdraft protection whereby the bank will cover the overdraft out of its own funds for a fee. If we ―opt-in‖ for this service, the bank may cover the largest overdrafts first making it easier to fall into an insufficient balance situation. Then any subsequent overdrafts, no matter how small will each trigger a fee. An automatic funds transfer agreement is a better option for your friend. This would allow the bank to cover the check automatically by transferring funds out of your friend’s savings account. Also beneficial is an automatic overdraft loan agreement which would have the bank make a credit card cash advance to cover the bad check. The overdraft protection would have the highest cost of these three protections. 3.

Forms of Account Ownership. When would you recommend using an individual account, a joint tenancy with right of survivorship account, and a tenancy by the entirety account for your monetary assets?

Answer: An individual account is best when you do not want anyone else to have access to the account. An account held in joint tenancy would allow all owners of the account total access to the asset. Joint tenancy would be the best for accounts with family members who you wish to have access to the assets on a day-to-day basis and immediate use of the funds at your death. A tenancy-in-common account would be best for situations where you want to hold an account with others but want to approve any withdrawals that they make, and vice versa. At your death, your share of the account would go to your heirs and not the other account holder(s). Tenancy by the entirety is available in only about half of the states and can be beneficial to those needing to protect assets from claims against one of the owners. 4.

Opting in. Many people desire protection from the possibility of overdrawing their checking account. Banks make it easy by allowing you to opt into overdraft protection. Explain how this and other overdraft protections work and why the true cost of opting in may exceed the benefits.

Answer: If you ―opt-in‖ for overdraft protection your bank will cover any overdraft checks you write up to a specified limit. While seemingly a good idea, this protection requires that you pay a fee each time your bank covers an overdraft. This may be less expensive than writing a bad check, but it is still costly. You may also be charged a fee for an ATM withdrawal even though the bank knew you had insufficient funds when you made the withdrawal. An automatic funds transfer agreement may be a better option. This would

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

allow the bank to cover the check automatically by transferring funds out of a savings account. Also beneficial is an automatic overdraft loan agreement which would have the bank make a credit card cash advance to cover the bad check. The overdraft protection would have the highest cost of these three protections. 5.

Earning Higher Interest on Savings. When might it be appropriate to save via a certificate of deposit versus a money market account?

Answer: A money market account is appropriate anytime an individual begins to have a substantial and sustained amount in a savings account, without ever dropping below that ―substantial‖ amount. Substantial is a subjective number and what matters most is that by not dropping below the value we know these are funds available for other accounts. A certificate of deposit is a wise idea whenever you have excess funds that you know you will not need for a specific period, or that you want to keep secure and unmingled with your other funds. 6.

Lost/Stolen Debit Cards. What should you do if your ATM or debit card is lost or stolen? Why?

Answer: You should immediately inform your financial institution of the loss of the card. Doing so within two days will limit your losses to $50. If you wait up to 60 days, you could lose $500, and beyond that, you could lose all the money in your account. 7.

Talking About Money. Have you ever had a disagreement with a friend or family member over a money issue? How might you communicate differently now?

Answer: A key to discussing such a dispute is to use ―I‖ statements that inform the other person of your feelings about the situation and avoid a blaming message. Another key is to look for a solution to the problem rather than fixing blame or avoiding responsibility for what occurred. 8.

Questions About Money. If you have trouble talking about money, complete these sentences with the first words that come to your mind: ―Sometimes financially I sabotage myself by….‖ ―Financially, I keep feeling I should….‖ And ―Money creates anxiety for me because….‖

Answer: Student answers will vary. The goal of this discussion is for students to recognize some of their feelings and attitudes about money. It may be best to have students write a note to themselves which may be used to improve their financial well-being.

DO THE MATH 1.

Invest Now or Later? Twins Natalie and Kaitlyn are both age 27. They both live in Warren, Ohio. Beginning at age 27, Natalie invests $2,000 per year for 10 years and then never sets aside another penny. Kaitlyn waits 10 years and then invests $2,000 per year for the next 30 years. Assuming they both earn 7 percent; how much will each twin have at age 67? (Hint: Use Appendixes A.1 and A.3.) (LO 5-1) Solution: Natalie would have $210,351 at age 67 ($2,000 × 13.8164 = $27,633 × 7.6123 = $210,350). Kaitlyn would have $188,922 at age 67 ($2,000 × 94.4608 = $188,922). Thus, Natalie would have $21,429 more although

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

she only invested a total of $10,000 compared to Kaitlyn’s $30,000. Time is what builds wealth. Also, if one takes the present value of all the savings, we see that Natalie saved more in present terms, so an equally important message is that more savings is what builds wealth. The best of both is saving earlier! 2.

The Benefit of a Higher APY. Isabel Lopez, from Lewiston, Idaho, is age 19, and she recently received an inheritance of $50,000 from her grandmother’s estate. She plans to use the money for the down payment on a home in 10 years when she finishes her education. Right now the funds are in a savings account paying 1.0 percent APY. How much would Isabel have in 10 years if instead she purchased a 10-year CD paying 3.0 percent? (Hint: Use Appendix A.1.) (LO 5-2) Solution: Isabel would earn two percentage points more on her money if she moved the funds to a CD. Using Appendix A.1 in the 1 percent column and 10-year row you find the factor 1.1046. So, Isabel would have $55,230 ($50,000 × 1.1046) after 10 years if she left the funds in the savings account. If she moved the funds to a CD at 3 percent, she would have $67,195 ($50,000 × 1.3439 from Appendix A.1). Thus, she could have $11,965 more because of the change in accounts.

Reconciling a Checking Account. Andrew Parker, of San Marcos, Texas, has a checking account at the credit union affiliated with his university. Illustrated below are his monthly statement and check register for the account. Reconcile the checking account and answer the following questions. (LO 5-2) a. What is the total of the outstanding checks? b. What is the total of the outstanding deposits? c. Why is there a difference between the uncorrected balance in the check register and the balance on the statement? d. What is the updated and correct balance in the check register? Solution: This is a potential ―Class Activity‖ exercise related to page 166 in the text. a. b. c.

$53.88; check # 241 is outstanding. $0; there are no outstanding deposits. Andrew made two errors in his check register. First, he recorded his debit card transaction on 11/23 as $67.88 when it should have been 68.87 thereby overstating his check register balance by $0.99. Second, his subtraction for check #241 was in error by $1.00. Furthermore, his check register must be updated to allow for the $4.50 service charge and the bank statement must be updated to allow for the outstanding check of $53.88. d. His check register balance should be $246.05 ($252.54 − $0.99 − $1.00 − $4.50). This is equal to his updated bank statement balance of $246.05 ($299.33 − $53.88) monthly statement Account Name Andrew Parker Period of Activity 11/2/24–12/01/24 Account # 123–45678 Summary of Your Activity This Month Date Activity Amount Balance 11/02 $412.66 11/04 Debit Card POS $17.46 395.20 Transaction 11/09 Check #237 33.33 361.87 11/12 Direct Deposit 876.99 1,238.86 11/13 Debit Card POS 84.56 1,154.30 Transaction 11/13 EFT 22.00 1,132.30 11/15 Check#238 645.00 487.30

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

11/23

Debit Card POS Transaction Debit Card POS Transaction Deposit Check#239 Service Charge ATM Withdrawal Check #240

11/27 11/28 11/30 11/30 11/30 12/01

check register Check #

Date 11/01 11/03 11/05

Debit Card 237

11/12 11/12

Deposit 238

11/13 11/13

68.87

418.43

43.00

375.43

200.00 125.00 4.50 100.00 46.00

575.43 450.43 445.93 345.93 299.93

Payee/Payor

For

Amount

Cold Meds Of Mice and Men Payday-Yeah! Rent

$ 17.46 33.33 876.99 645.00

1,238.86 593.86

Groceries Water Bill

84.56 22.00

509.30 487.30

11/23 11/23

Debit Card Electronic Payment Debit Card Debit Card

CVS Univ. Book store PNC Bank ABC Property Mgmt. Kroger’s Maysville Water Kroger’s Applebee’s

Balance 412.66 395.20 361.87

67.88 43.00

419.42 376.42

11/27 11/27

Deposit 239

Mom Duke Power

200.00 125.00

576.42 451.42

11/27 11/30

240 Debit Card

46.00 100.00

405.42 305.42

12/01

241

Conoco ATM Withdrawal Comcast

Groceries Dinner with Karen For Utilities Electric/Heat Bill Gas Carry Around Money Cable Bill

53.88

252.54

Saving for College. You want to create a college fund for a child who is now three years old. The fund should grow to $60,000 in 15 years. If an investment available to you will yield 6 percent per year, how much must you invest in a lump sum now to realize the $60,000 when needed? (Hint: Use Appendix A.2.) (LO 5-3) Solution: You must invest $25,038 ($60,000 × 0.4173).

Saving for Retirement. You plan to retire in 40 years. To provide for your retirement, you initiate a savings program of $4,000 per year yielding 7 percent. What will be the value of the retirement fund after 40 years? (Hint: Use Appendix A.3.) (LO 5-3) Solution: It will be worth $798,540 ($4,000 × 199.6351).

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

FINANCIAL PLANNING CASES CASE 1: How Should the Johnsons Manage Their Cash? In January, Harry and Belinda Johnson had $10,660 in monetary assets (see page 000): $1,100 in cash on hand; $1,200 in a statement savings account at First Credit Union earning 1.0 percent interest; $4,000 in a statement savings account at the Far West Savings Bank earning 1.1 percent interest; $2,260 in Homestead Credit Union earning a dividend of 1.3 percent; and $2,100 in their regular checking account at First Credit Union earning 1 percent. a. What specific recommendations would you give the Johnsons for selecting checking and savings accounts that will enable them to effectively use the first and second tools of monetary asset management? b. Their annual budget, cash-flow calendar, and revolving savings fund (see Tables 3-6, 3-7, and 3-8 on pages 107, 108 and 109) indicate that the Johnsons will have additional amounts to deposit in the coming year. What are your recommendations for the Johnsons regarding use of a money market account? Why? c. What savings instrument would you recommend for their savings, given their objective of saving enough to purchase a new home? Support your answer. d. If the Johnsons could put most of their monetary assets ($10,660) into a money market account earning 1.4 percent, how much would they have in the account after one year? e. Recall from Chapter 3 that Harry and Belinda had some disagreements regarding their anniversary dinner and holiday gift spending and ended up not having a balanced budget for the year. Provide some advice for the couple about how to resolve or, better, prevent such disagreements in the future. Solution: a. Harry and Belinda have four small accounts, earning around 1 percent. To increase their interest income and to reduce the recordkeeping associated with so many different accounts, they should move the funds from all their accounts into an account with higher returns (assuming they can maintain the required balance to avoid monthly service charges). Although some ―hidden money‖ for immediate access to cash may be viewed positively, $1,100 is an excessive (even dangerous) amount to have on hand. Most of these funds should also be deposited in the interest earning account, especially if needed to maintain the required balance necessary to earn the best rate, or into the savings account with the highest annual percentage yield (APY). To facilitate recordkeeping and allow for automatic transfers between the two accounts, the Johnsons should consider opening their interest-bearing checking and savings accounts at the same institution. b. A money market mutual fund would be a wise place for the Johnsons’ excess funds. Money market mutual funds usually pay the highest rate of interest that can be earned daily, and because checks can be written on the account, the funds are readily available for special financial needs. Given the projected surplus and the Johnsons’ plans to save monthly, they should consider moving funds among three accounts—the interest earning checking account, a savings account, and a money market mutual fund. A savings account could be used for immediate savings, and periodically, excess funds could be transferred to the money market mutual fund where higher interest could be earned. Shopping for all the best account using a resource like Bankrate.com might lead the Johnsons to select an online bank that pays higher rates because it does not need to cover the costs of brick-and-mortar branches. c. Once minimum balances are maintained in the savings account and the money market mutual fund and short-term and emergency savings minimums are met, Harry and Belinda should consider transfer of excess funds to a certificate of deposit. These excess funds could be committed for a longer term, during which they would earn a higher interest and still be protected by federal deposit insurance. CDs have varying lengths of maturity, which would facilitate the Johnsons’ accumulation of funds for the home at a specific time, like four or five years from now. d. After one year, the balance of the account would equal approximately $10,809 ($10,660 × 1.014).

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

Harry and Belinda should set aside some specific times over the next few weeks to discuss their specific disagreement. Then, they should set aside at least one hour per month to talk about their finances in general. This will prevent small issues from building into larger ones. Questions for them to focus on include their biggest financial worries, how they are doing financially, and things about their finances that they could understand better.

CASE 2: Victor and Maria Hernandez Need to Save Money Fast The Hernandez family is experiencing some financial pressures, even though the couple has a combined income of $85,000. Also, their eldest son, Joseph, will start college in only three years. Maria is contemplating going to work full time to add about $32,000 to the family’s annual income. a. How will this change in income affect the family’s emergency fund needs? b. How much should they save annually for the next three years if they want to build up Joseph’s college fund to $30,000, assuming a 3 percent rate of return and ignoring taxes on the interest? (Hint: Use Appendix A.3.) c. Given their 15 percent marginal combined federal and state tax rate, what is the after-tax return for the Hernandez family on their savings and how would that affect the amount they would need to save each year? d. What savings options are open to the Hernandez family that could reduce or eliminate the effects of taxes on their savings program? Solution: a. Since the couple’s monthly income will go up they will want to place a portion of Maria’s additional income into savings to build a three-month emergency fund. b. The Hernandez’s’ should save $9,705.91 per year for each of the next three years to accumulate a $30,000 college fund for Joseph ($30,000 ÷ 3.0909) (see Table A.3). c. The Hernandez’s’ after-tax return on their investment at 3 percent is 2.55 percent because they must pay 15 percent income tax on the interest [3% × (100% − 15%)]. Therefore, they should save about $9,756 per year for each of the next three years to accumulate $30,000 in Joseph’s college fund after taxes on the interest ($30,000 ÷ 3.075; estimated from Table A.3). With an uneven interest rate of 2.55 this is a good problem to use an online financial calculator entering FV = 30,000, PV = 0, a = 2.55, n = 3. Solve for PMT which will yield −$9,749.28. d. Victor and Maria could deposit the funds in a 529 Plan Account, which will accumulate interest taxfree and reduce the impact of taxes on saving for education.

CASE 3: Julia Price Thinks About Using Checking and Savings Accounts Julia’s six-figure salary has allowed her to build up a considerable cash reserve of over $20,000. She initially had basic checking and savings accounts. She also has a credit card with her bank that she uses to make most of her purchases, thereby earning reward points. She is careful to pay the account balance in full each month. Over time, she purchased several CDs. About three years ago, she also opened a money market deposit account at her bank in which she keeps almost $10,000. Last week she got a call from the bank suggesting that she open an asset management account to coordinate her accounts and maximize her overall earnings. She is hesitant to do so as she feels her current arrangement meets her needs. Offer your opinions about her thinking. Solution: Julia’s reluctance is understandable but short-sighted. Julia now has multiple accounts to keep track of; by having just one account statement to examine each month Julia can save time out of her busy schedule.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

CASE 4: Liability for a Lost ATM Card Joshua Franz, of Oxford, Mississippi, earned $4,600 during the summer and put $3,000 of the money in a newly opened savings account for use during the school year. It is now November 4 th and Joshua went to the bank to withdraw some cash. The teller informed him that there was only $2,100 in the account. When Joshua protested, the teller informed him that there had been three ATM $300 withdrawals from the account on the last day of the month in August, September, and October. Joshua typically neglects to open the statements he had received on the third day of each month. When he got home he could not find the ATM card he had received when he opened the account in August and recalled that he had found his car door open in his parking lot in late August but had thought nothing was taken. When he opened the statements he saw the record of each of the withdrawals. He went immediately back to the bank to tell them of the loss. How much money will Joshua lose because of these fraudulent transactions? Solution: This is a potential ―Class Activity‖ exercise related to page 175 in the text. Joshua was the victim of three identity thefts occurring on three different dates because of his stolen ATM card. The maximum loss is $50 had he informed the bank of the incident within two business days. Since Joshua received a statement on November 3 and visited the bank the next day, he is within two business days for the theft that occurred on October 31 and will only lose $50 for that theft. For the theft that occurred on September 30, Joshua is within 60 days so will lose $300 of the $300 theft as liability is up to $500 for a loss in that period. For the theft that occurred on August 31, Joshua is outside the 60-day window for limiting a loss to $500. Thus, again, he will lose the entire $300. So, Joshua’s total loss is up to $650.

CASE 5: The Impact of Federal Deposit Insurance Alexandra Bronson, of Pueblo, Colorado, age 58, has done a very good job of accumulating savings over the years. She has all of her accounts at the same depository institution and has multiple accounts. Her balances are as follows: $130,000 in a joint-checking account with her husband; $145,000 in a joint-savings account with her sister from an inheritance they received; $100,000 in a savings account in her own name with her sister as the payable at death party (also from the inheritance); and $75,000 in a savings account in her own name. She also has an individual retirement account (IRA) in her own name with a balance of $459,000. How much federal deposit insurance does Alexandra have in these accounts, and how much of her funds remain uninsured? Solution: This is a potential ―Class Activity‖ exercise related to page 162 in the text. Alexandra has a maximum $250,000 in insurance on the individual accounts in her own name at the one institution. Since the own name savings accounts total only $175,000 she is fully insured. Alexandra has two joint accounts totaling $275,000. She has $250,000 insurance on all joint accounts, so she is uninsured for $25,000 on the joint accounts. However, these joint accounts would be insured up to $500,000 as the insurance is per owner. Because the IRA is with the same federally insured institution, Alexandra also has $250,000 in insurance on her IRA account meaning that $209,000 of that account is not insured. However, because $175,000 is already in the single accounts, she only has $75,000 of the $459,000 insured. Alexandra needs to spread her assets around multiple institutions if she wants to have her assets fully insured.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

CASE 6: How Ownership Affects Who Will Receive Assets After a Death Bang Liu, of Scranton, Pennsylvania, passed away recently at age 67. Among his assets were the following items: (a) Checking and savings accounts with a total balance of $45,000 with his widow, Jen, held in joint tenancy with right of survivorship. (b) A paid-for $330,000 home with his widow, Jen, held in joint tenancy with right of survivorship. (c) A $144,000 vacation cottage owned equally with his brother held in tenancy in common. (d) A small business valued at $280,000 owned equal shares with his business partner, Cynthia, held in tenancy in common. (e) An automobile valued at $14,000 owned individually. (f) Two savings accounts of $20,000 each with his daughter named as payable at death party on one and his son named as payable at death party on the other. Bang’s will names his widow as his sole heir. For each asset, identify who will receive all, or what portions, of the asset. Solution: This is a potential ―Class Activity‖ exercise related to page 173 in the text. Bang Liu’s checking and savings account will be owned in its entirety by his widow immediately upon his death. His home will be owned in its entirety by his widow immediately upon his death. Bang Liu’s widow will inherit ownership of $72,000 of the vacation cottage as specified in his will. His widow, Jen, will inherit $140,000 of the shares in the ownership in his small business as specified in his will. Jen will inherit the automobile as specified in his will. Ownership of the two $20,000 savings accounts will pass directly to his children as specified in the payable-at-death designations on those accounts.

CASE 7: Which Is Better: A Minimum-balance Account or an Average-balance Account? Aaron Searle, a service station owner from Moscow, Idaho, has been paying $20 per month in fees on his checking account for about a year. He is considering changing banks but fears that the fees will be similar no matter where he banks. He has tracked his high, low, and average balance on his account for the past six months and found the following: Month 1 2 3 4 5 6 a. b.

Highest Balance $4,800 $4,300 $3,600 $5,100 $3,500 $4,100

Lowest Balance $1,200 $300 $900 $1,700 $400 $1,200

Average Balance $2,400 $1,700 $1,200 $2,700 $900 $2,100

In your opinion, would Aaron be better off with a minimum-balance account or an average-balance account to minimize fees? What other advice would you have for Aaron regarding the avoidance of a monthly fee on his account?

Solution: This is a potential ―Class Activity‖ exercise related to page 166 in the text. a. Aaron is probably better off with an average-balance account. His account balance drops incredibly low several months a year, but his monthly average balance stays reasonably high. He should take some steps to ensure that the average never drops below a set minimum given by the bank. He can do this by timing some of his payments during the month, paying bills still on time but later in the month and making deposits as quick as possible. b. Shopping for bank accounts with low fees will help Aaron. Many online banks offer the most competitive banking products as they avoid significant fixed costs. Other fees that come from overdrafts, low balances, bounced checks, and ATM use can all be avoided with careful money management and watching his balances closely.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 5: Managing Checking And Savings Accounts

CASE 8: Deciding Among the Tools of Monetary Asset Management Kwaku Addo, a licensed physical therapist from Topeka, Kansas, earns $5,200 per month takehome pay and has the funds directly deposited in a checking account. He spends only about $3,900 per month, and the excess funds have been building up in his account for about two years. a. What other types of accounts are available to Kwaku? b. How might he manage his accounts to earn as much interest as possible and keep his money safe? c. How might he use electronic money management to accomplish these tasks? Solution: a. Kwaku should open a savings account to deposit excess funds to build an emergency fund of three times his take-home pay. At that point, he should consider opening a money market account. He should make sure his checking account pays interest and has a low or no monthly fee. b. At some point in the future, Kwaku will have built up sufficient funds that he can purchase a CD and manage all his monetary assets with an asset management account. This would ensure that he would earn the highest overall interest as possible and make monitoring of his funds quite easy because all would be included in one monthly statement. c. Kwaku can use a debit card to make many of his transactions as paperless as possible. He can also begin paying many of his bills via computer or app to avoid postage and the paperwork involved. He can also regularly go online to check his balances to ensure that no errors have occurred in his accounts.

EXTENDED LEARNING 1. Checking Accounts Where You Live. Select three banks, savings banks, or credit unions in your community. Contact each to gather information on the types of checking accounts they offer and the basic rules of the accounts, including overdraft protections, fees, and interest rates. Make a table that summarizes your findings and identify one institution that best meets your needs. Solution: Students should prepare a table that summarizes their findings with an eye to determining which institution and type of account best meets their needs.

2. Account Monitoring. Survey three of your friends about their patterns of monitoring their checking and savings accounts. Compare what they do to your own pattern. Solution: Students should prepare a summary of their findings and compare what the friends do to monitor their accounts to what the individual student does to monitor their account.

3. Debit and ATM Activity. Survey three of your friends about the patterns and amounts of their typical debit and ATM card usage. Compare their patterns to your own and those recommended in this chapter. Solution: Students should prepare a summary of their findings and compare the friends’ patterns of debit and ATM cards to their own. They should then compare what they have found to the recommendations in this chapter.

4. Money Talk. Survey three couples to ascertain their patterns of money talk. Ask each the following questions: ―What are the areas of your finances that are easiest to discuss?‖ ―What are your areas of most difficulty?‖ ―How do you resolve disagreements?‖ Make a table that summarizes your findings. Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

Students should prepare a table that summarizes the responses to the three questions and then provide a reaction to the responses.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 6: BUILDING AND M AINTAINING GOOD CREDIT

TABLE OF CONTENTS Answers to Chapter Concept Checks ...................................................................................................... 65 What Do You Recommend Now? ............................................................................................................ 67 Let’s Talk About It ................................................................................................................................... 68 Do the Math ............................................................................................................................................... 69 Financial Planning Cases ......................................................................................................................... 70 Extended Learning.................................................................................................................................... 74

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

ANSWERS TO CHAPTER CONCEPT CHECKS LO6.4 List some advantages and disadvantages of using credit. 1.

Distinguish between the APR (annual percentage rate) and the finance charge on a debt. Answer: The finance charge is the cost of credit measured in dollars which is the total dollar amount paid to use credit (including interest and any other required charges such as a loan application fee). The Annual Percentage Rate (APR) is the annual cost of credit as a percentage number that represents the actual yearly cost of funds over the term of a loan. The APR can be used to compare among credit opportunities with the offer having the lowest APR being the better choice.

Which five advantages of credit seem appropriate to you? Answer: Student answers will vary. Many will say that education loans are a good use of credit, but there may not be consensus on the other advantages, such as convenience or online shopping.

Which five disadvantages of credit seem appropriate to you? Answer: Student answers may vary. Most will worry about the interest cost of credit. Others will talk about the pressure to repay the borrowed funds. Many may feel that credit usage is simply a bad idea.

What is identity theft? Answer: Identity theft is the fraudulent acquisition and use of a person's private identifying information, usually for financial gain.

LO6.5. Establish your own debt limit. 1.

Distinguish among the continuous debt method, debt payments-to-disposable income, and debt-toincome methods for setting your debt limit. Answer: The debt payments-to-disposable income ratio compares the relationship between monthly debt payments (excluding a first mortgage on a home) and monthly disposable income. The debt payments-toincome method compares monthly debt payments including a mortgage payment and any other loan or alimony payments) to monthly gross income (monthly debt repayments are divided by gross monthly income and multiplied by 100; 36% or less is desirable). The continuous debt method says that if you are unable to get completely out of debt every 4 years, except for mortgage loans, you lean on debt too heavily.

What are the borrower’s feelings when they have a limit of debt of 11 to 14 percent of disposable personal income compared to a debt limit of 15 to 18 percent? (Hint: See Table 6-1.) Answer: If monthly payments are from 11 to 14 percent of disposable income, the borrower is likely to be moderately stressed because of the high monthly debt payments. If monthly payments are 15 to 18 percent of disposable income, the borrower is seriously stressed and must hope that no emergency event occurs.

Summarize the effects of increasing debt payments from 10 to 15 percent on a budget. (Hint: See the Run the Numbers worksheet on page xxx.) Answer: Student answers will vary. Students should realize that such an increase in debt level cannot be managed by simply cutting back on entertainment or other less important areas of spending but will have an impact on such items as food, clothing, and transportation.

What is the best thought on the list of keeping student loan debt under control? Answer: Student answers will vary. Limiting student debt load in the first place is the one, best way to make sure that debt load stays manageable.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

LO6.6. Obtain credit and build a good credit reputation. 1.

Distinguish among the credit terms: prescreened, invitation-to-apply, and preapproved. Answer: Prescreening occurs when a credit card offer is aimed at a group of consumers based on their borrowing histories, credit scores, and other information available to the lender. Credit will be approved due to the prescreening information, but the APR will not be guaranteed or set until the consumer applies for credit. An invitation-to-apply is sent without prior screening, and no decision is made about granting credit or at what APR until the application is assessed. A preapproved offer of credit means that the lender will grant credit but will not assign an APR until verifying and updating the information in the applicant’s credit report.

What is a credit history, and what role do credit bureaus play in the development of it? Answer: A credit history is simply a compilation of a person’s previous credit usage and repayment patterns. Credit bureaus maintain computer records of millions of people’s credit histories and provide that information to lenders for a fee.

Name three steps to help establish a good credit history. Answer: To establish a good credit history, a consumer should (a) have both a checking account and a savings account, because lenders see consumers with both accounts as being better able to manage credit use; (b) have utility accounts billed in the consumer’s name, to establish a good payment pattern for these bills; (c) get and use a retail credit card, to establish a record of paying credit promptly; (d) apply for a bank credit card, to be better able to qualify for a card with a higher credit limit later; and (e) pay off student loans, to demonstrate that the consumer is a responsible borrower.

List two things to improve someone’s FICO credit score. Answer: Student answers will vary. Improving one’s credit utilization percentage is one of the easier ways to improve a FICO score.

Summarize how to fix errors in a credit report, and explain why some people add a consumer statement to their report. Answer: Consumers are protected against credit report inaccuracies under the Fair Credit Reporting Act. One part of the law requires that credit reports contain only accurate relevant information and allows consumers to challenge errors or omissions of information in their reports. If there is an error or omission in a credit report, we should take steps to correct the information. Notify the credit bureau and the original lender or company that provided the information in error. Ask the bureau to confirm the item or delete it. The credit bureau and lender must reinvestigate the information within 45 days, or it must delete the information from your credit file. If the information was erroneous, it must be corrected, and a corrected report must be sent to any creditor who sought the report over the past six months. If the credit bureau refuses to make a correction a consumer statement can be added to a file to provide our version of the information. The consumer statement will be included in any future credit reports.

LO6.4. Identify signs of over indebtedness and describe the options that are available for debt relief. 1.

Identify four signs of over indebtedness. Answer: Repossession is an obvious sign of over indebtedness. Paying only the minimum required payment on credit cards each month may be a sign of overextension. Requesting increases on credit card credit limits could also signal problems ahead. Skipping credit payments is a definite sign of overextension. So is taking on credit to repay other credit—add-on loans.

List the major provisions of the Fair Debt Collection Practices Act.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

Answer: The Fair Debt Collection Practices Act prohibits third-party credit collectors from using abusive tactics such as calling at odd hours, harassment with frequent contacts, telling others of the situation, and threatening to take actions that they are not legally allowed to take. 3.

What services are provided by a credit counseling agency, and how might a debt management plan work to provide relief for someone who is having debt problems? Answer: The primary service provided by credit counseling agencies is a debt management plan. A debt management plan is an arrangement whereby the consumer provides one monthly payment (usually smaller than the total of previous credit payments) that is distributed to all creditors. Creditor concessions, such as reduced interest rates, may also allow debtors to repay what they owe more quickly than would otherwise be possible.

Distinguish between Chapter 7 and Chapter 13 bankruptcy and explain who might be forced to use Chapter 13 rather than Chapter 7. Answer: The regular income plan under Chapter 13 is designed for those who might be able to repay most of their debts given certain protections from the court. A repayment plan is designed to repay as much of the debt as possible. Current bankruptcy laws require Chapter 13 for most persons who, although insolvent, have sufficient income to repay a portion of their debts. The immediate liquidation plan, a last resort, is available through Chapter 7 of the Bankruptcy Act. Once the bankruptcy trustee has examined the list of debts and determined that it would be unlikely that substantial repayment could be made, all the debts (with certain exceptions) are wiped out and the borrower is judged free and clear. Most of the person’s assets are sold by the court under straight bankruptcy, whereas the borrower is allowed to keep assets under the regular income plan.

WHAT DO YOU RECOMMEND NOW? After reading this chapter on building and maintaining good credit, what would you recommend to Julia Grace regarding: 1.

How might Julia go about establishing a debt limit? Answer: Julia has a considerable debt load now. She should use the debt payments-to-disposable income ratio method and the debt-to-income ratio methods to determine just how much additional debt she should take on. If her ratios exceed 14 percent and 36 percent, respectively, she should not take on any additional debt. If her ratios are low enough, she might consider additional debt but only so much that she stays within the guidelines for these ratios.

What two or three things can she do to help keep her student debt under control? Answer: Julia’s student loan payments will give her a debt payments-to-disposable income ratio of about 11.8 percent ($448 ÷ $3800) which is in the range of a safe limit. To stay within the safe range, she should carry no more than $532 ($3800 X 0.14) in monthly debt payments. She may have to wait a year or two to buy another vehicle as it is unlikely, she could finance a vehicle for $84 ($532  $448).

What can Julia do to build a good credit history? Answer: The one most important thing for Julia to do to build and maintain a good credit history is to make all her debt payments on time. It is also important for Julia to stay within the recommended ranges for the debt-to-income and debt payments-to-disposable income ratios.

Getting a free copy of her credit report?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

Answer: The law entitles Julia to a free copy of her credit report every 12 months. There is only one website that she should go to for obtaining a free report, www.annualcreditreport.com. Julia should never pay for a credit report. Julia can contact one of the three national credit bureaus to obtain a free copy of her credit report from that bureau. Then in four months, she can obtain a free report from one of the other two credit bureaus. Then four months later she can obtain a report from the last of the three bureaus. All these reports will be free. Then, after one year from obtaining the first report, she can go back to that first credit bureau and obtain a free report and repeat the cycle every year. In this way, she can obtain a free report every four months.

LET’S TALK ABOUT IT 1.

Creditworthiness. What aspects of our financial life make us creditworthy? What aspects might make it difficult for us to obtain credit? Answer: Students may cite the fact that they are students and do not have permanent or steady jobs as reasons that would make it difficult for them to get credit. Students may claim that their financial aid obligations may also make it difficult for them to get credit. However, students may cite the fact that they are getting an education to get a good job, which makes them more creditworthy.

Assessing Debt Load. How might students judge whether they are taking on too high a level of student loan debt? Answer: The traditional methods of determining whether one might be taking on too much debt—debt payments-to-disposable-income and debt-to-income—may not be all that useful for some college students because their income and assets are so low. The continuous debt method might be more insightful. Students should calculate the monthly payment that would pay off their loans in 3 to 5 years. Then they can judge whether it is realistic to be able to make that payment given their expected income. If the payment appears to be one that would be difficult to make, the student may be taking on too much student debt for the income they expect to make. Even though taking on debt for education is one of the best uses of debt, students must still learn to manage debt and determine whether debt load is too high. Students should take on as little student debt as possible. Choose the most advantageous repayment plan allowed. Negotiate a graduated loan repayment where the payment is lower in the early years of repayment and goes up as salary goes up. Students should never take on student loan debt just to maintain or obtain a certain lifestyle. Student loans should be used for educational purposes only.

Managing Student Loan Debt. Use the information on pages 194, 195, and 196 to discuss how best to deal with student loan debt. Answer: Student loan debt is a big concern for today’s college graduates. Many students do not even know their total student loan debt and what the likely loan payment will be after graduation. Knowing these two things is necessary. Once a student graduates, they have some options about the repayment pattern they will have, so making a good choice is beneficial. Making payments on time every time will help reduce the interest rate on their loan balance after 48 months. Graduates can also qualify for a slightly lower interest rate if they make their payments electronically and automatically out for their checking account monthly. It is usually wise to consolidate all student loans into one. Not only does this make repayment more convenient but it may also help to reduce the overall interest rate being paid. Finally, for students whose incomes after graduation are very low compared to the monthly student loan payments they may qualify for an income-based repayment plan.

Behind in Repayment. If you have ever missed a repayment deadline, what was the result? What could you have done differently/better?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

Answer: Student answers will vary. 5.

Your Privacy. Are you concerned that the major national credit bureaus may have files containing information about you? What do you think about the process required to correct errors in those files? Answer: Students may take issue with the fact that there may be files on them at major national credit bureaus. They need to learn how to order their credit reports and correct any errors on them. They will feel that the process necessary for correcting credit bureau errors is too long and cumbersome.

Easy Credit. Is it too easy for college students to get credit cards? Who do you know who has gotten into financial difficulty because of overuse of credit cards, and what happened? Answer: Most students will know someone, themselves, who have gotten into trouble through the overuse and inappropriate use of credit. They may also state that it is quite easy for students to get credit cards. It is too easy since these college students are young adults who, to date, may not be taught how to use credit wisely.

Feelings About Student Loan Bankruptcy. How do you feel about student loans not being subject to the bankruptcy law? Do you think the law should be changed? Why or why not? Answer: Most students will feel that bankruptcy is a last-resort step regarding debt management, particularly since bankruptcy remains on your credit record for 10 years. They may state that bankruptcy is justified if there are unexpected and large medical bills. Another situation where bankruptcy might be justified is in the case of divorce. Students may wonder why student loan debt is not eligible for bankruptcy. Opinions on whether this should be changed will vary among the students.

DO THE MATH 38. Taking Out a Motorcycle Loan. Kevin Jones, of Elon, North Carolina, is single and recently graduated from law school. He is employed and earns $9,000 per month, an awesome salary for someone only 26 years old. He also has $1,800 withheld for federal income tax, $500 for state income taxes, $700 for Medicare and Social Security taxes, and $230 for health insurance every month. Kevin has outstanding student loans of almost $80,000 on which he pays about $900 per month and a 0% loan on an auto loan payment of $300 on a Ford Fusion Hybrid he purchased new during law school. He is considering taking out a loan to buy a Kawasaki motorcycle (LO2). a. What is Kevin’s debt payments-to-disposable income ratio? b. Based on your answer to (a), how would you advise Kevin about his plan? Solution: This is a potential ―Class Activity‖ exercise related to page 193 in the text. a. b.

Kevin’s debt payments-to-disposable income ratio is 21% ($1200/$5770). According to Table 6.1 Kevin is seriously overindebted despite his high salary. He should not consider taking on additional debt. Even when he has his car loan paid off his debt level will be precarious.

39. Buying a Vacation Home. Barrie and Inga Adlington, of Birmingham, England, have just finished putting their three daughters through college. As empty-nesters, they are considering purchasing a vacation home in the United States on a lake because prices have dropped in recent years. The house might also serve as a retirement home once they retire in six years. The Adlingtons’ net worth is $383,000 including their home worth about $265,000 on which they currently owe $43,000 for their first mortgage, with a $778 per month payment. Their outstanding debts in addition to their mortgage include $12,500 on one car loan ($256 monthly payment), $13,700 on a second car loan ($287 monthly payment), and a $25,000 second mortgage

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

on their home taken out to help pay for their daughters’ college expenses ($187 monthly payment). Their gross income is $100,000. (LO2) a. Calculate the Adlingtons’ debt-to-income ratio. b. Advise them as to the wisdom of borrowing to buy a vacation home at this time. Solution: This is a potential ―Class Activity‖ exercise related to page 193 in the text. a. Debt-to-income ratio is the percentage of gross monthly income (before taxes) that goes toward payments for rent, mortgage, credit cards, or other debt. The Adlington’s debt-to-income ratio is 18.1% ($778 + $256 + $287 + $187) / ($100,000 / 12). b. Lenders typically say the ideal front-end ratio should be no more than 28 percent, and the back-end ratio, including all expenses, should be 36 percent or lower. The Adlington’s debt-to-income ratio is well below what is maximum desirable of 36%. They are in good shape for buying the vacation home now if their total monthly debt payments stay below about $3000 (($100,000 / 12) X .036). Since they have total monthly payments of $1508 now, that leaves room for a $1000–$1200 per month vacation home payment. 40. A Recent Graduate’s Debt Status. Chelsea Menken, of Providence, Rhode Island, recently graduated with a degree in food science and now works for a major consumer foods company earning $70,000 per year with about $58,000 in take-home pay. She rents an apartment for $1,100 per month. While in school, she accumulated about $38,000 in student loan debt on which she pays $385 per month. During her last fall semester in school, she had an internship in a city about 100 miles from her campus. She used her credit card for her extra expenses and has a current debt on the account of $8,000. She has been making the minimum payment on the account of about $240 a month. She has assets of $14,000 (LO2). a. Calculate Chelsea’s debt payment-to-disposable income ratio. b. Calculate Chelsea’s debt-to-income ratio. c. Comment on Chelsea’s debt situation and her use of student loans and credit cards while in college. Solution: This is a potential ―Class Activity‖ exercise related to page 193 in the text. a. Chelsea’s debt payments-to-disposable income ratio is 12.9% (($385 + $240)/$58,000/12). b. Chelsea’s debt-to-income ratio is 29.57% ($385 + 240 + $1100)/($70,000/12). c. Chelsea’s debt service-to-disposable income ratio puts her in the safe level (Table 6-1, less than 14%), she is close to a precarious level. Chelsea’s debt-to-income ratio is also in the safe range, less than 36%. While this situation is acceptable, taking on more debt would put Chelsea in a stressful situation and would make it unwise to take on any more debt. Her use of student loans while in college is typical, but her credit card debt is high, and it is especially important for her to pay down her debts as fast as possible.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Attempt to Resolve Their Credit and Cash-Flow Problems Harry and Belinda have a substantial annual joint income—$129,120, in fact. Nevertheless, they expect to experience some cash-flow deficits during the months of November and December of the upcoming year (see Tables 3-6 and 3-7 on Reference correct page xxx). To resolve this difficulty, the couple is considering opening a credit card account and using it exclusively for those expenditures that will cause the deficits they face. They could also open a line of credit that would allow them to borrow money by simply going online and having money placed in their checking account. a. What are the advantages and disadvantages of the Johnsons opening these accounts?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

b. c. d.

What financial calculations should Harry and Belinda undertake to see whether they could afford to borrow more money at this time? What might Harry and Belinda do before applying for credit to ensure that they will pay the lowest interest rate possible? Should they use credit to resolve their budget imbalances? Why or why not?

Solution: a. The obvious advantage is the flexibility that these accounts would provide. In addition, timely repayment of any balances would help build their credit scores. The downside is twofold. They will have to pay interest on any balances they carry from month to month, and they may be tempted by the easy credit availability to spend more. b. The Johnsons should calculate their debt payments-to-disposable income ratio and their debt-toincome ratio to see if their current and planned levels of debt are within the appropriate ranges. c. The Johnsons should contact one of the national credit bureaus to request their credit score. Credit scores are based on five factors: (1) payment history, (2) amounts owed, (3) length of credit history, (4) taking on more debt, and (5) types of credit used. Here are how these factors might affect the Johnsons’ credit score. (1) The Johnsons have a good payment history. They are regular in their payments on all their loans and credit cards. (2) The Johnsons will be taking on more debt until they pay off the cash advances on their credit cards. They might want to make the purpose of the loan clear to their lender so that the lender will understand that their overall debt will go down again once the cash advances are repaid. (3) As a young couple, the Johnsons are new to the world of credit. Thus, their credit history may negatively impact upon their credit score. (4) It is worrisome that the Johnsons do not appear to have room in their budget to pay the cash advances they have already used. They will need to revise their budget even if they take on the installment loan. (5) The Johnsons have been using credit appropriately with a good mix of installment loans and credit cards. d. Student answers will vary. While using credit will help them with their short-term budget imbalances, it might be better to address the imbalances by adjusting their budget, so they do not have to use credit. CASE 2: Victor and Maria Hernandez Advise Their Niece Victor and Maria have always enjoyed a close relationship with Maria’s niece Teresa, who graduated from college with a pharmacy degree. Teresa recently asked Maria for some assistance with her finances now that her education debts are coming due. She owes $29,000 in student loans and has $64,000 in disposable income annually. Teresa would like to take on additional debt to furnish her apartment and buy a better car. a. What advice might Maria give Teresa about managing her student loan debt? b. If next year Teresa were to consolidate her education debt into one loan at 6 percent interest, for five years with a monthly payment of $566, advise Teresa about taking on more debt. Solution: a. Teresa may want to consolidate loans so that they are easier to manage. She should then select a repayment period that will fit into her budget without lengthening the repayment period too much. Teresa could then decide to have the payments electronically deducted from her checking account. b. Using the debt repayment-to-disposable income method, it is recommended that this measure stays at or below 14 percent. With the 14 percent criterion, Teresa should keep her monthly payments at no more than $746 [($64,000 ÷ 12) × 0.14]. At 6 percent APR for 5 years, the $566 monthly payment for Teresa’s $29,000 debt would give her a debt payment-to-disposable income ratio of 10.6 percent [$566 × (12 ÷ $64,000)], below the recommended 14 percent. Since her monthly payment is less than the maximum payment she can afford, she should seriously consider making higher payments than the required minimum to pay off the student loan more quickly and reduce the total interest paid. If she decides to incur more debt, she should do so cautiously. According to the continuous-debt method, it is recommended that one should get completely out of debt every 4 years. This will be difficult for Teresa given her large student loan debt, but both methods suggest that Teresa should be careful about taking on additional debt at this time.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

CASE 3: Julia Price Thinks About a Loan to Buy an Inboard Ski/Wakeboard Boat Julia has been thinking about the purchase of a boat. As a teenager, she was an avid water skier at her parents’ summer home. Now that she has moved away, she wants to renew her hobby at a lake nearby. Julia recently received a raise of $200 per month and plans to visit a dealership near the lake to see what kind of boat she can buy with that level of payment. Offer your opinions about her thinking. Solution: Julia should do a bit more homework before visiting the boat dealership. She should first obtain at least one copy of her credit report. She should also determine an estimate of the cost of the type of boat she wishes to purchase. With that information, she could visit the financial institution at which she has her checking and savings accounts and find out if she might qualify for a loan for a boat and at what interest rate. She may also be able to determine her credit score through the institution. At this point, she is armed with the information she needs to visit the dealership and hear what it might offer her in the way of financing for a boat. She can compare the borrowing offers and, if necessary, even seek out other offers from other institutions. Once she knows how much it might cost to buy the boat monthly, she can determine if the payments would fit her budget and are within the guidelines of the debt payments-to-disposable income and debt-to-income ratios.

CASE 4: Reducing Expenses to Buy a New Car Courtney Bennett recently graduated from college and accepted a position in Bangor, Maine, as an assistant librarian at the university library. Courtney’s budget is shown in the second column (Single Working Person) in Table 3-5 on page 97. She now faces the question of whether to trade in her old car for a new one requiring a monthly payment of $400. Taking the role of a good friend of Courtney, suggest how Courtney might cut back on her expenses so that she can afford the vehicle. a. What areas might be cut back? b. How much in each area might be cut back? c. After finishing your analysis, what advice (and possibly alternatives) would you offer Courtney about buying the new car? Solution: This is a potential ―Class Activity‖ exercise related to page 194 in the text. a.

Courtney’s budget is extremely flexible since it is composed primarily of variable expenses. Variable expenses that might be cut back include food, utilities, transportation, charitable contributions, entertainment, clothing, vacations, cable TV, personal care, gifts, health club, miscellaneous, and savings. In addition, Courtney might be able to cut out the cost of life insurance if she has no real need for it, but she will face increased automobile insurance premiums if she purchases a new car. After looking at Courtney’s budget, her current $310 auto loan payment will increase to $400. She needs to reduce her variable expenses by an additional $90 to provide the $400 a month needed to buy a new car. Student answers will vary but should total to $90 in reasonable reductions in variable categories. Student answers vary. Since Courtney has not mentioned having issues with her current car, Courtney’s desire for a new car is a ―want‖ not a need. Given her current debt situation, it might be wise to encourage Courtney to defer the purchase of a new car. If Courtney really wants a new car immediately, she should be sure to shop around for the best price on the car, the most favorable financing arrangements, and the best buy for auto insurance. If Courtney is willing to wait a little longer before purchasing a new vehicle, she could save up for a larger down payment and further reduce the required monthly payment. Or she might decide to buy a used vehicle that is only 1 or 2 years old giving her the reliability of a new vehicle for a lower cost.

CASE 5: Cousins Discuss Their Debt Situations

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

Melinda Dennis from Sewell, New Jersey, just graduated from college and is concerned about her student loan debts. While at her graduation party she got to talking with three of her cousins, Kyle, Mariah, and Hadrian, who have been out of school for several years and found they each have had a somewhat different pattern with using credit and carrying debt. Mariah, who had taken a personal finance class, said she felt good about her credit management and mentioned she has a debt payments-to-disposable income ratio of 7 percent. None of the other three cousins even knew what such a ratio was. Mariah offered to do the calculations for the other three cousins. After doing so, she found ratios of 20 percent for Melinda due to her student loan debt, 12 percent for Kyle due primarily to a car loan, and 16 percent for Hadrian due to both a car loan and credit card debt. The cousins are planning to get together next week and discuss what Mariah has found. What assessment and advice should Mariah give to his cousins? Solution: This is a potential ―Class Activity‖ exercise related to page 193 in the text. Mariah is in good shape with her debts. This is not true for her other cousins including Melinda. Melinda is seriously overindebted due to her student loans. She needs to take steps to reduce her loan payments. This can be done primarily by consolidating her student loans. She should also make sure she has her payments set to be made electronically. If she pays on time, every time for four years her interest rate can go down making the monthly payments low. However, it may be necessary for her to see about setting up an income-based repayment plan. Melinda should not take on any additional debt. Hadrian is precariously overindebted and should not take out any more debt until he can pay off his vehicle loan. His first step should be to pay off his credit card debt as fast as possible since it is likely to be his highest interest rate debt. Kyle has a safe debt level but is fully extended financially. He too should not be planning to take on more debt until his vehicle loan is repaid. CASE 6: Preparation of a Credit-Related Speech Jacob Marchese of Vancouver, Washington, is the credit manager for a regional chain of department stores. He has been asked to join a panel of community members and make a 10-minute speech to graduating high-school seniors on the topic ―Using Credit Wisely.‖ In the following list of three topics that Jacob has prepared, provide him with some suggested comments. a. What is consumer credit? b. Why might graduates use credit? c. How can graduates use credit wisely? Solution: a. Consumer credit is nonbusiness debt used by consumers for purposes other than home mortgages. There are two types of consumer credit—installment credit and non-installment credit. Installment credit is repaid in a specific number of equal payments. One must reapply each time they want a new installment loan. Common examples of installment credit include auto, education, and debt consolidation loans. Non installment credit includes single-payment loans and open-ended credit. Of the two types of non installment debt, open-ended credit is used more frequently. One applies for openended credit and, if accepted, can use the credit repeatedly if the assigned credit limit is not exceeded. The amounts owed are repaid in full or in a series of payments that may or may not be equal. Common examples of open-ended credit are credit cards and charge accounts. b. There are numerous reasons for using consumer credit. Many people use credit (a) for convenience as credit cards are widely accepted and provide a record of payment, (b) for emergencies when unexpected expenses arise, (c) to buy an item before saving up to pay for it, (d) to get an education, (e) to offset the effect of inflation by purchasing items before prices rise, (f) to consolidate debts into more manageable monthly payments, (g) to take advantage of free credit using the grace periods provided on some credit cards, (h) for protection against fraud, (i) for identification, (j) to obtain discounts in the future, and (k) to make hotel reservations.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 6: Building and Maintaining Good Credit

It is extremely important for everyone, but especially for new credit users, to use credit wisely. The following tips should help graduates be successful in managing their credit. Apply for only a few credit cards and select the ones with the lowest APRs and no annual fees, if possible. Do not use credit cards for daily expenses such as food and gasoline unless you will be paying the total balance on billing. Avoid using high-interest credit cards to make ―big-ticket‖ purchases. Instead, use lower-cost installment loans for purchases such as appliances, furniture, and so on. Do not carry your credit cards if you are prone to making impulse purchases. Protect yourself from unauthorized use of your account,. Keep your receipts and cross-check them with your statements. Avoid giving your account number to someone over the phone (unless you initiated the call). Check your statement carefully each month. Most importantly, try to pay your credit card bills in full each month!

CASE 7: Debt Consolidation as a Debt-Reduction Strategy Justin Granovsky is an assistant manager at a small retail shop in Morgantown, West Virginia. He owes $5,400 to one bank, $1,800 to a clothing store, and $2,700 to his credit union. Justin is paying $460 per month on the three major obligations to pay them off when due in two years. He realized that his take-home pay of slightly more than $3,100 per month did not leave him with much excess cash. Justin discussed a different way of handling his major payments with his bank’s loan officer. The officer suggested that Justin pool all of his debts and take out an $11,000 debt-consolidation loan for seven years at 14 percent interest. As a result, he would pay only $206 per month for all his debts. Justin seemed ecstatic over the idea. a. Is Justin’s enthusiasm over the idea of a debt-consolidation loan justified? Why or why not? b. Why can the bank offer such a ―good deal‖ to Justin? c. What compromise would Justin make to remit payments of only $250 as compared with $460? d. How much total interest would Justin pay over the seven years, and what would be a justification for this added cost? Solution: This is a potential ―Class Activity‖ exercise related to page 207 in the text. a.

b. c. d.

A debt-consolidation loan usually looks good at first because of the lower monthly payment as compared to the total payments on all the consolidated debts. However, that positive aspect must be compared to the often-higher APR on a debt-consolidation loan, which results in a higher finance charge. The monthly payment is usually lower because the time of the new loan exceeds that of the prior loans, in this case, 7 years versus 2 years. The longer repayment period also adds to the overall finance charge. The bank is willing to take a lower monthly payment because of the higher APR on the debtconsolidation loan. Justin has traded high monthly payments for 2 years for one lower monthly payment for 7 years. He extended his payments, therefore compromised his financial flexibility by continuing a debt payment. If Justin kept with his $460 a month payment over the next two years (24 months) he would pay a total of $11,040. His debt consolidation payments of $206 for seven years (84 months) would total $17,304. The interest paid over seven years would be $6264 ($17,304-11,040). The only justification to take on a debt consolidation loan is to keep Justin in good standing on his loan payments. If he found it impossible to pay $460 as currently required, he might default on one or more of the obligations thereby damaging his credit reputation. The more affordable $206 debt-consolidation loan payment would make it easier for Justin to stay current on his debt and maintain his good credit but would cost a great deal in finance charges and financial freedom.

EXTENDED LEARNING 1.

Understanding Credit Applications. Visit a local bank or credit union and ask for an application for a credit card. Read through the items of information that are requested. Why do you think that the lender asks

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

for the information requested? Do you think the lender would view the information that you might provide in a positive manner? Solution: Student answers will vary. 2.

Good Uses of Credit. Survey three of your friends about their perceptions of when it is appropriate to use credit. Compare their views to your own and present your findings in a table. Solution: Student answers will vary. Reducing the overall level of debt and reducing one’s credit utilization percentage are the two most considered techniques.

The Downside of Credit. Survey three of your friends about their most negative experiences in using credit. Compare their experiences aspects to your own and present your findings in a table. Solution: Student answers will vary.

Perceptions of Bankruptcy. Survey three of your friends about their feelings about and understanding of bankruptcy. Do their feelings conflict with yours? Is their understanding of bankruptcy accurate? Solution: Student answers will vary. There may be some strong opinions about bankruptcy.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 7: CREDIT CARDS AND CONSUMER LOANS

TABLE OF CONTENTS Answers To Chapter Concept Checks .................................................................................................... 76 What Do You Recommend Now? ............................................................................................................ 78 Let’s Talk About It ................................................................................................................................... 79 Do the Math ............................................................................................................................................... 80 Financial Planning Cases ......................................................................................................................... 83 Extended Learning.................................................................................................................................... 85

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

ANSWERS TO CHAPTER CONCEPT CHECKS LO7.1 Distinguish among credit cards and other types of open-end credit. 5.

What is open-end credit and give three examples. Answer: With open-end credit, credit is extended in advance of any transaction so that the borrower does not need to reapply each time credit is desired. A maximum credit limit is established, and the borrower can access the credit any time and pay all or some of the amount owed monthly. This can go on for years if the maximum credit limit is not exceeded and required payments are made on time. Retail credit cards, bank credit cards, and lines of credit are examples of open-end credit.

Explain the basic features of bank credit cards. Answer: Bank credit cards are issued by depository institutions, such as banks and credit unions. The institution is the lender—not Visa or MasterCard. With a bank credit card, the borrower is provided a maximum level of debt and can draw on that credit at any time. The card can be used at any retail outlet (physical facility or online) to make purchases. The card can also be used at an ATM to take a cash advance. Any amounts owed will be repaid in full in a single payment or via a series of equal or unequal payments, usually made monthly. The borrower can use the account if the total owed does not exceed their credit limit.

Distinguish between an unsecured line of credit and a home equity credit line. Answer: Any line of credit acts very much like a revolving credit account. The borrower is provided a maximum level of debt and can draw on that credit at any time up to the maximum credit limit. An unsecured line of credit is not backed up by collateral. With a home equity line of credit, the borrower’s home serves as collateral for the debt.

LO7.2 Manage credit cards wisely. 1.

Distinguish between a statement date and a payment due date on a credit statement. Answer: The statement date is the date that the statement is sent to the borrower. The time between statement dates is the billing period. Thus, the statement contains all the account activity during that billing period. The due date is the date by which at least the minimum payment must be remitted to the lender. It must be a minimum of 21 days after the statement date.

Distinguish between transaction and posting dates on a credit statement. Answer: The transaction date is the date on which the transaction occurred such as a purchase made with the credit card. The posting date is the date on which the transaction is posted to the account. Typically, these occur simultaneously but there may be a delay of a day or two before a transaction is posted to an account.

How does a penalty rate work on a credit card? Answer: A penalty rate is a higher rate than the typical APR on an account. A penalty rate can be triggered when the account holder violates some requirement on the account. The most common reasons for triggering a penalty rate are a late payment or failing to make the minimum payment for a billing period. The penalty rate will be cured after a specified number of on-time payments depending on the rules of the account.

What is the liability for a lost or stolen credit card?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

Answer: If we report that our credit card has been lost or stolen before it is used, we are not responsible for any unauthorized charges. If there is unauthorized use of our credit card before we report it missing, our liability is a maximum of $50. If someone steals and uses our account number, there is no liability for unauthorized use. It is important to notify our card issuer promptly if it is lost or stolen. 5.

What are action steps to dispute an error on a billing statement? Answer: We are protected regarding billing errors under the Fair Credit Billing Act. To preserve our rights under the act, we must send a written notice of the error explaining fully why we feel there is an error to the credit card issuer within 60 days after the first bill containing the error was mailed. We are then allowed to withhold payment on the item(s) in dispute. In addition, it is recommended that we phone the credit card issuer as soon as the error is discovered and that we review our credit report from a credit bureau after the dispute is settled to ensure that no information regarding our refusal to repay the disputed amount was included. If the credit bureau refuses to make a correction, we can add a consumer statement to our file to provide our version of the information. The consumer statement will be included in any future credit reports.

LO7.3 Distinguish among the sources of consumer installment loans. 1.

What is a sales finance company and how does it work? Answer: A sales finance company is an affiliate of a retail store or product manufacturer that provides loans to make purchases at the retail store or of the manufacturer’s products. A consumer finance company is a non-depository institution that makes small loans directly to consumers. Consumer finance company’s costs are higher because they do not take deposits and, thus, must borrow the money elsewhere to make the loans they offer.

Where would you go to obtain an installment loan to finance a vehicle if we had a good credit rating and wanted to pay a low interest rate? Answer: The lowest credit costs are with the lenders who accept only the best credit risks. We want to obtain credit from the lender where it is most difficult to be approved and not the easiest. A sales finance company affiliated with the vehicle dealer, or a credit union would typically have the lowest rates.

LO7.4 Be familiar with the different types of installment loans. 1.

Distinguish between a single-payment and an installment loan. Answer: With a single-payment loan, the borrower is not required to make payments until the end of the loan period. At that time, the principal borrowed plus any accrued interest must be paid in full. An installment loan requires payment of interest and principal monthly until the debt principal is repaid, typically a specified number of years. These monthly payments are typically the same amount each month.

What is the difference between a secured and an unsecured loan? Answer: A secured loan requires collateral, which is a certain asset that the borrower pledges to back up the debt, or a cosigner who agrees to pay the loan should the borrower fail to do so. An unsecured loan, which has neither the assurance of collateral nor a cosigner, is a loan given on the good character of the borrower.

What reasons do some people offer for not having a cosign a student loan? Answer: A cosigner on a loan is fully liable for the debt if the original borrower fails to repay. Thus, the cosigner would be required to repay the debt and any associated fees even if the original borrower had the wherewithal to pay but simply did not.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

What is an acceleration clause? Answer: The lender will enforce an acceleration clause if they feel that the loan is in default and will not be repaid. That action will make the entire remaining balance of the loan immediately due and payable. Obviously, if the borrower was having trouble making the monthly payments, he or she will not be able to pay off the balance—a difficult situation indeed.

Which alternative lender probably charges the highest interest rate? Answer: When a person cannot access credit, they must turn to high-cost, high-fee alternative credit market. Payday lenders have the highest effective interest rates of any alternative lenders.

LO7.5 Calculate the interest and annual percentage rate on consumer loans. 1.

Explain how the interest is calculated on a consumer loan that uses the declining-balance method. Answer: With the declining-balance method, the interest is calculated by applying the periodic (monthly) interest rate to the outstanding balance of the loan each month to arrive at the finance charge for the month. This amount is paid along with a portion of the principal in a single payment on the loan due date—a process called amortization. As the loan is paid down, the portion of each payment that is required for the finance charge will decline, and the amount that is applied to the debt itself will go up. This method recognizes that interest is higher in the early months when the balance owed is highest.

Summarize how interest is calculated on a consumer loan that uses the add-on method. Answer: With the add-on method, the add-on rate (not the APR) is multiplied by the amount borrowed, and the number of years over which the loan will be repaid. This amount is added on to the amount borrowed and divided by the number of payments (months) to arrive at the loan payment required each month.

What is the effect of the rule of 78s when a borrower repays an add-on method loan early? Answer: The rule of 78s results in a prepayment penalty. It recognizes that with an add-on loan the interest is assumed to be the same each month but should be higher in the early months. The rule of 78s is not used on declining-balance loans.

Explain how the interest is calculated on a consumer loan that uses the discount method. Answer: With the discount method, the discount rate (not the APR) is multiplied by the amount borrowed and the number of years over which the loan will be repaid. This amount is subtracted from the amount borrowed such that the borrower receives the difference only at the time of taking out the loan. However, they must repay the entire amount either monthly or in a single payment at the end of the loan period.

WHAT DO YOU RECOMMEND NOW? Now that you have read this chapter on credit cards and consumer loans, what would you recommend to Zachary Cochrane regarding: 1.

His approach to using credit cards, including the number of cards he has? Answer: Zachary is not an effective manager of his credit cards. He has too many cards, but at this point, he should not close any of the accounts. This is because his credit score would go down as his percentage of money owed on all cards based on the total of the credit limits on all his cards would rise if he closed accounts.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

Estimating the credit card interest charges he is paying each month? Answer: Zachary should multiply the amount he owes on each card by the periodic rate (the APR on the card divided by 12). The periodic rate will be listed on his most recent billing statements on the accounts.

How might he lower his interest expense each month? Answer: Zachary should move his balances to the cards with the lowest APRs. He should use a card on which he does not carry a balance to make convenience purchases to be paid off monthly, thereby avoiding interest on new purchases. He should make the minimum payments on his lowest APR cards and put the remainder on the cards with the highest APRs, thereby paying that one off first. As he pays off his higher APR cards, he can increase his payments on the next highest APR card until all are paid off.

Consolidating his credit card debts into one installment loan? Answer: Zachary could look for a lender that would be willing to provide him with a loan to pay off the balances on all his cards. This debt consolidation loan would provide him with one payment each month. The risk here is two-fold. The debt consolidation loan may have an APR higher than some of Zachary’s lower rate cards. And, if Zachary continues to use his cards after taking out the consolidation loan, he may fall deeper into debt.

LET’S TALK ABOUT IT 1.

Learning More About Credit. Most young adults form their opinions about credit and debt from what they see in their parents’ experiences. How has your perception of carrying credit card debt, student loans, and other borrowing changed as a result of reading Chapters 6 and 7? Answer: Student answers will vary. Many students will be less likely to carry balances on their credit cards or take out unnecessary student loans in the future.

What Type of Borrowing Might Be Best? If you wanted to borrow money to study abroad for a semester and could pay it back within two years after returning, would you prefer a single-payment loan, an installment loan, or a cash advance on a credit card? Why? Answer: Student answers might vary. The lowest cost option is the installment loan. It also has the advantage of having a set schedule to ensure the debt is paid within two years.

Are Rewards Cards a Good Idea? Some credit cards offer rewards points or a cash back reward for all purchases made on the card. Which rewards card would you prefer and why? Answer: If you pay off a rebate credit card in full every month, then you need to check out whether the rebate you receive is greater or less than the annual fee assessed by the credit card company. If your rebates are not equal to or greater than your annual fee, then you should not use this type of card.

The Declining-Balance Method. If you were the borrower, how would you feel about the fact that interest costs are higher in the early months of a declining-balance loan than they are in the later months? Answer: A declining balance loan may have higher finance charges in the early months of the loan since the interest is calculated on the unpaid balance of the loan. Some students may feel that the higher finance charges in the early years of the loan are burdensome. Other students may recognize that it is fair to charge higher finance charges when the amount owed is higher and conversely.

The Rule of 78s. Are prepayment penalties such as that applied with the rule of 78s justified? Why or why not?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

Answer: The rule of 78s is considered a prepayment penalty because the borrower does not get a full proportionate forgiveness of future of interest if a loan is paid off early. For example, paying off a 12month loan in half the time (six months) results in an interest refund of only 27 percent [(1 + 2 + 3 + 4 + 5 + 6) ÷ 78]. Students may feel that this penalizes them for doing something positive paying a loan off early. But they also should recognize that interest paid in the early months of an add-on method loan is not reflective of the amount owed. 6.

Mistakes in Credit Cards. Given your experiences in using credit cards, what mistakes or errors have your made, or seen people you know make, if you don’t currently own a credit card? Choose one and concisely share the story. Answer: Student answers will vary.

DO THE MATH 41. Monthly Payments and Finance Charges or an Add-on Rate Loan. Zachary Porter of Abilene, Texas, is contemplating borrowing $10,000 from his bank. The bank could use add-on rates of 6.5 percent for three years, 7 percent for four years, and 8 percent for five years. Use Equation 7.1 to calculate the finance charge and monthly payment for these three options. (LO2 and LO5) Solution: This is a potential ―Class Activity‖ exercise related to page 232 in the text. For the 6.5 percent loan the finance charge would be $1,950 ($10,000 × 0.065 × 3) and the monthly payment would be $331.94; ($10,000 + $1,950)/36. For the 7 percent loan the finance charge would be $2,800 ($10,000 × 0.07 × 4) and the monthly payment would be $266.67; ($10,000 + $2,800)/48. For the 8 percent loan the finance charge would be $4,000 ($10,000 × 0.08 × 5) and the monthly payment would be $233.33; ($10,000 + $4,000)/60. 42. Monthly Payments and Finance Charges. Kimberly Jensen of Storm Lake, Iowa, wants to buy some living room furniture for her new apartment. A local store offered credit at an APR of 16 percent, with a maximum term of four years. The furniture she wishes to purchase costs $4,800, with no down payment required. (LO2 and LO5) Using Table 7-2 make the following calculations: a. What is the amount of the monthly payment if she borrowed for four years? b. What are the total finance charges over that four year period? c. How would the payment change if Kimberly reduced the loan term to three years? d. What are the total finance charges over that three year period? e. How would the payment change if she could afford a down payment of $500 with four years of financing? f. What are the total finance charges over that four-year period given the $500 down payment? Solution: This is a potential ―Class Activity‖ exercise related to page 231 in the text. a. The monthly payment for $4,800 at 16 percent for four years would be $136.03 (4.8 × 28.34). b. Total finance charges are $1,729.44 ($136.03 × 48 − $4,800). c. The monthly payment for $4,800 at 16 percent for three years would be $168.77 (4.8 × 35.16), an increase of $32.74 compared to the four-year loan. d. Total finance charges are $1,255.80($98.45 × 36 − $4,800) over three years, a decrease of $473.64 compared to the four-year loan.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

e. f.

The monthly payment for $4,300 at 16 percent for four years would be $121.86 (4.3 × 28.34), a decrease of $14.17 compared to the $4,800 four-year loan. Total finance charges over four years are $1,549.28 ($121.86 × 48 − $4,300) with the $500 down payment.

43. Average Daily Balance and Finance Charges Kayla Sampson, an antiques dealer from Mankato, Minnesota, received her monthly billing statement for April for her MasterCard account. The statement indicated that she had a beginning balance of $600, on day 5 she charged $150, on day 12 she charged $300, and on day 15 she made a $200 payment. Out of curiosity, Kayla wanted to confirm that the finance charge for the billing cycle was correct. (LO2 and LO5) a. What was Kayla’s average daily balance for April without new purchases? b. What was her finance charge on the balance in part (a) if her APR is 19.2 percent? c. What was her average daily balance for April with new purchases? d. What was her finance charge on the balance in part (c) if her APR is 19.2 percent? Solution: a. Ignoring new purchases, Kayla’s balance was $600 for 14 days and $400 for 16 days giving an average daily balance of $493.33 (($600 × 14) + ($400 × 16) = $14,800/30 days = $493.33; assuming the balance is reduced on the 15th day and a 30-day month). b. Her finance charge would be $7.89 ($493.33 × 0.192/12). c. With new purchases, Kayla’s balance was $600 for four days, $750 for seven days, $1,050 for three days, and $850 for 16 days. This gives an average daily balance of $813.33 (assuming a 30-day month). d. Her finance charge would be $13.01 ($813 × 0.192/12). 44. Average Daily Balance. Alexis Monroe, a biologist from Dyersburg, Tennessee, is curious about the accuracy of the interest charges shown on her most recent credit card billing statement, which appears as Figure 7-1 on page 204. Use the average daily balances provided at the bottom of the statement in the "Interest Charge Calculation" section to recalculate the interest charges and compare the result with the amount shown on the statement. (LO2 and LO5) Solution: Looking at the billing statement section titled ―Interest Charge Calculation,‖ the purchases category under Type of Balance, has an average daily balance of $512.14 and an APR of 14.99%. The APR converts to a periodic rate of 1.2492% (14.99/12) and thus her interest for the month is $6.40 ($512.14 × 0.012492. The cash advances category under Type of Balance, has an average daily balance of $253.50 and an APR of 21.99%. The APR converts to a periodic rate of 1.8325% (21.99/12) and thus her interest for the month is $4.65 ($253.50 × 0.018325). Thus, the credit card billing statement is accurate. 45. Comparing APRs. James Sprater of Grand Junction, Colorado, has been shopping for a loan to buy a used car. He wants to borrow $18,000 for four or five years. James’s credit union offers a declining-balance loan at 9.1 percent for 48 months, resulting in a monthly payment of $448.78. The credit union does not offer five-year auto loans for amounts less than $20,000, however. If James borrowed the $18,000 from his credit union, this monthly payment amount is too high and would strain his budget. A local bank offered current depositors a five-year loan at a 9.34 percent APR, with a monthly payment of $376.62. This credit would not be a declining-balance loan. Because James is not a depositor in the bank, he would also be charged a $25 credit check fee and a $45 application fee. James likes the lower payment but knows that the APR is the true cost of credit, so he decided to confirm the APRs for both loans before making his decision. (LO3 and LO5) a. What is the APR for the credit union loan? b. Use the n-ratio formula to confirm the APR on the bank loan as quoted for depositors. c. Use equation 7.1 to find out what is the add-on interest rate for the bank loan, solving for R.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

What would be the true APR on the bank loan if James did not open an account to avoid the credit check and application fees?

Solution: a. The APR for the credit union is 9.1 percent since it is a simple-interest loan with no fees. b. Finance charges would be $4,597.20 ($376.62 × 60 − $18,000).

(12)[(95  60)  9]4,597.2 12(60)(60  1)[(4  18,000)  4,597.2] 12     4597.2  720  61 76,597 314,944,977  3, 364, 149,024  9.36% The n-ratio method, which estimates the true APR on an add-on loan, gives a 9.36 percent APR. To calculate, use formula 7.2 on page 232 where Y = 12, $4,597.20, D = $18,000 and P = 60. The add-on interest rate for the bank loan is I = PRT 4,597 = 18,000r(5) 4,597 = 90,000r 5.1 percent = r The added charges would effectively add $70 to the finance charge on the loan making the effective finance charge $4,667.20. The n-ratio method which estimates the true APR on an add-on loan, gives a 9.5 percent APR. To calculate use formula 7.2 on page 232 where Y = 12, F= $4,667.20, D = $18,000 and P = 60. APR=

46. Rule of 78s. Miguel Perez of Pomona, California, obtained a two-year installment loan for $1,500 to buy a television set eight months ago. The loan had a 12.6 percent APR and a finance charge of $204.72. His monthly payment is $71.03. Miguel has made eight monthly payments and now wants to pay off the remainder of the loan. The lender will use the rule of 78s method to calculate a prepayment penalty. (LO3 and LO5) a. How much will Miguel need to give the lender to pay off the loan? b. What is the dollar amount of the prepayment penalty on this loan? Solution: This is a potential ―Class Activity‖ exercise related to page 233 in the text. a.

Using the rule of 78s, $112 of finance charge is due for the first eight months of the debt. 24 + 23 + 22 + 21 + 20 + 19 + 18 + 17 300 (t he sum of all num bers bet w een 1 an d 24) 164 ÷ 300 × $204.72 = $112 Miguel has already paid $568.24 ($71.03 × 8). Therefore, only $456.24 ($568.24 − $112.00) was paid on the amount borrowed, leaving $1,043.76 ($1,500 − $456.24) still owed. Since this loan is being paid off after only one-third of the loan period, one might assume that only one-third of the finance charges would accrue. This would mean that $67.56 ($204.72 × 0.33) would be due in finance charges from the $568.24 already paid. If that were correct, $500.68 ($568.24 − $67.56) of the $1,500 loan would be paid and only $1,000 would still be due. This makes a prepayment penalty of $43.76 ($1,043.76 − $1,000).

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

FINANCIAL PLANNING CASES CASE 1: The Johnsons’ Credit Questions They are considering trading their car in for a newer used vehicle so that Harry can have dependable transportation for commuting to work. The couple still owes $5,130 to the credit union for their current car, or $285 per month for the remaining 18 months of the 48-month loan. The trade-in value of this car plus $1,000 that Harry earned from a freelance interior design job should allow the couple to pay off the old auto loan and leave $1,250 for a down payment on the newer car. The Johnsons have agreed on a sales price for the newer car of $21,000. a. Make recommendations to Harry and Belinda regarding where to seek financing and what APR to expect. b. Using the information in Table 7-2, calculate the monthly payment for a loan period of three, four, five, and six years at 6 percent APR. Describe the relationship between the loan period and the payment amount. c. Harry and Belinda have a cash-flow deficit projected for several months this year (see Table 3-6 and Table 3-7 on pages 97–98). Suggest how, when, and where they might finance the shortages by borrowing. Solution: a. When purchasing their new car, the Johnsons should consider a bank, their credit union, or financing the dealer might arrange. They can arrange financing elsewhere before visiting the dealership and use the offer with the lowest APR. A typical 48-month used-car loan might have an average APR of around 3 to 5 percent for low-risk borrowers. b. At 6 percent APR, the monthly payment would be $600.80 for a three-year loan (19.75 × 30.42), $446.31 for a four-year loan (19 × 23.49), and $381.77 for a five-year loan (19.75 × 19.33), and $327.26 for a six-year loan (19.75 × 16.57). As the loan period is extended, the monthly payment declines. (Note, for example, the difference of $219.03 between the three- and five-year payments.) However, the total interest paid is significantly increased. Extending the loan from three to five years would cost the Johnsons an additional $1,277.76 [(60 × $381.77) − $19,750] − [(36 × $600.79) − $19,750]. Alternatively, the cost estimate could be obtained this way: $1,277.76 = 76 [(60 × $381.77)] − [(36 × $600.79)] c. Harry and Belinda could prearrange a personal line of credit at their bank, savings and loan association, or credit union. At the time the deficits occur, they could obtain the needed cash by telephoning, using special checks, or using a preapproved credit card. A less convenient alternative would be to apply for a small loan shortly before each deficit occurred. This could be done at a credit union, bank, savings and loan association, or consumer finance company. The credit union would be the least expensive source, whereas the consumer finance company would be the most expensive source of small loans. CASE 2: Victor and Maria Have a Billing Dispute Maria Hernandez was reviewing her recent bank credit card account statement when she found two charges that she and Victor could not have made. The charges were for rental of a hotel room and purchase of a meal on the same day in a distant city. These charges totaled $219.49 out of the couple’s $367.89 balance for the month. a. What payment should Maria make on the account? b. How should she notify her credit card issuer about the unauthorized use? c. Once the matter is resolved, what should Maria do to ensure that her credit history is not negatively affected by this error? Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

a. b.

Maria should pay only the $148.40 ($367.89 − $219.49) charge that she knows they are responsible for paying. Maria should notify her card issuer both in writing and by telephone. She must send a written notice of the error within 60 days after the date the first bill containing the error was mailed to preserve her consumer rights protected by federal law. Maria should review her credit bureau file to ensure that it does not include any negative information regarding her refusal to pay the disputed amount.

CASE 3: Julia Price Thinks About Her Use of Credit Cards Julia has been thinking about how she uses credit cards. She has two bank cards and three store cards. The APRs on the cards range from 10.5 to 24.9 percent, with the store cards being among the highest. She uses the cards often and picks whatever card she comes to first in her wallet. Most months she pays the balance off in full. However, sometimes she is unable to pay the balance on one or more of the cards, and so she only pays the minimum balance. Julia feels she is doing her best on managing her cards but wants to do better. She is thinking about using just one of her bank cards for any purchases that she thinks she will be unable to pay at the end of the month. Offer your opinions about her thinking. Solution: Julia is like many people who carry balances on one or more cards. She should realize the carrying a balance means that she loses the grace period on the cards and pays interest from the day a charge is made even if she has not been billed yet. She should try to pay all her balances in full each month. If she cannot, she should consider moving all her balances on to one of her bank cards. She should then refrain from using that card as the balance is paid down. She can use the other bank card and store cards for purchases that will only be paid in full at the end of the month. In that way, she will maintain her grace periods and have interest-free use of the funds until she pays her bill in full. CASE 4: A Delayed Report of a Stolen Credit Card Jia Li Sun, of Shreveport, Louisiana, took her sister-inlaw Ah-Iam Johnson out for an expensive lunch. When it came for the time to pay the bill, Jia Li noticed that her Visa credit card was missing, so she paid the bill with her MasterCard. While driving home, Jia Li remembered that she had last used the Visa card about a week earlier. She became concerned that a sales clerk or someone else could have taken it and might be fraudulently charging purchases on her card. a. b.

Summarize Jia Li’s legal rights in this situation. Discuss the likelihood that Jia Li must pay Visa for any illegal charges to the account.

Solution: This is a potential ―Class Activity‖ exercise related to page 221 in the text. a.

Jia Li is protected in this situation by the Truth in Lending Act. If someone has made unauthorized charges on her Visa card, Jia Li’s maximum liability is $50. Regardless of the low liability, Jia Li should call the 800 number provided by Visa as soon as possible and report the card missing. When her statement arrives, Jia Li will need to check it carefully to identify any unauthorized charges. Jia Li will not have to pay even the $50 for which she may legally be liable. Most credit card companies waive the $50 charge as a gesture of goodwill.

CASE 5: Clauses in a Car Purchase Contract Lauren Rowland is a dentist in Hebron, Kentucky, who recently entered into a contract to buy a new automobile. After signing to finance $38,000, she hurriedly left the office of the sales finance company with her copy of the contract. Later that evening, Lauren read the contract and noticed several clauses—an acceleration, a deficiency payments, a recourse, and a rule of 78s. When she signed the contract, Lauren was told these standard clauses should not concern her. a. Should Lauren be concerned about these clauses? Why or why not?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 7: Credit Cards and Consumer Loans

b. c.

Considering the rule of 78s clause, what will happen if Lauren pays off the loan before the regular due date? If Lauren had financed the $38,000 for four years at 6 percent APR, what would her monthly payment be, using the information in Table 7-2 or on the Garman/Fox companion website?

Solution: a. Lauren should be concerned about these clauses. The acceleration clause would mean that should she miss a payment or two and be declared in default, the entire debt would become due. The repossession clause means that should Lauren be in default, the vehicle could be seized by the lender and sold at auction. Should the auction not bring enough money to pay off the debt, Lauren would still owe the remaining debt as a deficiency balance. Finally, the rule of 78s’s clause would mean that should Lauren want to pay the loan off early, she might be required to produce additional money beyond the remainder of the balance owed on the debt. a. Should Lauren pay the loan off early, the lender would calculate a prepayment penalty based on the number of months left on the loan. The longer the remaining months on the loan, the higher the penalty. b. A four-year loan at 6 percent would have a monthly payment of $23.49 per thousand dollars borrowed (from Table 7.1). Her monthly payment would be $892.62 (38 × $23.49).

EXTENDED LEARNING 1.

Comparing Credit Card Offers. Select two local retailers, a local bank, and a local credit card and request credit card applications from all four. Compare the applications for the types of information they require. Compare the APRs offered among the cards and others that you may already hold. Make a table that summarizes your findings and write some brief reactions to what you found. Solution: Students should prepare a summary of their findings with an eye to determining the institution, the type of account, and the interest rate that best meets their needs.

Credit Card Repayment Patterns. Survey three of your friends about their patterns of using their credit card accounts including, if any, their choice to make the minimum payment rather than pay off the balance in full each month. Compare what they do to your own habits, and write a summary of your findings. Solution: Students should prepare a summary of their findings and compare what their friends do to manage payments on their accounts to what the individual student does to manage their account.

Credit Card Billing Errors. Survey three of your friends about experiences they have had concerning a billing error on their credit cards. Compare the steps they took to resolve the error(s) with those recommended in this chapter. Write a summary of your findings. Solution: Students should prepare a summary of their findings concerning their friends’ experiences with credit card billing errors. They should then compare what they have found to the recommendations in this chapter.

Installment Loan Interest Methods. Visit a bank and a credit union in your community. Tell them that you are considering taking out a loan to purchase a vehicle. Inquire whether they offer declining-balance or add-on method loans and which approach they would recommend. Compare the responses to the information provided in this chapter, and write a summary of your findings. Solution:

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

Students should prepare a summary of the responses concerning the use of declining balance versus add-on method loans and the recommendations of the institutions as to which method is best. They should then assess these recommendations considering the information provided in this chapter.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 8: VEHICLES AND OTHER MAJOR P URCHASES

TABLE OF CONTENTS Answers to Chapter Concept Checks ...................................................................................................... 87 What Do You Recommend Now? ............................................................................................................ 89 Let’s Talk About It ................................................................................................................................... 90 Do the Math ............................................................................................................................................... 91 Financial Planning Cases ......................................................................................................................... 92 Extended Learning.................................................................................................................................... 95

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

ANSWERS TO CHAPTER CONCEPT CHECKS LO 8.7 Explain the first three steps in the planned buying process that occur prior to interacting with sellers. 8.

What is planned buying? Answer: Planned buying involves defining a purchasing process, identifying personal needs and wants in the context of personal values and goals, identifying alternatives through preshopping research and the realities of a budget, comparison shopping, negotiating for and selecting the best alternative, and accepting and evaluating the action. Commitment to a planned buying process is important for all purchases, but critical for higher-cost items like homes and vehicles.

Distinguish between needs and wants and explain why it may be better to act as if no needs exist. Answer: A need is something that is considered a necessity, such as food, housing, and clothing. A want is desired but not necessary. Wants may include certain options on an automobile or a certain brand or style of clothing. Acting as though no needs exist makes everything a want. Then all wants will have to be prioritized as it is impossible to buy everything with our limited budgets. By not calling something a need, one is committing to the planned buying process and making an informed decision to buy or not to buy.

10. When shopping for a vehicle what are three things we need to know about when conducting preshopping research? Answer: Price, information about the cost of financing, and the value of any trade-in are key areas of knowledge that allow buyers to do a better job of interacting with vehicle sellers. All of this information should be obtained before interacting with sellers. 11. Summarize the process to determine whether we can afford a particular purchase. Answer: The first step is to determine if financing is needed for the purchase. If so, estimate the interest rate and resulting monthly payment. Then fit the payment into the monthly budget. For cash purchases, determine the opportunity cost of the funds you will use. In other words, always ask, what else could be done with cash?

LO 8.8 Describe the process of comparison shopping. 1.

What is the goal of comparison shopping? Answer: The goal of comparison shopping is to determine the best buy. This means the product that provides the best quality at a given price. Comparison shopping requires that we obtain information from several sellers.

Summarize what is involved in comparison shopping for a safe vehicle. Answer: To comparison shop for a safe vehicle, we would want to assess the various safety features of the vehicles such as a V2V crash-avoidance system, forward collision warning, stability control, lane-departure warning, and blind spot warning features. We would also use the National Highway Traffic Safety Administration (NHTSA) and Insurance Institute for Highway Safety (IIHS) websites for their information on vehicle safety tests and recalls.

Explain why lease payments for a new vehicle are lower than loan payments for the same vehicle. Answer: Lease payments are less than auto loan payments because we are paying for only the reduction in the car’s value over the period of the lease and not its total value.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

How do we choose between a low interest rate and a rebate? Answer: Often car buyers are given the choice between a rebate and a low-interest rate. They can only take one or the other. To choose we need to treat the lost rebate as interest added to the low-interest rate loan offered by the dealer. Equation 8.1, which is the add-on method of calculating APR, is used to calculate the effective interest rate accounting for the lost rebate. Comparing this add-on rate to those that we can get at credit unions or banks tells us which option to select.

How do we comparison shop between financing and leasing? Answer: To compare financing and leasing a vehicle we first need to break down the cost of leasing. The gross capitalized cost of a lease includes the price of the car, plus any cost to the dealer to finance the purchase, plus anything else that we as the lessors agree to pay over the life of the lease, such as insurance or a maintenance agreement. Capital cost reductions are payments at the inception of a lease, such as down payments, trade-in values, or rebates. The residual value is the projected value of a leased asset at the end of the lease period. We can use these figures to determine the dollar cost of leasing and compare it to the finance charge if we purchase the vehicle with an installment loan.

What are some pitfalls of leasing? Answer: The biggest pitfall of leasing is the potential that we will put excess miles on the vehicle and be required to pay an excess mileage charge when the vehicle lease terminates. Other concerns are excess wear and tear and excess depreciation in an open-end lease.

Explain the difference between an implied warranty and an express warranty, and how do they relate to the term as is? Answer: An implied warranty (―warranty of merchantability‖ or ―warranty of fitness for a particular purpose‖) provides that products sold are suitable for sale and will work effectively whether there is a written warranty or not. An express warranty, which can be full or limited, always accompanies a product in writing and is offered by a manufacturer on a voluntary basis to induce customers to buy that product. Implied warranties are governed by state law. To avoid them, the seller can state in writing that the product is sold ―as is.‖

What is a service contract and what is its disadvantages? Answer: A service contract provides free or almost free repair services on covered product components for a specified period. This can limit the number of unexpected expenses one has to include in a budget and provides peace of mind. The primary disadvantage is that a service contract may (and does) cost more than the average value of the repairs received over the covered period. Economically, service contracts are always unwise purchases.

LO 8.9 Negotiate successfully when making major purchases. 1.

Why should a shopper negotiate? Answer: Shoppers should negotiate simply because they can obtain a lower price, better product features, a better warranty, or lower financing costs. Most big-ticket items can be negotiated. In fact, the seller typically sets original price, financing, and trade-in levels with the expectation of negotiating on all three.

What is dealer holdback and why is it important? Answer: A dealer holdback is an amount of money a dealer can deduct from what it must pay (the invoice price) a manufacturer for a new vehicle after it is sold to a customer. It is an important piece of information because while it might appear that a dealer is making little or no profit when comparing the customer’s

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

purchase price with the invoice price, there may still be room for additional negotiation for a lower price. Dealer holdback is typically 1 to 3 percent of the MSRP. 3.

What three aspects of a vehicle purchase should be negotiated? In what order? Answer: The three key areas of negotiation are the price of the vehicle, the APR on the financing, and the value of any trade-in. They should be negotiated in that order. Never tell a seller your affordable monthly payment. Agree on a price for a given vehicle before disclosing what can be afforded or whether a vehicle will be traded in.

Why should we make major purchase decisions at home using a decision-making matrix? Answer: A decision grid is designed to add numerical value and objectivity to the various criteria set for a large purchase, put a weight on those criteria, and then give a score for each criterion for each alternative product. By multiplying the weight times the score and then arriving a total score for each alternative, we can determine which one is the overall best option.

LO 8.10 1.

Use effective complaint procedures when appropriate. Summarize the FTC’s cooling-off rule to cancel a contract. Answer: The FTC Rule allows a three-day window during which consumers may cancel a contract for a purchase of $25 or more if the sale occurred away from the seller’s usual place of business such as the buyer’s home, a hotel, or dormitory. The purchaser may cancel for any reason including a simple change of heart. The rule does not apply to mail order or online purchases, purchases needed in an emergency, real estate, insurance, or investment securities.

Distinguish between mediation and arbitration. Answer: Mediation is an alternative (to the courts) dispute resolution mechanism where a neutral third party works with the two parties to the dispute to help them arrive at a satisfactory solution. Arbitration is similar except that the neutral third party will issue a decision that is binding on at least one of the two parties to the dispute.

How do lemon laws work? Answer: Essentially, lemon laws describe the criteria by which an arbitrator can order a manufacturer to buy back a vehicle.

Summarize how a small claims court works. Answer: Small claims courts provide an avenue for seeking redress for a product or service-related dispute. While part of the court system, small claims courts are inexpensive, not time-consuming, and do not require the use of an attorney.

WHAT DO YOU RECOMMEND NOW? 1.

How to search for a vehicle to replace Alyssa’s? Answer: David and Alyssa should first decide what types of vehicles they want and prioritize the desired features and options. They can use the internet for much of their preshopping research by looking at prices, financing, and rebates. A rebate may be important to them because they will need funds for a down payment on one or both of their replacement vehicles.

Whether to replace Alyssa’s vehicle with a new or used vehicle?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

Answer: Since Alyssa’s vehicle was three years old, they may want to find a used vehicle identical to the one that was destroyed, thereby avoiding a second round of early-year depreciation in new-car values. 3.

Whether to lease or buy a vehicle? Answer: Leasing may be an option if they plan to replace the vehicle with a new one and then let Alyssa purchase her own vehicle within a few years. David and Alyssa should compare the cost of leasing with the cost of financing a purchase using a worksheet like the one on page 255 of this chapter.

How to decide between a rebate and a special low APR financing opportunity if they decide to purchase a new vehicle for Alyssa? Answer: Should they choose to buy a new vehicle for Alyssa, they may find a vehicle that has a rebate/low APR offer. They should arrange financing through a financial institution and compare its rates to the adjusted rates for the dealer financing using the worksheet provided on page 252 of this chapter.

How to negotiate with the sellers of the vehicles? Answer: The key to successful negotiation is knowledge and the willingness to walk away from a lessthan-optimal deal. The fact that David and Lisa need to replace Alyssa’s vehicle quickly works against them. They will want to resist the temptation to accept the first opportunities that come along to strike the best deal overall. Any negotiations should begin with determining the actual purchase price of the vehicle before negotiating financing. In this case, a trade-in would not be negotiated as Alyssa’s car was totaled.

LET’S TALK ABOUT IT 1.

Steps in the Planned Buying Process. Should all of the steps in the planned buying process be used when buying simple everyday products (such as a loaf of bread or a half-gallon of milk), or should they be used only when buying big-ticket items? Why or why not? Answer: The steps in the planned buying process should be used for everyday items as well as for bigticket items. Even when buying a loaf of bread, we do not want to do it on impulse as we may have a loaf of bread at home, or we may need to pause and reevaluate based on the monthly or annual cost of bread. Ideally, we want to pay cash for both every day and big-ticket items, avoiding the extra cost of financing. We want to buy at the right time, such as in the case of sales and promotions. We can store extra bread, bought on sale, in the freezer. We do not want to pay extra for name-brand items when a store or generic brand is just as good.

Positives and Negatives of Leasing. What benefits are there you see in leasing a vehicle? What negatives exist when leasing? Answer: One benefit from leasing a vehicle is that the monthly payment is lower than a monthly payment on a loan for the same vehicle because we are paying for only the reduction in the asset’s value, not its entire cost. A negative about leasing a vehicle is that if we go over the allotted mileage, we will be charged a per-mile rate at the end of the lease. In addition, many people use leasing to obtain a more luxurious vehicle than they otherwise could afford. Leasing is also of concern because the more ―expensive‖ (higher depreciation) years of the vehicle are what we are paying for, thus the appeal of a three- or four-year used car. Finally, leasing comes with multiple terms and conditions at the start and end of the lease.

A Bad Purchase Decision. What is the worst purchase decision you have ever made? What step(s) in the planned buying process could you have done better in that situation? Answer: Students will give a variety of answers to this question. Some may say that purchasing a car that turned out to be a big expense was their biggest purchase mistake. Some students may focus on other

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

unwise purchase decisions like audio and video equipment. Students could say that the step in the planned buying process that they could have done better was identifying wants and needs. 4.

Do You Complain? When was the last time you were seriously dissatisfied with a purchase? Did you complain? Why or why not? If you complained, what was the outcome? Answer: Students may focus on automobiles because an automobile may have been their largest purchase to date. They may say that they complained about a car that did not perform up to specifications or about service on their car. Students may have had different outcomes with complaining about, for example, service on a car. A common complaint is over service or poor-quality food in a restaurant. Most students will have just left without complaining. Discussing the consequences of not complaining might lead to concern that a seller/restaurant is missing valuable feedback.

A Good Purchase. Did you ever purchase a big-ticket item and get a good deal? Explain what happened that made it a good purchase. Answer: Students will give a variety of answers to this question. Most will focus on getting a good price or finding an item that fits very closely with their wants and needs. They may discuss shopping on the internet or taking advantage of specials on Black Friday or Amazon Prime Day.

Credit Card Pain. Using credit cards can feel like not having to pay for items and services. Do you feel less pain when using credit cards? Are your spending decisions made more carefully when you spend cash or use a debit card that takes the funds immediately out of your account? Answer: Students will give a variety of answers to this question. The key is to reveal that using a credit card makes it easier to spend more money than we may have access to in the short term, and that the credit card purchasers often overspend and then must finance their purchases and extremely high credit card rates. Over half of all credit card accounts have a balance carrying forward to the next month and thus the card holders are paying interest on all purchases.

DO THE MATH 1.

Future Value on Cost of Extended Warranty. Allison Jones of Flagstaff, Arizona, is considering paying $400 a year for an extended warranty on several of her major appliances. If the appliances are expected to last for five years and she can earn 2 percent on her savings, what would be the future value of the amount she will pay for the extended warranty? Solution: $441.64 = $400 × 1.1041 (from Appendix A.1)

Value of Shopping Carefully. James Canter of Auburn, Alabama, is a good shopper. He always comparison shops and uses coupons every week. James figures he saves at least $40 a month as a result. Assuming an interest rate of 2 percent, what is the future value of this amount over ten years? Solution: James will save $480 per year. Saving that amount per year and putting the money in the bank at 2 percent over ten year will yield $5256 = $480 × 10.9497 from Appendix A.3.

Buy Versus Lease. Amanda Forsythe of Springfield, Missouri, must decide whether to buy or lease a car she has selected. She has negotiated a purchase price (gross capitalized cost) of $35,000 and could borrow the money to buy from her credit union by putting $3,000 down and paying $751.68 per month for 48 months at 6 percent APR. Alternatively, she could lease the car for 48 months at $495 per month by paying a $3,000 capitalized cost reduction and a $350 disposition fee on the car, which is projected to have a residual value of $12,100 at the end of the lease. Use the Run the Numbers worksheet on page 238 to advise Amanda about whether she should finance or lease the car. Solution: This is a potential ―Class Activity‖ exercise related to page 255 in the text.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

If Amanda decides to purchase this car, she will be borrowing $32,000 ($35,000 − $3000) and her finance charges will be $4,080.64 [($751.68 × 48) − $32,000]. If she leases the car, the capitalized cost after taking the capitalized cost reduction will be $32,000 ($35,000 − $3000). The dollar cost of leasing compared with the finance charges of borrowing will be $4,210 [($495 × 48) + $350 + $12,100 − $32,000]. Therefore, leasing would be more costly than purchasing for Amanda. 4.

Rebate Versus Low Interest Rate. Kyle Parker of Concord, New Hampshire, has been shopping for a new car for several weeks. He has negotiated a price of $34,000 on a model that carries a choice of a $2,500 rebate or dealer financing at 2 percent APR. The dealer loan would require a $1,000 down payment and a monthly payment of $578 for 60 months. Kyle has also arranged for a loan from his bank with a 5 percent APR. Use the Run the Numbers worksheet on page 236 to advise Kyle about whether he should use the dealer financing or take the rebate and get financing from the bank. Solution: This is a potential ―Class Activity‖ exercise related to page 252 in the text. Kyle should take the dealer financing. Using the n-ratio APR formula to calculate an adjusted APR for the dealer financing, it is only 4.79 percent, compared to the 5 percent loan through Kyle’s bank. Use formula 8.1 where Y = 12, F = $4180 {$2500 + [($578 × 60) − $33,000]}, D = $33,000, and P = 60. Calculating the values in the numerator and denominator will lead to 286,363,440/5,981,025,600 = 0.047878651 or 4.79 percent.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Decide to Buy a Car After several years of riding a bus to work, Belinda finds that she can no longer do so because her employer moved to a location that is not convenient for public transportation. Thus, the Johnsons are in the market for another car. Harry and Belinda estimate that they could afford to spend about $12,000 on a used car by making a down payment of $2,000 and financing the remainder over 36 months at a 6 percent interest rate for $304 per month. a. Make suggestions about how the $304 might be integrated into the Johnsons’ budget (Table 3-6 on page 97) by making reductions in certain expense categories. b. If they cannot make room in their budget for a $304 monthly car payment, should they finance a vehicle for 48 or 60 months? Why or why not? c. Assume that the Johnsons have narrowed their choices to two cars. The first car is a four-year-old Chevrolet with 64,000 miles; it is being sold for $12,500 by a private individual. The seller has kept records of all maintenance and repairs. The second car is a four-year-old Toyota with 81,000 miles, being sold by a used-car dealership. Harry contacted the previous owner and found that the car was given in trade on another car about three months ago. The previous owner cited no major mechanical problems but simply wanted a bigger car. The dealer is offering a written 30-day warranty on parts only. The asking price is $12,200. Which used car would you advise the Johnsons to buy? Why? d. Would you recommend that they purchase or lease a low-priced new vehicle instead of buying a used vehicle? Why or why not? Solution: a. It might appear that the Johnsons would save money by no longer using public transportation. However, there will be increased budget needs for gasoline, repairs, automobile insurance, and other car-related expenses. Thus, the $304 must come from non-transportation-related expenses. Four categories that are candidates for cutbacks are personal allowances, entertainment, clothing, and miscellaneous. They will also probably need to cut back on groceries and meals out. It will be difficult to make a $304 car payment fit into the Johnson’s budget without some serious sacrifices. Going through this process before buying the car is critical for the Johnsons. They need to try the

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

purchase within their budget and see if this is still a purchase, they want to make given the necessary sacrifices in other spending categories. Student answers will vary. Extending the payment period out for 48 or 60 months would lower their payment about $70 or $111, respectively. This savings would be offset by the additional interest that they will have to pay. Further, financing a used car for a longer time runs the risk of having the car no longer be useful before the loan is paid off. In this case, the Johnsons would still be making payments on a vehicle that is no longer in use. Nobody feels good about paying for items that are no longer of use. Student answers will vary. The Chevrolet is a better choice than the Toyota for several reasons. First, the mileage is lower, and it is lower over the same time of time, which indicates moderate usage. Second, even though the asking price is higher, the private seller may be less sophisticated than the used-car dealer in haggling over prices. Third, the seller’s records indicate a careful owner and regular maintenance, both of which are essential to getting the maximum life out of a car. Fourth, the Toyota is being sold by a used-car dealer even though it had been traded in to a new-car dealer on a new car. This means that the car was deemed unacceptable for resale by the new-car dealer and unloaded to the used-car wholesale system three months earlier. Nevertheless, before buying the Chevrolet, the Johnsons should have it inspected by a mechanic for any defects. Student answers will vary. It might be possible for the Johnson’s to lease a new vehicle for $304 per month for two years. Driving a new car would be attractive and would lower the costs for maintenance and gasoline as new cars tend to be more efficient. The significant downside to leasing would be that they would have nothing to show for their payments in two years and will again be faced with the decision of buying a vehicle.

CASE 2: Victor and Maria Hernandez Buy a Third Car The Hernandezes’ older son, Jacob, has reached the age at which it is time to consider purchasing a car for him. Victor and Maria have decided to give Maria’s old car to Jacob and buy a later-model used car for Maria. a. What sources can Victor and Maria use to access price and reliability information on various makes and models of used cars? b. How might Victor and Maria check out the cars in which they are most interested? c. What strategies might Victor and Maria employ when they negotiate the price for the car they select? Solution: a. There are several sources of information Victor should consult. For price information, Victor can look at Kelly Blue Book or Edmunds. He could also use the Consumer Reports Used Car Price Service. For reliability information, Victor should consult the April issue of Consumer Reports for its list of recommended used vehicles and frequency-of-repair histories. b. Victor should inspect the cars he is interested in inside and out. He should test-drive the vehicles, ask for maintenance, and repair records from the seller. If buying from a dealer, Victor should get the name and address of the previous owner and try to talk with them. Before buying a used vehicle, Victor should have it examined by a qualified mechanic. c. The first step for Victor and Maria is to obtain a price for the car before discussing any other details of the purchase (such as financing). They should not pay the asking price as this price is inflated since the seller is expecting negotiation. They should not answer any questions the seller might ask about how much they can afford to pay for a vehicle. They should get all verbal agreements in writing and then return home to decide. CASE 3: Julia Price Wants to Drive a BMW. It has been almost 15 years since Julia graduated with a major in aeronautical engineering, and now she makes ―buckets of money‖ working as a project manager for a large defense contracting company. While she is not very thrifty, she does like a good deal, especially on expensive purchases. Julia recently

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

compared new models of the BMW 330 i, Jaguar XF, and Lexus RX. She checked out reviews in Consumer Reports and other magazines and test drove each vehicle. After deciding on the BMW, Julia shopped online for dealers beyond her community. Julia thinks that she will save about $3,800 if she buys her car from a dealer located 40 miles from her home instead of her hometown seller. She is not sure whether she should take advantage of the dealer’s 3 percent financing versus a $4,000 rebate, is she takes the rebate she can get a 6 percent loan from a nearby credit union, or lease the vehicle. Offer your opinions about her thinking. Solution: Responses may or may not include student’s opinions about Julia’s choice of a BMW instead of the Jaguar, Lexus. Response should comment on Julia’s decision to spend money on a luxury vehicle instead of buying something less expensive, observations on buying from a dealer located so far from her hometown seller, a viewpoint on buying an extended warranty, and a suggestion for her to use the ―Run the Numbers Worksheet: Choosing Between Low-Interest-Rate Dealer Financing and a Rebate,‖ and whether or not she should consider leasing. CASE 4: Purchase of a New Refrigerator This is a potential ―Class Activity‖ exercise related to page 245 in the text. Steve Martin, a financial planner from Northridge, California, is remodeling his kitchen. Steve, who lives alone, has decided to replace his refrigerator with a new model that offers more conveniences. He has narrowed his choices to two models. The first is a basic 16-cubic-foot model with a bottom freezer for $1,699. The second is a 25.4-cubic-foot model with side freezer for $2,400. Additional features for this model include icemaker, textured enamel surface, and ice and water dispenser. Steve’s credit union will lend him the necessary funds for one year at a 12 percent APR on the installment plan. Following is his budget, which includes all of his $3,345 in monthly take-home pay. Food $400 Entertainment 300 Clothing 100 401(k) retirement plan 400 Gifts 70 Charities 75 Car payment 330 Personal care 120 Automobile expenses 120 Savings 130 Housing 1,200 Miscellaneous 100 Total $3,345 a. What preshopping research might Steve do to select the best brand of refrigerator? b. Using the information in Table 7-2 on page 210 or the Garman/Fox companion website, determine Steve’s monthly payment for the two models. c. Fit each of the two monthly payments into Steve’s budget. d. Advise Steve to help him make his decision. Solution: a. Steve’s best source of research before he buys the refrigerator would be product-testing magazines, such as Consumer Reports, which analyze products and report data related to the quality of each product. Consumer Reports is considered the best source of information as they accept no advertising and are funded only by member dues. Trusted friends and other people who have experience using similar products can also offer good consumer advice.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 8: Vehicles and Other Major Purchases

If Steve buys the basic model for $1699 at 12 percent over one year, his monthly payments will be about $151 calculated as (1.699 × 88.85). If Allen buys the higher-priced model, his monthly payment would be about $213 calculated as (2.4 × 88.85). Steve’s budget has some room for the lower payment without cutting back too much. To buy the lower-priced model for $150 monthly, he could cut $40 from his food category, $30 from his $130 for savings, $20 from his $70 gift category, $20 from personal care, and $40 from his entertainment category. To make room for the additional $60 monthly needed for the higher-priced model he could cut $20 more from entertainment and $10 more from each of the other four categories. Steve might want to consider making cuts in areas other than saving. As it is now, he is saving only 6 percent of his salary.

CASE 5: A Dispute over New-Car Repairs Christopher Hardison, a high school football coach from Buffalo, New York, purchased a new SUV for $48,000. He used the vehicle often. In less than nine months, he put 14,000 miles on it. A 24,000-mile, two-year warranty was still in effect for the power-train equipment, although Christopher had to pay the first $100 of each repair cost. After 16,500 miles and in month 11 of driving, the car experienced some severe problems with the transmission. Christopher took the vehicle to the dealer for repairs. A week later he picked the car up, but some transmission problems remained. When Christopher took the car back, the dealer said that no further problems could be identified. Christopher was sure that the problem was still there, and he was amazed that the dealer would not correct it. The dealer told him he would take no other action. a. Was Christopher within his rights to take the car back for repairs? Explain why or why not. b. What logical steps might Christopher follow if he continues to be dissatisfied with the dealer’s unwillingness or inability to repair the car? c. Should Christopher seek any outside help? If so, describe what he could do without spending money on attorney’s fees. Solution: This is a potential ―Class Activity‖ exercise related to page 263 in the text. a. Christopher was surely within his rights to take the car back to the dealer for repairs. The car was still under warranty, and warranties state that a product must perform as expected. The recurring problem meant that Christopher’s car was not performing to acceptable standards. With the car still under warranty, the repairs should be corrected by the dealer. b. Christopher should telephone the automobile’s manufacturer and state the problems he has encountered with the dealership. He should file a complaint with the manufacturer’s consumer affairs manager and, if necessary, with the company president or its chief executive office. If he cannot obtain satisfaction from the manufacturer, the Better Business Bureau may be helpful in resolving his problem. c. Christopher could take his complaint to court if all else fails. If the cost of Christopher’s repairs is under the state’s legal maximum, small claims court would be the place to go. No attorneys are needed, and only minimal fees are required. To file a small-claims action, Christopher would clearly describe in writing the details of his complaint with the dealership and submit the complaint to the court with full documentation. Christopher should also learn about mediation and arbitration opportunities available through his warranty as well as the new-car lemon laws in his state.

EXTENDED LEARNING 1.

Needs and Wants. Using Figure 8-2 on page 244 as a guide, make a list of the options in the first column that you would want if you could have any car you wanted. Realizing that getting all the options would be a dream (these are wants), go back to the list, move the priority level on certain items, and move the

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 09: Obtaining Affordable Housing

checkmarks to the second or third priorities. Your needs should now be in the column ―high‖ with wants in the other columns. Solution: Response should be a table like Table 8.2 that includes in the first column a list of vehicle options noted as ―needs‖ with one or two other columns noted as ―wants.‖ 2.

Price Available Vehicles. Shop the internet (using a site like TrueCar or Carvana) for a particular make and model of vehicle that is of interest to you, for example, a two-year-old Toyota Prius. Find out about number of vehicles available of the make and model of interest, colors, options of interest, and asking prices. Make a table of your findings. Solution: Response identifies one vehicle of interest to the student and a table showing names of online dealers. Plus, responses from each dealer to the following: number of vehicles available of the make and model of interest, colors, options of interest, and asking prices.

Compare Financing Terms. Visit Bankrate.com/loans/auto-loans/rates to determine some financing details on used vehicles. Assume your FICO credit score is above 750 and that you want to finance $28,000 after making a $4,000 down payment. Find out the interest rate, number of years one could finance, and the monthly payments. Make a table of your findings. (Hint: Also see Table 7-2.) Solution: Response is a table showing names of potential lenders with the following: interest rate, number of years one could finance, and the monthly payments.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 09: OBTAINING AFFORDABLE HOUSING

TABLE OF CONTENTS Answers to Chapter Concept Checks ...................................................................................................... 97 What Do You Recommend Now? .......................................................................................................... 100 Let’s Talk About It ................................................................................................................................. 101 Do the Math ............................................................................................................................................. 102 Financial Planning Cases ....................................................................................................................... 105 Extended Learning.................................................................................................................................. 108

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 09: Obtaining Affordable Housing

ANSWERS TO CHAPTER CONCEPT CHECKS LO9.1 Decide whether renting or owning a home is better. 1.

Explain the purpose and value of a written lease for both the renter and the property owner. Answer: The purpose of a written lease is to set out the legal responsibilities of both the tenant and the property owner. It specifies the amount of rent and security deposit, the length of the lease, who pays for utilities and repairs, penalties for late payment of rent, eviction procedures, and so on. Lease agreements also may contain legally binding restrictions regarding pets, number of people who can live on the property, and subleasing arrangements. The value of the lease is to protect both parties from misunderstandings and the potential whims or abuses of the other.

Distinguish between periodic tenancy and tenancy for a specific time when renting housing. Answer: Periodic tenancy is a rental arrangement that goes from month-to-month with either the renter or proprietor free to change the terms or even end the arrangement with as little as 30 days’ notice. With tenancy for a specific time, there is an agreement that the renter will stay in the dwelling for the time specified, typically one year. If the renter moves early, they may be liable for the expenses incurred by the property owner to find another tenant.

Identify three ways that home buyers can save on their income taxes. Answer: First and second, home buyers may be able to deduct their mortgage interest and property tax payments as itemized deductions on their tax returns. However, this is becoming less common as the amount of the standard deduction has risen leading to fewer taxpayers using itemized deductions as they are below the total standard deduction. Third, when they sell the home, they can exclude up to $250,000 in capital gains if single, or $500,000 if married, from taxes that year if they lived in the home two out of the previous five years.

Illustrate how housing buyers can pay less than renters when taxes and appreciation of housing values are considered. Answer: For a similar type of housing unit, homeowners usually spend more money out of pocket than renters. However, homeowners might receive tax breaks for mortgage interest and property taxes if their total itemized deductions exceed their standard deduction. For more expensive homes with larger mortgages, higher interest payments, and higher property taxes the homeowner/taxpayer is more likely to itemize. In addition, most forms of housing appreciate over time despite periodic downturns. When the tax breaks and appreciation are included in the buy-versus-rent analysis, homeownership tends to look more appealing than renting.

LO9.2 Explain the up-front and monthly costs of buying a home. 1.

What is the standard down payment amount on a mortgage loan? Answer: The standard down payment on a mortgage loan is at least 20 percent of the selling price. This would be an 80 percent loan-to-value ratio and under normal circumstances allow the homebuyer to avoid the cost of mortgage insurance.

If making a down payment that is lower than standard, identify the extra costs incurred in buying a home. Answer: Making a down payment of less than 20 percent generally results in the lender requiring mortgage insurance either from a private mortgage insurer or a government insurer such as the Federal Housing Administration or the Department of Veterans Affairs. The cost of such insurance can range from 0.25 to 2

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 09: Obtaining Affordable Housing

percent of the loan amount annually and/or 1 to 2 percent up-front, depending on the amount below 80 percent loan to value and they type of insurance used. 3.

Why do lenders use points in home loans, and who is responsible for paying points? Answer: Points are a way of requiring the borrower to prepay additional interest on the loan. One point equals 1 percent of the amount borrowed. Points are usually paid by the buyer of the home but occasionally the seller will pay points when and if negotiated as part of the deal. Points are paid by consumer to get loans with lower interest rates. If planning to stay for a long time in a home, paying several points might be advantageous over the long term.

Explain why the down payment and mortgage principal and interest understate the actual up-front and monthly costs of home ownership. Answer: There are many additional costs, both up-front and monthly, that go beyond the interest, principal, down payment, and purchase price. Additional monthly costs include property taxes, homeowner’s insurance, private mortgage insurance, upkeep, and maintenance. These can add 10 to 30 percent or more to the monthly outlay of homeownership. Additional up-front costs include points, attorney fees, inspection fees, initial funds placed in an escrow account for the payment of taxes and homeowner’s insurance, and title fees and insurance. These can add as much as an additional 10 to 20 percent to the amount needed initially.

When should we request that private mortgage insurance be canceled if such insurance was required at the time of purchase of a home? Answer: One can ask about dropping the private mortgage insurance when the unpaid balance of the mortgage falls below the required loan-to-value ratio (LTV). Many people continue making the same monthly payment even after the PMI has been dropped to pay down the principal more quickly. When the LTV goes below 78 percent the insurance must be removed.

Identify the components of PITI. Answer: PITI is acronym that stands for principal (P), interest (I), taxes (T), and homeowner’s insurance (I), all included in the typical monthly payment made by a homeowner.

LO9.3 Describe the steps in the home-buying process. 1.

What is involved in cleaning up a credit record when planning to buy a home? Answer: Cleaning up credit simply means that we would make sure that the information in our credit bureau files is up-to-date and accurate. We should also take any steps to maximize the credit score. One of the easiest ways to do that is to make sure that the credit utilization ratio is as low as possible on all credit card accounts.

Distinguish between the two rules of thumb that lenders use to assess housing affordability. Answer: The two rules of thumb that lenders use are the front-end ratio and the back-end ratio. The frontend ratio assesses the ability of the borrower to afford the costs of the new housing including principal, interest, taxes, and insurance relative to gross income. The back-end ratio looks at the impact of current debt and the future housing costs on the ability of the borrower to afford the mortgage loan, again, relative to gross income. Lenders set requirements for both as part of the loan application process. Values too high in either measure will lead to rejection of the application.

When using a Realtor® why should you be cautious when working with a seller’s agent?

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 09: Obtaining Affordable Housing

Answer: Buyers must understand that unless they pay the agent for their services (a buyer’s agent), the agent legally represents the seller as a seller’s agent. This is because the seller pays the commission from which the agent is compensated. 4.

What steps are involved with agreeing to terms with a seller? Answer: Coming to an agreement over the sale of a property involves: making an offer to buy, providing earnest money to show good faith, accounting for all contingencies, responding to a counteroffer, and signing the purchase contract.

Distinguish among loan estimate, closing disclosure, and uniform settlement statement. Answer: A loan estimate is a document that provides the key features, cost, and risk of the mortgage loan for which someone is applying. A loan disclosure must be provided three business days before the closing date of the loan. It is designed to provide the borrower an understanding of costs of the transaction, including the payment schedule, fees to be charged, terms of the transaction, and state law provisions. The uniform settlement statement is provided at the closing to outline all the costs and fees to be paid at the closing. Borrowers have the right to see the uniform settlement statement one day before the closing.

LO9.4 Understand how to finance a mortgage loan and distinguish among ways to purchase a home. 1.

Explain why the portions of a monthly mortgage payment that are allocated toward interest and toward principal will vary as the loan is repaid. Answer: Mortgage loans are declining balance loans. This means that the interest to be paid each month is based on the amount of principal still owed, which continues to decline. As the principal owed declines, so does the interest for each month. In return, the amount of the payment applied to the principal goes up.

Distinguish between a conventional mortgage loan and an adjustable-rate loan. Answer: The conventional mortgage is a fixed-interest rate, fixed-term, and fixed-payment loan. It requires a large down payment (20 percent) and is amortized over a 15- to 30-year period. Adjustable-rate loans have similar time frames and down-payment requirements. However, the interest rate will fluctuate with prevailing interest rates in the economy. As a result, the monthly payment will also fluctuate over the term of the loan. In adjustable-rate loans, the borrowers assume the interest rate risk. In fixed-rate loans, the lender assumes interest rate risk.

Identify the two ways that homebuyers build equity in their property. Answer: Homeowners build equity by paying down the mortgage principal each month and because of increases in the market value of the home. Over the course of a 30-year mortgage, it is likely that more equity is built up through appreciation when home values appreciate at historical rates.

LO9.5 Identify some key considerations when selling a home. 1.

List some disadvantages of trying to sell a home by ourselves, without the assistance of a real estate professional. Answer: Selling a home ourselves limits its exposure to prospective buyers. In addition, many people are not adept at setting an appropriate asking price for the home. Asking too little for the home might cost us more than the commission paid to a real estate agent. Some estimates are that homes sold by owners sell for as much as 25 percent less than homes sold through real estate brokers. Asking too much for a home can also keep prospective buyers from making offers on the home.

List one advantage and one disadvantage of using a real estate broker to sell a home.

Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 09: Obtaining Affordable Housing

Answer: The advantage of using a broker is that they should know the market value of the home and may be able to get more people who are serious buyers to look at the home than the owner can. The obvious disadvantage is that the seller will have to pay the 5 to 7 percent commission. 3.

Describe two costs associated with selling a home in addition to the real estate commission. Answer: Prepayment penalties and real estate transfer taxes are two costs associated with selling a home.

WHAT DO YOU RECOMMEND NOW? After reading the chapter on buying housing, what is recommend for Shelby Clark regarding: 1.

Buying or renting housing in the Denver area? Answer: Shelby should be cautious about buying due to the possibility of her being promoted or transferred out of the Denver area in the next two or three years. She should complete the ―Decision Making Worksheet: Buy or Rent?‖ provided in this chapter. It typically takes five to seven years to recover the costs of buying a home, thus she needs to be cautious when first moving to Denver.

Steps she should take prior to actively looking at homes. Answer: Shelby should make good use of the internet to gather information. She can shop for homes and mortgages completely online. She should make sure her credit history is accurate and up to date. She should also check her FICO credit score and prequalify for a mortgage.

Finding a home and negotiating the purchase? Answer: Shelby could use the services of a real estate agent in her search but should understand the roles of seller’s and buyer’s agents. She should be prepared to offer 5 to 15 percent less than the asking price (depending on market conditions) on any home and negotiate a price based on the seller’s counteroffer. Any purchase contract should contain a contingency clause allowing Shelby to back out at no cost should she not be able to obtain a mortgage loan for that particular property. An inspection clause will also be important for Shelby in any purchase agreement.

The closing process in home buying? Answer: Shelby should carefully review the loan disclosure document outlining the closing and other costs she will receive when she applies for her mortgage loan. She should negotiate lower charges for items she feels are not appropriate. When she receives the ―uniform property settlement‖ the day before the closing, she should confirm that it agrees with the loan disclosure and ask questions about any discrepancies that she does not understand.

Selecting the type of mortgage to fit her needs? Answer: There are many mortgage variations. The standard conventional mortgage is sometimes difficult for first-time buyers because of the 20 percent down payment required and the high monthly payment required to amortize the debt. It is often tempting instead to opt for an adjustable-rate, graduated-payment, or rollover mortgage, or even an interest-only loan. Shelby should be careful to ensure that the low payment initially available through such a mortgage doesn’t tempt her into taking on payments she might not be able to afford when and if the payments go up.

Things to consider regarding the sale of her home should she be promoted to a position in another of the four regions?

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Answer: Shelby will have to consider the pros and cons of listing her home with a real estate broker versus selling the home herself. Time will be a large factor since being promoted to another region may present additional problems of relocating and depending on the real estate market in the Denver area, how quickly the home will sell.

LET’S TALK ABOUT IT 1.

Renting Versus Buying. What do you see as the advantages and the disadvantages for you of renting or buying housing at the current time? How might your feelings change in the future, such as within five years? Answer: Traditional college students will state that they must rent a home until after they graduate because they may move on graduation and because from a credit score standpoint, they could not qualify to buy a home. Students may also realize that in the future, they may want to buy a home when they start a family and for the potential tax and wealth building advantages. Although many might feel that the risk associated with housing market fluctuations and the time and dollar costs of maintenance might outweigh the advantages. Recent conditions, like a hot or cooling market, are likely to enter the discussion.

Feelings About Long-Term Debt. In the early years of the standard 30-year mortgage loan, little of the monthly payment goes toward repaying the debt. As a result, it takes years for the loan balance to come down to any significant extent. Explain how that affects your feelings about taking on such a long-term obligation. Answer: Students will realize that buying a home in the future may very well be the biggest expenditure they ever make. When a traditional student graduates from college and goes on to a career, 30 years may seem like a very long time to be in debt especially when it can take at least 20 years for that debt to be cut in half. The plus side is that the value of the home should appreciate over that time, and there are alternate financing tools, like the growing-equity mortgage (GEM) that can be used to build equity more quickly.

Alternative Mortgages. Would you prefer a conventional mortgage, an adjustable-rate mortgage, or one of the other financing mechanisms described in this chapter to finance a home purchase? Why? Answer: Many students will realize the value of the fixed-rate mortgage about the interest rate and the predictability of monthly payments. Some students, however, will suggest that they may start off with a variable-rate mortgage if the interest rate on the variable-rate mortgage is significantly lower than that on the fixed-rate mortgage, especially if only planning to stay in their first home for five to seven years where the rates may not adjust. Students will have to be aware of the level of interest rates in the economy at the time they discuss this issue. They can go to www.bankrate.com and find out interest rate levels for mortgages in their area of the country.

Negotiating the Purchase of a Home. All closing costs on a home purchase are negotiable. Would you feel comfortable entering a discussion of these items? Why or why not? Answer: Students may not feel comfortable negotiating closing costs when they apply and receive their first mortgage loan. The closing meeting can be intimidating, especially for first-time homebuyers. They should be encouraged to go ahead and negotiate closing costs anyway; it never hurts to ask for a reduction or transfer of the cost to the seller. Students should be advised that they should want to pay the lowest closing costs possible in every case, but especially if they do not plan to live in their home for a long period of time, as they won’t recover the up-front costs.

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DO THE MATH 1.

Deciding to Buy. Dave and Diane Starr of New Orleans, Louisiana, both of whom are in their late twenties, currently are renting an unfurnished two-bedroom apartment for $1,200 per month, plus $230 for utilities and $34 for insurance. They have found a condominium they can buy for $170,000 with a 20 percent down payment and a 30-year, 6.5 percent mortgage. Principal and interest payments are estimated at $860 per month, with property taxes amounting to $150 per month and a homeowner’s insurance premium of $900 per year. Closing costs are estimated at $4,200. The monthly homeowner’s association fee is $275, and utility costs are estimated at $240 per month. The Starr’s have a combined income of $90,000 per year, with take-home pay of $5,800 per month. They are in the 25 percent combined state and federal tax bracket, pay $225 per month on an installment loan (ten payments left), and have $39,000 in savings and investments outside of their retirement accounts (LO 9.2). a. Can the Starr’s afford to buy the condominium? Use the results from the the information on page 288 to support the answer. Also, consider the effect of the purchase on their savings and monthly budget. b. Dave and Diane think that their monthly housing costs would be lower the first year if they bought the condominium. Do you agree? Support your answer. Assume that they currently have $10,000 in tax deductible expenses. c. If they buy, how much will Dave and Diane have left in savings to pay for moving expenses? d. Available financial information suggests that mortgage rates might increase over the next several months. If the Starr’s wait until the rates increase 0.5 percent, how much more will they spend on their monthly mortgage payment? Use the information in Table 9-4 on page 299 to calculate the payment. Solution: a. Applying a 28 percent front-end ratio, the Starr’s qualify for a mortgage requiring total annual expenditures of less than $25,200 (0.28 × $90,000). Their yearly housing costs would be $13,020 [12($860) + 12($150) + $900]. For a 36 percent backend ratio, their monthly gross income of $7,500 ($90,000/12) would result in a maximum of $2,700 for monthly debt and housing payments. Their monthly debt and housing payments would be $1,585 [$225 + $860 + $275 + $150 + ($900/12)]. This is true assuming the lender would require the $275 per month homeowner’s fee also be included in the calculations as a housing cost. Including all housing-related costs, the purchase of the condominium would take $1,360 [$860 + $275 + $150 + ($900/12)] from their $5,800 monthly take-home income compared to their current monthly housing expenditures of $1,234 ($1,200 + $34). Dave and Diane do have enough savings and investments ($39,000) to make a $34,000 down payment and pay $4,200 closing costs. Based on the rules of thumb and their available savings, Dave and Diane can afford this house. However, their budget may seem tight, especially during the next 10 months until the $225 per month installment debt is paid off. Using only the information on page 272 as a guide, the Starr’s have enough income to afford the $180,000 home financed at 6.5 percent. b. Dave and Diane’s monthly housing costs are lower as renters than they would be if they purchased this condominium. As renters, they pay $1,464 a month for rent, utilities, and insurance. Their monthly costs as condominium owners would be $1,600 [$860 + $275 + $150 + ($900/12) + $240]. They would pay approximately $8,840 in deductible interest ($136,000 × 0.065) and $1,800 in deductible real estate taxes. Assuming they currently have $10,000 in itemized deductions and take the standard deduction of over $25,000, the condominium would not save the Starr’s in taxes. Thus, the total monthly cost of renting is $136 ($1,600 − $1,464) less than owning. c. They would have only $800 ($39,000 − $34,000 − $4,200) left in their savings and investments. d. Financing $136,000 for 30 years at 7 percent interest requires a monthly mortgage payment (principal and interest) of $905 ($136 × $6.6530). The Starr’s would pay an additional $45 per month ($905 − $860) on principal and interest if they wait and rates go up.

Mortgage Affordability. Seth and Alexandra Moore of Elk Grove Village, Illinois, have an annual income of $110,000 and want to buy a home. Currently, mortgage rates are 5 percent. The Moore’s want to take out

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a mortgage for 30 years. Real estate taxes are estimated to be $4,800 per year for homes like what they would like to buy, and homeowner’s insurance would be about $1,500 per year (LO 9-4). a. Using a 28 percent front-end ratio, what are the total annual and monthly expenditures for which they would qualify? b. Using a 36 percent back-end ratio, what monthly mortgage payment (including taxes and insurance) could they afford given that they have an automobile loan payment of $470, a student loan payment of $350, and credit card payments of $250? (Hint: Subtract these amounts from the total monthly affordable payments for their income to determine the amount left over to spend on a mortgage.) c. Using a 36 percent back-end ratio, if the Moore’s had zero debt, what monthly mortgage payment (including taxes and insurance) could they afford? Solution: This is a potential ―Class Activity‖ exercise related to page 288 in the text. a. Using the front-end ratio of 28 percent, 110,000 × 0.28 = $30,800 annually, or $2,567 monthly. b. Using the maximum 36 percent back-end ratio, they could afford monthly mortgage payments of $2,230 [($110,000 × 0.36/12) − $470 − $350 − $250]. c. Using the maximum 36 percent back-end ratio, they could afford monthly mortgage payments of $3,300 ($110,000 × 0.36/12). 3.

Rent Versus Buy. Alex Guadet of Nashville, Tennessee, has been renting a two-bedroom house for several years. He pays $900 per month in rent for the home and $300 per year in property and liability insurance. The owner of the house wants to sell it, and Alex is considering making an offer. The owner wants $160,000 for the property, but Alex thinks he could get the house for $150,000 and use his $25,000 in 3 percent certificates of deposit that are ready to mature for the down payment. Alex has talked to his banker and could get a 5 percent mortgage loan for 25 years to finance the remainder of the purchase price. The banker advised Alex that he would reduce his debt principal by $1,700 during the first year of the loan. Property taxes on the house are $1,400 per year. Alex estimates that he would need to upgrade his property and liability insurance to $1,200 per year and would incur about $3,000 in costs the first year for maintenance and improvements. Property values are increasing at about 3 percent per year in the neighborhood. Alex will have to pay $50 a month for private mortgage insurance. He is in the 25 percent marginal state and federal income tax bracket and has $5,000 in other potential itemized deductions (LO 91). a. Use Table 9-4 on page 299 to calculate the monthly mortgage payment for the mortgage loan that Alex would need. b. How much interest would Alex pay during the first year of the loan? c. Use the Run the Numbers worksheet, ―Buy or Rent?‖ on page 276 to determine whether Alex would be better off buying or renting. Solution: This is a potential ―Class Activity‖ exercise related to page 277 in the text. a. b. c.

The monthly payment for principal and interest would be $876.89 (150 × $5.8459 from Table 9.4). Alex would pay $8,822.68 interest the first year ($876.89 × 12 − $1,700). Your Figures Costs Annual Cash-flow Considerations Annual rent or mortgage payments Property and liability insurance Private mortgage insurance Real estate taxes Maintenance Other housing fees

Rent

Buy

$10,800.00 300.00 n/a 0.00 0.00 0.00

$10,523.00 1,200.00 600.00 1,400.00 3,000.00 0.00

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Your Figures Less interest earned on funds not used for down payment Cash-flow cost for the year Tax and appreciation considerations (using a 25 percent marginal tax rate) Less principal repaid on the mortgage loan Plus, tax on interest earned on funds not used for down payment Less tax savings due to deductibility of mortgage interest Less tax savings due to deductibility of real estate property taxes Less appreciation on the dwelling Net cost for the year

750.00 $10,350.00

n/a $16,723.00

n/a 187.50

1,700.00 n/a

n/a n/a

0.00 0.00

n/a $10,537.50

4,500.00 $10,523.00

Based on cash flow, Alex would be about even. The annual cost of owning would be $16,723.00 compared with first-year costs of $10,350.00 to rent. However, when tax savings and appreciation are considered, the estimated cost of renting is $10,537.50 while buying the housing would cost $10,523. Because of the high threshold set by the standard deduction, it is not likely that interest and real estate expenses will add to Alex’s total deduction used in taxes, thus there are now tax savings from owning. However, the reduction in principal and increase in value both add to the equity in the home and thus reduce the cost of home ownership. In this case the financials are about even, Alex may have to decide based on other factors like pride in ownership and the ability to make changes without consulting a property owner. 4.

Refinancing a Mortgage. Kevin Tutumbo of Terre Haute, Indiana, has owned his home for 15 years and expects to live in it for at least five more. He originally borrowed $135,000 at 6 percent interest for 30 years to buy the home. He still owes $96,000 on the loan. Available interest rates are now 4.5 percent, and Kevin is considering refinancing the loan for 15 years. He would have to pay two points on the new loan with no prepayment penalty on the current loan (LO 9-4). a. What is Kevin’s current monthly payment? b. Calculate the monthly payment on the new loan. c. Advise Kevin on whether he should refinance his mortgage using the Run the Numbers worksheet, ―When to Refinance a Mortgage‖ on page 303.

Solution: This is a potential ―Class Activity‖ exercise related to page 303 in the text. a. Kevin’s current monthly payment for principal and interest is $809.39 ($135 × 5.9955). b. The monthly principal and interest payment on the new loan would be $734.39 ($96 × 7.6499). c. Decision Factor Your Figures 1. Current monthly payment $809.39 2. New monthly payment 734.39 3. Annual saving [(line 1 − line 2) × 12] 900.00 4. Additional years expected to live in the house 5 5. Future value of an account balance after five years if the annual 4,778.19 savings were invested at 3 percent after taxes (using Appendix A.3) 5.3091 (FVA) 6. Prepayment penalty on current loan (if any) 0.00 7. Points and fees for new loan 1,920.00 8. Future value of an account balance after five years if the prepayment 2,225.86 penalty and closing costs had been invested instead at 3 percent after taxes (Using Appendix A.1) 1.1593 FVLS

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Net saving after 60 months (line 5 − line 8) $2,552.33 Under these conditions, Kevin should refinance his home since he would be ahead after five years. The 1.5 percentage point drop-in interest rate from 6 to 4.5 percent yields a considerable savings of $2,552.33.

Illustrating Amortization. Heather McIntosh of Watertown, South Dakota, recently purchased a home for $190,000. She put $25,000 down and took out a 25-year loan at 5.5 percent interest (LO 9-4). a. Use Table 9-4 on page 299 to determine her monthly payment. b. How much of her first payment will go toward interest and principal and how much will she owe after that first month? c. How much will she owe after three months. Hint: Use the logic of Table 9-2 on page 297. Solution: This is a potential ―Class Activity‖ exercise related to Tables 9-3 and 9-4 in the text. a. $1,013.25 = 6.1409 × ($190,000 − $25,000)/1,000. b. Interest will be $756.25 = $165,000 × 0.055/12 Principal will be $257.00 = $1,013.25 − $756.25 c. Heather will owe $164,225.46. Her principal went down $257.00 after month one, $258.18 after month two and $259.36 after month three.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Decide to Buy a Home Belinda Johnson’s parents and maternal grandmother have combined their finances and presented Harry and Belinda with $50,000 cash gift to use to purchase a home. The Johnsons have shopped and found a house in a new housing development that they like very much. They could either borrow from the developer or obtain a loan from one of three other mortgage lenders. The financial alternatives and data for the home are summarized in the table below. a. Which plan has the lowest total up-front costs? The highest? b. What would be the full monthly payment for PITI and PMI for each of the options? c. If the Johnsons had enough additional cash to make the 20 percent down payment, would you recommend lender one or lender two? Why? d. If the Johnsons will need about $3,000 for moving costs (in addition to closing costs), which financing option would you recommend? Why? Financing Details on a Home Available to the Johnsons Price: $290,000. Developer A will finance the purchase with a 10 percent down payment and a 30-year, 5 percent ARM loan with two interest points. The initial monthly payment for principal and interest is $1,401.10 ($261,000 loan after the down payment is made: 261 x $5.3682After one year, the rate rises to 5.5 percent, with a principal plus interest payment of $1,481.94. At that point, the rate can go up or down as much as 2 percent per year, depending on the cost of an index of mortgage funds. There is an interest-rate cap of 5 percent over the life of the loan. Taxes are estimated to be about $3,800, and the homeowner’s insurance premium should be about $1,800 annually. A mortgage insurance premium of $88 per month must be paid monthly on the two 10 percent down options. Home: Price, $290,000; Taxes, $3,800; Insurance, $1,800 Loan term and type Interest rate Down payment

Developer A 30-year ARM* 5.0% $29,000

Lender 1 30-year Con† 5.5% $58,000

Lender 2 15-year Con 6% $58,000

Lender 3 20-year Ren‡ 5.5% $29,000

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Loan amount Points Principal and interest payment PMI

261,000 2 1,401 88

232,000 1 1,317 0

232,000 0 1,957 0

261,000 2 1,795 88

Adjustable-rate mortgage. Conventional. ‡ Renegotiable every five years. †

Solution: a. Developer A and Lender 3 have the lowest total up-front costs ($34,220 for the home including down payment of $29,000 and two points on a $261,000 loan costing $5,220). Lender 1 has the highest total up-front costs ($60,320 for the home calculated as $58,000 down and one point on a $232,000 loan equaling $2,320). b. Developer A Lender 1 Lender 2 Lender 3 PITI payment $ 1,867 $1,784 $2,424 $ 2,262 PMI $88.00 $ 0.00 $ 0.00 $88.00

The PITI payments are calculated as the principal and interest payments given in the problem plus monthly taxes and insurance [($3,800 + $2,800)/12] Lender 1 is a better choice because of its lower APR. Although both lenders 1 and 2 offer conventional, fixed-rate mortgages, the terms of the mortgages vary. The lower monthly payment will of course result in a higher finance charge due to the 30-year term. But the Johnson’s could pay additional amount on their principal if they wanted to pay the loan off faster. The Johnsons will have $50,000 from relatives and will need to use $3,000 of that for moving-in costs, leaving only $47,000 available for total closing costs. Therefore, lenders 1 and 2 may not be affordable alternatives. If the Johnsons want to buy the condominium, the developer offers the lowest interest rate, although they must pay two points. Lender 3 might also be better if interest rates are expected to drop over the next five years.

CASE 2: Victor and Maria Hernandez Learn About Real Estate Agents Victor and Maria have been thinking about selling their home and buying a house with more yard space so that they can indulge their passion for gardening. Before they make such a decision, they want to explore the market to see what might be available and in what price ranges. They will then list their house with a real estate agent and begin searching in earnest for a new home. a. What services could a real estate agent provide for the couple, and what types of agents could represent them as they sell their current home? b. A friend has advised them that they really need a buyer’s agent for the purchase of the new home. Explain to the Hernandez’s the difference between buyer’s and seller’s agents. Solution: a. Two of the most important functions a real estate agent can provide in the sale of a home are determining the appropriate price to ask for a home and qualifying prospective buyers. In addition, an agent will advertise the home and advise Victor and Maria on what to do to the home to make it attractive to buyers. Victor and Maria could be represented by a listing agent with whom they sign the listing agreement and by a selling agent who is working to find buyers for homes. b. The buyer’s agent is paid by the home buyer, and therefore, the agent has a fiduciary obligation to the buyer. The seller’s agent is paid by the seller. Even though a seller’s agent may be helping Victor and Maria find a new home, they would be working for and be paid by the home seller so the seller’s interests are financially tied to the seller, not the buyer.

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CASE 3: Julia Price Contemplates Buying a Home Julia has been thinking about buying a home. For several months, she has been watching real estate shows on television and visiting open houses in her community. She thinks it is time to take the plunge and buy a much larger home since she can genuinely afford it. She also thinks that housing prices will rise in the next five years. She has explored the interest rates currently being charged for mortgages and has calculated the amount of money she can afford to pay given her income. She is thinking that her next step would be to call a real estate agent and begin looking in earnest. Offer your opinions about her thinking. Solution: Julia has done a fairly good job of getting ready to buy a larger home. But before she talks to a real estate agent, she should do a few specific tasks. First, she should order her credit report and ensure that the information is accurate and, if not, request that the information be brought up to date. She should then prequalify for a mortgage in the price range she envisions. Prequalifying will tell her specifically what monthly amount she will need to pay for a mortgage, and she should then get her finances in order by adjusting her budget accordingly. Then, she can start doing some searching on her own using the internet and websites like www.realtor.com and www.zillow.com. Only then, when ready to look at some specific homes, should she consult a real estate agent.

CASE 4: Michael and Maggi Weigh the Benefits and Costs of Buying Versus Renting Michael Joseph and Maggi Lewis of Saluda, Virginia, are trying to decide whether to rent or purchase housing. Michael favors buying and Maggi leans toward renting, and both seem able to justify their choice. Michael thinks that the tax advantages are an incredibly good reason for buying. Maggi, however, believes that cash flow is so much better when renting. See whether you can help them make their decision. a. Does the home buyer enjoy tax advantages? Explain. b. Discuss Maggi’s belief that cash flow is better with renting. c. Suggest some reasons why Michael might consider renting rather than purchasing housing. d. Suggest some reasons why Maggi might consider buying rather than renting housing. e. Is there a clear-cut basis for deciding whether to rent or buy housing? Explain why or why not. Solution: This is a potential ―Class Activity‖ exercise related to page 278 in the text. a. The main tax advantage for a home buyer is the income tax deductibility of mortgage interest and real estate property taxes. Such costs reduce can one’s income tax liability. However, recent tax reform has significantly increased the size of the standard deduction thus reducing the number of households, including homeowners, who itemize their deductions. Depending on how much Michael and Maggi have in other itemized deductions, the interest and real estate may be of tax benefit. However, the fact that gains on real estate used as a personal residence are not taxable up to $250,000 per individual and $500,000 for a couple might be beneficial when it comes time to sell the home. b. Renters pay out less on an annual cash flow basis. Renters have a fixed rent amount due every month, but homeowners have mortgage payments (often higher than rent), property taxes, and maintenance expenses. Maintenance expenses for homes are highly unpredictable. Renters do not have to make a down payment, only a security deposit, and can invest and earn interest on the cash an owner would need for a down payment. c. Michael should consider renting over buying if he may need to move quickly because of his job. Renting offers easy mobility. Renters also have few responsibilities for maintenance or repairs. Some apartments offer amenities, such as pools, tennis courts, and party rooms, which usually do not come with houses. Also, the fixed expenditure of a rented home is easier to budget compared to the multiple expenditures of an owned home. d. Maggi might consider buying over renting because of the tax benefits and because of the potential for price appreciation that can result in a significant capital gain—that would not be taxable if under

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$500,000 for the couple. Homeowners also have more freedom to make changes or improvements and often have more living space than renters. There is no clear-cut basis for deciding whether to rent or to buy housing. The decision lies solely with an individual’s values and personal goals. Renters often have a better cash flow, but owners may see an increase in their property values and might be able to take advantage of tax breaks. Performing the calculation in the rent versus buy worksheet can help one make a more informed decision.

CASE 5: Jeremy Decides to Sell His Home Himself Jeremy Jorgensen of Lawton, Oklahoma, is concerned about the costs involved in selling his home, so he has decided to sell his home himself rather than pay a broker to do it. a. Should Jeremy sell the house himself or list with a broker? Explain. b. Would Jeremy really save money by selling his home himself if he considers his time as part of his costs? Why or why not? c. Can you suggest any ways that Jeremy might reduce his selling costs without doing the selling himself? Explain. Solution: a. A major problem Jeremy could face trying to sell his home is knowing how to set the right asking price. Asking too little could generate a significant loss. Homes marketed by owners can sell for as much as 25 percent less than those marketed by real estate professionals. Advertising his home effectively may also cost a good deal. A lot of browsers will come by and waste Jeremy’s time. If Jeremy does not know what price to ask for his house, he should use the services of a professional. A real estate agent can appraise the property and give Jeremy a good first asking price. Agents often can quickly supply customers in need of a house. b. If Jeremy’s house sells quickly, he might save money by not having to pay the fee a real estate agent charges for listing and commissions. If Jeremy has a great deal of free time available to show the property, he can save money by doing it himself. But if he must take time off from work to show the property, Jeremy could lose money, depending on how much he earns. c. The primary way Jeremy might reduce selling costs is to negotiate the realtor’s fees, which realtors are willing to do.

EXTENDED LEARNING 1.

Do Some Home Shopping. Sellers often open homes for sale to the public, typically on weekends. on Sunday afternoons. Spend an afternoon looking at housing that is for sale in a neighborhood near you. You can find out which houses are having an open house using the www.realtor.com website. Gather the information sheets that are provided at the homes and take notes during your visits. Prepare a brief report that summarizes what you have learned about housing costs, features, and locations in the community. Solution: Students will be surprised by the information they gather. Many will feel that they are not financially ready to buy a home and the complexity of the information obtained.

Comparing Leases. Survey three of friends who live in rental housing about their feelings about written leases. For those who have written leases, compare some of them for the rights and responsibilities of tenants outlined in the leases. Write a summary of your findings. Solution:

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Students often have varied opinions about written leases. Many like the flexibility of an oral lease but other prefer to have the contract in writing. After reading the chapter the importance of a written agreement should impact their thinking. 3.

Assess the Real Estate Market. Make an appointment to talk with a real estate agent in your community. Ask whether home sales are slow or brisk, how long it typically takes for sellers to sell a home, buyers to find a desirable home, whether home values are rising or declining, and tips the agent would give to people in your situation who hope to own their own homes. Write a summary of your findings. Solution: Students should prepare a summary of their findings especially concerning tips for preparing to purchase a home. It will be interesting to explore the willingness of local real estate professional in terms of engaging with students.

See How Others Go About Buying a Home. Ask friends and relatives for the names of one or two people who have bought a home in recent years. Contact the homebuyers and ask them for an interview to discuss how they went about buying a home and their feelings about how the process turned out for them. Compare their procedures and experiences with what you have learned in this chapter. Solution: Students should prepare a summary of responses of their friends. They should also indicate the degree to which the friends followed recommended procedures outlined in the text in Figure 9.1.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 10: MANAGING PROPERTY AND LIABILITY RISK

TABLE OF CONTENTS Answers to Chapter Concept Checks .................................................................................................... 110 What Do You Recommend Now? .......................................................................................................... 113 Let’s Talk About It ................................................................................................................................. 114 Do the Math ............................................................................................................................................. 115 Financial Planning Cases ....................................................................................................................... 118 Extended Learning.................................................................................................................................. 122

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ANSWERS TO CHAPTER CONCEPT CHECKS LO10.1 Apply the risk-management process to address the risks to our property and income. 12. Distinguish between pure risk and speculative risk. 47. Answer: Pure risk involves a situation where the outcome is unknown, but the only possibility is a loss. Speculative risk involves both the possibility of loss and gain. Insurance can be purchased to address pure risk but not speculative risk such as what exists when investing. 13. Explain the distinctions between risk and odds. 48. Answer: Risk is defined as uncertainty; the not knowing what will happen in the future. Odds involve the likelihood of various outcomes. Risk is lowest when odds are high and when odds are extremely low. In the first instances, the outcome is likely to occur, and certainty is high. In the latter instance, the outcome is unlikely to occur and thus certainty is high. In the middle, when odds are neither high nor low, there is more uncertainty. 14. List, describe, and give an example of each of the five ways to handle risk of loss. 49. Answer: Risk can be managed five ways. First, risk can be avoided. This means we simply do not expose ourselves to risk. Many people in large cities do not own a vehicle and, thus, avoid risks associated with owning a vehicle. Second, risk can also be retained. This means that a person chooses to take the chance that a loss will occur and will pay the associated costs. Choosing not to buy renters insurance is an example of risk retention. Third, risk can be managed by loss control. This means that one takes steps to reduce the likelihood and severity of losses. Burglar alarms (to reduce likelihood) and smoke alarms (to reduce severity) are examples of loss control. Fourth, risk can be transferred. This means that one would arrange for another party, typically an insurance company, to pay for a loss. Fifth, risk can be reduced. Insurance reduces risk not only for the person buying the insurance but also for society. 15. When considering likelihood of loss and severity of loss, explain which one of these two concepts is more important when deciding whether to buy insurance and why. 50. Answer: Severity of loss is much more important than likelihood. Likelihood is known to the insurance company and is simply reflected in the rates charged. Rates for unlikely events are lower than for events given the same severity. But for the insured person, severity is the key. One must buy sufficient insurance to cover the highest possible severity. The large-loss principle states that we should buy insurance to cover the severe losses and not worry so much about small losses that we can cover out of our own pocket.

LO10.2 Explain how insurance works to reduce risk. 1.

Define insurance.

51. Answer: Insurance is a mechanism for transferring and reducing risk by having many individuals share in the financial losses suffered by members of the group. 52. 2.

Distinguish among the three types of hazards.

53. Answer: A physical hazard exists when the characteristics of the insured property or person increase the likelihood of a loss. A car with bad brakes has a physical hazard. A morale hazard exists when the insured person, knowing that they are covered, is careless or indifferent about the occurrence of a loss. Leaving our keys in the car is a morale hazard. A moral hazard exists when the insured person, knowing that they are covered, intentionally causes a loss. Many arson cases are the result of this moral hazard.

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Why is the principle of indemnity so important to insurance sellers?

54. Answer: The principle of indemnity protects insurers from paying an insured more than their actual financial loss. This keeps individuals from using insurance for making a financial gain. 4.

Summarize how to use deductibles, coinsurance, hazard reduction, and loss reduction to lower the cost of insurance.

55. Answer: Four ways to reduce insurance premiums are (1) to increase our deductible, (2) to use coinsurance, (3) to take action to reduce hazards, and (4) to take action to reduce losses. By increasing the deductible, we pay the first-dollar costs of a loss from our budget and can take advantage of lower insurance premiums. Coinsurance also lowers insurance premiums because we share the costs of a loss, above the deductible, with the insurance company. Taking steps to reduce the probability of loss, such as locking our car, and to reduce the severity of a loss should the peril occur, such as installing smoke detectors, will also reduce insurance premiums. 5.

Summarize how companies select among insurance applicants.

56. Answer: Insurance companies use various characteristics about the insurance applicant and property to be insured to classify the applicant for the setting of an insurance rate. The rate is the average loss for applicants in a class. Then the insurance company looks at other characteristics such as driving violation history to determine whether the applicant might qualify for the standard rate, receive a lower rate, receive a higher rate, or be rejected altogether. 6.

Differentiate between independent agents and exclusive agents.

57. Answer: Independent insurance agents represent several different companies and try to match the needs of their clients with the plans these companies offer. Exclusive agents represent just one company and try to match the needs of their clients with the plans the one company offers. Direct sellers are insurance companies that do not use agents to market their plans. They advertise directly to prospective insureds.

LO10.3 Design a homeowner’s or renter’s insurance program to meet our needs. 1.

List the four types of losses covered under the property insurance portion of a homeowner’s policy.

58. Answer: Four types of losses covered under the property insurance portion of a homeowner’s insurance policy are (1) damage to the dwelling, (2) damage to other structures on the property, (3) damage to personal property and dwelling contents, and (4) expenses arising out of a loss of use of the dwelling. 2.

Give three examples of liability protection under homeowner’s insurance policies.

59. Answer: The liability portion of a homeowners’ policy includes comprehensive personal liability protection. The standard limit is typically $100,000 to $300,000. Most policies also include no-fault bodily injury protection (up to $1,000) and no-fault property damage protection (up to $500). 3.

Name the three types of homeowner’s insurance policies for most residences: HO-3, HO-4, and HO6.

60. Answer: All the HO forms provide coverage for the three liability exposures, loss of use and additional living expenses, and personal property. However, differences exist in the perils covered and the type of dwellings for which the HO forms are appropriate. HO-3, a special-form policy, provides all-risk protection for four of the five property losses. Contents and personal property are covered on a named-perils basis for seventeen of the eighteen major perils. The exception is glass breakage. HO-4, the renter’s contents broad form, protects the contents of a dwelling but not the dwelling itself. HO-six, the condominium form, protects owners from losses to contents and personal property as well as losses to the alteration and additions that condominium owners might make to their units.

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Identify four types of personal property for which the covered loss is limited to a specific dollar amount under standard homeowner’s insurance policies (see Table 10-1).

61. Answer: The four most common types of personal property that have special limits of coverage are jewelry, furs, coins and stamps, and firearms. The dollar amounts are sufficient for most insureds. Persons who own higher amounts of these items can purchase higher limits for an additional premium. 5.

List the three questions we should ask ourselves when determining the policy limits for a homeowner’s insurance policy.

62. Answer: The three questions are: What is the value of my home? What is the value of my personal property? Do I own any items of personal property that are subject to specific limits, and should I purchase higher coverage?

LO10.4 Design an automobile insurance program to meet our needs. 1.

Identify the four types of automobile insurance coverage.

63. Answer: First, liability insurance covers the insured when he or she is held responsible for losses suffered by others. Second, medical payments insurance covers bodily injury losses suffered by the driver of the insured vehicle and any passengers, regardless of who is at fault. Third, uninsured and underinsured motorist insurance protects the insured and the insured’s passengers from bodily injury losses resulting from an automobile accident caused by an uninsured or underinsured motorist. Fourth, physical damage insurance provides protection from losses due to damage to the insured’s car from collision, theft, and other perils. 2.

Explain the meaning of the numbers 100/200/75.

64. Answer: The one hundred figure signifies that the policy will pay no more than $100,000 in bodily injury liability losses to any one person in an accident. The two hundred figure signifies that the policy will pay no more than $200,000 in total bodily injury liability losses in any one accident. The seventy-five figure signifies that the policy will pay no more than $75,000 in property-damage liability losses in an accident. 3.

Identify who is protected by medical payments coverage.

65. Answer: Medical payments coverage protects bodily injury-related losses for the driver and passengers in a vehicle involved in an accident regardless of who is at fault for the accident. 4.

Distinguish between collision and comprehensive insurance.

66. Answer: Collision insurance reimburses the vehicle owner for damages to the vehicle itself due to a collision or rollover regardless of who is at fault for the accident. Comprehensive insurance reimburses the vehicle owner for damages to the vehicle caused by other perils such as fire, theft, windstorm, vandalism, and hail. 5.

Explain why selecting a policy with a high deductible and high liability limits is better than one with a low deductible and low liability limits.

67. Answer: A policy with a high deductible and high liability limits fits the large-loss principle. In this way, we are protected from the very severe losses that can occur because of a vehicle accident. An accident with severe injuries and/or a death can easily result in a $1 million liability or more. High limits are essential to protect us from an accident ruining our financial life, not to speak of the obligation to be responsible for the injury we cause. Using a high deductible will help make the policy more affordable and help compensate for the premium required for the high liability limits.

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LO10.5 Describe other types of property and liability insurance. 1.

Explain how purchasing an umbrella liability insurance policy applies the large-loss principle.

68. Answer: An umbrella liability policy can be purchased to increase the dollar amount of liability coverage above what is continued auto, homeowners, or professional liability policies. Umbrella policies are low in cost when they supplement basic policies and cover virtually all major liability exposures one might face. They are often the best way to apply the large-loss principle as they provide extremely high limits at a nominal cost. 2.

Who should consider buying flood and earthquake insurance?

69. Answer: Certain areas of the country are prone to flooding and earthquakes. Persons living in those areas should consider purchasing flood and earthquake insurance because losses from these two types of events are not covered under standard homeowner’s insurance policies. 3.

If preparing for a professional career that might expose us to liability losses, how might we protect ourselves from such losses?

70. Answer: Many students are preparing for careers in medicine, engineering, the law, and other professions. All of these might expose them to liability for errors they might make. Professional liability insurance is the best way to protect against this risk. 71. 4.

Give two examples of someone who might want to purchase a floater insurance policy.

72. Answer: A professional photographer and a plumber are two good examples. Their tools are subject to loss, and as business items, they are not covered under the floater protection provided by a homeowner’s policy.

LO10.6 Summarize how to make an insurance claim. 1.

What is the best way to establish documentation for potential losses to our personal property?

73. Answer: Original purchase receipts are always the best way to provide documentation. Companies may also accept written inventories, photos, or videotapes of the property that include information such as approximate dates of purchase, cost, model, style, and other descriptive information. 2.

Describe what we should do to file a claim most effectively when involved in an automobile accident.

74. Answer: The first step is to always file a police report. Also, if possible, document how the accident occurred through photographs and diagrams. Then contact your agent to begin the claims process. 3.

Describe the term release and explain why signing a release too soon might work to our disadvantage.

75. Answer: A release is our affirmation that the payment(s) received from the company will provide us with full reimbursement and that there will be no further claims made. Signing a release too early before the full extent of the loss is known might result in inadequate repayment; lower than what might have been possible.

WHAT DO YOU RECOMMEND NOW? 76. Now that the chapter on risk management and property liability insurance has concluded, what would recommendations should we make to Nick and Amber in the case at the beginning of the chapter regarding:

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77. The risk-management steps they should take to update their insurance coverages? 78. Answer: Nick and Amber should first identify their risk exposures and then estimate the level of risk and magnitude of the possible (not probable) losses. They should consider each exposure considering the various mechanisms for addressing risk of which insurance is only one option. Then they should implement the mechanisms they have decided on. Finally, they should periodically evaluate their insurance coverages to ensure that it continues to meet their needs. 79. The relationship between severity and frequency of loss when deciding whether to buy insurance? 80. Answer: Frequency of loss is not the most important factor in deciding whether to insure a risk. In fact, small, frequent losses should be managed in the family’s budget. It is the large, severe, but infrequent losses that have the greatest risk of financial ruin for Nick and Amber. Fortunately, since such severe losses are infrequent, buying high policy limits to cover severe losses does not significantly increase policy premiums. 81. Adequately insuring their home? 82. Answer: Nick and Amber should make sure they carry a level of coverage on their dwelling to comply with their insurer’s replacement-cost requirement, be it 80 or 100 percent. They should also make sure that they have adequate coverage on their personal property, which usually is set at 50 percent of the insurance on the dwelling itself. If Nick and Amber own jewelry, furs, collectibles, and other property for which special limits of liability apply, they should talk to their agent about raising the policy limits for these items. 83. The use of deductibles and policy limits to keep their automobile insurance premiums at a manageable level while still maintaining vital coverage? 84. Answer: Automobile liability exposures are among the highest that the average family will ever face. Nick and Amber should consider purchasing liability limits approaching $1 million. Raising the deductibles on their vehicles will help them afford these higher limits that, in any event, are not as expensive as many people believe.

LET’S TALK ABOUT IT 85. Insurance Underwriting. How do you feel about being grouped into classes in the insurance underwriting process? Do you feel that insurance companies should treat all such groups of people alike? 86. Answer: Feelings will differ on this topic. Young men pay higher automobile insurance rates than young women. Some students will be married or older and pay even lower rates. Companies have data that back up the differential rates for these groups, but there are bad and good drivers within each class. 87. Actual Cash Value. Many people complain that property insurance policies should pay more than what the insurance companies say is the actual cash value of the property, such as for a used motor vehicle with low mileage that is in near-perfect condition. How do you feel about this issue, and what would happen if insurance companies were more generous in their reimbursements? 88. Answer: If insurance companies paid more than the actual cost of repairs or the car, everyone’s insurance policy costs would eventually rise. They must base their payments on some sort of standard, such as the book value of the car. Furthermore, there is a moral hazard should insurance companies pay more than the book value since there is the possibility of the insured being better off after the accident than before.

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89. Auto Liability Limits. Do you know the liability limits on the automobile insurance policy under which you are covered? Are the limits appropriate? 90. Answer: Students will have different answers on this question. Some students are still covered under their parents’ policy and may have no idea of the terms of the policy. Even if they are covered under their own policies, many will never have read them. Most students will not know if the limits are appropriate. This can make for good class discussion about always reading our policy and understanding the terms of the policy. 91. Personal Property Protection. Is your personal property, such as furniture and computer, covered under a homeowner’s or renter’s insurance policy? If so, what are the policy limits? If not, why not? 92. Answer: Renter’s insurance may be of particular interest to college students. They need to have renter’s insurance on their personal property if they are renting a space while in college. Students living in a dormitory are likely to have coverage under a parent’s homeowner’s policy. Talking to them about renter’s insurance and the policy limits should generate good class discussion. 93. Auto Insurance Claims. What experiences have you or a family member had with the automobile insurance claims process? What if anything might have been done differently or better? 94. Answer: By the time teenagers enter college, they may have already been involved in an auto accident. As a result, they may have had some experience in the insurance claims process. They may have made some mistakes, such as signing a release before they should do so. In the excitement after an accident, they may have forgotten to diagram the accident or get the name or address of the other driver. 95. Renter’s Insurance Claims. What experiences have you or a family member had with the claims process on a renter’s insurance policy? What if anything might have been done differently or better? 96. Answer: Many college students are renters. As a result, they or a family member may have had some experience in the renter’s insurance claims process. They may have made some mistakes, such as not purchasing high enough limits or being familiar with the types of property excluded from a renter’s policy.

DO THE MATH 1.

How Much of Fire Loss Will Be Covered? Toula and Ian Miller of Gainesville, Florida, recently suffered a fire at their home. The fire, which began in a crawl space at the back of the house, caused $50,000 of damage to the dwelling itself. Their detached garage, valued at $20,000, was totally destroyed but did not contain a car at the time of the fire. Replacement of the Millers’ personal property damaged in the home and garage amounted to $23,000. In addition, $350 in cash and a stamp collection valued at $3,215 were destroyed. While the damage was being repaired, the Millers stayed in a motel for one week and spent $1,350 on food and lodging. The house had a value of $195,000 and was insured for $150,000 under an HO-3 policy with a $250 deductible. Use Table 10-1 on pages 304 and 305 to answer the following questions (LO2 and LO3). (Hint: You must first determine whether the Millers have adequate dwelling replacement coverage and, if not, what percentage of the necessary 80 percent coverage they do have. The resulting answer will determine the percentage of the loss to the dwelling covered, and consequently the amount to be reimbursed by the insurance company.) a. Assuming that the deductible was applied to the damage to the dwelling, calculate the amount covered by insurance and the amount that the Millers must pay for each loss listed: the dwelling, the garage, the cash and stamp collection, and the extra living expenses. b. How much of the amount of the personal property loss would be covered by the insurance policy? Paid for by the Millers?

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Assuming that they have contents replacement-cost protection on the personal property, what amount and percentage of the total loss must be paid by the Millers?

97. Solution: This is a potential ―Class Activity‖ exercise related to pages 326 and 327 in the text. a. The amounts covered by the insurance and those paid by the Millers for each type of loss are as follows: 98. The dwelling—$47,836 {($50,000 − $250) × [$150,000 ÷ ($195,000 × 0.8)]} was paid by the insurance company, and the Millers were responsible for $2,164. 99. The garage—$15,000 was paid for by the insurance company (10 percent of the coverage on the value of the dwelling itself [$150,000]; the limit on detached structures), and the Millers paid the remaining $8,000. 100. The cash—$200 was paid by the insurance company, the limit for HO policies, and the Millers were responsible for the other $150. 101. The stamp collection—$1,000 was paid by the insurance company, the limit for HO policies, and the Millers were responsible for the remaining $2,215. 102. The extra living expenses—$1,350, the full amount, was paid by the insurance company. b. The cost to replace the damaged personal property for the Millers totaled $23,000, which does not exceed the limit of 50 percent of the coverage on the dwelling. So, the insurance company paid this entire amount. However, the actual amount of reimbursement depends on whether the policy paid based on actual cash value or contents replacement-cost protection. If the policy included the latter, the total $23,000 would be paid by the insurance company. On the other hand, the depreciated value of the property cannot be determined from the information given, although it would be less than $23,000. c. The total loss was $97,915 ($50,000 + $20,000 + $23,000 + $350 + $3,215 + $1,350). The Millers paid a total of $12,529 ($2,164 +$8,000 + $150 + $2,215). Therefore, the Millers paid 12.80 percent of the loss ($12,529/$97,915). 2.

Sufficient Dwelling Coverage? Colton Gentry of Lancaster, California, has owned his home for ten years. When he purchased it for $178,000, Colton bought a $160,000 homeowner’s insurance policy. He still owns that policy, even though the replacement cost of the home is now $300,000 (LO2 and LO3). a. If Colton suffered a $20,000 fire loss to the home, what percentage and dollar amount of the loss would be covered by his policy? b. How much insurance on the home should Colton carry now to be fully reimbursed for a fire loss? 103. Solution: This is a potential ―Class Activity‖ exercise related to page 327 in the text. a. Colton’s insurance would pay $13,333 {$20,000 × [$160,000 ÷ ($300,000 × 0.8)]}, assuming there is no deductible. This is 66.7 percent of the loss. b. Colton needs to carry at least $240,000 ($300,000 × 0.80) to be fully reimbursed for a fire loss.

Coverage on a One-Vehicle Accident. Bill Converse of Rexburg, Idaho, recently had his truck slide off a gravel road and strike a tree. Bill’s vehicle suffered $17,500 in damage. The truck has a book value of $40,000. Bill carried collision insurance with a $500 deductible. How much will Bill be reimbursed by his policy?

104. Solution: 105. Bill will be reimbursed $17,000; $17,500 minus the $500 deductible . 4.

How Much of a Major Auto Accident Loss Will Be Covered? Ashley Diamond of Estes Park, Colorado, drives an eight-year-old Toyota valued at $5,600. She has a $75,000 personal automobile policy with $10,000 per-person medical payments coverage and both collision ($200 deductible) and comprehensive coverage. David Smith of Loveland, Colorado, drives a four-year-old Chevrolet Malibu valued at $9,500. He has a 25/50/15 automobile policy with $20,000 in medical payments coverage and both collision ($100

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deductible) and comprehensive insurance. Late one evening, while he was driving back from Rocky Mountain National Park, David’s car crossed the centerline of the road, striking Ashley’s car and forcing it into a ditch. David’s car also left the road and did extensive damage to the front of a roadside store. The following table indicates the damages and their dollar amounts. 106. Item

Amount

107. Bodily injuries suffered by Ashley 108. Bodily injuries suffered by Fran, a 109. passenger in Ashley’s car 110. Ashley’s car 111. Bodily injuries suffered by David 112. Bodily injuries suffered by Cecilia, 113. a passenger in David’s car 114. David’s car 115. Damage to the roadside store

$6,800 28,634 5,600 2,700 12,845 9,500 14,123

116. Complete the following chart and use the information to answer these questions: a. b. c. d. e. f. g.

How much will Ashley’s policy pay Ashley and Fran? Will subrogation rights come into play? In what way? How much will David’s bodily injury liability protection pay? To whom and how much will David’s property damage liability protection pay? To whom and how much will David’s medical protection pay? How much reimbursement will David receive for his car? How much will David be required to pay out of his own pocket?

117. David Smith’s Accident: Who Pays What? 118. COVERAGE 119. 120. Liability (limits) 121. Bodily injury 122. Ashley 123. Fran 124. Cecilia 125. Medical payments (limits) 126. David 127. Ashley 128. Fran 129. Cecilia 130. Collision coverage (limits) 131. David’s car 132. Ashley’s car 133. David’s out-of-pocket expenses 134. Fran’s bodily injury 135. Excess property damage losses 136. Collision insurance deductible 137. TOTAL

David’s Policy

Ashley’s Policy

___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___

138. Solution: This is a potential ―Class Activity‖ exercise related to page 336 in the text. a. Under Ashley’s medical payments coverage, Ashley would receive $6,800 and Fran $10,000 (the policy’s per-person limit) from her insurance company.

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b. c.

e. f. g.

Subrogation rights would come into play. Ashley’s company would sue David and his insurer for the losses paid to Ashley and Fran. David’s bodily injury protection will pay the losses for which he is liable. This protection will pay $6,800 for Ashley’s injuries and $10,000 for Fran’s injuries to Ashley’s insurance company, when it exercises its subrogation rights. The protection will also pay $15,000 for Fran’s injuries above the payment she received from Ashley’s policy, but only up to the per-person limit of David’s policy which is $25,000. David’s property-damage liability will reimburse him for up to $15,000 in losses to others’ property for which he is liable. The two property-damage losses in this accident for which David will be liable are the damage to Ashley’s car ($5,600) and the damage to the roadside store ($14,123). Ashley and the owner of the roadside store will receive $15,000 from the insurance company and $4,723 from David. David’s medical payments coverage will pay $12,845 for Cecilia’s injuries and $2,700 for his own injuries. David will be reimbursed $9,400 for his car, which is the $9,500 in damages less the $100 deductible. David’s out-of-pocket expenses will be $8,457. This amount consists of $3,634 for Fran’s losses above the bodily injury liability per-person limit, plus $4,723 in losses exceeding the propertydamage liability limits, plus the $100 deductible on his car.

139. David Smith’s Accident: Who Pays What? 140. Coverage 141. Liability (limits) 142. Bodily injury 143. Ashley 144. Fran 145. Cecilia 146. Medical payments (limits) 147. David 148. Ashley 149. Fran 150. Cecilia 151. Collision coverage (limits) 152. David’s car 153. Ashley’s car 154. David’s out-of-pocket expenses 155. Fran’s bodily injury 156. Excess property-damage losses 157. Collision insurance deductible 158. Total 159. *Amounts that will be subrogated

David’s Policy

Ashley’s Policy

25/50/15

$75,000

$ 6,800 $25,000 $20,000 $ 2,700

$10,000 $ 6,800* $10,000*

$12,845 ACV $ 9,400

ACV $ 5,600*

$ 3,634 $ 4,723 $ 100 $8,457

FINANCIAL PLANNING CASES 160. CASE 1: The Johnsons Decide How to Manage Their Risks 161. Several years have passed since the Johnsons were married, and their financial affairs have become more complicated. They recently purchased a $200,000 condominium that has added only about $400 per month to their housing expenses. And they have purchased a second used car for $12,000. As a result of these changes, Harry and Belinda realize that they now face greater risks in their financial affairs. They have © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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decided to review their situation with an eye toward managing their risks more effectively. Use the steps in the risk-management process (pp. 300–302), their net worth and income and expense statements in Table 36 on page 97 and Table 3-7, and other information in this chapter to answer the following questions: a. What are Harry and Belinda’s major sources of risk from home and automobile ownership, and what is the potential magnitude of loss from each? b. Given the choices listed in Step 3 of the risk-management process, how should the Johnsons handle the sources of risk listed in part a? 162. Solution: a. The major sources of risk associated with the Johnsons’ condominium are the potential loss of their $200,000 dwelling and the loss of use of the condominium and contents because of fire or theft. If a fire damaged or destroyed the condominium, the Johnsons would move temporarily into a hotel, thus incurring the costs of a room and restaurant food. Such expenses could easily run $100 to $150 a day. In the event of theft, the Johnsons’ personal property and furniture are valued at $4,000. In addition, the Johnsons face a liability risk in association with their condominium. A person injured while on their property might claim the Johnsons’ negligence contributed to the injury. 163. The major source of risk associated with the ownership of automobiles is bodily injury and property damage to others. The Johnsons would be liable if they caused an accident, and the dollar amounts of bodily injury and property-damage liability could easily exceed $100,000. They would also face temporary or permanent loss of their vehicles. The couple’s two cars, valued at $17,000 and $12,000, are subject to collision, vandalism, theft, and other perils. b. The Johnsons will need to buy an HO-6 condominium homeowner’s insurance policy. They should choose contents replacement-cost protection because it provides protection from the effects of inflation and ensures available funds to replace household contents in the event of a disaster. The policy should be for at least $12,000 and more to cover the Johnsons’ future accumulation of new and more expensive items of personal property. The policy should cover personal property, additions, and alterations the couple might make to their condominium, and additional living expenses if they must seek outside shelter when a covered peril occurs. The policy should also provide comprehensive personal liability protection of at least $100,000 (and $300,000). They should retain a limited amount of risk through buying the highest deductible they can afford ($500 or $1,000). In addition, they should reduce losses by installing safety devices such as smoke detectors, sensors that detect a water or gas leak, and a security system. 164. Regarding auto insurance, Harry and Belinda should purchase a policy with limits of 250/500/100 or higher for liability and uninsured motorists’ coverage. Medical payments coverage should be at least $50,000. Again, they should save money on premiums by purchasing the largest deductible they can afford on both collision and comprehensive coverage ($250 to $500). Collision and comprehensive insurance may not be necessary on the Johnsons’ second car because of its low book value. The decision to buy collision and comprehensive coverage should be based on the value of an auto, the insured’s ability to pay for a total vehicle loss, and the premium cost of these coverages. 165. CASE 2: The Hernandezes Consider Additional Liability Insurance 166. Victor and Maria’s next-door neighbor, Ray Jackson, was recently sued over an automobile accident and eventually was held liable for $437,000 in damages. Ray’s automobile policy limits were 100/300/50. Because of the shortfall, he had to sell his house and move into an apartment. Victor and Maria are now concerned that a similar tragedy might potentially befall them. They have a homeowner’s policy with $100,000 in comprehensive personal liability coverage and an automobile policy with 50/100/25 limits, and Maria has a small ($100,000) professional liability policy for her work as a medical records assistant. a. How might Victor and Maria more fully protect themselves through their homeowner’s and automobile insurance policies?

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What additional benefits would they receive in buying an umbrella liability policy?

167. Solution: a. Victor and Maria could increase the liability limits on both their homeowner’s and auto policies. The comprehensive personal liability through the HO policy could be increased to $300,000 or $500,000. The auto insurance policy could be increased to 250/500/100 or even higher. Victor and Maria should contact their insurance agent to investigate the available limits and the cost of increasing coverage on the HO and auto policies. b. By purchasing an umbrella policy, Victor and Maria could buy additional liability coverage for $1 million or more. In addition to covering higher dollar amounts, the umbrella policy covers a broader variety of losses. Their umbrella policy would cover general liability, auto liability, and professional liability losses. 168. 169. 170. CASE 3: Julia Price Thinks About Managing Her Property and Liability Risk 171. Julia has always tried to keep her insurance spending under control by purchasing low limits on her policies. Now that her assets and income have grown, she is beginning to reconsider the wisdom of this approach when buying insurance. Julia knows she has a lot more to lose in terms both of property and liability exposures. Last week, she called her insurance agent to discuss raising her policy limits on her homeowner’s and automobile insurance policies. The agent suggested she consider an umbrella liability policy. Julia still wants to be frugal and is considering simply raising the limits on the policies she already has rather than obtaining another policy. Offer your opinions about her thinking. 172. Solution: 173. Julia is correct in her thinking about the need to raise her liability limits. She could do so by raising the limits on all her policies. However, she will be better served by purchasing an umbrella liability policy to raise her overall limits. This is because the umbrella policy will not only raise her limits, but it may cover gaps in coverage in her basic policies. 174. CASE 4: The Princes’ Auto Insurance Is Not Renewed 175. Mark and Kelly Prince of Emmetsburg, Iowa, face a crisis. Their automobile insurance company has notified them that their current coverage expires in 30 days and will not be renewed. Mark and the Prince’s younger son each had a minor, at-fault accident during the past year. Their children are otherwise good drivers, as are both parents. The Princes are confused because they know families whose members have much worse driving records but still have insurance. a. Explain to Mark and Kelly why their policy might have been canceled. b. Use the box on page 336 to give Mark and Kelly some pointers on how to save money when shopping for a new auto insurance policy. 176. Solution: a. Mark and Kelly’s policy may have been canceled because the insurance company is concerned about the two recent accidents. Those accidents may have triggered a search of the family members’ motor vehicle reports, which could have revealed speeding tickets, and so on. It may also be that the Princes’ insurance company is just wanting to write fewer auto policies and have decided to drop a certain number of insureds, including them. Nonrenewal is not the same as a cancellation and automobile insurance companies generally are free to not renew policies at their discretion. b. There are numerous ways to save money on an auto insurance policy. The most important is to shop around for the lowest-cost coverage. Mark and Kelly should get on the telephone and call three to five companies that have been recommended by friends or have received favorable

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reviews in Consumer Reports or from their state insurance regulatory agency. They should also check the companies’ ratings with Standard & Poor’s and make sure the agents have a CPCU designation. They should purchase only the needed coverages and should purchase the largest deductibles they can afford. Mark and Kelly should inquire about all discounts available and take advantage of any that they qualify for. They should also take steps to reduce loss and make sure that they have been placed in the proper class for premium-determination purposes. 177. 178. CASE 5: A Student Buys Insurance for a Used Car 179. Makiko Iwanami, a student from Osaka, Japan, is in one of your classes. She is considering the purchase of a used car and has been told that she must buy automobile insurance to register the car and obtain license plates. Makiko has come to you for advice, and you have decided to focus on three aspects of automobile insurance. a. Explain how liability insurance works in the United States. Advise Makiko about which liability insurance limits she should select. b. Makiko is especially impressed that automobile insurance includes medical payments coverage because she has no health insurance. Explain why the medical payments coverage does not actually solve her health insurance problem and describe the type of coverage it provides. c. Makiko plans to pay cash for the car and doesn’t want to spend more than $5,000. Outline the coverage provided by collision insurance and factors that might make such coverage optional for Makiko. 180. Solution: a. Liability insurance pays the losses of others when the insured is responsible for those losses. Auto liability insurance is stated with split limits such as 50/100/30. This coverage would pay up to $50,000 per person and $100,000 for all persons for bodily injury losses from an accident. The policy would also pay up to $30,000 for property losses in an accident. At the very least, Makiko must purchase the minimum liability coverage required by the state in which she lives. However, 100/300/50 or higher would-be preferable coverage limits. b. Medical payments coverage is only for injuries suffered in auto accidents, and it is written for exceptionally low limits ($5,000 to $10,000). For both reasons, it is not a good substitute for health insurance. c. Collision coverage reimburses the insured for losses to one’s automobile resulting from a collision or rollover. The insurance company will limit the coverage to the book value of the car. Because Makiko is purchasing an older car worth only $5,000, the premium for the collision coverage will be high in comparison to the potential loss. Makiko might be better off not buying collision insurance and putting the money saved aside should an accident occur or for a down payment on her next car. 181. CASE 6: An Argument About the Value of Insurance 182. You have been talking at a party to some friends about insurance. One young married couple in the group believes that insurance is almost always a real waste of money. They argue, ―The odds of most bad events occurring are so low that you don’t need to worry.‖ Furthermore, they say, ―Buying insurance is like pouring money down a hole; you rarely have anything to show for it in the end.‖ Based on what you have learned from this chapter, how might you argue against this couple’s point of view? 183. Solution: 184. It is true that the odds of many loss-causing perils occurring are exceptionally low. But the low odds factor into a lower price for the coverage. Even so, there is considerable uncertainty as to whether the peril will happen to a particular individual. When the peril occurs, there is also uncertainty regarding the magnitude of the financial loss. Purchasing insurance reduces this uncertainty. Freedom from

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worry that an unforeseen event could destroy a person’s financial security is a benefit that insurance provides, even if no financial loss is ever incurred. 185. CASE 7: Enlai Contemplates a New Homeowner’s Insurance Policy 186. Enlai Li Zhang of Los Angeles, California recently bought a home for $700,000. The previous owner had a $600,000 HO-1 policy on the property, and Enlai can simply pay the premiums to keep the same coverage in effect. Her insurance agent called her and cautioned that she would be better off to upgrade the policy to an HO-2 or HO-3 policy. Enlai has turned to you for advice. Use the information in Table 10-1 on pages 304 and 305 to advise her. a. What additional property protection would Enlai have if she purchased an HO-2 policy? b. What additional property protection would Enlai have if she purchased an HO-3 policy? c. What property protection would remain largely the same whether Enlai had an HO-1, HO-2, or HO-3 policy? d. Advise Enlai on what differences in liability protection, if any, exist among the three policies. 187. Solution: This is a potential ―Class Activity‖ exercise related to page 326 in the text. a. Enlai’s property would be covered for seven additional perils if she purchases the HO-2 policy rather than the HO-1 policy. The additional perils are (1) falling objects; (2) weight of ice, snow, and sleet; (3) collapse of building; (4) leakage or overflow of water from plumbing, heating, or airconditioning systems; (5) bursting, cracking, burning, or bulging of hot-water heating systems; (6) freezing of plumbing, heating, and air-conditioning systems; and (7) injury to electrical appliances from short circuits. b. If Enlai purchases the HO-3 policy, she would have all-peril coverage (except for stated exclusions) on her home and coverage for seventeen of the eighteen major perils (except glass breakage) on her personal property. c. Enlai would have replacement-cost coverage on her home and the same amount of coverage for detached buildings, landscaping, personal property, and loss of use on all three of the HO forms she is considering. d. The liability coverage limits are the same for the HO-1, HO-2, and HO-3 forms. 188. www.insure.com, netquote.com, or selectquote.com.

EXTENDED LEARNING 1.

The Benefits of Renter’s Insurance. Identify three of your friends who currently live in rental housing. Ask them if they are covered by a renter’s insurance policy. If they are covered, ask them to give their assessment of the costs and benefits of having a policy. If not, ask them why they have not decided to buy such coverage.

189. Solution: 190. Students should prepare a summary of their findings. They may find that none of their friends have renter’s insurance. The reasons given will be related to the low level of property assets that the typical college student owns. Most students underestimate the liability risk associated with renting housing. 2.

Independent Versus Exclusive Insurance Agents. Interview two insurance agents, one who is an independent agent and one who is an exclusive agent. Ask each to describe the benefits to a customer who buys insurance from that type of agent.

191. 192. Solution: 193. Benefits associated with an exclusive agent are likely to focus on cost and the discounts associated with having all one’s coverage with the same company. Independent agents are likely to focus on being able to match the needs of the customer with a range of companies.

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Automobile Insurance Claims. Interview two or three people who have been involved as an insured party in an automobile accident. Ask them to summarize the claims process as they experienced it and how they now view the process compared to what they expected.

194. Solution: 195. Students should prepare a summary of their findings and compare the friends’ experiences with their own. They may find that people have negative feelings about the claims process and that many of the negatives are because the coverage desired was not part of the coverage purchased.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 11: PLANNING FOR HEALTH CARE EXPENSES

TABLE OF CONTENTS Answers to Chapter Concept Checks .................................................................................................... 124 What Do You Recommend Now? .......................................................................................................... 128 Let’s Talk About It ................................................................................................................................. 128 Do the Math ............................................................................................................................................. 130 Financial Planning Cases ....................................................................................................................... 130 Extended Learning…………..………………………………………………………………………………14

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ANSWERS TO CHAPTER CONCEPT CHECKS LO 11.1 Explain how the Affordable Care Act works and how consumers shop and pay for health insurance coverage. 16. What does the book say about why the United States has such an expensive health care system? Answer: Several reasons can be given for why the U.S. health care system is so expensive. First, the system for paying for health care in the United States is fragmented among the government, private insurance companies, employers, and consumers’ own out-of-pocket payments. Industrial countries with a single-payer system provide health care for a much lower overall cost and with equal or better results in terms of health outcomes such as longevity and morbidity. Second, the U.S. system is highly inefficient because no one entity monitors the delivery of care. 17. Summarize what the Affordable Care Act is supposed to accomplish. Answer: The Affordable Care Act (ACA) is seen primarily to make sure that everyone has access to and obtains a health care plan. To do so, the Act provides tax subsidies to make having a health care plan more affordable and sets up an on-line mechanism to shop for, compare, and obtain a health care plan. Even more important, the law requires that all health care plans provide ten essential health benefits. The result of this is that all plans will be ―quality‖ plans that indeed provide good coverage. Other important provisions of the ACA include: no cancellation of policies or denial of coverage for preexisting conditions, men and women must be charged the same rates, free preventative care, and annual checkups, no limits on maximum payouts, children can remain on a parent’s plan until age 26, prohibiting the overcharging of older consumers, and no need for a referral when choosing a provider within the plan’s network or outside the network for emergency care. 18. Who does the ACA impact and who does it not? Answer: The effect of the Act was directed at those persons who had no access to or chose not to obtain health insurance coverage. The ACA had no impact on approximately 85 percent of Americans who were insured through private or public plans before the Act took effect. 19. List three of the ten essential benefits of all new health care plans. Answer: The ACA established ten comprehensive essential health benefits for adequate coverage that all health care plans now must include:  Ambulatory patient services, such as doctor’s visits and outpatient services  Emergency services  Hospitalization  Pregnancy, maternity, and newborn care  Mental health and substance use disorder services, including behavioral health treatment  Prescription drugs  Rehabilitative services and devices  Laboratory services  Preventive and wellness services and chronic disease management  Pediatric services, including oral and vision care 20. Summarize how subsidies reduce the price of insurance premiums under the ACA. Answer: Premium subsidies in the form of federal tax credits are available for people buying their own insurance in the exchanges who have incomes from one hundred up to 400 percent of the federal poverty

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level. Annually, an individual who earns 400 percent of the federal poverty line makes about $51,520, and for a family of four, it is about $106,000 annually. 21. If we choose a ―silver‖ health insurance plan, how much of our out-of-pocket medical costs will be paid by the plan? Answer: Seventy percent.

LO 11.2 Distinguish among the types of health care plans. 1.

Explain how managed care has reduced the cost of health care in America. Answer: Managed care is a system designed to control the conditions under which health care can be obtained, thereby reducing the cost of health care overall. Examples include preapproval of hospital admissions and restrictions on which hospitals or doctors may be used, and the cost of treatment being monitored by a managing company.

Summarize how an employer’s group health care plan provides coverage to employees. Answer: Employer’s group health plans typically have lower premiums, and employers often pay all or a portion of the premiums. Employee applicants are less likely to be rejected because of their health condition.

Distinguish between a traditional health insurance plan and a health maintenance organization (HMO). Answer: A health maintenance organization (HMO) is an entity that provides a broad range of health care services to members for a set monthly fee on a prepaid basis. HMO coverage is limited to care from medical professionals within a network unless it is an emergency. Traditional health insurance provides protection against financial losses resulting from illness and injury. A person pays a monthly premium for traditional health insurance, which is often referred to as a ―fee-for-service‖ plan as it pays for services after they occur rather than on a pre-paid basis.

What is a high-deductible health insurance plan and how does it work with a health savings account (HSA). Answer: A high-deductible health insurance plan focuses on keeping the cost of insurance affordable while protecting the insured from the costs incurred from a catastrophic health care event. The high deductible keeps the policy affordable but, of course, can result in higher out-of-pocket payments for the deductible itself. To ease this burden, a Health Savings Account allows the insured to place pre-tax dollars into a special account through their employer that can be drawn upon when out-of-pocket expenses occur.

Distinguish between the government health programs called Medicare and Medicaid. Answer: Medicare is a Federal government health care program for persons aged sixty-five and older. It is administered by the Social Security Administration and is paid for by a Medicare tax withheld from all workers’ paychecks. Medicaid is a government health care program for low-income individuals and families. It is jointly administered by the Federal government and state governments. It is funded by general tax revenues.

LO 11.3 Describe the typical benefits and limits of health care plans. 1.

Distinguish among an exclusion, deductible, coinsurance, and a copay.

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Answer: Distinguish among an exclusion, deductible, coinsurance, and a copay. Exclusions are medical costs not covered by a health care plan. Deductibles are clauses in health care plans that require the insured to pay an initial amount before receiving reimbursement. A copayment requires the insured to pay a specific dollar amount each time one has a specific covered expense. Examples of common copayments are a specific dollar amount each time one visits the doctor or needs a prescription drug. The dollar amount of a copayment is typically much smaller than the dollar amount of a deductible. Coinsurance requires that the insured party pay a proportion, often 10 or 20 percent, of any covered portion of an expense that exceeds the deductible and/or copayment. 2.

What is meant by the out-of-pocket maximum? Answer: An out-of-pocket maximum is the maximum dollar amount number of combined deductibles, coinsurance, and copays that an insured must pay on their own under the provisions of a health care plan.

LO 11.4 Explain the fundamentals of planning for long-term custodial care. 1.

What are activities of daily living? Answer: Insurance companies use the inability to perform a certain number of activities of daily living (ADLs) as a criterion for deciding when the insured becomes eligible for long-term care benefits. A policy typically pays benefits when a person cannot perform two or three ADLs without assistance. The ADLs commonly used in this type of decision making are bathing, bladder control, dressing oneself, eating without assistance, toileting (moving on and off the toilet), and transferring (getting in and out of bed).

Distinguish among the three levels of care in long-term insurance. Answer: The levels of nursing home care are usually categorized in three ways. Skilled nursing care is intended for people who need intensive care, meaning 24-hour-a-day supervision and treatment by a registered nurse, under the direction of a doctor. Intermediate care is appropriate for people who do not require around-the-clock nursing but who are not able to live alone. Custodial care is suitable for many people who do not need skilled nursing care but who nevertheless require supervision (e.g., help with eating or personal hygiene).

Distinguish between the benefit period and the waiting period for a long-term care policy. Answer: The benefit period is the maximum time period over which long-term care benefits will be paid. The waiting period is the period between the beginning of the need for long-term care and when benefits can be received. In considering long-term care insurance, the consumer should bear in mind the type of care covered, the insured’s age, the benefit amount, the benefit period, the waiting period, and in some cases, inflation protection.

LO 11.5 Develop a plan to protect our income when we cannot work due to disability. 1.

Summarize how to determine your level of need for disability income insurance. Answer: Your level of need for disability income is the difference between the amount of your current income that you would need to replace after becoming disabled and the benefits you already have through an employer plan and/or Social Security.

Explain who needs disability insurance. Answer: All workers need disability income insurance. According to the Social Security Administration, about one quarter of 20-year-old workers has a chance of becoming disabled and out of work for at least a

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year during their working career and before reaching retirement age. Older workers who become disabled may have retirement money available because certain types of pension plans (not 401(k) plans or IRAs) provide benefits to workers who become disabled while still employed. However, such benefit plans often fall far short of fully meeting the income needs of most workers. 3.

Identify three policy provisions to consider when purchasing disability income insurance. Answer: There are six major policy provisions to consider when buying disability income policies. (1) The elimination period (waiting period) is the time between when the disability occurs and when you first become eligible to receive benefits. (2) The benefit period is the length of time you will receive benefits once you become eligible. (3) The degree of disability defines the conditions under which the disability income will be paid. (4) The residual clause allows for a reduced level of benefits when you suffer a partial, rather than a total, disability. (5) The Social Security rider provides extra protection through increased benefits if you do not qualify for Social Security disability benefits. (6) Cost-of-living adjustments increase your benefit amount to keep up with inflation.

Distinguish between own-occupation and any-occupation disability income insurance plans. Answer: An any-occupation policy will provide benefits only if you cannot work at all. An ownoccupation policy will pay benefits if you cannot perform your normal occupation even though you could work at some other occupation.

LO 11.6 Summarize the benefits of preparing advance medical directive documents. 1.

Offer some reasons why people should create advance directive documents. Answer: Advance directives serve several functions. First, they ensure that your wishes regarding medical care are known to medical care providers and to your loved ones should you not be able to speak for yourself. Second, they can ensure that your financial management activities are taken care of when you are unable to do so because of medical issues. Third, and most importantly, they take much of the emotional burden for your medical decision making off your loved ones who will have guidance to do your wishes as provided for in the documents.

What is a living will and what does it try to accomplish?

Answer: A living will allow you to document in advance your specific wishes concerning medical treatments in an emergency or during end-of-life health care. The document sets forth one’s wishes about life-prolonging treatments in case of terminal illness or persistent unconsciousness where the individual is no longer capable of participating in their health care decisions. This document only goes into effect if you meet specific medical criteria and are unable to make decisions. 3.

What does a health care proxy achieve?

Answer: A health care proxy specifies an individual whom you name to make medical decisions for you when you are unable to do so for yourself. A living will specify one’s wishes for medical treatments in case of terminal illness or persistent unconsciousness where the individual is no longer capable of participating in their health care decisions. 4.

What does a durable power of attorney provide, and can it be changed?

Answer: A durable power of attorney gives a designated person the power to manage your financial affairs when you suffer from an incapacitating medical condition. A durable power of attorney can be changed at any time if the person who made the designation is mentally capable of doing so.

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WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on health care planning, what do you recommend to Danielle DiMartino in the case at the beginning of the chapter regarding: 1.

Choosing among the four alternatives available to her? Answer: HMOs often work well for families where health care is frequently sought as is the case with Danielle’s daughter’s susceptibility to ear infections. Danielle should also have her health status monitored regularly considering her mother’s chronic conditions that Danielle may begin to exhibit as she ages. It is also the least costly plan. If Danielle feels she would like more choices for her health care, she could choose the PPO option. She could use the PPO for her daughter’s frequent care to avoid deductibles and coinsurance. But she would still be free to choose other providers should other medical situations arise for either her or her daughter. The third option would be the costliest but would provide Danielle with the most choices for health care providers. The fourth choice may be attractive to Danielle because of its low monthly cost. This would be outweighed by the high deductible, resulting in high out-of-pocket costs for Danielle. The trade-off of cost versus choice is a personal one that only Danielle can make.

Danielle’s concerns about providing for her mother’s health care needs. Answer: Danielle’s mother requires frequent health care and monitoring of her chronic conditions. One of the Medicare HMO options may reduce out-of-pocket costs for Danielle’s mother. It may be possible to use the same HMO that is available to Danielle through her employment.

Danielle’s need for her own disability income insurance? Answer: Danielle’s income is crucial to her family as she is the sole breadwinner. Should Danielle become unable to work due to disability, the financial support for her children and mother would be lost. She should investigate buying a disability income policy. A waiting period of 90 days would work for her and allow her to affordably buy a longer benefit period—the more serious concern for Danielle.

How can Danielle cover her long-term care risk? Answer: Danielle must be realistic about her own health prospects. Her mother’s conditions all have hereditary aspects that might result in long-term care needs for Danielle. She would be wise to explore long-term care insurance. To make her coverage more affordable and provide better coverage, she would want a policy with a three- to six-month waiting period and a long benefit period of 10 years.

LET’S TALK ABOUT IT 1.

The Affordable Care Act and You. Are you affected directly by the Affordable Care Act? If so, in what ways. Answer: Student answers will vary. Many will know that the Affordable Care Act allows them to stay on a parent’s plan until age 26. Some students, especially those above age 25, may have been required to buy a health care plan because of the ACA.

ACA Protections and Benefits. Given the list of requirements for the Affordable Care Act, what are your thoughts about yesterday’s health policies compared to today’s? Answer: Student answers will vary. Some students may appreciate the improved quality of care, others may know someone with a preexisting condition who was unable to get a plan prior to the ACA, and some students may note the increased coverage of so many Americans because of the ACA.

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Your Health Care Plan. Are you covered by a health care plan? If so, what do you see as the largest potential for losses if you become ill or injured? How well do you understand the plan? Answer: Some or most students will still be covered by their parents’ health care plan. As a result, they are likely to know very little about the benefits of the plan or the potential losses. Take a sample health insurance policy to class, make sure the students have a copy, and discuss the parts of the plan. Many students who are not covered by a health insurance plan will not have health insurance at all. Some may have the plan the university offers, although there is usually a premium to pay.

HMOs Versus Health Insurance. HMO plans and traditional health insurance plans take different approaches to health care. What are the major differences between the two types of plans? Which plan would you prefer for your own health care protection, and why? Answer: Most students will probably not know the differences between HMO plans and other health insurance plans. With an HMO plan, by paying a monthly fee, you buy medical services in advance. Although the fee may be higher than the monthly cost of traditional health insurance, you don’t have to worry as much about copayments and deductibles. The importance of staying in-network may be something students point out. Students will have varying answers, with little information, to the question of which type of insurance they would prefer. Most will not have the information to make an informed decision, at least not before reading this chapter in the book. Most, also, won’t think it is important to them right now if they are on their parents’ policies. You will also encounter those students who flatly say that health insurance is so expensive they cannot afford it. Others may say they don’t need it, that they are healthy.

Long-Term Care Insurance. Are you covered by a long-term care insurance plan? What would happen if you became so incapacitated that such care was necessary? What could you do? Answer: Unless you have an older, nontraditional student in your class, you probably won’t find any students with long-term care insurance. Most of us don’t think about this insurance until we are 40 or 50 years old. Financial planners suggest 50 years of age as the point at which we should consider buying a long-term care insurance policy. Ask students to describe the experience of someone in their life who has required long-term care. Most students won’t have the answer to the question of what they would do if they became incapacitated. They would likely rely on their parents, spouse, or guardians.

Disability Income Insurance. Are you covered by disability income insurance? What would happen if you were unable to work for two or three years because of illness or injury? Answer: You are likely to get similar answers to this question on disability insurance as you are on the question about long-term care insurance. Students, however, may realize that disability insurance is more necessary for them sooner than long-term care insurance.

Disability Social Security. Are you covered by Social Security disability insurance? What would happen if you were unable to work for a year because of illness or disability? Answer: Most students will not be covered sufficiently by Social Security Disability Income Insurance. That is because the benefits are based on the lifetime income pattern of the worker, and most students have not had a long working life and will have only had part-time employment. For any disability expected to last less than one-year, Social Security Disability Income Insurance will not apply unless the disability is expected to end in death. Thus, most students will be unprotected for a disability lasting up to one year.

Advance Directive Documents. Give some thought to establishing a living will, health care proxy, and a durable power of attorney. What are some provisions that you might put into the documents, and who might you name?

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Answer: Student answers will vary. Many students have likely never considered the need for advance directive documents. Ask students to describe any observations they’ve made about these documents or discussions they’ve had with someone they know about these documents.

DO THE MATH 1.

Health Care Coverage Amounts. Michael Howitt of Berkley, Michigan, recently had his gallbladder removed. His total bill for this surgery, which was his only health care expense for the year, came to $13,890. His health insurance plan has a $500 annual deductible and an 80/20 coinsurance provision. The cap on Michael’s coinsurance share is $2,000. a. How much of the bill will Michael pay? b. How much of the bill will be paid by Michael’s insurance? Solution: This is a potential ―Class Activity‖ exercise related to page 363 in the text. a. Michael will pay $2,500. This total includes the $500 deductible and the $2,000 coinsurance cap (since 20 percent of $13,390 exceeds $2,000). b. Michael’s insurance will pay $11,390 ($13,890 − $2,500).

Health Care Event Protection. Christina Haley of Elko, Nevada, age 57, recently suffered a stroke. She was in intensive care for 3 days and was hospitalized for 14 more days. Her total bill for this care was $125,500. After being discharged from the hospital, she spent 25 days in a nursing home at a cost of $170 per day. Christina, who earns $4,500 per month, missed two months of work. Christina had a health insurance plan through her employer. The policy had a $1,000 deductible and an 80/20 coinsurance clause with a $2,000 coinsurance cap. She had also accumulated twenty-one sick days (equivalent to one month) at work. Otherwise, she had no long-term care or disability income insurance. a. How much of Christina’s direct medical expenses was paid by her insurance policy? b. What did Christina have to pay for her nursing home care? c. How much income did Christina lose? Solution: This is a potential ―Class Activity‖ exercise related to page 363 in the text. a. Christina’s policy paid $122,500. Christina paid $3,000. This figure represents the total of $1,000, her deductible; $2,000, her share of the coinsurance. b. Christina would have to pay the entire $4,250 ($170 × 25 days) since she had no long-term care insurance. c. Christina missed 42 days of work of which the income from 21 days would be provided via her accumulated sick days. The other 21 days, or one month, would represent $4,500 of lost income.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Consider Buying Disability Insurance Dual-income households often have overlapping health care benefits. For example, both Harry and Belinda Johnson’s employers provide partially subsidized family health insurance plans as employee benefits. The Johnsons chose to be covered under Belinda’s policy because it provides more protection and is less expensive. Belinda’s coverage is fully paid for, and she can add Harry to the plan for only $150 per month. Harry can then drop his health plan through his employer and sign up instead for other benefits such as disability income insurance, flexible benefits coverage, education reimbursement, and/or contribute more to his 401(k)-retirement plan. The bad news is that many employers assess an average surcharge of $100 per month when spouses can get health care from their own jobs.

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Although Belinda’s employer offers a generous employee benefit program, it does not provide disability income protection other than eight sick days per year, which may accumulate to 20 days. Harry also has no disability income insurance. Although both have worked long enough to qualify for Social Security disability benefits, based on information they have received from the Social Security Administration, Belinda has figured that Harry would receive about $1,020, and she would receive about $1,330 per month from Social Security. Harry and Belinda realize that they could not maintain their current living standards on only one salary. Thus, the need for disability income insurance has become evident even though they will be challenged to afford such protection at this time. Advise them on the following points: a. Use the Run the Numbers worksheet on page 348 to determine how much disability insurance Harry and Belinda each need. Since it has been more than 10 years since they started working full-time, their incomes have risen about 4 percent annually. Belinda’s after-tax income now is $92,000 and Harry’s is $58,000. b. Use the information on pages 348 and 349 to advise the Johnsons about their selections related to the following major policy provisions: 1. Waiting period 2. Benefit period 3. Residual clause 4. Cost-of-living adjustments Solution: This is a potential ―Class Activity‖ exercise related to page 368 in the text. The Johnsons Consider Buying Disability Insurance a. Harry and Belinda both need disability coverage. Harry needs to replace approximately $3,813 of income in the event of a disability. Currently, only $1,020 of his after-tax income of $4,833 ($58,000/12) would be replaced by Social Security disability benefits. Belinda’s after-tax income equals $7,666 ($92,000/12) from which the $1,330 Social Security disability benefit is subtracted, for a total required disability replacement income of $6,336. b. An elimination period of 30 days or less would be a good idea because neither Harry nor Belinda has employee benefits that cover this period, and the amount of their liquid assets is small. Available sick leave pay benefits or emergency fund savings could be used to extend the elimination period, thus reducing the premium. Although a higher premium will be required for a long benefit period, Harry and Belinda should select that option because they are young, and a long-term disability is a major financial setback. A residual clause would be beneficial if the Johnsons were only partially disabled; the policy would cover the percentage of income lost. A cost-of-living adjustment would cover the effects of inflation and is recommended for couples like the Johnsons. The Johnsons should also obtain a policy with a Social Security rider to cover the possibility that they may not qualify for Social Security disability benefits. This rider would protect their incomes and keep the premiums reasonable. CASE 2: The Hernandez’s Face the Possibility of Long-Term Care Victor Hernandez recently learned that his uncle has Alzheimer’s disease. While discussing this tragedy with Maria, he realized that both of his grandparents had Alzheimer’s or another dementia disease, although no formal diagnoses were ever made. As a result, Victor and Maria have become interested in how they might protect themselves from the financial effects of long-term health care. a. What factors should the Hernandez’s consider as they shop for long-term care protection? b. Victor is still in his forties. How does his age affect their decisions related to long-term care protection? Solution: This is a potential ―Class Activity‖ exercise related to page 365 in the text. The Hernandez’s Face the Possibility of Long-Term Care

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Victor and Maria should first think about the type of care they want the long-term care policy to cover. Nursing home stays are covered in all policies, but many also cover the costs of in-home care. They also need to determine the dollar amount of coverage desired. To make this decision, Victor and Maria need to find out the daily cost of nursing home care in their region. They must consider both the length of the benefit period and the waiting period. The longer the benefit period and the shorter the waiting period, the more expensive the premiums will be. Finally, they need to consider whether inflation protection would be important. Adding this coverage would increase premiums, but it would keep the value of the daily benefit from eroding due to inflation. Because Victor is in his forties, the premiums for a long-term care policy will be lower than if he waits to purchase the policy. It will also be easier to qualify for the coverage while he is healthy. However, the sooner Victor purchases the policy, the longer he will have to pay the premiums. Another consideration associated with his age is the inflation protection. If Victor decides to purchase the longterm care policy during his forties, inflation protection would be recommended.

CASE 3: Julia Price Assesses Her Health Care Plan Julia is about to change jobs. Her new employer offers several different health care plans including a traditional health care plan, an HMO, a PPO, and a high-deductible plan. Her employer will pay the first $300 per month for any plan she chooses. This means that Julia will have to pay the remainder of the premium for the plan plus any out-of-pocket costs. These expenses are higher than they were at her previous employer, and she is concerned about the added expenses. After talking with the employee benefits office at the new firm, she is considering saving money by opting for the low-cost high-deductible plan and establishing a health savings account. Offer your opinions about her thinking. Solution: This is a potential ―Class Activity‖ exercise related to page 359 in the text. Julia Price Assesses Her Health Care Plan Provided Julia has no chronic health conditions or issues that require regular appointments with medical professionals, Julia would be wise to strongly consider the high-deductible plan and sign up for the tax savings aspects provided by the health savings account, premium conversion, and setting up a flexible spending arrangement. She will be paying more out-of-pocket under her new plan, and although she will be liable for an even higher deductible, she can save money on the premium for the high-deductible plan and lowered taxes because of the expenses she must pay herself. CASE 4: A New Employee Ponders Disability Insurance Charles Napier of Barstow, California, recently took a new job as a manufacturer’s representative for an aluminum castings company. While looking over his employee benefits materials, he discovered that his employer would provide ten sick days per year, and he can accumulate these to a maximum of sixty sick days if any go unused each year. In addition, Charles’s employer provides a $3,000-per-month, short-term, one-year total disability policy. When he talked with the human resources office, Charles found that he might qualify for $1,100 per month in Social Security disability benefits if he became unable to work. Charles earns a base salary of $5,000 per month and expects to earn about $40,000 in commissions, for an average after-tax income of $7,000 per month. After considering this information, Charles became understandably concerned that a disability might destroy his financial future. a. What is the level of Charles’s short-term, one-year disability insurance needs? b. What is the level of Charles’s long-term disability insurance needs? c. Help Charles select from among the important disability insurance policy provisions to design a disability insurance program tailored to his needs. Solution: This is a potential ―Class Activity‖ exercise related to page 368 in the text. A New Employee Ponders Disability Insurance

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b. c.

Charles needs $4,000 in short-term disability insurance. This is arrived at by subtracting from Jim’s current $7,000 monthly after-tax income the $3,000 from his employer-provided disability policy. While Charles might qualify for $1,100 in Social Security benefits, it is risky to count on this $1,100 for a short-term disability as Social Security only pays if the disability is expected to last at least one year. Charles needs $5,900 in long-term disability insurance. This is arrived at by subtracting his project Social Security disability benefit from his after-tax income ($7,000 − $1,100). Jim should buy a disability policy covering $5,900 in needs with a Social Security rider that would increase his benefit to $7,000 if he did not receive Social Security disability benefits. This policy should provide cost-of-living adjustments with a benefit period to age 65. It should have a waiting period of at least 60 days, though Jim might decide to accept a one-year waiting period as he is covered under the employer’s policy for the first year.

CASE 5: A CPA Selects a Health Care Plan Your friend Taliesha Jackson of Edwardsville, Illinois, recently changed to a new job as a CPA in a moderate-size accounting firm. Knowing that you were taking a personal finance course, she asked your advice about selecting the best health insurance plan. Her employer offered five options. In addition, she could open a flexible spending arrangement to pay some of the premiums:  Option A: A traditional health insurance plan with a $500 annual deductible and an 80 percent/20 percent coinsurance clause with a $2,000 out-of-pocket limit. Taliesha must pay $80 per month toward this plan.  Option B: Same as option A except that a PPO is associated with the plan. If Taliesha agrees to have services provided by the PPO, her annual deductible drops to $200 and the coinsurance clause is waived. As an incentive to get employees to select option B, Taliesha’s employer will provide dental expense insurance worth about $40 per month.  Option C: Another PPO health insurance plan with a $200 annual deductible and a 90 percent/10 percent coinsurance clause with a $1,000 out-of-pocket limit. Taliesha must pay $170 per month toward the cost of this plan.  Option D: Membership in an HMO. Taliesha will have to contribute $40 extra each month if she chooses this option. a. To help her decide, Taliesha has asked you to list two positive points and two negative points about each plan. Prepare such a list. b. Why might Taliesha’s employer provide an incentive of dental insurance if she chooses option B? c. Which plan would you recommend to Taliesha? Why? Solution: a. Student answers will vary. Positive and negative points about each plan appear in the following table: Option A Traditional Health Plan

B PPO

Plan Features Points For Points Against $500 annual deductible 80/20 percent Lower premium than option $500 deductible coinsurance $2,000 out-of-pocket limit C $80 per month Taliesha must pay toward the cost of this plan Freedom to choose any 80/20 percent coinsurance provider $200 annual deductible No coinsurance Possible low deductible Reduced freedom of choice clause Dental insurance worth $40 per month

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Waiver of coinsurance

$200 annual deductible 90/10 percent Low coinsurance cap 90/10 coinsurance $1,000 out-of-pocket limit. percent coinsurance $170 per month Taliesha must pay toward the cost of this plan $40 extra each month if she chooses Preventive care this option No or low out-of-pocket expenses

C PPO

D HMO

High out-of-pocket costs on a non-participating health care provider $170 premium right after the deductible

Possible problems with quality of service Reduced freedom of choice

The dental insurance incentive is likely offered by the employer because it will cost the employer less money by paying lower rates for those employees who choose option B. Most employers work to reduce health plan costs because they are expensive to provide. At the same time, most want to provide valuable benefits to their employees. There really is no correct answer here, given the varying factors and trade-offs, such as plan type, annual deductible, percent of coinsurance, and out-of-pocket limit. Students will vary in their recommendations. This can serve to enhance understanding of the varieties of options they will face for themselves.

EXTENDED LEARNING 1.

Costs and How to Pay for Long-Term Care. Visit the government’s website (https://acl.gov/ltc/costsand-who-pays) to learn the costs and how to pay for long-term care insurance. Write a summary of your findings. Solution: Students should prepare a summary of their findings about the costs and how to pay for long-term care.

Assessment of Your State’s Health Insurance Exchange. Visit your state’s health insurance exchange (kff.org/state-health-marketplace-profiles). How easy was it to navigate through the information provided? Why or why not? Would you feel comfortable using the state or the federal health exchange to obtain coverage? Solution:

Student answers will vary. Ask them about the type of marketplace their state had—federally facilitated or statebased. Find out about the ease of navigating the marketplace site and exploring the insurance types by medal. 3.

Views Concerning Having Health Care Protection. Talk to three fellow students who are not taking your personal finance class. Ask them to tell you about their health care plan. Then ask them how they plan to meet their health care needs once they graduate. Make a table that summarizes your findings. Solution:

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Students should prepare a summary of their findings. They may find that several of their friends have no health care plan. The reasons given will likely be the cost of the plan even though they are under age 26 and eligible to be on a parent’s plan. Most students will probably underestimate the risk associated with health care. 4.

What Is It Like to Choose Among an Employer’s Health Care Options? Survey three individuals or couples who are covered by a group health care plan at work. Ask them how they went about making the choice among the plans the employer offered. Include a discussion of how they approach the same decisions when the open-enrollment period occurs with the plan each year. Write a summary of their responses and how their experiences impacted your thinking about an employer-provided plan. Solution:

Students should prepare a summary of their findings. They are likely to find that making decisions about health care plans is extremely complicated. Many people simply stay with the plan they currently have when open enrollment is available. Many students will feel that they are unprepared to make such decisions when they obtain employment after graduation. 5.

Applying the Large-Loss Principle to Health Care Planning. The large-loss principle says that one is better off paying a higher initial portion of any loss and expanding the coverage for the largest and most catastrophic losses. In health care planning, this would mean selecting a health care plan with a high deductible for your health care expenses and a longer waiting period and longer benefit period for your disability income and long-term care insurance plans. Talk to three students in your personal finance class on their views of this approach. Also talk to three people outside of your class who are covered by a health care plan for their views. Write a summary of the responses of these two groups and how their views affect your own thinking about the large-loss principle. Solution:

Students should prepare a summary of their findings. They will find that those friends who have used a high-deductible plan and a longer benefit period will feel that they have made a wise choice. Those who have not will feel that the higher deductibles and longer benefit periods are a cost they do not want to bear even though the cost of the policies will be lower and provide higher reimbursements © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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for a major event. Students’ opinions will vary as to how they would approach such decisions when they are required to do so. 6.

Addressing the Need for Disability Income Insurance. Talk to a family member who has gone through the process of deciding about disability income insurance. Ask what motivated him or her to decide to buy or not buy such insurance. Also ask about which aspects were the most difficult part of the process. Write a summary of the responses and how your family member’s efforts, or lack thereof, affect your thinking about disability income insurance. Solution:

Students should prepare a summary of their findings. Before talking with the family member, the student may have felt that disability income insurance was something that they could do without. Many students will feel differently after discussing such insurance with someone who has gone through the process of make such a decision. 7.

Planning for Long-Term Care. Talk to a family member who has had to decide how to meet the longterm care needs of a loved one. Ask what aspects the most difficult part of the process was. Also ask your family member how going through the process affected his or her thinking about planning for their own long-term care needs. Write a summary of your family member’s responses and how his or her efforts, or lack thereof, affect your thinking about long-term care. Solution:

Students should prepare a summary of their findings. Some students may find that their parent or guardian has had to address the long-term care needs of their parents, the student’s grandparent(s). The expense of care and the quality of care available may be part of the discussion. Before talking with the family member, the student may have felt that long-term care income insurance was something that they could do without. [return to top]

Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 12: LIFE INSURANCE PLANNING

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TABLE OF CONTENTS Answers to Chapter Concept Checks .................................................................................................... 138 What Do You Recommend Now? .......................................................................................................... 141 Let’s Talk About It ................................................................................................................................. 141 Do The Math............................................................................................................................................ 142 Financial Planning Cases ....................................................................................................................... 145 Extended Learning.................................................................................................................................. 149

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ANSWERS TO CHAPTER CONCEPT CHECKS LO 12.1 Understand why we might need life insurance and calculate the appropriate amount of coverage. 22. Distinguish between the dying-too-soon concern and the living-too-long concern and the best ways to address each. Answer: The dying-too-soon concern relates to the possibility that our death would create a financial hardship for others. The living-too-long concern relates to the possibility that we will outlive our income and not be able to fully support ourselves in our later years. The dying-too-soon concern should be resolved by purchasing life insurance. The living-too-long concern should be addressed by investing through a taxsheltered retirement plan such as a 401(k) plan at work or an IRA. 23. List five types of needs that can be addressed through life insurance. Answer: In addition to the loss of income, five other factors affecting the need for life insurance are (1) final expenses, (2) readjustment-period expenses, (3) debt-repayment expenses, (4) college expenses, and (5) other special needs. 24. Explain why the multiple-of-earnings approach is less accurate than a needs-based approach to life insurance planning. Answer: The multiple-of-earnings approach simply addresses the loss of income aspect of dying too soon. And it does so in an oversimplified way. The needs approach includes the five other factors and considers the investment return that survivors can receive when the insurance proceeds are invested until needed to replace future income. 25. Identify periods in a typical person’s life when the need for life insurance is low and one when it is high. Answer: Life insurance needs are lowest when single and childless and during one’s retirement years. They are highest during the early years of raising children. 26. What two factors in the process of calculating life insurance needs are likely to be the most expensive to replace? Answer: The two most expensive factors in calculating the dollar amount of needed life insurance on a person are the need to replace the lost income of the individual involved and the cost of education expenses for a surviving spouse and children.

LO12.2 Distinguish among types of life insurance. 1.

Distinguish between term life insurance and cash-value life insurance. Answer: Term life insurance pays benefits only if the insured dies within a specified time period covered under the contract. The policy must be renewed at the end of its term with a premium increase reflecting the higher age of the insured person. There is no investment component, although that is offset by its much lower cost. Cash-value insurance pays benefits on the death of the insured, but it also has a savings element that allows payment of benefits prior to death. Cash-value life insurance does not need to be renewed, and the premium stays the same over the years. This extra benefit makes cash-value insurance more expensive than term life insurance.

Explain why the premiums for term insurance are always so much lower than those of cash-value life insurance.

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Answer: Term insurance premiums are much lower because you are buying insurance protection only. In addition, the commission paid to the salesperson is much lower for term insurance. 3.

Describe the benefit of buying guaranteed renewable term insurance. Answer: Guaranteed renewable term insurance is written in such a way that the insured does not have to prove insurability each time they want to renew the policy. The renewability option insures against the possibility of becoming uninsurable.

Explain why the amount of ―insurance‖ declines over time under a cash-value life insurance policy. Answer: A cash-value life insurance policy is a combination of decreasing term insurance and an investment account, the sum of which equals the face value of the policy. With the passage of time, the policyholder builds up the investment portion of the insurance policy. Because the face value of the policy is constant, the remaining term insurance portion of the policy declines commensurately.

Distinguish between cash-value life insurance with a fixed return and with a variable return. Answer: Cash-value life insurance with a fixed return allows the insured person to predict the buildup of the cash value in the policy. The life insurance company chooses the investments made and guarantees a specific rate of return regardless of how the underlying investments do. Policies with a variable return allow the rate of return to fluctuate with the success of the underlying investments. In some years, the rate will be higher than others; usually, there is some minimum rate that is guaranteed.

LO12.3 Explain the major provisions of life insurance policies. 1.

Distinguish among the owner, the insured, the beneficiary, and the contingent beneficiary of a life insurance policy. Answer: The owner of a life insurance policy is the policyholder, whose rights include amending the policy and designating who will receive the proceeds from the policy. The insured is the person whose life is insured. The beneficiary is the person or organization who will receive the life insurance proceeds when the insured dies. The contingent beneficiary becomes the beneficiary if the original beneficiary dies before the insured dies.

Distinguish between an incontestability clause and a suicide clause in a life insurance contract. Answer: An incontestability clause limits the time period, usually two years after issuance of the policy, when a life insurance company can deny paying a claim due to errors in the application when the policy was issued. A suicide clause allows a life insurance company to deny payment of a claim when the cause of death is a suicide within the first two years of the issuance of the policy.

What are nonforfeiture values and why are they important? Answer: The choices available when a cash-value life insurance policy is cancelled by the owner are referred to as nonforfeiture options. They include (1) taking the cash value as a lump-sum payment, (2) using the cash value to buy the same amount of insurance on a term basis for a specified period of time, (3) using the cash value to buy some reduced level of insurance for life, and (4) taking the cash value in a series of payments over a specified period of time or in a specified dollar amount until the money runs out or for the life of the insured.

Identify three of the five settlement options for the payment of the proceeds of a life insurance policy to its beneficiary. Answer: Settlement options are the choices of the beneficiary or the insured regarding the form of payment of the death benefit. One option (1) is to receive the death benefit in a lump sum at the time of the insured’s

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death. Other options are to receive (2) interest earned on the death benefit, (3) income for a specific period of time, (4) income for life, and (5) income of a specific amount. 5.

Distinguish between an automatic premium loan and a waiver-of-premium option in a life insurance policy. Answer: An automatic premium loan uses some of the cash value in the policy to pay the premium that was missed. The withdrawal is considered a policy loan, and interest will be charged until it is repaid. A waiver of premium option completely waives the premium missed if due to some situation, most commonly a disability preventing the insured person from working.

Explain how guaranteed renewability for term life insurance and guaranteed insurability for cashvalue insurance protect insured people who develop serious health conditions. Answer: Guaranteed renewability is an optional, but highly recommended, feature of term insurance that allows the insured to renew the policy at its expiration without having to show continued good-health status. The premium can only go up since the insured is older. Cash-value life insurance does not have to be renewed. However, a health problem might prevent an insured from buying more insurance at standard rates. The guaranteed insurability option in cash-value life insurance allows the insured to buy additional insurance at various intervals regardless of health status. The additional cost of selecting either of these options is quite low.

LO12.4 Apply a step-by-step strategy for implementing a life insurance plan. 1.

What is meant by integrating your life insurance into your financial plan over the life cycle? Answer: In young adulthood, you have little or no need for life insurance as few, if any, people depend on your income. When you marry or are in a committed long-term relationship, such as one that includes cohabitation, you have increased responsibility for another person, although life insurance needs remain low because each spouse or partner usually has the potential to support himself or herself if the other partner were to die. The arrival of children triggers a sharp increase in life insurance needs. Once children become independent, the need for life insurance is, once again, lower. Retirement and the possibility of another period of being single again reduce the need for life insurance. This pattern means that life insurance and retirement planning should be separated in one’s financial plan. Life insurance need is best met through the purchase of term life insurance, especially in those stages of life when the need for life insurance is high. Retirement planning requires an accumulation during working years of a nest egg primarily through use of tax-sheltered investment avenues such as a 401(k) plan and an Individual Retirement Account (IRA).

Give some examples of fair prices for life insurance and one example of why some people must pay higher premiums than others. Answer: Premiums for a term life insurance for persons under age 40 should be less than $1 per $1,000 of coverage. Cash-value life insurance can cost 8 to 10 times more per $1,000 of coverage. People pay higher premiums for term life insurance as they age. The premiums for cash-value life insurance, once purchased, do not go up with age. However, the older one is when they buy a policy, the higher the premiums will be. Smokers also pay more for life insurance.

List the benefits of buying term and investing the rest. Answer: By buying term insurance and investing the premiums saved by not purchasing the more expensive cash-value insurance, a careful investor can earn a rate of return much greater than that typically paid on cash-value life insurance policies. In this way, the person can be adequately insured for an affordable cost and at the same time build a nest egg for retirement years.

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Give three signs of an unethical life insurance agent. Answer: Unethical life insurance agents exhibit several behaviors of which to be aware. Three important signs are (1) quickly recommending an amount to purchase without thoroughly analyzing your financial situation and family status; (2) pushing cash-value life insurance over term insurance for the bulk of your insurance needs; and (3) encouraging you to cash-in an existing policy to buy a policy from the agent.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on protecting loved ones through life insurance, what would you recommend to Stephanie and Will Bridgeman in the case at the beginning of the chapter regarding: 1.

Their changing need for life insurance now that they have a child? Answer: Both Stephanie and Will should complete a life insurance needs assessment. While Will was adequately insured before the birth of their baby, their need for life insurance is now probably more than a combined $1,000,000. It is likely that their children will go to college and graduate school. Thus, future college expenses will be an important part of their needs assessment.

What types of life insurance they should consider? Answer: Stephanie and Will have enough cash-value life insurance to take care of basic final expenses for the near future. If they need more life insurance, they should consider purchasing a series of level-premium term life insurance policies using a layered approach.

Coordinating their retirement savings and other investments with their life insurance program? Answer: Stephanie and Will could be saving more to meet their retirement needs. Both have additional opportunities to use tax-sheltering mechanisms to save for retirement. In Stephanie’s case, she would be served well to bump up her contributions another 3 percent of her salary for a total of 12 percent. Both Will and Stephanie could also consider contributing to an IRA each year.

Shopping for life insurance? Answer: If needed, term life insurance can easily be purchased online from reputable sellers. Stephanie and Will could use one of the premium quote services to obtain low-cost term insurance. These services also have calculators and explanatory material on their websites that Stephanie and Will can use to more fully understand their life insurance program.

LET’S TALK ABOUT IT 1.

Thinking About Life Insurance. What were your feelings about your need for life insurance before you read this chapter? What are they now? Answer: Most people feel that life insurance is for older people. They also feel that it is expensive. In fact, after reading this chapter, readers can see that life insurance is most needed by young couples, especially if they have children. And if purchased correctly via term insurance, it need not be expensive at all.

Are You Insured? Are you covered by life insurance? If so, how much? Given what you have read, do you feel that you are over- or under-insured?

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Answer: Many students will not know the answer to this question without asking their parents. And their parents may not know the exact amount of the coverage. Most college students need little life insurance, so if they are covered, they may be over insured rather than underinsured. That status will change in the next few years, so they can keep what they have and then periodically do a needs assessment to see if they need more coverage. 3.

Term Versus Cash-Value Insurance. Why do you think people persist in buying cash-value life insurance when, in most cases, they would be better off buying term insurance and investing the money saved into a retirement account? Answer: Many people think it is easier to buy cash-value insurance because it solves two problems at once. It builds a nest egg, and it provides insurance protection. Unfortunately for most people, it does not do as good a job at building a nest egg as a tax-sheltered retirement account would do. And it is so expensive that many people end up underinsured because they cannot afford to buy enough coverage to meet their needs.

Life Insurance for Unmarried Couples. Many people today choose to cohabitate rather than marry (at least for some time period). How might this affect their thinking about life insurance? Answer: Cohabiting couples usually depend on each other for some financial support. As a result, they need life insurance to the same degree as would married couples. There is an added and serious complication, however, especially for long-term cohabiters. A cohabiting partner typically has no legal rights to the estate of a partner who passes away unless the partner is specifically provided for in a will or named as a beneficiary on a retirement plan account. Further, they cannot count on Social Security Survivor’s Benefits as would a married widow or widower. If there are children involved, such an outcome could be doubly tragic.

DO THE MATH 1.

Life Insurance Needs for a Young Single. Matthew Kennedy of Urbana, Ohio, is single and has been working as an admissions counselor at a university for five years. Matthew owns a home valued at $250,000 on which he owes $135,000. He has a two-year-old vehicle valued at $32,000 on which he owes $26,000. He has about $20,000 remaining on his student loans. His retirement account has grown to $32,000, and he owns some stock valued at $9,000. Matthew has no life insurance and is considering buying some. How much should he buy (LO1)? Solution: This is a potential ―Class Activity‖ exercise related to page 383 in the text. Since Matthew is single, he has no obligation to provide for the lost income should he die. He will need funds to pay for his final expenses, $10,000. However, the equity in his home is enough to pay off all his debts. In addition, his retirement account and stocks could pay his final expenses. Thus, he needs no life insurance currently. He might consider buying a small ($20,000–$50,000) cash-value policy to serve as a base should he plan to marry and have a family one day.

Life Insurance Needs for a Young Married Couple. Amy and Mack Holly from Rapid City, South Dakota, have been married for three years. They recently bought a home costing $212,000 using a $190,000 mortgage. They have no other debts. Mack earns $62,000 per year, and Amy earns $71,000. Each has a retirement plan valued at approximately $20,000. They recently received an offer in the mail from their mortgage lender for a mortgage life insurance policy of $190,000. Their only life insurance currently is a $20,000 cash-value survivorship joint life policy. They each would like to provide the other with support for at least five years if one of them should die (LO1). a. Assuming $15,000 in final expenses and $20,000 allocated to help make mortgage payments, calculate the amount of life insurance they should purchase using the needs-based approach.

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How would their needs change if Amy became pregnant?

Solution: Life Insurance Needs for a Young Married Couple, Amy and Mack Holly from Rapid City, South Dakota, a. Assuming $15,000 in final expenses and $20,000 allocated to help make mortgage payments, calculate the amount of life insurance they should purchase using the needs-based approach. The answers will depend on the degree to which the couple wishes to include repayment of their mortgage in their calculations and the interest rate to be earned on the insurance proceeds once received. Assuming a 4 percent return and that they want to support the other for five years, a provision of $20,000 to help make mortgage payments seems reasonable. They do not qualify for Social Security survivors benefits because they do not have children. Mack could replace 75 percent of his income for five years, provide funds for mortgage payments, and provide $10,000 for his final expenses if he purchased an additional $140,000 in life insurance. Amy could do the same with approximately $137,000 in additional life insurance. Since they already have a base of cash-value life insurance, each should buy a five-year, guaranteed renewable, level-premium term policy. b. Their needs would change if Amy became pregnant. Having dependents are the primary reason for buying life insurance. It allows family members to continue with their lives free from the financial burdens that Amy or Mack’s death would bring. Needs Approach Worksheet for Mack Holly Factors Affecting Need 1. Income-replacement needs* 2. Final-expense needs 3. Readjustment-period needs 4. Debt-repayment needs 5. College-expense needs 6. Other special needs 7. Subtotal (combined effects of items 1–6) 8. Government benefits** 9. Investment Assets Available 10. Current insurance assets 11. Life insurance needed *Income Replacement Needs Calculator Current Annual Income Percent of Annual Income to Be Replaced Annuity Amount (% desired of annual income) i (assumed interest rate) n (number of annuity payments) PV (present value) of Income Replacement Needs **Present Value of Social Security Benefits Calculator Estimated Monthly Benefit (See Appendix B in Text) Estimated Annual Benefit i (assumed interest rate n (number of annuity payments) PV (present value) of Government Benefits

Needs Approach Worksheet for Amy Holly

Determining My Life Insurance Needs Insert Your Figures $207,010 $ 15,000 $— $ 20,000 $— $— $ 242,010 $— $ 20,000 $ 20,000 $ 202,010 $62,000 75% $46,500 4.00% 5 $207,009 $0.00 $0 4.00% 15 $0

Determining My Life Insurance Needs

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Insert Your Figures Factors Affecting Need 1. Income-replacement needs* 2. Final-expense needs 3. Readjustment-period needs 4. Debt-repayment needs 5. College-expense needs 6. Other special needs 7. Subtotal (combined effects of items 1–6) 8. Government benefits** 9. Investment Assets Available 10. Current insurance assets 11. Life insurance needed *Income Replacement Needs Calculator Current Annual Income Percent of Annual Income to Be Replaced Annuity Amount (% desired of annual income) i (assumed interest rate n (number of annuity payments) PV (present value) of Income Replacement Needs **Present Value of Social Security Benefits Calculator Estimated Monthly Benefit (See Appendix B in Text) Estimated Annual Benefit i (assumed interest rate n (number of annuity payments) PV (present value) of Government Benefits c.

$237,060 $ 15,000 $— $ 20,000 $— $— $ 272,060 $0 $20,000 $ 20,000 $ 232,060 $71,000 75% $53,250 4.00% 5 $237,058 $0.00 $0 4.00% 15 $0

Their needs would change significantly if Amy were pregnant. First, the time period for which they would need income to be replaced would increase to as many as 24 years. Second, the survivor would qualify for some level of Social Security Survivor Benefits once the baby was born. Third, Mack and Amy would likely want to include some savings for a college education for their child. Fourth, the couple might wish to allocate additional life insurance to provide a readjustment period so the surviving spouse could take a leave of absence from their job to care exclusively for their child.

Calculating a Death Benefit. Alexandra Cunningham of Gardner, Massachusetts, has a $100,000 participating cash-value policy written on her life. The policy has accumulated $4,700 in cash value; Alexandra has borrowed $3,000 of this value. The policy also has accumulated unpaid dividends of $1,666. Yesterday, Alexandra paid her premium of $1,200 for the coming year (LO2). What is the current death benefit from this policy?

Solution: This is a potential ―Class Activity‖ exercise related to page 392 in the text. Face amount $ 100,000

1,666 +

1,200

$ 102,866 -

3,000

99,866

Unpaid dividends Premiums paid in advance Subtotal

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Outstanding cash-value loan Death benefit

FINANCIAL PLANNING CASES CASE 1: The Johnsons Change Their Life Insurance Coverage Harry and Belinda Johnson spend $20 per month on life insurance in the form of a premium on a $10,000, paid-at-65 cash-value policy on Harry that his parents bought for him years ago. Belinda has a group term insurance policy from her employer with a face amount of $200,000. By choosing a group life insurance plan from his menu of employee benefits, Harry now has $100,000 of group term life insurance. Harry and Belinda have decided that, because they have no children, they could reduce their life insurance needs by protecting one another’s income for only four years, assuming the survivor would be able to fend for himself or herself after that time. They also realize that their savings fund is so low that it would have no bearing on their life insurance needs. Harry and Belinda are basing their calculations on a projected 4 percent rate of return after taxes and inflation. They also estimate the following expenses: $15,000 for final expenses, $20,000 for readjustment expenses, and $5,000 for repayment of short-term debts. a. Should the $3,000 interest earnings from Harry’s trust fund be included in his annual income for the purposes of calculating the dollar loss if he were to die? (See the discussions about the Johnsons in Chapter 1 beginning on page 28.) Explain your response. b. Based on your response to the previous question, how much more life insurance does Harry need? Use the Run the Numbers worksheet on page 382 to arrive at your answer. c. Repeat the calculations to arrive at the additional life insurance needed on Belinda’s life. d. How might the Johnsons most economically meet any additional life insurance needs you have determined they may have? e. In addition to their life insurance planning, how might the Johnsons begin to prepare for their retirement years? Solution: a. It would be safer if Harry’s $3,000 from the trust fund be added to his annual earned income for the purpose of calculating the dollar loss if Harry were to die. The Johnsons rely on this income to meet their financial needs, and it is an essential part of their budget. b. Since Harry currently has an insurance policy of $10,000, his remaining life insurance need is $178,288. The dollar income loss if Harry were to die is $188,288{([0.75($50,000 + $3,000) − $0]  3.6299) + $15,000 + $20,000 + $5,000 = $188,288 minus $10,000 in current life insurance on Harry}. This figure is based on the assumptions that (1) Belinda will not qualify for Social Security survivor’s benefits at Harry’s death unless they have children, (2) Belinda could earn 4 percent after inflation and taxes on life insurance proceeds for the four years of need, and (3) final expenses will equal $15,000; readjustment expenses, $20,000; and repayment of any short-term debts, $5,000. c. Because Belinda currently has a policy through her employer for $200,000, her remaining life insurance need is $49,626. The dollar loss if Belinda were to die is about $249,626 {[(0.75  $77,000) − $0]  3.6299} + $15,000 + $20,000 + $5,000 = $249,626 minus the $200,000 life insurance provided by her employer}. This figure is based on the same assumptions used to calculate the dollar loss from Harry’s death. d. Harry needs about $180,000, and Belinda could use about $50,000 more life insurance to cover their estimated four years of needs. Their best bet would be to buy five-year guaranteed-renewable term insurance policies on their lives at a face value of $200,000 for Harry and $50,000 for Belinda. At their ages, these two policies would cost them approximately $220 per year. These policies, because of the

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guaranteed renewability, could serve as a beginning for the Johnsons’ insurance programs when the arrival of children increases their insurance needs. Harry and Belinda need to begin a systematic, regular investment program to start preparing for their retirement years. They should do this through tax-sheltered retirement accounts through their employers or through Individual Retirement Accounts (IRAs). By the time they reach retirement, their life insurance needs will have diminished and their investment program will have grown sufficiently to provide retirement income.

CASE 2: Victor and Maria Hernandez Contemplate Switching Life Insurance Policies Victor and Maria Hernandez have a total of $200,000 in life insurance. Victor has a $50,000 cash-value policy purchased more than 20 years ago soon after when they married and a $100,000 group term policy through his employer. Maria has a $50,000 group term insurance policy through her employer. The couple has been approached by a neighbor who is a life insurance agent. He thinks that they need to change their policy mix because, he says, they are inadequately insured. Specifically, the agent has suggested that Victor cash in his cash-value policy and buy a new variable-universal life insurance policy. a. If Victor cashes in his policy, what options would he have when received the cash value? b. Determine what the $16,000 in cash value in Victor’s life insurance policy would be worth in 20 years if that sum were invested somewhere else and earned an 8 percent annual return. c. Would cashing in the policy be a wise decision? Why or why not? d. As the Hernandez’s children are now grown and out on their own, and both Victor and Maria are employed full-time, give general reasons why Victor may need more or less insurance. e. Explain why it would be a bad idea for Victor to buy a variable-universal life insurance policy. Solution: a. Victor could simply receive the cash surrender value in the form of a check. However, if he wants continued life insurance protection, he could buy either paid-up coverage of the same face value ($50,000) for a limited time period or a reduced face value paid up for the rest of his life. b. $16,000 invested for 20 years and earning 8 percent annually would provide an ending balance of $74,576 ($16,000  4.6610 from Appendix A1). c. Cashing in Victor’s policy may not be a wise decision. Victor’s cash-value policy was purchased more than 20 years ago. Cash-value policies that are 7 to 10 years old (or older) might best be held as the return has finally become competitive with term policies or higher-yielding cash-value policies. In the earlier years of Victor’s cash-value policy, much of the premium went toward the agent’s commission. d. Since they no longer need to provide financial support for their children and they both work, Victor and Maria’s life insurance needs are probably less than when the children were younger. e. Because of the heavy front-end costs of cash-value insurance, it is generally not a good idea to cancel a policy that one has and replace it with a new policy. In addition, variable-universal life insurance would expose Victor to investment risk in his insurance programs.

CASE 3: Julia Starts Thinking About Life Insurance Julia Price is now in her late thirties and has always wanted children. She has arranged to adopt two siblings from overseas, ages 2 and 4. Julia is happy that she earns enough money to support the children, but the agency sponsoring the adoption also requires that adoptive parents purchase sufficient life insurance. Julia currently has a $20,000 paid-up cash-value life insurance policy purchased by her parents when she was a child. In addition, Julia’s employer provides term insurance that matches her salary as an employee benefit. She talked with the agency, and they suggested that she buy a whole life insurance policy in the amount of $450,000 based on her current salary of $150,000. Julia isn’t sure this is the way to go. For one thing, the policy would cost about $3,400 per year. Further, she realizes that the amount the agency requires would not maintain the children’s lifestyle for long and be insufficient to pay for their college educations. Julia is thinking that guaranteed renewable term insurance would be a better way to go. Offer your opinion about her thinking.

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Solution: This is a potential ―Class Activity‖ exercise related to page 397 in the text. Julia’s thinking is on the mark. She understands that you simply should not multiply your earnings by some figure to determine the amount of needed life insurance. Julia should do a life insurance needs calculation using the worksheet in this text to determine how much life insurance she needs. The amount is likely to be more than $2 million dollars given the ages of the children she will adopt and her level of income. Julia also understands that buying guaranteed renewable term insurance is the least expensive and most flexible way to buy life insurance. She should layer several policies totaling to the level of need she has calculated. Then she can add and drop policies as her children grow older.

CASE 4: Life Insurance for a Newly Married Couple Just-married couples sometimes over-indulge in the type and amount of life insurance that they buy. Hakeem and Leshaniqua Jackson of Barstow, California, took a different approach. Both were working and had a small amount of life insurance provided through their respective employee benefit programs: Hakeem, $60,000, and Leshaniqua, $65,000. During their discussion of life insurance needs and related costs, they decided that if Leshaniqua went back to school full-time and completed her master’s degree in industrial psychology, she would have better employment opportunities. Consequently, they decided to use money they had available for additional life insurance to pay for Leshaniqua’s education. They both feel, however, that they do not want to have inadequate life insurance. a. In what way does Leshaniqua’s return to school alter the Jackson’s life insurance needs? b. Would you agree that the amount of life insurance provided by the Jackson’s respective employers is adequate while Leshaniqua is in school? Explain your response. c. Summarize how the Jackson’s life insurance needs might change over their life cycle. Solution: This is a potential ―Class Activity‖ exercise related to page 381 in the text. a. By returning to school, Leshaniqua is improving her skills and education. Upon graduation, she will be better able to support herself and not be as dependent on Hakeem’s income. This might reduce the Jackson’s need for life insurance until children come along. It is possible that Leshaniqua will become the primary breadwinner after her graduation and will need to be insured accordingly, especially if the couple starts a family. b. Leshaniqua has adequate life insurance coverage currently. Hakeem, however, may need a larger life policy since he is partially supporting Leshaniqua while she is in school. If Hakeem were to die, Leshaniqua could support herself only if she dropped out of school. More insurance coverage on Hakeem would reduce this risk. c. With Leshaniqua’s reentry into the workforce, life insurance needs for the Jacksons will again need to be reviewed. Marriage brings with it increased responsibility for another person. Nevertheless, life insurance needs remain low if both spouses are capable of self-support. Should the Jacksons choose to have children, their life insurance needs will drastically increase and could remain high for as long as 25 years while they provide for the children’s years of dependency. With the independence of the children come reduced life insurance needs due to reduced expenses. In addition, they should have income from investments. The latter years of one’s life require little or no life insurance protection.

CASE 5: Fraternity Members Contemplate Permanent Life Insurance Biming Chen is a college student from Cleveland, Mississippi. Soon to graduate, Biming was approached recently by a life insurance agent, who set up a group meeting for several members of his fraternity. During the meeting, the agent presented six life insurance plans and was very persuasive about the benefits of a universal life insurance plan that his company calls Affordable Life II. Under the plan, the prospective graduate can buy $100,000 of permanent life insurance for an extremely low premium during the first five years and then pay a higher premium later when income will have increased. Biming was confused after the

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meeting, as were his friends. Armed with your knowledge from this personal finance book, you have been asked to respond to some of their questions. a. Do you think universal life insurance is a good deal for these people? Why or why not? b. How can the individual fraternity members decide how much life insurance they need? c. Life insurance cannot be as confusing as the agent made it seem. What clearer explanation would you give to the fraternity members? d. What type of life insurance, if any, would you advise for the fraternity brothers? e. How would they know if a life insurance policy is offered at a fair price? Solution: a. No, universal life insurance is not a good idea. Young, single people need little life insurance. Disability income insurance is a much more important concern for them. b. The young men should do the Needs Approach to Life Insurance calculations to determine the loss that would result from a death. Then they could subtract existing insurance and other assets to determine their need for life insurance. c. Life insurance is not as confusing as it sometimes seems to be. The agent presented six types of policies. There are only two types of life insurance, term insurance and cash-value insurance. All life insurance policies are variations on these two types. Term insurance provides pure death protection only and provides the most coverage for the least cost. Cash-value insurance is permanent insurance that also has an investment component that must be examined very carefully as it is often not competitive with other investments. Young people who need little life insurance protection should find appropriate investment vehicles. Cash-value insurance usually does not qualify. d. None. If the men need coverage, as indicated by applying the needs approach, term insurance would be their best deal. e. When the time comes for the fraternity brothers to buy life insurance, they should shop around for the lowest cost policy. But they should only do this after deciding how much and what type of insurance to buy. At that time, a premium quote service would be a good place to start for their comparison shopping.

CASE 6: A Married Couple with Children Address Their Life Insurance Needs Joseph and Marcia Michael of Athens, Georgia, are a married couple in their mid-thirties. They have two children, ages 5 and 3, and Marcia is pregnant with their third child. Marcia is a part-time book indexer who earned $30,000 after taxes last year. Because she performs much of her work at home, it is unlikely that she will need to curtail her work after the baby is born. Joseph is a marriage counselor; he earned $75,000 last year after taxes. Because both are self-employed, Marcia and Joseph do not have access to group life insurance. They are each covered by $50,000 universal life policies they purchased three years ago. In addition, Joseph is covered by a $50,000, five-year guaranteed renewable term policy, which will expire next year. The Michaels are currently reassessing their life insurance program. As a preliminary step in their analysis, they have determined that Marcia’s three survivors would qualify for Social Security survivor’s benefits of about $1,900 per month, or an annual benefit of $22,800, if she were to die. For Joseph’s survivors, the figure would be $2,800 per month, or an annual benefit of $33,600. Both agree that they would like to support each of their children to age 22, but to date, they have been unable to start a college savings fund. The couple estimates that it would cost $300,000 to put all three children through a regional university in their state as measured in today’s dollars. They expect that burial expenses for each spouse would total about $12,000, and they would like to have a lump sum of $50,000 to help the surviving spouse make payments on their home mortgage. They also feel that each spouse would want to take a threemonth leave from work if the other were to die. a. Calculate the amount of life insurance that Marcia needs based on the information given. Use the Run the Numbers worksheet on page 362 Assume a 3 percent rate of return after taxes and inflation and an income need for 22 years because the unborn child will need financial support for that many years.

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Calculate the amount of life insurance that Joseph needs based on the information given. Use the Run the Numbers worksheet on page 362. Assume a 3 percent rate of return after taxes and inflation and an income need for 22 years because the unborn child will need financial support for that many years.

Solution: a. Marcia needs $375,751 in additional life insurance. Her income replacement needs are $358,580 [0.75 × $30,000 × 15.9369 (22 years at 3 percent)]. She also needs $12,000 for her burial, $18,750 for her husband’s three-month bereavement period, $50,000 for the home mortgage, and $300,000 for their three children’s college educations [$12,000 + $18,750 + $50,000 + $300,000 = $380,750]. Her total financial needs equal $739,330 ($358,580 + $380,750). To find her additional life insurance needs, subtract the present value of her Social Security benefits $313,580 [$1,900 × 12 × 13.7535 (the youngest child’s benefits will run out after 18 years; at 3 percent)] and her universal life insurance policy of $50,000 ($739,330 − $358,580 − $50,000 = $330,750). b. Joseph needs $951,397 in additional life insurance. His income replacement needs are $896,451 [0.75 × $75,000 × 15.9369 (22 years at 3 percent rate)]. In addition to his Social Security benefits of $462,118 [$2,800 × 12 × 13.7535 (18 years at 3 percent)], he desires that his life insurance plan provides $12,000 for his burial, $7,500 for his wife’s three-month bereavement period, $50,000 for the home mortgage, and $300,000 for their three children’s college educations ($12,000 + $7,500 + $50,000 + $300,000 = $369,500). His total financial needs equal $1,265,951 ($896,451 + $369,500). To find his additional life insurance needs, subtract his Social Security benefits and his universal and term life insurance policies of $50,000 each ($1,265,951 − $462,118 − $50,000 − $50,000 = $703,833).

EXTENDED LEARNING 1.

Review Life Insurance Company Websites. Visit the websites of two large life insurance companies. Focus on how their approaches to educating the public about life insurance are similar to or different from the information provided in this chapter. Write a summary of your findings. Solution:

Students should prepare a summary of their findings. They may find that some of the websites provide information congruent with the advice presented in this chapter. Other sites may overestimate the benefits of buying cash-value life insurance. 2.

Talk to a Life Insurance Agent. Visit a life insurance agent and ask for an assessment of your life insurance needs given your current situation. Compare the information you receive with what you have learned in this chapter and write a summary of your findings. Solution:

Students will likely find that the life insurance agent overestimates their need for life insurance and is more interested in selling them a cash-value policy. © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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While a cash-value policy in the range of $20,000– $50,000 may provide a good base for young adults, the students may already have such coverage purchased by their parents. And even if they do not have any life insurance currently, their need for life insurance is likely to be extremely low. Students who are married and/or have children will have significantly higher need for life insurance and guaranteed renewable term insurance is the most affordable and flexible way for them to obtain the coverage needed. 3.

How Others Approach the Need for Life Insurance. Talk to two friends and/or relatives below age 30 who are married. Ask about their approach to life insurance and how they have gone about setting up a life insurance program. Write a summary of your findings and compare what they have done to what you would do if you were in a similar situation. Solution:

Students should prepare a summary of their findings and compare the friends’ patterns to their own preferences. It is likely that the friends will not have established a life insurance program and, if they have done so, are underinsured, and overly relying on cash-value life insurance. 4.

Term Versus Cash-Value Life Insurance. Talk to two of your friends or acquaintances who have never purchased life insurance. Explain to them the differences between term and cash-value life insurance. Then inquire about which type they would prefer to buy. Write a summary of your findings and compare their views with yours. Solution:

Students should prepare a summary of the responses. Despite the explanation provided, the friends may still think that cash-value life insurance is the better option because of its investment aspects. Students may need to explain to their © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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friends that even though cash-value life insurance is an investment of sorts it provides an inadequate return as compared to other options readily available. [return to top]

Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 13: INVESTMENT FUNDAMENTALS

TABLE OF CONTENTS Answers to Chapter Concept Checks .................................................................................................... 152 What Do You Recommend Now? .......................................................................................................... 155 Let’s Talk About It ................................................................................................................................. 156 Do the Math ............................................................................................................................................. 157 Financial Planning Cases ....................................................................................................................... 159 Extended Learning.................................................................................................................................. 161

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ANSWERS TO CHAPTER CONCEPT CHECKS LO13.1 Explain how to get started as an investor. 27. Offer some suggestions on where to get money to invest. Answer: There are multiple ways to get the money to invest. Of course, as a general statement we must spend less than our income. Some specific suggestions include setting a pay ourselves first mechanism such as automatic withholding from our paychecks or automatic transfer from a checking account, divert any raises at work into investments, and taking the opportunity when a debt is repaid to continue making that same dollar amount into an investment account. 28. How does savings differ from investing? Answer: Saving is the accumulation of liquid funds. The emphasis is on holding an amount of money until needed with a small amount of interest being earned. Investing is about earning money on our money. Investing builds wealth because the returns on the amounts set aside are left on deposit to also earn money through compounding. Savings grow primarily by simply adding more money to the account. Investments grow through the earnings on the money in the account and earnings on the earnings (the definition of compounding). 29. What are the two parts of an investor’s total return? Answer: The two parts to an investor’s total return are current income earned while holding an investment (interest, dividends, and rent) and capital gains when an investment is sold at a profit after subtracting transaction costs. 30. What average investment returns from stocks are anticipated in the future? Answer: Most financial planners expect 6 to 9 percent annually for investments in stocks. Based on historical returns this is probably somewhat conservative, but the objective of the planners is to increase the likelihood of meeting financial goals so being conservative with returns is smart. About one-third of the return on stocks comes from dividends with the remainder from appreciation in the market price of the shares.

LO13.2 Identify an investment philosophy and invest accordingly. 1.

Review the risk pyramid in Figure 13-2 to identify three investments that might be used in a portfolio of someone seeking long-term returns well in excess of inflation. Why might these three be appropriate investments? Answer: Selection will vary but choices like aggressive-growth mutual funds, growth and income mutual funds, and growth stocks are well justified for their higher expected return with acceptance of more risk. These options can be part of a diversified portfolio seeking long-term gain with higher year-to-year volatility. As the period of analysis extends beyond a year, the volatility drops making these investments more appropriate for long-term goals.

Describe an investment philosophy that is either conservative, moderate, or aggressive What is the key factor that distinguishes between the three approaches to investing? Answer: Answers should focus on the idea that short-term goals require a more conservative philosophy and longer-term goals can be addressed more aggressively. A moderate philosophy is based on a blend of both short- and long-term goals. A key difference in investing approach and philosophy will be the level to which the investor believes they can beat the markets. Believing that they can outperform the average

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return of a given market (say all large stocks) lends to a more aggressive philosophy and active approach to trading. Belief that there is no way to consistently beat the market links to a more conservative and passive investing strategy. 3.

What differentiates an active from a passive investor? Answer: The amount of trading within a portfolio is the key difference between active and passive investing. Believing that one can do better than the market leads to actively managing investments. A buyand-hold philosophy and a more ―steady as you go‖ approach is the more passive approach linked to joining the market and accepting market returns and volatility.

Summarize lending and owning investments. What is better for a new investor seeking long-term financial goals? Answer: Lending investments tend to be more conservative than ownership investments. Higher long-term gains are more likely with ownership-type investments seeking capital gain. Most of the items toward the top of the pyramid in Figure 13-2 are ownership investments. A key difference between the two is the distribution of returns between periodic payments (interest, rent, and dividends) and capital gains.

Comment on how investing differs when planning for short and long-term goals. Answer: For long-term investment goals, capital gains should be emphasized as any current income will need to be reinvested to reach the goal. Investors needing steady income, such as retirees, can focus more on investments that provide current income.

LO13.3 Describe the major risk factors in investing. 1.

What is random risk, and how does it get reduced? Answer: Random risk is the risk associated with the fact that any one investment may do well or do poorly. Random risk is associated with the specific investment chosen such as stock in a particular company that is being successful or having difficulty earning a profit. Random risk can be reduced by diversifying one’s portfolio across multiple different investments, such as stock in many companies.

Explain market risk, what causes it, and how it fits in one’s portfolio. Answer: Market risk is associated with the possibility that an entire market of investments, such as stocks in general, will move up and down over time. Even successful companies can see declines in their stock price during a downturn in the market. Market risk can be reduced by investing one’s portfolio into several different classes of investments, such as stocks and bonds.

Summarize three other types of investment risks and their importance in investing. Answer: Student answers may vary covering any of the risks covered in section 13.3c. Inflation risk results from the possibility that the value of an investment will be helped or hurt by inflation in the economy. Marketability risk is associated with investments for which the seller may have to take a lower price if they are in a hurry to sell an investment. Interest rate risk is associated with the effect that changes in interest rates will have on the value of an investment. Lending investments are particularly susceptible to interest rate and inflation risk. There are many risks to consider in investing that vary from investment to investment and investor to investor. Being aware of these risks will make the difference between good and bad investment decisions.

Explain how transactions costs and leverage may increase or decrease investment returns.

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Answer: Transaction costs affect capital gains as any gain from the sale of an investment will be reduced by these costs. Leverage can increase the risk of an investment in both directions and thus enhances both gains and losses.

LO13.4 Accept the realities of the market and avoid investing mistakes. 1.

Distinguish between bull and bear markets. Answer: A bull market is one in which stock prices have risen 20 percent or more following two declines of 20 percent or more. A bear market is one in which stock prices have declined 20 percent or more from a previous high.

What should long-term investors do about market volatility? Answer: Long-term investors should accept that market volatility is an inherent aspect of investing. Volatility simply means that prices go up and down over time. But the general historical trend has been up for more than one hundred years, and the long-term investor has time to ride out the peaks and valleys and tap into this long-term growth.

Identify three trading mistakes that can be avoided by long-term investors. Answer: Long-term investors should avoid: being overconfident in their knowledge of investing, setting unrealistic goals, trading too much and too often, letting their emotions lead them into buying high such as when a market is peaking and selling low when a market is at a low point, borrowing to invest more to recover losses, taking on too much risk, and being loss averse.

Summarize how herd behavior sometimes leads to a stock market bubble. Answer: Herd behavior that occurs when market prices are rapidly rising can give rise to a market bubble. This surge in market prices is unsustainable and not supported by fundamental reasons related to actual company or sector profitability growth. As soon as a slight downturn occurs, the herd behavior to sell leads to a rapid decline. Hence, the bursting of the bubble.

LO13.5 Decide which of the four long-term safe and effective investment strategies to utilize. 1.

Summarize what the buy-and-hold long-term investment strategy is all about. Answer: The buy-and-hold strategy emphasizes selecting a broad diversity of investments chosen to do well over time such that the investor is confident of average or above average returns. The emphasis is on holding the assets through good and bad times understanding that their values will go up and down, but most importantly up over the long term.

What is the goal of portfolio diversification, and how is this accomplished? Answer: The goal of portfolio diversification is to reduce unsystematic risk. By diversifying, an investor will have a broad portfolio of investments. At any point in time, some will be doing well and others not as well providing an average return somewhere in between. Without diversification, an investor runs the risk that the one investment they hold can drop with no other investments to balance out the losses.

Explain the concept of dollar-cost averaging including why one is guaranteed to acquire assets at below-average costs. Answer: Dollar-cost-averaging focuses on making investments of the same dollar amount on a very regular basis such as monthly or quarterly over long periods of time. As a result, the investor buys more shares when the market price is low and fewer shares when the market price is high thereby pushing the average share cost below the average market price.

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What is asset allocation, and why does it work? Answer: Asset allocation involves two steps. The first step is to select appropriate percentages of one’s overall portfolio to be allocated to equities (typically stocks), lending investments (typically bonds) and cash (typically money market instruments). An example might be 60/30/10 percent. The second step is to review allocations periodically, every year, to ensure that the ratios remain the same. If they have changed, some of the investments in the segment(s) that have grown as a percentage are sold and invested in the segment(s) that have become smaller as a percentage. This rebalancing has the long-term effect of selling high and buying low to enhance overall investment returns.

Comment on three popular rules of thumb of asset allocation including being 100 percent invested in stocks. Answer: There are three asset allocation rules of thumb discussed in the text. The 110 percent rule says that equities should comprise the same percentage as one’s age subtracted from 110. Thus, a 30-year-old would have 80 percent of their portfolio in equities and the remainder in bonds and cash equivalents. The 120 percent rule is similar except one’s age is subtracted from 120 to arrive at the percentage to be invested in equities. Because of lower interest rates over the past thirty years, a new set of rules relates to portfolio percentages for investors based on their age. The thinking identifies these equity percentages; 100 percent for those in their 20s and 30s, 90 to 100 percent for people in their 40s, 75 to 85 percent for investors in their 50s, 70 to 80 percent in their sixties, and 30 to 60 percent in their seventies and later. Investing 100 percent in stocks may be most appropriate for a young investor given that there is time to recover from any significant drop in the market.

What happens to a worker’s retirement account if they use an auto-rebalance account service? Answer: Once a worker has signed a contract with a vendor approved by the employer, the worker decides on their preferred asset allocation. Then, the company sells and buys assets to keep the fund in balance with a set asset allocation. The rebalancing is typically done quarterly, on behalf of the worker; each time adjusting the portfolio back to the specified asset allocation percentages.

LO13.6 Create an investment plan. 1.

Review Figures 13-1 and 13-2 and record in writing an investment plan to fund retirement, the most common, and biggest, long-term goals held by Americans. Answer: Student answers will vary. Investing for retirement is best accomplished through a portfolio dominated by equity investments of moderate to aggressive risk potential. Dollar-cost averaging and asset allocation are especially important in retirement investing.

WHAT DO YOU RECOMMEND NOW? 1.

Portfolio diversification for Sarena? Answer: Sarena is doing a fairly good job of setting aside money for her retirement. She does need to recognize that over 50 percent of her overall portfolio is invested in just one stock. This is far too little diversification although the investment has done well. Her company’s stock could just as easily go down in value. She should investigate ways to diversify her retirement account.

Dollar-cost averaging for Shanice? Answer: Shanice made a smart move by opening an IRA. But she has not funded the plan beyond her initial deposit. She should emulate her sister and begin putting a specific dollar amount, $100 per month, into the account. This would achieve the benefits of dollar-cost-averaging in the mutual fund she has

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selected. Dollar-cost averaging will ensure she buys more shares at low prices and less shares at high prices, guaranteeing that the average cost of shares held is below the average price offered at each point of investing. 3.

Investment alternatives for Sarena? Answer: Sarena has an aggressive growth mutual fund for her Roth IRA account. She should consider moving some of that money into a more broadly diversified mutual fund or into a more conservative investment as she plans to use the funds for a home down payment, at some period in the not-too-distant future.

LET’S TALK ABOUT IT 1.

Why Invest. Why should people invest? Give two reasons each for college students, young college graduates in their twenties, couples with young children, and people in their fifties. Answer: Students will provide a wide variety of answers. However, when asked why people should invest, most students will say to save for the future and meet SMART financial goals. College students may invest to achieve more near-term financial goals, such as buying a car. Young professionals may also invest to achieve financial goals, such as buying a house and retirement. They may also invest for their children’s future. People in their fifties should continue and increase their investing to have funds available during retirement.

Long-Term Rates of Return. Review Figure 13-1, ―Long-Term Rates of Return on Investments‖ on page 412 and offer your views on which two investment types would be most suitable for yourself. Explain why. Answer: Student answers will vary. Since long-term investing for retirement should be foremost among students’ investment goals stocks and bonds would be wise choices. Some discussion of an allocation heavy in equity demonstrates a good initial understanding of portfolio construction.

Market Risk. What do you think is the likelihood of several consecutive years of poor stock market returns? Answer: Responses will range from substantial pessimism about the economic future to an expectation of normalcy or optimism. Multiple reasons should support the response. Yet, the long-term success of the stock market is well documented despite downturns like those connected to the Great Depression and the more recent Great Recession of 2008. When thinking of longer-term investing, especially 20-year periods there have been no recent instances of a negative annual return. Optimism for long-term equity investing should be high when based on past performance.

What Is Your Tolerance for Risk in Investing? Is it the same as for other members of your class? Why or why not? Answer: Student answers will vary. Most of the population, in general, is risk averse. However, some college students will think they are risk takers. In actuality, young students can be risk takers as they have the time to make up for investment advances and declines.

Risk and Return Trade-Offs. Review Figure 13-2, ―Risk Pyramid Reveals the Trade-Offs Between Risk and Return‖ on page 415 and give your views on which three investments would be most suitable for you. Answer: Student answers will vary. They should understand that the suitability of an investment is highly correlated to the time horizon for the investment goal. For shorter-term goals, less risk can be tolerated. For longer-term goals, higher risk can be tolerated.

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Your Investment Philosophy. Is your investment philosophy conservative, moderate, or aggressive? Give two reasons to support the adoption of your philosophy. How does your view compare with the philosophies of other members of your class? Answer: This is a potential ―Class Activity‖ exercise related to page 415 in the text. Many students may not have thought about of developed their investment philosophy at such a young age. You can use this discussion issue to help them understand the different investment philosophies so they can start forming their own opinions. Using an investment risk assessment tool, like the one on the Vanguard website is a good exercise to enhance the discussion.

Two Worries. Review section 13.4c on. Review section 13.4c on ―Trading Mistakes‖ and note two that might worry you the most in the world of investing. Answer: Student answers will vary but consistent themes of taking too much or little risk and not matching the time horizon within the goal, or the investment philosophy should be present. Holding on to losing investments too long is a response.

Investment Strategy. Review the four investment strategies in section 13.5 and select your favorite. Why do you like it so much? Answer: This is a potential ―Class Activity‖ exercise related to page 429 in the text. Student answers will vary but common themes of not having to do too much day-to-day thinking, following the rule of the strategy, should be shared. Emotions and deep analysis are not part of any of the strategies which matches the needs of most individual investors. Each strategy is easy to follow and provides a ―mission statement‖ for the investment plan.

Invest How Much? Assume you have graduated from college and have a good-paying job. As you commit to investing regularly, how much will you put away every month? Explain why you selected this amount. How does your view compare with the views of other members of your class? Answer: Student answers will vary. Many students will not be able to invest much money just yet, so the goal is to start thinking about a time when income is coming in steadily. The goal here is to get them to see that time is on their side and that starting young even with modest amounts is better than waiting to invest when one thinks that they finally have enough extra income to invest. Thinking that way might mean the day never comes. Students will say that it depends on their income. This is where they can be taught the principle of pay yourself first and allocating a set percentage of income (say 20 percent) to investing. Be sure to focus on investing a portion of income rather than a specific amount. Ten percent (including any employer retirement plan contributions) is a good starting point. Then as income goes up the amount invested will go up as well.

DO THE MATH 1.

Annual Investments. Sheldon Cooper and Amy Fowler are married and live in Pasadena, California. They have as a new investment goal to create a college fund for their newborn daughter. They estimate that they will need $200,000 in 18 years. If the Cooper-Fowler family could obtain a return of 5 percent, how much would they need to invest annually to reach their goal? Use Appendix A-3 or the Garman/Fox companion website. Solution: Sheldon and Amy would need to invest $7,109 annually ($200,000 ÷ 28.1324 from Appendix Table A.3). The values in Table A.3 yield what each annual dollar investment over the 18 years will become, thus, to end with $200,000 they need to save $7,109 in the education savings fund yielding 5 percent.

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Number of Years. Mary Cooper, Sheldon’s mother, who lives in east Texas, wants to help pay for her grandchild’s education. How long will it take Mary to reach her goal of $200,000 if she invests $10,000 per year, earning 6 percent? Use Appendix A-3. Solution: It would take approximately 13.5 years. In Appendix Table A.3 look down the 6 percent column until you see factors of 18.8821 for 13 years and 21.0151 for 14 years. We are looking for the factor of twenty since $200,000 is twenty times the $10,000 annual saving made my Mary. From the tables, the best we can say is that twenty comes about halfway between 13 and 14 years to reach the goal. Using a financial calculator, we can be slightly more exact: pmt=-$10,000, FV=$200,000, PV=$0, i=6 percent; solve for n and find 13.53 years.

Future Cost. If one year of college currently costs $25,000, how much will it cost Grand Rapids, Michigan’s resident Michelle Spindle to pay for one year of schooling for newborn daughter, Melissa, 18 years from now, assuming a 5 percent annual rate of inflation for education? Use Appendix A-1. Solution: One year of college will cost $60,165 ($25,000 × 2.4066 from Appendix Table A.1). The cost of one year of education will be well over double if prices consistently rise at 5 percent.

Rebalancing. Kunal Nayyar from London, had $50,000 in investments in the United States at the beginning of the year that consisted of a diversified portfolio of stocks (40 percent), bonds (40 percent), and cash equivalents (20 percent). His returns over the past 12 months were 13 percent on stocks, 6 percent on bonds, and 1 percent on cash equivalents. a. What is Kunal’s portfolio return for the year? b. If Kunal wanted to rebalance his portfolio to its original position, what specific actions should he take? Solution: This is a potential ―Class Activity‖ exercise related to page 434 in the text. a. 7.8% = (.40 × 13) + (.40 × 6) + (.20 × 1) b. His entire portfolio is now worth $53,900 4 × $50,000) × 1.13] + [(.4 × $50,000) × 1.06] + [(.2 × $50,000) × 1.01]}. He has $22,600 in stocks 20,000 × 1.13)], $21,200 in bonds ($20,000 × 1.06)], and $10,100 [$10,000 + ($10,000 × 1.01)]. To get back to his original percentage allocations, he would want to have $21,560 in stocks (.4 × $53,900), $21,560 in bonds (.4 × $53,900), and $10,780 in cash equivalents (.2 × $53,900). He would need to sell $1,040 ($22,600 – $21,560) of his stocks and buy $360 ($21,560 – $21,200) in bonds and $680 ($10,780 – $10,100) in cash equivalents to achieve these targets.

Early and Later. Jordan and Jeremy, who are twins living in Concord, New Hampshire, took different Approaches to investing. Jordan saved $2,000 per year for 10 years starting at age 23 and never added any more money to the account. Jeremy saved $2,000 per year for 20 years starting at age 35. If the brothers earned a 6 percent return, who had accumulated the most by the time they reached age 63? Use Appendix A-1 and Appendix A-3. Solution: Jordan would have $151,407.84 by the time he was 63 [($2,000 per year for 10 years at 6 percent = $26,361.60 ($2,000 × 13.1808); $26,361.60 at 6 percent for 30 years = $151,407.85 ($26,361.60 × 5.7435)]. Jeremy would have $117,257.78 by the time he was 63 ($2,000 per year for 20 years at 6 percent = $73,571.20 ($2,000 × 36.7856); $73,571.20 at 6 percent for eight years = $117,257.78 ($73,571.20 × 1.5938). Therefore, by age 63 Jordan would have accumulated $34,150.06 ($151,407.84 − $117,257.78) more than Jeremy despite having invested $20,000 less in total. The timing of the investments makes all the difference. If one were to take the present value of all investments then we would see that Jordan invested (saved) more in present terms, explaining the extra he has at age 63.

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FINANCIAL PLANNING CASES CASE 1: The Johnsons Embark on a Solid Investment Program This is a potential ―Class Activity‖ exercise related to pages 412 and 414 in the text. After 14 years of marriage, Harry and Belinda’s finances have improved, even though they have incurred debts for an automobile loan and a condominium. Plus, they now have a five-year-old son, Benjamin. They have not yet saved enough for retirement, so they want to catch up. Harry’s retirement account at work is currently worth only $44,000 and Belinda’s at her workplace is valued at $105,000, and they do have $24,000 in investments outside their employers’ retirement plans. The Johnsons have decided to seriously forgo some current spending for the next three years to boost a solid investment program under way while they still have two incomes available and before they expand their family. In addition to continuing their contributions to their retirement programs at work, they are willing to accept a moderate amount of risk and expect to invest $800 per month over the next three years. a. In what types of investments (choose only two) might the Johnsons place the first annual installment of $9,600? Review Figures 13-1 on page 412 and 13-2 on page 415 for ideas and available options. Give reasons for your selections. b. In what types of investments might they place the second $9,600? Why? c. What types of investments should they choose for the third $9,600? Why? Solution: The Johnsons Start an Investment Program a. Harry and Belinda are still relatively early in their investment journey, and they would do well to place their first $9,600 in a diversified portfolio of small stocks with the highest expected return and a balanced mutual fund given their still relatively long investing time frame. Such investments could earn an attractive return, with significant variation year-to-year but less risk when considered over longer (e.g. 20-year time periods). b. For their next $9,600, the Johnsons could consider additional stocks and continued investing in the balanced mutual fund that is heavily weighted in stocks. Yields could be well above inflation for a solid real rate of return. The returns would not be subject to annual taxes as they are investing in retirement accounts. c. The Johnsons’ next $9,600 could go toward additional common stocks and mutual funds and even toward aggressive growth mutual funds. Potential returns on these investments could be good for the long term should they stay invested. The Johnsons should continue to diversify and keep an allocation heavy in stocks. CASE 2: Victor and Maria Hernandez Try to Catch Up on Their Investments The expenses associated with sending two children through college prevented Victor and Maria Hernandez from adding to their investment program. Now that their younger son, Joseph, has completed school and is working full time, they would like to build up their investments quickly. Victor is 47 years old and wants to retire early, by age 60. In addition to the retirement program at his place of employment, Victor believes that their investment portfolio, currently valued at $120,000, will need to triple to $360,000 by his planned retirement time, in 13 years. He and Maria realize that they will have to sacrifice a lot of current spending to save and invest for retirement. a. What rate of return is needed on the $120,000 portfolio to reach their goal of $360,000 (assuming no additional contributions)? Use Appendix A-1. b. Victor and Maria think they will need a total of $600,000 for a retirement financial nest egg to supplement his anticipated small pension from teaching. Therefore, they will need to create an additional sum of about $240,000 through new investments. Assuming an annual return of 8 percent, how much do the Hernandez’s need to invest each year to reach their goal of $240,000? Use Appendix A-3.

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If they assume a 6 percent annual return, how much do the Hernandez’s need to invest each year to reach their goal of $240,000? Use Appendix A-3.

Solution: a. They would need to earn slightly less than 9 percent annually for the $120,000 to grow to $360,000 in 13 years. Look across the 13-year row in Appendix Table A.1 until you see a factor closest to three and then up that column to see that a return of nine is required for their investment to triple. A more exact figure can be obtained with a financial calculator with inputs: PV = −$120,000, n = 13, FV = $360,000, solve for i and find 8.818 percent. b. They will need to invest $11,165.23 annually ($240,000 ÷ 21.4953) to accumulate an additional $240,000 in 13 years if they can earn 8 percent. Each annual dollar invested yields $21.4953 at 8 percent over 13 years. c. Assuming only a 6 percent return, Victor and Maria would need to save $12,710.45 annually ($240,000÷ 18.8821). CASE 3: Julia Price’s Goal is to Buy a Luxury Condominium It has been about 20 years since Julia graduated with a major in aeronautical engineering, and she has been quite successful in her career and her personal finances. Accordingly, she wants to sell her home and buy a luxury condominium. She has $40,000 in savings, and she figures that she can continue her savings and investment program for three more years before making a 50 percent down payment on a luxury condominium. The home that she wants to purchase is currently priced at $800,000. Julia thinks she should invest her $40,000 and additional savings during the next three years by using lending investments like certificates of deposit and bonds rather than owning stocks or stock mutual funds. Offer your opinions about her thinking. Solution: Responses should focus on Julia making a safe lending investment for the next three years because she needs to avoid any market risk to her money that will be used to buy a luxury condominium. Comments also may be offered on the wisdom of Julia buying a home that is so expensive. Moreover, the price of the condominium may continue to rise, and her savings may not keep pace if invested so conservatively. CASE 4: A First-Time Investor Gets a Head Start Lucia Gomez, a flight attendant from Kent, Ohio, is thinking about jump-starting her retirement savings plan by investing the $50,000 gift that her elderly uncle gave her. She also wants to invest $3,000 a year for the next 25 years for retirement. Lucia knows little about investments and does not seem to have a big desire to learn. a. What can you suggest to Lucia about figuring out her investment philosophy? (Mention the information in Figure 13-2 in your response.) b. Would you recommend active or passive investing for her, and why? c. Should Lucia be a lender or owner? d. Identify three mistakes people make when investing for retirement that Lucia should try to avoid. e. Select two of the four recommended investment strategies to recommend to Lucia and explain why she should follow them. f. If Lucia’s $50,000 is invested in a standard investment account and her $3,000 yearly is invested in a tax-sheltered account, with each account growing at 8 percent annually for 25 years, how much money will she have accumulated in each account? She is in the 25 percent combined state and federal tax bracket. (Hint: Adjust the lump-sum investment return for 25 percent taxes.) Solution: a. Jennifer should determine whether she is a conservative, moderate, or aggressive investor. Then, using something like Figure 13-2 she can begin to select appropriate investments that match her attitude toward risk and need to grow investments to meet financial goals.

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b. c.

With little desire to learn about investing, Jennifer should consider passive investing strategies. Jennifer should be an owner at first. She has the time to ride out the peaks and valleys of ownership investments. Over time she can balance ownership and lending investments through an asset allocation strategy. One risk is inflation risk. She can avoid it by accepting enough risk to obtain a rate of return that beats inflation by 4 to 6 percentage points. Another risk is random risk. She can avoid this risk with a diversified portfolio. Another risk is market risk. She can help avoid this risk by investing across several types of markets such as in stocks, bonds, and cash equivalents. Jennifer should use dollar-cost averaging for her $3,000 annual investments. She should also use an asset allocation strategy with a starting allocation of 60 percent in stocks, 30 percent in bonds, and 10 percent in cash equivalents. Her $50,000 dollars would earn 6 (8% × 0.75) after taxes and would grow to $214,595 ($50,000 × 4.2919). Her $3,000 annually would grow to $219,318 ($3,000 × 73.1059) at the full 8 percent rate. Thus, she will have $433,913 at the end of 25 years.

EXTENDED LEARNING 196. Your Investment Strategy. The text discusses four strategies for long-term investors in Section 13.5. Which one appeals to you most and why? Solution: Responses should explain one of the four long-term strategies and why it is appealing. Students drawn to more active investment strategies may find none of the strategies appealing. This is fine and good motivation for class discussion. The strategies presented in the chapter are more connected to passive portfolio management that appeals to busy individuals who are not expecting to invest the time necessary to manage funds with the hopes of beating the market. This discussion should be connected to one’s level of belief that investment markets are (or are not) efficient. 197. Research a Mutual Fund Company. Visit the website of an investment company like Vanguard or Fidelity and determine what it takes to open an account. Summarize your findings by reporting on minimum investment requirements (if any), guidance on investment options, and overall complexity of what it takes to start investing with the company. Is it easy to get started as an investor with this company? Solution: Hopefully, students find it easy to get started with investing. Some companies reviewed may have high minimum investment levels, making entry into investing impossible for a current college-age student. Others may be unnecessarily complex, requiring assistance from firm representatives. Have students share and discuss their findings as they explore what it takes to get started in investing. Ask if this process should be easy? Are there potential dangers in making it too easy?

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 14: INVESTING IN S TOCKS AND BONDS

TABLE OF CONTENTS Answers to Chapter Concept Checks .................................................................................................... 163

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What Do You Recommend Now? .......................................................................................................... 166 Let’s Talk About It ................................................................................................................................. 167 Do the Math ............................................................................................................................................. 169 Financial Planning Cases ....................................................................................................................... 173 Extended Learning.................................................................................................................................. 178

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ANSWERS TO CHAPTER CONCEPT CHECKS LO14.1 Explain how stocks and bonds are used as investments. 31. Distinguish between common stocks and bonds in investments. Answer: Common stocks are shares of ownership in the assets and earnings of a business corporation. Each shareholder has a proportionate interest in the ownership and, therefore, in the assets and income of the corporation. Bonds represent the debt of the entity that originally issued the bond. The holder of a bond has a right to the interest paid semiannually, to sell the bond to another investor at any time, and, if they still hold the bond, the face amount of the bond at its maturity. The basic difference between stocks and bonds is that stocks represent ownership and bonds are lending type investments. 32. How do public corporations use stocks and bonds? Answer: Corporations use both stocks and bonds to raise capital for use in the company. When they sell stock, the funds raised can be used for any legitimate business purpose desired by management. When a company sells bonds, it is borrowing money from the purchaser of the bonds and agrees to pay interest to whoever holds the bond in the future and to redeem the bond (pay back the loan) to whomever owns the bond at its maturity date.

LO14.2 Describe ways to evaluate stock prices and calculate a stock’s potential rate of return. 1.

Distinguish between the term’s income stocks and growth stocks. Answer: Income stocks are stocks in companies that regularly earn a profit and distribute the bulk of those profits to stockholders as dividends. Owners of income stocks expect to receive their return on their investment as dividends are paid while they own the shares. Growth stocks are stocks in companies that retain most of their profits to finance corporate growth. Owners of growth stocks expect to receive the return on their investment in the form of capital gains when the stocks are sold.

Define beta and explain what it means. Answer: Beta is a measure of risk for an investment based on variability of price relative to the variability in the market. A stock with a beta of 1.0 would track the overall stock market. It would go up when the market goes up and go down when the market goes and to the same degree; hence the value of 1.0. Stocks with betas of 1.2 and 2.5 would also go up and down with the overall market. However, the magnitude of the rise and fall would be more pronounced than the overall market. A stock with a beta of 2.5 would be very volatile, rising and falling at 2.5 times the rate of the overall market.

What is fundamental analysis and what is its appeal? Answer: The focus of fundamental analysis is on evaluating the financial strength of the corporation, its position in its market compared to its competitors, and its prospects for the future based on quality management and a strong product line. Fundamental analysis is popular with some because it is a way to choose companies in which to invest based on business data. Investors who believe that markets are not completely efficient may believe that research using this data will give them an edge over other investors when predicting returns from an investment.

Choose three measures of corporate earnings that might be used when selecting a stock. Evaluate what each measure tells the potential investor about the stock. Answer: Corporate earnings are the profits a company makes during a specific time. Corporate earnings are at the core of fundamental analysis. The investor must study past market data, primarily price and sales volume, to learn about an investment’s corporate earnings. A company’s earnings per share (EPS) is annual

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profit divided by the number of outstanding shares. It indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings. The EPS is a measure of the firm’s profitability on a common-stock-per-share basis, and it is helpful because investors can use it to compare financial conditions across companies of different sizes. The price/earnings ratio (P/E ratio) (or multiple) is the current market price of a stock divided by earnings per share (EPS) over the past four quarters. This ratio is the primary means of valuing a stock relative to its earnings. The trailing P/E ratio compares the current market price of a stock to its recent earnings. It is ―trailing‖ because it looks back at previous corporate earnings. The projected P/E ratio compares the current market price of a stock with an estimate (or projection) of what earnings the company is expected to have in the future. It is these expected earnings that should interest individual investors the most as we attempt to chart projected returns from the investment. 5.

What is involved in figuring a potential rate of return for a stock? Answer: First one can use beta to evaluate the risk of the investment relative to the market. Next, we can estimate the market risk for the type of investment we are analyzing. Then we determine our required rate of return. Next, we can calculate the potential return for the investment from both dividends and the potential for capital gains. Finally, we compare the potential return with our required rate of return to determine if the stock is over- or underpriced.

LO14.3 Use the Internet to evaluate common stocks in which to invest. 1.

How does one use a stock screening tool? Answer: An investor can research stocks, bonds, and mutual funds by using stock-screening tools available on the Internet. Screening enables investors to quickly sift through vast databases of numerous companies to find those that best suit their investment objectives.

Name two places where we can go to find information about a company? Answer: Sources of information include the company itself from its annual report and 10-Q and 10-K reports, basic investment information from various financial publications, and information from the appropriate stock exchange, stock ratings services, and stock-screening tools.

Distinguish between the Dow Jones Industrial Average and the S&P 500. Answer: The Dow Jones Industrial Average tracks the share prices of thirty major corporations traded in the United States. The S&P 500 Index tracks five hundred companies. Both are used as gauges of the movement of the market, although the S&P 500 is more representative because of the larger number of stocks it tracks.

Where can we go to look up stock symbols and prices? Answer: The websites of the relevant stock exchange, stockbrokers, and major financial websites are all resources to look up stock symbols and prices.

LO14.4 Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short. 1.

Where can you go to look up stock symbols and prices? Answer: Discount brokers specialize in simply executing buy-and-sell orders placed by investors. Online brokers also do this but do so online. They may or may not offer advice and investment information. Fullservice brokers offer financial advice as well as execute orders and may even make buy-and-sell decisions for investors who ask them to do so on their behalf. The fees range from zero to as much as 2 percent of the value of the transaction depending on the level of service and advice provided by the broker.

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Summarize the differences among these types of stock orders: market, limit, and stop. Answer: Investors might want to use a market order to instruct a broker to execute an order at the best price currently available. Investors would use a limit order to buy at a specified price lower than the current price or to sell at a specified price that is higher than the current market price. A stop order is used to protect a profit or to limit a loss by ordering the broker to sell if the price falls to a specified price.

What is buying on margin and how can it go wrong for an investor? Answer: Buying on margin involves buying shares of stock with money borrowed from a broker. The benefit is that for a percentage of the actual cost one can control a larger number of shares than if purchasing the entire amount with one’s own funds. If the share price goes up, the investor reaps all the profit based on the amount put up thereby increasing the return. There is an equally larger (or amplified) downside risk as well. If the share prices drop sufficiently, the amount borrowed may exceed the maximum allowable amount based on the number of shares. The result would be a margin call resulting in an even sharper financial loss. Margin investing uses leverage to amplify returns. This is good news for the investor if prices rise and equally bad news for the investor as prices fall.

What is selling short and how can it go wrong for an investor? Answer: Selling short involves selling shares of stock not owned (borrowed from the broker) in the hopes that market price for that stock will drop and shares can be repurchased and replaced at a lower. Things can go terribly wrong if the price of the stock were to go up instead. Then the investor would be forced to go into the market and buy at a higher price than received on the sale. Because there is no limit to how high a stock price can rise, there are theoretically no limits to the amount that an investor could lose selling a stock short.

LO14.5 Describe how to invest in bonds. 1.

Distinguish between investment- and speculative-grade bonds. Answer: Investment grade bonds have high ratings and pay lower interest rates that reflects the lower risk. Speculative bonds are ones for which the default rate is high and thus they have a lower rating. The lower rating means that the interest rate on the bonds would have been much lower when the bonds were initially sold. The higher current rate reflects the higher risk of default.

What are the basic differences between corporate, U.S. government, and municipal bonds? Answer: Corporate bonds are debt instruments issued by private corporations seeking to raise capital to finance company operations and growth. U.S. government bonds are debt instruments issued by the U.S. Treasury to cover budget deficits or other government agencies to fund their operations. Municipal bonds are debt instruments issued by states, counties, and cities and their agencies to fund their operations such as to build roads, bridges, and schools. Corporate bonds typically pay the highest rates as they carry the most risk. Municipal bond interest is exempt from Federal income taxation and thus carries lower interest rates. U.S. government bonds are very safe. For example, U.S. Treasury debt is backed up by the full faith and credit of the U.S. government.

Distinguish among Treasury bills, notes, and bonds. Answer: Treasury bills, or T-bills, are typically issued at face amount of at least $1,000 and have maturity from 4 to 52 weeks. They are sold at a discount, meaning that they pay no periodic interest and the return to the investor comes from the difference between the price paid at purchase and the amount paid (the face value) when redeemed at maturity. Treasury notes are sold at face value of at least $100 with maturities of 2, 3, 5, 7, and 10 years. Interest is paid to the investor every six months. Treasury bonds are sold at face

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value of at least $100 and have a maturity in 20 or 30 years. They also pay interest every six months. All these securities are marketable, meaning that they can be bought and sold among investors between their issue date and maturity date. 4.

Summarize the differences between I-bonds and TIPS bonds. Answer: I-bonds are small-denomination ($50 or more) federal government bonds sold to small investors who want an interest rate that will fluctuate with inflation. TIPS also have an interest rate that goes up and down with inflation, but these bonds come in higher denominations ($500 or more) and can be sold on the bond market after initial purchase.

Summarize why bonds and interest rates have an inverse relationship. Answer: Bonds are issued with a fixed interest rate (or coupon rate) for the life of the bond. Interest rates in the economy go up and down over time. When interest rates go up, the rate on a bond will be less relative to the rates that could be obtained elsewhere by an investor. The investor will want to pay less for the bond to compensate for the now lower relative yield on the bond. Thus, higher rates mean lower bond prices as the price of the bond can change, but the coupon rate cannot. The opposite is true when rates in the economy are declining.

Give a math example of how to calculate a bond’s yield to maturity that is different than the one in Section 14.5d. Answer: Any combination of values can be entered into Equation (14.5). The key is to show the income (annual interest payments and average annual price change) in the numerator and the average of the starting and ending value of the bond in the denominator.

WHAT DO YOU RECOMMEND NOW? 1.

Investing for retirement in 18 years? Answer: With her substantial salary, Ariya needs to consider increasing the amount she is saving in her retirement plan. Most important of all is the need for diversification beyond her company’s stock within her retirement fund.

Owning blue-chip common stocks and preferred stocks rather than other common stocks given Ariya’s investment time horizon? Answer: Ariya’s investments, mostly preferred stocks, blue-chip common stocks, and bonds, are quite conservative and usually pay a lower return relative to a diversified portfolio of smaller capitalization stocks. She should also consider growth and value common stocks because they typically provide higher long-term returns, and she still has 18 years until her planned retirement.

The wisdom of owning municipal bonds rather than corporate bonds? Answer: All else the same corporate bonds pay higher returns than tax-exempt municipal bonds, but Ariya should compare the after-tax returns of different municipal and corporate bonds to determine which pays her the higher after-tax return. Some municipal bonds will avoid state, local, and federal income taxes, making the after-tax return higher than the return on corporate bonds. The benefits of avoiding taxes increase as an investor moves into higher tax brackets.

The selling price of her corporate bonds, if sold today?

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Answer: Ariya can use Equation (14.3) to determine the selling price for her bonds. As with all investments, a good way to determine the value or price that one should pay for any investment is to add up the present value of all cash flows. Equation 14.3 does just that by adding the present value of the stream of interest or coupon payments to the present value of the sale price of the bond once it hits maturity. 5.

Investments that might be appropriate to fund her children’s education? Answer: Zero-coupon bonds might be an attractive investment, and if they are held in the names of the children, any interest will be taxed at the child’s presumed low marginal rate, 10 percent. Her children are too old to make growth stocks or other higher-risk stocks appropriate. However, income stocks or blue-chip stocks held through a 529 plan account might also be an option for Ariya. Government bonds that provide tax benefits when used to save for education include Series EE/E and Series I Savings Bonds.

LET’S TALK ABOUT IT 198. Investing Today. What counsel can you offer long-term investors who are hesitant to invest in stocks and bonds? Answer: Although the economy grew in the 2010s and early 2020s with commensurate growth in the stock market, many investors are still wary of the stock and bond market given the crash of 2007–2008, the COVID-19 pandemic, and return of higher levels of inflation. Even with all this uncertainty, someone starting out today will find that, over the long term, stocks earn the greatest returns closely followed by bonds. The task will be to find a mix of fundamentally strong companies in which to invest and then link investments to specific financial goals. 199. Common or Preferred Stock. Make a list of the plusses and minuses of investing in either common stock or preferred stock and explain which is better for you. Answer: Common stocks have the advantages of being able to share fully in the success of the corporation. Of course, if the company has a rough patch, one’s investment in its stock will not do very well. Common stockholders also have a say in the running of the corporation. Common stock shares sell for affordable prices; typically, less than $100 per share. Preferred stockholders have the advantages of knowing exactly what dividends they will receive and will receive their dividends even when common stockholders are not receiving a dividend. However, preferred stock tends to pay lower dividends than common stock may pay when a company is doing well and there is less chance of capital gains from the investment in preferred stock. For investors with a long-time horizon, focused on long-term goals, common stock is the better fit. For investors needing steady income, preferred stock is the better option. 200. Three Good Companies. Make a list of three products and services that you buy on a weekly or monthly basis and the companies that sell them. Offer your initial views on whether each company would be a good place to invest money. Answer: Student answers will vary considerably. Some students will name products and services like renewable energy, health care, food products, computer services, communications, and financial services. You can have a spirited class discussion about the companies that sell these products and services. The focus of the discussion and student answers can be directed toward expectations of future sales. Stock prices are forward looking, meaning it is about what is coming next and not what has already happened. Probe students about the long-term prospects for the products currently offered (or planned to be offered) by the company.

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201. Two Useful Measures. The text introduced a variety of ways to measure stock performance. Name two of those measures that you might use in your own decision making. Offer reasons for selecting those measures. Answer: Students will offer different measures. For example, they may mention earnings per share. Three reasons for using this measure in decision making are (1) it indicates the earnings income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings; (2) it measures the company’s profitability on a common stock, per-share basis; and (3) it is useful because investors can use it to compare the financial conditions of several companies. Any of the measures reviewed in Section 14.2d are appropriate indicators of stock performance. 202. Would You Buy? You have just heard that Microsoft’s stock price dropped $15. If you had the money, would you buy one hundred shares? Give three reasons why or why not. Answer: Some students will immediately say that, yes, they would buy Microsoft stock if it dropped $15. We all need to understand that before buying, we must understand why the drop in the stock price happened. The drop can certainly lead to increased efforts to evaluate company fundamentals along with current economic conditions. We should compare Microsoft to other companies in the industry to get a better comparative financial picture and full understanding of the significant price drop. We all need to ask: What has fundamentally changed in terms of expectations about future earnings at Microsoft? 203. Interesting Stock. Review the classifications of common stock in Table 14-1 on page 424. Based on your personal comfort level for risk, which one type of stock would be of interest to you? Give reasons why. Answer: Some students will state that they do not want to take much risk with their money. If not, they should stick with income and blue-chip stocks. Other students will realize that at their young age, they have time to make up any losses that they may experience, so they are willing to invest in growth stocks that carry a little more risk and the expectation of higher returns. 204. Sources of Information. If you had an investment portfolio of stocks worth $20,000, identify three sources for information that you would use to keep abreast of current information affecting your investments. Answer: There are many sources of information on stocks. Three sources of reliable information would be the Wall Street Journal, the Morningstar, and Bloomberg. 205. Potential Rate of Return. Do you think anyone really calculates the potential rate of return on a particular investment? Should they? Why or why not? Answer: It is difficult to calculate, in the real world, the potential rate of return on the investment. A good discussion issue would be to discuss why the variables involved are difficult to estimate and how that affects securities trading. Investors should, theoretically, calculate the potential rate of return on their investment to be sure they invest at or above their required rate of return. Really, it is an issue of making an educated guess and then readjusting at set intervals. Over time, and as we approach our financial goals, the predictions become more accurate as we hone in on our financial destination. Think of it as a rocket engaging thrusters to correct the path to the ultimate goal. 206. Invest Using Credit. Buying on margin and selling short both involve using credit. Would you invest this way? Give two reasons why or why not. Answer: Students will vary in their views of using credit to invest on margin or through short selling. Advantages are the higher return that is possible and the fact that we can get in with fewer dollars. Disadvantages are the high risk involved and the possibility of a margin call. Potential losses are also enhanced when these two techniques are used. 207. Interest in Bonds. Do bonds interest you as an investment? Why or why not?

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Answer: Student answers will vary. More conservative investors may be attracted to the ―fixed‖ income that comes with most bonds. Some students might be put off by the high dollar amount required to buy just one bond. This issue can be avoided by investing in a bond mutual fund (covered in Chapter 15).

DO THE MATH 208. Numerical Measures. A stock sells at $15 per share. a. What is the EPS for the company if it has a P/E ratio of twenty? b. If the company’s dividend yield is 3 percent, what is its dividend per share? c. What is the book value of the company if the price-to-book ratio is 1.5 and it has 100,000 shares of stock outstanding? Solution: 1. This is a potential ―Class Activity‖ exercise related to page 456 in the text. a. P/EPS  twenty, if P  $15 then $15/EPS  twenty $15/20  EPS EPS  $0.75 b. Dividend Yield  Dividend/Price D/$15  0.05 D  0.05  $15 Dividend  $0.75 c. P/B  Price/Book Value Per Share (BVPS) P/BVPS  1.5 $15/BVPS  1.5 BVPS  $10 Book Value  $10  100,000  $1,000,000 209. Bond Selling Price. What is the market price of a $1,000, 8 percent bond if comparable market interest rates drop to 6 percent and the bond matures in 15 years? Solution: $1,196 = (Annual interest payment  Ai,n)  (Lump sum  PVIFi,n) = ($80/2  PVIFA3%,30)  ($1,000  PVIF3%,30) = ($40  19.6004)  $1,000  0.4120) = $784  $412  $1,196 Interest rates fell so the value of the original bond must go up and the bond is selling at a premium of $196. 210. Market Price. What is the market price of a $1,000, 8 percent bond if comparable market interest rates rise to 10 percent and the bond matures in 14 years? Solution: $851 = (Annual interest payment  PVIFAi,n)  (Lump sum  PVIFi,n) = ($80/2  PVIFA5%,28)  ($1,000  PVIF5%,28) = ($40  14.8981)  $1,000  0.2551) = $595.92  $255.10  $851 Interest rates rose so the value of the original bond must go down and the bond is selling at a discount of $149. 211. Equivalent Taxable Yield. For a municipal bond paying 3.7 percent for a taxpayer in the 24 percent tax bracket, what is the equivalent taxable yield?

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Solution: 4.87%  3.7/(1  .24) 212. Equivalent Taxable Yield. For a municipal bond paying 3.7 percent for a taxpayer in the 32 percent tax bracket, what is the equivalent taxable yield? Solution: 5.44%  3.7/(1  .32) Note how the higher the applicable tax rate leads to a higher the equivalent taxable yield. For planning purposes, investments like municipal bonds are more valuable when the income is earned within higher tax brackets. 213. Yield, Price, and YTM. A corporate bond maturing in 15 years with a coupon rate of 9.9 percent was purchased for $980 and it now selling for $1,010. a. What is its current yield? b. What will be its selling price in two years if comparable market interest rates drop 1.9 percentage points? c. At 15 years to maturity, calculate the bond’s YTM using Equation 14.5 Solution: a. $99/$1,010  9.8% b. If rates drop to 8% the bond price drops to $1,151.85 = (Annual interest payment  PVIFAi,n)  (Lump sum  PVIFi,n) = ($99/2  PVIFA4%,26)  ($1,000  PVIF4%,26) = ($49.50  15.9828)  $1,000  0.3607) = $791.15  $360.70  $1,151.85 As expected, the drop in interest rates leads to the bond being sold at a premium of $151.85 above face value. Investors are willing to pay more to get the 9.9% annual coupon rate or $99 payment. c.

$99  [($1,000  $1,010 )/ 15] ($1,000  $1,010 )/ 2 = $98.33/$1,005 = 9.78% Because the bond was purchased at a premium, the yield to maturity will be below the coupon rate as $10 is lost over the 15 years. YTM 

214. Yield, Price, and YTM. A corporate bond maturing in 22 years with a coupon rate of 8.2 percent was purchased for $1,100 and is now selling for $1,190. a. What is its current yield? b. Calculate the bond’s YTM using Equation 14.5. c. What will the bond’s selling price and YTM be if comparable market interest rates rise 1.8 percentage points in two years?

Solution: This is a potential ―Class Activity‖ exercise related to pages 478 and 480 in the text. a. 6.89%  $82/$1,190 Bond price is up so the interest rate must go down. b. YTM  $82  [($1,000  $1,190)/22] ($1,000  $1,190)/2 = 73.36/1,095

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= 6.7% Bond Value  (Annual interest payment  PVIFAi,n)  (Lump sum  PVIFi,n) = ($82/2  PVIFA5%,40)  ($1,000  PVIF5%,40) $845.52  ($41  17.1591)  ($1,000  0.1420) $82  [($1,000  $845.52)/ 20 ) YTM  ($1,000  $845.52)/ 2 = 89.72/922.76 =9.72% Note the significant increase in the YTM because of the price decline of the bond from $1,190 to $845.52. At this price of $845.52, the exact YTM at that moment must be 10 percent. However, the YTM formula approximates the average return over the 20-year holding period. The assumption that the amount invested is the average of the face value and the price paid is reasonable, but not exact. c.

215. Beta Calculations. Michael Margolis is a single parent and motivational training consultant from Palatine, Illinois. He is wondering about potential returns on investments given certain amounts of risk. Michael invested a total of $6,000 in three stocks ($2,000 in each) with different betas: stock A with a beta of 0.8, stock B with a beta of 1.7, and stock C with a beta of 2.5. a. If the stock market rises 7 percent over the next year, what will be the value of each investment? b. If the stock market declines 8 percent over the next year, what will be the value of each of Michael’s investments? Solution: This is a potential ―Class Activity‖ exercise related to page 456in the text. b. Stock A Stock B Market Increase .07 .07 Beta × 0.8 × 1.7 Percentage increase 0.056 0.119 Beginning value $2,000 $2,000 1.056 1.119 One  percent increase Value $2,112 $2,238 c. Stock A Stock B .08 .08 Market decrease Beta  0.8  1.7 Percentage decrease 0.064 0.136

Stock C .07 × 2.5 0.175 $2,000 1.175 $2,350 Stock C .08  2.5 0.20

Beginning value $2000 $2000 $2000 X 1 minus the percentage  .936  .864  .80 decrease $1872 $1728 $1600 Value Note that more volatility is expected to benefit the investor when the general level of stock prices is going up, but links to higher losses when the market is going down. This explains why everyone is risk seeking in rising markets and very risk averse during declining markets, yet one of the many anomalies observed in the field of behavioral finance. 216. Investment Calculations. Xiao and Kere Jing-Jian, newlyweds from Laramie, Wyoming, have decided to begin investing for the future. Xiao is a store manager, and Kere is a high-school teacher. The couple intends to take $3,000 out of their savings for investment purposes and then continue to invest an additional $200 to $400 per month. Both have a moderate investment philosophy and seek some cash dividends as well as price appreciation.

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Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 14: Investing in Stocks and Bonds

Calculate the five-year return on the investment choices in the table below. (Hint: Start with calculations in tabular form like that shown in Table 14-2. (When making these calculations assume that at the end of the first year, the EPS for Running Paws will be $2.40 with a dividend of $0.66, and the EPS for Eagle Packaging will be $2.76 with a projected dividend of $0.79.) a. Using the appropriate P/E ratios, what are the estimated market prices of the Running Paws and Eagle Packaging stocks after five years? b. Show calculations in determining the projected price appreciations for the two stocks over the five years. c. Add the projected price appreciation of each stock to its projected cash dividends and show the total five-year percentage returns for the two stocks. d. Determine the average annual dividend for each stock and use these figures in calculating the approximate compound yields for each. e. Assume that the beta is 2.5 for Running Paws and 2.8 for Eagle Packaging. If the market went up 20 percent during the year, what would be the stock prices for Running Paws and Eagle Packaging? f. Assume that inflation is approximately 4 percent and the return on high-quality, long-term, corporate bonds is 8 percent. Given the Jing-Jians’ investment philosophy, explain why you would recommend (1) Running Paws, (2) Eagle Packaging, or (3) a high-quality, long-term corporate bond as a growth investment. Support your answer by calculating the potential real (after-tax and inflation) rate of return. The Jing-jians are in the 25 percent combined state and federal marginal tax bracket.

Current price Current earnings per share (EPS) Current quarterly cash dividend Current P/E ratio Projected earnings annual growth rate Projected cash dividend growth rate

Running Paws $30.00 $2.00 $0.15 15 20% 10%

Eagle Packaging $48.00 $2.30 $0.18 21 20% 10%

Solution: The expected earnings and dividends for the two stocks are shown in the table below. These figures reflect 20 percent growth in earnings and 20 percent growth in dividends. End Running Paws Eagle Packaging Year Earnings Dividends Earnings Dividends 1 $2.40 $0.66 $2.76 $0.86 2 $2.88 $0.73 $3.31 $0.95 3 $3.46 $0.80 $3.97 $1.04 4 $4.15 $0.88 $4.77 $1.14 5 $4.98 $0.97 $5.72 $1.26 Total Dividends $4.04 $5.25 a. b. c.

As P/EPS  15 and 21 respectively, the estimated market price of Running Paws after 5 years would be $74.70 (15  $4.98) and that of Eagle Packaging would be $120.12 (21  $5.72). The price appreciation for Running Paws would be $44.70 ($74.70  $30.00) and that for Eagle Packaging would be $72.12 ($120.12  $48.00). The total five-year return on Running Paws would be $48.74 ($4.04  $44.70), for a percentage return of 162 percent ($48.74 ÷ $30.00). The total five-year return on Eagle Packaging would be $77.37 ($5.25  $72.12), for a percentage return of 161 percent ($77.37 ÷ $48).

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The average annual dividend per share would be $.81 ($4.04 ÷ 5) for Running Paws and $1.05 ($5.25 ÷ 5) for Eagle Packaging. The approximate compound yields for both companies are shown below. Running Paws $74.70  $30.00 $0.81  5 ACY   18.6% $74.70  $30.00 2 Eagle Packaging $120.12  $48.00 $1.05  5 ACY   18.4% $120.12 + $48.00 2 Instructors may want to pause here and have students reflect on the ACY and YTM formulas. Both may look daunting, but the formulas are identical where the only difference is that one uses stock terminology and the other bond terminology. See if students can make this connection. The important understanding is that investments in stocks and bonds both have an annual cash flow (dividend or interest) and a price change component. The ACY and the YTM formulas go about calculating annual yields using the same approach. e. In a year in which the market went up by 20 percent, Running Paws stock would increase by 50 percent (2.5  0.2). The increase in the stock’s price would be 50 percent  $30.00, or $15.00. The total price of Running Paws stock would be $45 ($30  $15). In a year in which the market went up by 20 percent, Eagle Packaging stock would increase by 56 percent (2.8  0.20). The increase in the stock’s price would be 0.56  $48.00, or $26.88. The total price of Eagle Packaging stock would be $74.88 ($48.00  $26.88). f. The real return on these three investments is calculated below. Running Paws Eagle Packaging Bond Growth return 18.6% 18.4% 8%

 0.75

13.95%

13.80%

6.00%

 4.00

9.95%

9.80%

2.00%

Marginal tax rate 25 percent After-tax return Inflation 4 percent Since the Jing-jians are young with a moderate investment philosophy, one might typically recommend a growth investment. The bond investment with only a 2.00 real rate of return after taxes will not meet their needs. However, with only $3,000 to invest, they cannot get adequate diversification by investing in either of the two stocks. In addition, they want to make monthly additions to their investment of $200 to $400. This is not practical with any of the three investments they are considering. Xiao and Kere need to consider investments like growth mutual funds to meet their investment needs. Learning about mutual funds is the focus of the next chapter.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Want Greater Yields on Investments

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Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 14: Investing in Stocks and Bonds

The investments of Harry and Belinda have done well through the years. While the cash portion of their portfolio has risen to $16,000, it is earning only 1 percent in a money market account; thus, they are seeking greater yields with bond investments. Examine the following table, which identifies eight investment alternatives, and then respond to the questions that follow. The coupon rates vary because the issue dates range widely, and market prices are above par because older bonds paid higher interest than today’s issues. Name of Issue

Bond Denomination

Corporate ABC Corporate DEF Corporate GHI Corporate JKL Corporate MNO Corporate PQR Treasury note Municipal bond

$1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000

a. b. c. d.

Coupon Rate Percent 5.4 5.5 5.9 4.8 4.1 5.3 2.2 2.1

Years Until Maturity 4 20 12 5 15 11 3 20

Moody’s Rating

Market Price

Aa Aa Baa Aaa B B — Aa

$1,400 1,550 1,250 1,500 1,260 1,200 1,600 1,200

Current Yield

YT M

What is the current yield of each investment alternative? Use Equation (14.4) and complete the column in the table. What is the yield to maturity for each investment alternative? Calculate the YTMs by using Equation (14.5). Knowing that the Johnsons follow a moderate investment philosophy, which one of the six corporate bonds would you recommend? Why? Given that the Johnsons are in the 25 percent combined federal and state marginal tax rate, what is the equivalent taxable yield for the municipal bond choice? Should they invest in your recommendation in part (c) or in the municipal bond? Why? Which three of the eight alternatives would you recommend as a group so that the Johnsons would have some diversification protection for their $16,000? Why do you suggest that combination?

Solution: a. The current yield for each investment is 3.9 percent ($54 ÷ $1,400) for ABC, 3.55 percent for DEF, 4.72 percent for GHI, 3.2 percent for JKL, 3.25 percent for MNO, 4.42 percent for PQR, 1.38 percent for the Treasury note, and 1.75 percent for the municipal bond (see table below). b.

(a) (f) (g) (h) (i) (j) (k) (l) (m)

The yield to maturity for each investment is shown in the table below. For example, Corporate ABC YTM  [$54  (1,000 – 1,400)/4]/[(1,000+1,400)/2]  −0.0383 or −3.83%

Name of Issue (b) Corporate ABC Corporate DEF Corporate GHI Corporate JKL Corporate MNO Corporate PQR Treasury note Municipal bond (n)

F Value (c) $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000

Percent(d) (I) 5.4 5.5 5.9 4.8 4.1 5.3 2.2 2.1

Maturity (e) 4 20 12 5 15 11 3 20

Rating Aa Aa Baa Aaa B B Aa

Price $1,400 $1,550 $1,250 $1,500 $1,260 $1,200 $1,600 $1,200

Current Yield 3.9 3.55 4.72 3.20 3.25 4.42 1.38 1.75

YTM % −3.83 2.16 3.39 0.51 2.09 3.17 −13.69 0.09

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Solution and Answer Guide: Garman/Fox, Personal Finance 14e; Chapter 14: Investing in Stocks and Bonds

The best corporate bond for the Johnsons might be bond DEF because of its high rating and positive returns. It has the highest rating (Aa) and YTM of 2.16 percent. Although the bond matures in 20 years, it has a high current yield (3.55). Therefore, the Johnsons would experience some gain on their investment during their time scale of three to five years at which time they could sell the bond. The taxable yield-to-maturity of 0.09 percent of the municipal bond equals a 0.12 (0.09/(1  .25) percent taxable yield. Therefore, the Johnsons should invest in the taxable corporate bond DEF, which has a taxable yield-to-maturity of 3.55 percent, well above the taxable equivalent yield of 0.12 percent. The Johnsons can combine corporate bonds DEF and JKL and the municipal bond. All the bonds have a (relative) high to moderate Moody’s rating, a high to moderate current yield, and positive taxable yields. This pattern fits with the Johnsons’ moderate investment philosophy.

CASE 2: Victor and Maria Hernandez Wonder About Investing This is a potential ―Class Activity‖ exercise related to pages 452 and 456 in the text. Victor and Maria have decided to increase their contribution to their investment portfolio since Victor is now age 59 and thinking about retiring in five years. For years, they have followed a moderate-risk investment philosophy and put their money in suitable stocks, bonds, and mutual funds. The value of their portfolio is now $420,000, and this is in addition to their paid-for rental property, which is worth $300,000. They plan to invest about $8,000 every year for the next five years. a. Why should Victor and Maria consider buying common stock as an investment with the additional money? Why or why not? b. If Victor and Maria bought a stock with a market price of $50 and a beta value of 1.8, what would be the price of an $8,000 investment after one year if the general market for stocks rose 6 percent? c. What would the same investment be worth if the general market for stocks dropped 8 percent? d. Review the types of stocks in Table 14-1 and select two that you think Victor and Maria might prefer as investments. Explain why. e. Discuss the positives and negatives of preferred stock for Victor and Maria. Solution: Victor and Maria Hernandez Wonder About Investing a. Victor and Maria should consider common stocks because of the potential cash dividends and price appreciation they offer. The average combined annual cash dividend and price appreciation of common stock has been between 8 and 9 percent over the past 80 years. Common stock also offers the potential for high returns. With retirement so close (5 years away), it is tempting to avoid higher risk investments like common stock; however, they also need to be planning for a long period in retirement where they will need to take additional risk to maintain the value of their spending power through retirement. b. If the stock Victor and Maria purchased had a beta of 1.8 and the market rose 6 percent, it is probable that the price of the stock would rise 10.8 percent (1.8  6 percent). If the price went from $50 to $55.40, their investment would rise to $8,864 from $8,000. c. If the market declined by 8 percent, the value of the stock might decline by 14.4 percent (1.8  8), from $50 to $42.80. Victor and Maria’s investment would then be worth only $6,848. d. The theme in student answers should reflect the need for continued growth and stability within their portfolio. A diversified portfolio of income, blue-chip, value, large-cap, and mid-cap types of stock is appropriate. They still will be leaving these funds in the market for many years but with retirement approaching, and a moderate investment philosophy, they should limit more volatile investments like speculative, tech and growth type stocks. e. As owners of preferred stock, Victor and Maria will receive a fixed dividend per share that the corporations are required to distribute before any dividends are paid out to common stockholders. They very rarely will receive any extra income from the stock other than their fixed dividend, even

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when the firm is highly profitable. The regular dividend payments appeal to those who desire a reliable stream of income, such as when Victor and Maria are in retirement. With five years to go before retirement, the benefits of a set income stream are lower. While the income stream may be consistent, the market price of preferred stock is sensitive to changes in interest rates. Victor and Maria will not have voting privileges. CASE 3: Julia Price Seeks Rewards in the Bond Market Julia’s investments survived the last recession and bear stock market declines because she was well diversified and was investing more heavily in bonds in the years preceding the decline. Julia cashed out of some equities and moved most of that money into corporate bonds and Treasuries. As a result, over the past four years, the bond portion of her portfolio rose over 20 percent due to low inflation and declining interest rates, which pushed up the value of her bonds. Now she thinks inflation and bond prices will rise so she is selling all her bonds and investing the proceeds into equities. But the stock market prices seem too high already, so she is hesitating. Offer your opinions about her thinking. Solution: While Julia was wise to capitalize on bond prices in a market of declining inflation and long-term interest rates, putting all her investment portfolio into bonds would result in an extreme lack of diversification. If she did buy more bonds and interest rates rose because of rising inflation, Julia would very quickly suffer losses of 10 to 20 percent or more because long-term rates are sensitive to rate changes. She should retain a balanced portfolio and consider TIPS and I-bonds to protect against inflation. CASE 4: An Aggressive Investor Seeks Rewards in the Bond Market Jessica Varcoe works as a drug manufacturer’s representative based in Irvine, California. She has an aggressive investment philosophy and believes that interest rates on new bonds will drop over the next year or two because of an expected economic slowdown. Jessica, who is in the 35 percent combined federal and state marginal tax rate, wants to profit in the bond market by buying and selling during the next several months. She has asked your advice on how to invest $15,000. a. If Jessica buys corporate or municipal bonds, what rating should her selections have? Why? b. Jessica has a choice between two $1,000 bonds: a corporate bond with a coupon rate of 5.1 percent and a municipal bond with a coupon rate of 3.2 percent. Which bond provides the better after-tax return? c. If Jessica buys fifteen, 30-year bonds with 21 years left until maturity, $1,000 corporate bonds with a 5.1 percent coupon rate for $960 each, what is her current yield? (Hint: Use Equation [14.4].) d. If market interest rates for comparable corporate bonds drop 1 percent over the next 12 months (from 5.1 percent to 4 percent and now 20 years left until maturity), what will be the approximate selling price of Jessica’s corporate bonds in (c)? (Hint: Use Formula 14.3.) e. Based on the market interest rates drop of 1.1 percent in 12 months, using calculations from part (d) how much is Jessica’s capital gain on the $15,000 investment if she sells? How much was her current return for the two semiannual interest payments? How much was her total return, both in dollars and as an annual yield? (Ignore transaction costs.) f. If Jessica is wrong in her projections and interest rates go up 0.9 percent over the year, what would be the probable selling price of her corporate bonds? (Hint: Use Formula 14.3.) Explain why you would advise her to sell or not to sell. Solution: a. If Jessica buys corporate or municipal bonds, her bonds should have a rating of Baa or BBB+ because she could expect good investment quality, suggesting the issuer’s ability to repay principal and interest on time along with a higher return. A more speculative investment would be a B- or Caa and CCC+ rated bonds; however, the lower the rating, the less price increase there will

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c. d.

be if rates decline because the higher return is based on the quality of the company more than current interest rates. If Jessica is in the 35 percent combined state and federal marginal tax bracket, the taxable equivalent yield for the municipal bond is 4.92 percent [0.032 ÷ (1.00  0.35)]. All else the same, Jessica should buy the corporate bond with the 5.1 percent taxable yield. These returns are close and depends on the tax treatment by the state of the municipal bond selected. If the municipal bond is not also state and local tax exempt, then the corporate bond is more clearly the better option. Jessica’s current yield would be 5.31 percent ($51 ÷ $960). Each bond would be worth about $1,150.47. Bond Value  (Annual interest payment  PVIFAi,n)  (Lump sum  PVIFi,n) = ($51/2  PVIFA2%,40)  ($1,000  PVIF2%,40) $1,150.47  ($25.50  27.3555)  ($1,000  0.4529) The price of the bond had to increase to compensate for the 1.1 percent drop-in rates for comparable debt. Jessica bought fifteen bonds at $960 each for a total investment of $14,400. If the rates drop 1.1 percent, each bond can be sold for $1,150.47. Assuming no transaction costs, she earns a capital gain of $190.47 on each bond ($1,150.47  $960) for a total of $2,867.05 in capital gains ($190.47  15). She should have also received interest during the year totaling $51 for each of the fifteen bonds, or $765. Thus, Jessica’s total return is $765 plus $2,867.05, or $3,632.05. On an investment of $14,400, this is an annual yield of 25.22 percent ($3,632.05 ÷ $14,400). If Jessica is wrong and interest rates rise from 5.1 to 6 percent, she will still receive her interest payments of $51 per bond, but the value of her bonds will drop to $864.77. Bond Value  (Annual interest payment  PVIFAi,n)  (Lump sum  PVIFi,n) = ($51/2  PVIFA3%,40)  ($1,000  PVIF3%,40) $896.03  ($25.50  23.1148)  ($1,000  0.3066) Jessica should not sell unless interest rates are expected to continue to increase. Right now, Jessica’s paper loss would be $63.97 ($960  $896.03) per bond, or 6.67 percent ($63.97 ÷ $960). If interest rates do rise, Jessica should reevaluate her alternatives as a speculative investor.

CASE 5: Two Brothers’ Attitudes Toward Investments Kyle Broflovski, a high school guidance counselor in South Park, Colorado, has purchased several corporate and government bonds over the years, and his total bond investments now exceeds $40,000. He prefers investments with some inflation protection. His kid brother Ike, a highly paid physician, has more than $150,000 invested in various blue-chip income stocks in a variety of industries. a. Justify Kyle’s attitude toward bond investments. b. Justify Ike’s attitude toward stock investments. Explain why both brothers might be happy investing some of their money in TIPS bonds. Solution: a. Kyle prefers the variable-value and fixed-yield investments because he can be quite confident about the exact amount of interest, he will earn every six months. He must intend to hold these bond investments until maturity or consider selling only when interest rates have dropped substantially. His selection might reveal his modest to conservative investment strategy and lower level of risk tolerance. b. Ike, on the other hand, has his investments in blue-chip income stocks. He will receive consistent income but in the form of dividends, which will rise a little each year but might vary with economic conditions. In addition, should the value of the stock rise, he could profit by selling shares. Ike has accepted more risk than Kyle. Ike’s dividends are not as guaranteed as are Kyle’s interest obligations, and the price of Ike’s stock could decline (with no guarantee of rising before he needs the funds) if the issuing companies fell on hard times.

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Both brothers might benefit from TIPS or Series-I bonds because they are the only investments guaranteed by the full backing of the U.S. government to outpace inflation. If inflation occurs throughout the life of the security, every interest payment will be greater than the one before. Additionally, Kyle would like TIPS and Series-I bonds because there is steady income, which follows the same schedule as his other investments.

CASE 6: A College Student Ponders Investing in the Stock Market Ji Wu of Troy, New York, has $5,000 that he wants to invest in the stock market. Ji is in college on a scholarship and does not plan to use the $5,000 or any dividend income for another five years, when he plans to buy a home. He is currently considering a small company stock selling for $25 per share with an EPS of $1.25. Last year, the company earned $900,000, of which $250,000 was paid out in dividends. a. Review Table 14-1 and explain which classification of common stock is the best to recommend to Ji? Why? b. Calculate the P/E ratio and the dividend payout ratio for this stock. Given this information and your recommendation in part (a), would this stock be an appropriate purchase for Ji? Why or why not? c. Identify the components of the total return Ji might expect and estimate how much he might expect annually from each component. Solution: a. If Ji is flexible with his plans on when to purchase a home, he should strongly consider growth stocks because they typically pay some dividends and offer a good opportunity for appreciation. If he is completely set on buying a home in five years, then less volatile income and blue-chip stocks may be the better option. As he gets closer to the home purchase, bond and lending type investments are the better option. b.

current price $25.00   20 earnings per share (EPS) $1.25 The price-earnings ratio is twenty times earnings, suggesting that it is a rapidly growing company, and the expectation is for strong growth in the future. The dividend-payout ratio measures the percentage of the total earnings paid out to stockholders as cash dividends. The lower the payout ratio, the greater the odds that the company’s earnings will sustain future dividend payments and would be appropriate for Ji: dividends $250,000 Dividend payout rat io    28% earnings $900,000 Total return is the combination of the cash dividends paid and the capital gain. The return to investors from growth stocks comes primarily from increases in share price appreciation and the payment of dividends. Based on historical returns for long-term investors Ji can expect to earn about 8 to 10 percent on his growth stock investments. However, if he needs the funds in the shorter to medium term, he cannot plan on a ―fixed‖ 8 to 10 percent return. P/ E rat io 

EXTENDED LEARNING 1.

Latest Stock Market Values. Using a resource like The Wall Street Journal or the Internet in general, find the latest values for the following market indexes and indicate how each has performed over the past 12 months: DJIA, S&P 500, NASDAQ Composite, and Wilshire 5000 Index. Solution: Findings will be presented in a narrative or table and will show the change in the four indices.

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Prices of Popular Stocks. Find the latest values for the following stocks and indicate how each has performed over the past 12 months: American Express, AT&T, Caterpillar, Coca-Cola, Dell, Merck, Walmart, and Walt Disney. Solution: Findings will be presented in a narrative or table and will show the change in the eight common stocks.

Characteristics of Bonds. Review Table 14-5 ―Unique Characteristics of Bonds‖, select two that would be critically important to you as a bond investor. Explain why Solution: Student answers will vary. The two most critical should be the coupon rate and whether the bond was callable. Secured or Unsecured may be important to others based on the level of perceived risk.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 15: MUTUAL AND EXCHANGE T RADED FUNDS

TABLE OF CONTENTS Answers To Chapter Concept Checks .................................................................................................. 180 What Do You Recommend Now? .......................................................................................................... 181 Let’s Talk About It ................................................................................................................................. 182 Do the Math ............................................................................................................................................. 183 Financial Planning Cases ....................................................................................................................... 185 Extended Learning.................................................................................................................................. 188

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ANSWERS TO CHAPTER CONCEPT CHECKS LO15.1 Describe the features, advantages, and unique services of investing through mutual funds. 1.

Explain how net asset value is calculated and how it is used by mutual funds. Answer: Net asset value is calculated by adding up the current value of a fund’s total net assets (securities, cash, and any accrued earnings after deduction of liabilities) divided by the number of shares of the investment company that are outstanding. Therefore, if the value of the securities in the fund’s portfolio increases, the net asset value of the fund will also increase. The NAV is used by mutual funds to set the price for its shares.

List five advantages of investing in mutual funds. Answer: Diversification, affordability, professional management, liquidity, low transactions costs (as compared to stocks and bonds), and uncomplicated investment choices are all advantages of investing in mutual funds. Ease of diversification is the biggest advantage and appeal of fund investing.

Name five services that are unique to mutual funds. Answer: Five services unique to mutual funds include telephone and Internet switching privileges, automatic dividend reinvestment, systematic withdrawal plans, beneficiary designation, and easy establishment of retirement accounts.

LO15.2 Differentiate mutual funds by investment objectives. 1.

Distinguish between a managed mutual fund and an unmanaged mutual fund. Answer: With a managed mutual fund, a fund manager or team of managers selects the stocks to hold in the fund and makes buy and sell decisions related to those funds. With an unmanaged fund, the holdings of the fund simply mirror the stocks in a particular stock market index such as the Standard and Poor’s 500 index. The fund manager simply ensures that the holdings mirror the index over time; hence, the term index fund.

Distinguish among mutual funds with an income objective, growth objective, and growth and income objective. Answer: Funds with an income objective invest in bonds and stocks of companies that tend to pay regular dividends and do not retain earnings for future growth. Bond funds and money market funds are examples. Growth funds invest in stocks of companies that tend to retain earnings for future growth of the company. Examples include aggressive growth funds and value funds. Funds with a growth and income objective seek a balanced return made up of current income and capital gains. Examples include equity-income funds and asset allocation funds.

Explain why investors like index mutual funds and exchange traded funds. Answer: Many investors put some or all their money into an index fund or exchange traded fund because the value of such a fund is likely to match the total return performance of a standard set of securities, such as the Standard & Poor’s 500. Such funds make an attractive choice for retirement savings through employer-sponsored 401(k) plans. Investing in an index funds and ETFs gives many investors a degree of peace of mind, knowing that their money will grow along with the growth in the U.S. economy. Index funds and ETFs also have lower management fees than most managed accounts.

LO15.3 Summarize the fees and charges involved in buying and selling mutual funds. 1.

Give three examples of fees or charges associated with load funds.

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Answer: Mutual funds charge management fees, front-end loads when shares are purchased, back-end loads at sale, and 12b-1 fees to cover their marketing costs. The degree to which they charge these fees will vary by type of fund with load funds having front-end loads and no-load funds sometimes having higher 12b-1 fees. 2.

Which is better for most investors, load, or no-load funds? Why? Answer: A no-load fund is the better choice for most investors since load funds do not typically perform any better than no-load funds. No-load funds are always better for shorter-term investors, and some load funds might be better for longer-term investors, especially if the fund only has back-end charges which may fall to zero over time. It is possible to find very well-performing no-load funds with incredibly low 12b-1 fees. Fees impact investor returns with certainty. The higher returns ―promised‖ in managed funds may never come to be.

Summarize the effects of loads and fees on investment returns. Answer: Loads and fees reduce the return to the investor. All other things being equal, funds with a low expense ratio (below 1.0) are the best choice for individual investors. Even if annual fees can be reduced by 0.5 percent, over the long term that small percentage will reduce total returns well more than 25 percent. This could be the difference between being able to retire early and not being able to retire at all.

LO15.4 Establish strategies to evaluate and select mutual funds that meet investment goals. 1.

Explain why it is important to review investment philosophy and goals when selecting mutual fund investments. Answer: Even though mutual funds give us the opportunity to benefit from the investment expertise of the fund manager, we still must select funds that fit our investment philosophy and the time horizon of goals. Someone investing for a home down payment in two years would not want to be in an aggressive growth fund. Someone in their twenties would not want to be investing for retirement in a money market fund or even an income fund.

Explain how to eliminate funds inappropriate for investment goals. Answer: Mutual funds are very up front about their investment objectives so busy people can find the information easily. The investor should read the funds’ prospectuses on-line and use the services of the various fund-rating and screening services. Funds that do not match the investor’s goals can be eliminated from consideration.

What is the best way to monitor mutual fund investments? Answer: Mutual fund information is readily available online and in financial publications. We can monitor the day-to-day price fluctuations of a fund by consulting online resources at a financial site such as Yahoo! Finance or the Wall Street Journal or even at the site for the fund itself. We can also monitor the experiences of the fund at Morningstar.com and by reading the fund’s profile prospectus.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on mutual funds, what do you recommend to Helen Lamb and David Lilienthal in the case at the beginning of the chapter regarding: 1.

Redeeming their CDs and investing their retirement money in mutual funds?

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Answer: Helen and David seem to not be investing in a qualified retirement plan. Most employers offer a full range of investments within a retirement plan, including those suitable for conservative investors, such as balanced funds and bond funds. Both would provide higher returns than their certificates of deposit. 2.

Investing in growth and income mutual funds instead of income funds? Answer: Even though Helen and David are conservative investors, investing in growth-related investments is appropriate given their long-time horizon. So, growth and income funds would enhance their return at minimal additional risk. It is critical to keep in mind that the variability between returns over long periods of time (comparing multiple 20-year time periods) is quite low, thus the additional risk is not as much as it seems on a year-to-year basis.

Buying no-load rather than load funds? Answer: No-load funds typically are best for the retail investor. They would, however, want to ensure that the no-load funds they choose also have low 12b-1 fees, match their investment philosophy, and are in line with their goals.

Buying mutual funds through their employers’ retirement accounts, rather than saving through a taxable account as they have been doing? Answer: Helen and David would be well served by investing through the tax-sheltered funds available through their employers. Not only are they currently hurting themselves by investing so conservatively, but they are also paying taxes on their earnings, as well. Their employers’ retirement accounts provide opportunity for higher yielding investments that delay taxation until the money is needed in retirement.

LET’S TALK ABOUT IT 1.

Investing in Tough Economic Times. Comment on this statement: ―A great time to invest is during times of economic turmoil when assets are undervalued.‖ Answer: This is a true statement. We always want to buy low and sell high. Mutual fund investing through a dollar-cost-averaging approach guarantees good buying decisions because we buy more shares when the economy is in turmoil and prices are low and then we buy less shares when prices are higher.

One Fund of Interest. Review the three broad objectives of mutual funds. Based on your investment philosophy, which one type of fund would be of most interest to you if you were saving to buy a home several years from now? Give reasons why. Answer: To discuss this issue, the students should investigate their own personal risk tolerance and understand that it may change over time and over the course of their careers. Income funds might be preferable for those saving to buy a home in several years.

Two Funds. Assume you graduated from college a few years ago, have a job paying $75,000 annually, and want to invest $300 per month in mutual funds for retirement. Which combination of two or more mutual fund types (see Section 15.2) would you think appropriate? Give reasons for each of your selections. Answer: Some students may say that the more aggressive funds might be comfortable for a young professional with a salary of $75,000. Any losses they might take would be recoverable long before retirement. A combination of aggressive growth, value, and index funds would be appropriate when saving for retirement. It might be beneficial to talk about the more middle-of-the-road funds working for a wide cross-section of investors.

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Spread Your Money over Funds. Assume that your uncle gave you $50,000 to invest solely in mutual funds. Based on your point in the life cycle and your investment philosophy, identify your investment goals and explain how you would spread your money among different types of funds. (See Section 15.2.) Answer: The students should realize the value of diversification and compose a portfolio of stocks, bonds, and mutual funds commensurate with the students’ different investment goals.

Good Choices. Identify the types of mutual funds that would be good choices to meet the following four investment objectives: emergency fund, house down payment, college fund for 2-year-old child, and retirement fund for a 25-year-old. (See Section 15.2.) Give reasons why each one of your recommendations would be appropriate. Answer: It is important that students realize the investment goals that might be appropriate at different stages of their lives. For an emergency fund, a safe money market mutual fund might be a good choice. For a house down payment, the same may be true, although a good short-term bond fund might also work. A college fund for a two-year-old child could reside in a moderate-risk mutual fund, such as a balanced fund or even a growth fund, depending on the financial situation of the parents. A retirement fund for a 25-yearold could be in a growth or even an aggressive growth fund. Expenses should be of paramount importance regardless of the type of fund.

Load or No-Load. Which is a better choice for you, load, or no-load mutual funds? Give some reasons. Answer: All else the same, a no-load fund is the better choice for most investors since load funds do not perform any better than no-load funds. Load funds are ―sold‖ by sales representatives who may be biased, rather than purchased by investors. There are thousands of no-load funds from which to choose. One should seek a no-load fund with a very low 12b-1 fee and, thus, a low-expense ratio.

Select Two Funds. Review Table 15-1 on the ―Advantages of Investing Through Mutual Funds‖ on page 494, and select two that would be important to you as an investor. Explain why. Answer: Students will have differing views of which advantages are most important and why. Emphasize that mutual funds’ advantages make it an ideal way to begin as an investor. Diversification is the first and most obvious benefit but push students to consider all the additional benefits listed in Table 15-1.

Investing in Mutual Funds. Have you or anyone in your family invested in mutual funds or exchange traded funds? What positive and/or negative experiences can they report? Answer: Student answers will vary. The discussion should bring out the major positives (diversification, automatic reinvesting, convenience) and negatives (less control of taxes, expenses) of mutual fund and exchange traded fund investing.

DO THE MATH 1.

Net Asset Value. Last year, David McCullough of La Junta, Colorado, bought the XYZ mutual fund, which has total assets of $240 million, liabilities of $10 million, and fifteen million shares outstanding (LO 15-1). a. What is the net asset value? b. If the current price is $18, is this a good deal?

Solution: a. b.

($240,000,000 − $10,000,000) / 15,000,000 = $15.33 This fund is selling at a significant premium above its net asset value. An investor should be cautious about investing in the fund.

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Back-end Load. Your neighbor, Kitty Kardashian, of Philadelphia, Pennsylvania, bought $5,000 worth of mutual funds with a back-end load of 5 percent if she sells within the first year. It decreases 1 percent a year afterward (LO 15-3). a. If Kitty sells during the third year, how much will be the back-end load? b. Did Kitty make a good decision buying such a mutual fund?

Solution: a.

Five percent − 1% − 1% = 3% The reduction would be an additional 1 percent (lowering the charge to 2 percent) had she waited for the end of the third year, but because she sold during the third year, the back-end load is still 3 percent. If Kitty plans to hold the fund for more than five years, the fact that it has a back-end load in the first five years would be unimportant to Kitty. Unfortunately, she needed the money sooner, and the 3 percent load is high relative to many other mutual funds.

Profits and Taxes. A year ago, George Jetson, from Orbit City, Texas, invested $1,000 by buying one hundred shares of the Can’t Lose Mutual Fund, an aggressive growth no-load mutual fund. George reinvested his dividends, so he now has 112 shares. So far, the NAV for George’s investment has risen from $10 per share to $13.25 (LO 15-4). a. What is the percentage increase in the NAV of George’s mutual fund? b. If George redeemed the first one hundred shares of his mutual fund investment for $13.25 per share, what would be his capital gain over the amount invested? c. Assuming George pays income taxes at the 25 percent combined state and federal rate, how much income tax will he have to pay if he sells those first one hundred shares? d. What would be the tax implications of selling all 112 shares?

Solution: a.

$ 13.25  10.00 b. c. d.

3.25/ 10.00 = 32.5 percent $3.25 × 100 = $325 $325 × 0.25 = $81.25. If George had waited until a year had passed, he would have qualified for the long-term capital gains rate of 15 percent and saved $32.50 in taxes. Selling all 112 shares means that George sold the shares that were purchased with his dividends. Income taxes would be paid on the dividend itself, and the twelve additional shares have a basis equal to the price paid at the time of the dividend distribution. For long-term stockholders, this can lead to a significant accounting problem. Thankfully, brokers track these reinvestment transactions, and figuring the profit on those twelve shares is often easy using the records linked to the account.

Mutual Fund Sales. Two years ago, Izabella Martinez, from Atlanta, Georgia, invested $1,000 by buying 125 shares ($8 per share NAV) in the Can’t Lose Mutual Fund, an aggressive growth no-load mutual fund. Last year, she made two additional investments of $500 each (50 shares at $10 and forty shares at $12.50). Izabella reinvested all her dividends. So far, the NAV for her investment has risen from $8 per share to $13.25. Late in the year, she sold sixty shares at $13.25 (LO 15-4). a. What were the proceeds from Izabella’s sale of the sixty shares? b. Investors can use the Internal Revenue Service’s ―average-cost basis method‖ to determine the average price paid for one share. Begin by calculating the average price paid for the shares. In this instance, the

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c. d.

$2,000 is divided by 215 shares (125 shares + 50 shares + 40 shares). What was the average price paid by Izabella? To finally determine the average-cost basis of shares sold, we multiply the average price per share times the number of shares sold—in this case, 60. What is the total cost basis for Izabella’s 60 shares? If Izabella must pay income taxes on the difference between the sales price for the sixty shares and their cost, how much is this difference? What might be the disadvantage of using the average-cost basis versus selling specific shares with their original basis?

Solution: a. b. c. d. e.

$13.25 × 60 = $795 $2000 ÷ 215 =$9.30 $9.30 × 60 = $558 60 × $13.25 = $795; $795 − $558 = $237 Some opportunities to manage taxes are lost when using the average-cost basis. In this case, to minimize any capital gains tax, Izabella would want to designate the higher priced shares for sale (assuming she has held them for over a year), thus minimizing the taxable profit. Investors may also have some stocks that were purchased at higher amounts that could be designated for sale and then the loss can be used for tax purposes.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Decide to Invest Through Mutual Funds After learning about mutual funds, the Johnsons are confident that they are a great way to invest, especially because of the diversification and professional management that funds offer. The couple has a financial nest egg of $9,500 to invest through mutual funds. They also want to invest another $300 per month on a regular basis. Although not yet completely firm, Harry and Belinda’s goals at this point are as follows:  They want to continue to build their retirement income fund to retire in about 26 years.  They will need about $10,000 in six to eight years to use as supplemental income if Belinda has a baby and does not work for six months.  They might buy a new automobile requiring a $10,000 down payment if they decide not to have a child. Knowing that the Johnsons have a moderate investment philosophy, that they live on a budget, and that they have a well-established cash-management plan, advise them on their mutual fund investments by responding to the following questions: a. Some comparable mutual fund performance data on stock funds are shown in Table 15-2 on page 476. Using only that information and assuming that you are recommending some funds for the Johnsons’ retirement needs, which two funds would you recommend? Why? b. How would you divide the $9,500 between the two stock funds? Why? c. How much of the $300 monthly investment amount would you allocate to each of the stock funds? Why? d. Assume that both funds increase in value over the next 10 years. Another bear market then occurs, causing the NAVs to drop 25 percent from the previous year. Would you recommend that the Johnsons sell their accumulated shares in the funds? Why or why not? e. Determine the value of the shares purchased with their $9,500 original investment in 10 years, if the two funds’ NAVs increase 6 percent annually for the 10 years. (Hint: Use Appendix A.1.)

Solution: a.

As the Johnsons are investors with a moderate investment philosophy, they will avoid sector and emerging market funds. To earn the best return for retirement, the Johnsons want to avoid funds that

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c. d.

charge sales loads and strive to not invest in managed funds that might underperform the market. Thus, they should consider Vanguard Total Stock Market Index Fund, Vanguard 500 Index Fund, and Fidelity Contra fund. The first fund owns virtually all stocks in the market, the second one the five hundred most popular stocks, and the third tries to buy and sell share using a contrarian philosophy. The first two funds might suit them best. There are some other no-load funds in Table 15-2 that they might consider as well, although the performance data over the past five years is quite mixed. Their $9,500 might be split equally between the two stock funds, although the Vanguard Total Stock Market Index Fund has earned a better return over one, three, and five years. Accordingly, they might want to invest more than half, even two-thirds of the $9,500 into that fund because they might earn a little higher return on that fund rather than the other. But it is impossible to know for sure. The return values are in the past, and unless we have a crystal ball or a time machine, we will never be able to be certain as the best pick. All we can do is assume that past performance is indicative of what might happen in the future. The one thing that is for sure is the fees, these can and should be avoided. Using the same logic as above, the Johnsons could put more than half into the Vanguard Total Stock Market Index Fund. There is no reason for the Johnsons to sell mutual fund shares in which they have been investing for a decade when the returns have been average or better. Their index funds are a great place to invest, and now that the NAVs are off 25 percent, this might very well be an excellent time to invest additional cash into the market via mutual funds. Selling when prices are down—especially if the money is not needed to meet a financial goal—simply locks in the loss. $17,012.60 = $9,500 (1.7908)

CASE 2: Victor and Maria Invest for Retirement Victor and Maria Hernandez plan to retire in less than 15 years. Their current investment portfolio is distributed as follows: 40 percent in growth mutual funds, 40 percent in corporate bonds and bond mutual funds, and 20 percent in cash equivalents. They have decided to increase the amount of risk in their portfolio by taking 10 percent from their cash equivalent investments and investing in some mutual funds with strong growth possibilities. a. Of the stock mutual funds listed in Table 15-2 on page 476, which two would you recommend meeting the Hernandez’s’ goals? Why? b. Would you recommend that the Hernandez’s remain invested in those two funds during their retirement years? Why or why not?

Solution: This is a potential ―Class Activity‖ exercise related to page 506 in the text. a. Student answers will vary, but no-load funds with higher and more stable three- and five-year returns are the best options. b. While most experts argue that investors should be a bit more conservative in their investment philosophy during their retirement years, it is likely that a 65-year-old is going to live at least another 20 years in retirement. Thus, the Hernandez’s should not be too conservative with their investments as they begin retirement, and the index funds would be quite appropriate for some of their funds during retirement.

CASE 3: Julia Price Is Going to Invest Big in Mutual Funds It has been over 25 years since Julia graduated with a major in aeronautical engineering, and she has been quite successful in her career as well as in managing her personal finances. She has moved up the career ladder, earns a high salary, has $50,000 in equity in her condominium, and has an investment portfolio valued at $400,000 that includes $200,000 in retirement assets through her employer’s retirement plan. She wants to liquidate her remaining $200,000 investment portfolio now invested in stocks, bonds, and gold and put everything into mutual funds. Julia is optimistic about the future of investing. After serious

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research, Julia has decided to invest $200,000 into ETFs and index mutual funds rather than actively managed funds. Offer your opinions about her thinking.

Solution: Julia is making an excellent decision by moving her investments from stocks, bonds, and gold as each of these is difficult to manage and maintain diversification without incurring significant transaction costs. Transaction costs for ETFs and index mutual funds are about as small as exist in the world of investments. This decision also will get Julia away from the necessity to actively manage these funds for retirement, thus giving her more time for other activities. By shifting her investments, Julia is deciding to join the market instead of trying to beat the market. It is likely a wise move given the poor track record of active fund managers.

CASE 4: Matching Mutual Fund Investments to Economic Projections Joshua Wickler, an automobile salesperson for the past 10 years in Albuquerque, New Mexico, is divorced and contributes to the support of his two children. He is interested in investing in mutual funds. Joshua wants to put $20,000 of accumulated savings into a stock index mutual fund and then continue to invest $200 monthly for the near future, perhaps using the money for retirement starting in about 25 years. Joshua has limited his choices solely to the index mutual funds listed in Table 15-2 on page 476. a. In Table 15-2, note that there are two index funds based on the S&P 500 Index. Suggest a reason Joshua should invest in one or the other, noting that the returns for the Vanguard 500 Index Fund are about the same as the Fidelity 500 Index Fund. b. Given that Joshua plans to invest $2,400 annually for the next 25 years, which of the other two index funds (Vanguard Total Stock Market Index Fund or Vanguard Emerging Markets Stock Fund) would you recommend, and why?

Solution: This is a potential ―Class Activity‖ exercise related to page 506 in the text. a. To distinguish between the two S&P 500 index funds, a bit more research is needed. The Vanguard fund has a management fee of 0.14 percent, and the Fidelity fund is a bit lower at 0.09 percent so Joshua might earn a better annual return with Fidelity. The difference is small, and these funds can change so really either fund will match his needs. b. Some will recommend investing in overseas stock markets via the emerging markets fund while others may suggest staying domestically with the total stock market fund, although the latter might be better from a diversification point of view. Investing in both these index funds could be the best recommendation.

CASE 5: Selection of a Mutual Fund as Part of a Retirement Plan Lola Garcia, a single parent of a six-year-old child, works for a utility company in Baltimore, Maryland, and is willing to invest $3,000 per year in a mutual fund. She wants the investment income to supplement her retirement pension starting in approximately 30 years, and she has a moderate investment philosophy. Lola is concerned about not investing too conservatively because she expects to live a long life, given that her eldest relatives lived well into their nineties. Advise Lola by responding to the following questions: a. If Lola invests $3,000 annually into two growth mutual funds, which two types would you recommend and why? See the list within Section 15.2b. b. Alternatively, if Lola invests $3,000 annually into two growth and income funds, which two would you recommend and why? See Section 15.2c. c. Summarize why these two types of mutual funds might be suitable for Lola.

Solution: a.

Lola’s employer provides a pension that she can depend upon assuming she continues to work for the same employer. Therefore, Lola can take at least some moderate risk in her other investments for retirement. She might invest in growth and value mutual funds, both of which should increase in value

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b. c.

as the economy grows. Given her pension, she might want to consider small-cap or microcap funds that have had the highest returns historically. Since these investments are for retirement, Lola might consider target-date mutual funds. Balanced funds are good too so that there is little Lola would need to do to keep her desired asset allocation. Growth and Growth and Income funds are a good fit for the long-term investor. If Lola invests for retirement, she is highly likely to succeed financially by seeking growth to stay ahead of inflation. All these funds should increase in value as the economy grows.

CASE 6: Selection of an Exchange Traded Fund as Part of a Retirement Plan Ernesto Melendez, a married father of two adult children, works for a finance company in Las Vegas, Nevada, and is willing to invest $5,000 per year in an exchange traded fund. He wants the asset balance to be available to supplement his retirement pension starting in 20 years. He has a moderate investment philosophy, and he is planning to keep investment costs extremely low. Advise Ernesto by responding to the following questions: a. If Ernesto invests $5,000 annually into one ETF, which two would you recommend as finalists to him? See the list in Table 15-3. b. Summarize why one or these two ETFs might be most suitable for Ernesto.

Solution: This is a potential ―Class Activity‖ exercise related to 507 in the text. a. Student answers will vary. Ernesto will want funds that have done well over a period of years not just recently. He will also want a fund with a low expense ratio. b. Student answers will vary. Low fees and steady returns should justify the selection of funds.

EXTENDED LEARNING 1.

Model Mutual Fund Portfolios. Go to Kiplinger’s article on model portfolios at https://www.kiplinger.com/investing/mutual-funds/604463/kiplinger-25-model-portfolios and review the aggressive, moderate, and conservative illustrative portfolios Which of these three portfolios is most appealing to you? Explain why. Solution: Response will be unique for each student and summarize how three illustrative portfolios might fit their investment needs. This exercise can be supported by using some sort of assessment of students’ risk tolerance. One of many good examples is fund here: https://www.moneyunder30.com/risk-tolerance.

Fund Research Explore the fund resources at Yahoo! Finance (finance.yahoo.com) and look up three funds of interest, using some of the names of funds found in Table 15-2. Summarize your findings. How does this resource compare to Morningstar that we used as part of Online Activities? Solution: Response will be unique for each student and summarize information about three mutual funds that interest them. There should be some observation that the Morningstar resources used in a previous question are more oriented to investment professionals, and Yahoo! Finance is more focused on individual investors. However, both provide much of the same information, and whichever is preferred by the student is the best choice.

Screening for ETFs. Go to VettaFi’s ETF screener (etfdb.com/screener/) and experiment with the "basic screener." What items did you select to reduce the number of potential ETFs for consideration? Are any ETFs of particular interest? Why? Solution:

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Response will be unique for each student. Students will experience new terms as they select from the many items that can be entered into a screen. Guide students to focus on the topics discussed in this class including asset class, expenses, returns, and risk measures. 4.

Mutual Fund Services. Review Table 15-1 on ―Advantages of Investing Through Mutual Funds‖ on page 464 and select two that would be important to you as a mutual fund investor. Explain why. Solution: This is a potential ―Class Activity‖ exercise related to page 494 in the text. Response will be unique for each student. Items selected should highlight the ease and convenience of investing in funds as new investors see diversification and investment options that match their investment philosophy and goals.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 16: REAL ESTATE AND HIGH -RISK INVESTMENTS

TABLE OF CONTENTS Answers to Chapter Concept Checks .................................................................................................... 190 What Do You Recommend Now? .......................................................................................................... 193 Let’s Talk About It ................................................................................................................................. 194 Do the Math ............................................................................................................................................. 195 Financial Planning Cases ....................................................................................................................... 197 Extended Learning.................................................................................................................................. 199

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ANSWERS TO CHAPTER CONCEPT CHECKS LO16.1 Demonstrate how to make money investing in real estate. 1.

Name two things investors should consider doing before investing in real estate.

Answer: Two things investors should do before investing in real estate are included in this list:  Consider investing in properties only in locales where there are thriving businesses located near good schools, supermarkets, and public transportation.  Line up financing options before searching for properties.  Hire an inspector to inspect the physical condition of all properties seriously under consideration.  Hire an accountant experienced in real estate investing.  Set up a limited liability corporation to own real estate investments because it protects personal assets in case someone is injured on rental property and sues.  Consider hiring a licensed contractor for plumbing, electrical, and expensive repair jobs.  Consider hiring a management company to tend to property, including maintenance; the cost is usually 8 to 12 percent of monthly rental income.  Contribute to a reserve fund equal to about three to six months’ expenses for vacancies, repairs, and maintenance.  Set aside a contingency fund for unanticipated problems with real estate investment property. Twentyfive percent of annual operating expenses are reasonable for a contingency fund. 2.

What are the two key financial considerations to consider before investing in real estate?

Answer: The two financial considerations relate to whether there will be a positive cash flow from the property and the prospects for price appreciation that can result in a capital gain when the property is sold. Like all other investments, it comes down to cash flow and price changes. 3.

Distinguish between the price-to-rent ratio and the rental yield as measures of current income.

Answer: The price-to-rent ratio is the purchase price divided by the annual rent. The lower the number, the more likely it is that the investor will make money. The rental yield gives an estimate of the income the investor might net each year as a percentage of the purchase price. The higher the figure, the better for the real estate investor. 4.

Distinguish between capital improvements in real estate investing and repairs.

Answer: Capital improvements are costs incurred in making changes in real property—beyond maintenance and repairs—that add to its value. Installing a pool and adding a room represent capital improvements. Repairs are expenses (taken against an investor’s annual cash-flow income) necessary to maintain the value of the property. The bottom line is that capital improvements impact the ultimate capital gain when the property is sold, and repairs go against periodic cash flows.

LO16.2 Recognize how to take advantage of beneficial tax treatments in real estate investing. 1.

Summarize how depreciation is used to reduce the taxable income from a real estate investment.

Answer: Depreciation is the decline in value of an asset over time due to normal wear and tear and obsolescence. Tax laws written by Congress and administered by the IRS allow depreciation based on the purchase value

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of a property (less the value of the land itself) to be taken as an expense against rental income. Residential properties can be depreciated over 27.5 years and commercial properties over 39 years. The amount of depreciation is deducted from rental income, thus lowering the taxable (but not actual) income from the property and increasing the investor’s after-tax return. When the property is sold, the total depreciation taken against the property will lower the cost basis and increase any capital gain. 2.

Briefly explain how the interest paid on the mortgage of a real estate investment reduces one’s income taxes.

Answer: Persons who invest in real estate that produces income can subtract mortgage interest from the rental income received from a property. They can also subtract property taxes, repairs, and depreciation from the rental income generated by the property. The amount of expenses can be deducted from rental income, thus lowering taxes, and increasing the investor’s return. Expenses like interest and property taxes are only itemized deductions for residential homeowners. Because mortgage interest and property tax expenses reduce investor income without having to itemize deductions, they prove to be more valuable to investors than residential homeowners. 3.

Summarize the special income tax regulations on renting out vacation homes.

Answer: If we rent out a vacation property for fourteen or fewer days during the year, the income is tax free. If we limit our own use to fewer than 15 days or 10 percent of the time it is rented, whichever is greater, we have turned the endeavor into a business, and we may deduct expenses attributable to the rental business, such as mortgage interest, property taxes, depreciation, utilities, repairs, insurance, advertising, homeowner’s association fees, and property management fees, as well as auto and other travel expenses.

LO16.3 Calculate the right price to pay for real estate and how to finance a purchase. 1.

Summarize how the discounted cash-flow method helps determine the right price to pay for a real estate investment.

Answer: The discounted cash-flow method provides a way to use time value of money considerations to bring the future flows of income from the property into a present value. This can be compared to the asking price (the seller’s estimate of its present value) to determine if the investment will be successful. 2.

Comment on the wisdom of buying a timeshare as an investment.

Answer: It is very hard to sell a timeshare, and sales commissions of legitimate resellers are high. Timeshare sellers rarely receive 50 percent of their original investment in the sale, and that is if they can sell it at all. An entire industry has emerged to help consumers get out of the annual fees connected to timeshare ownership. Timeshares are neither an investment nor a good way to secure vacation accommodation. 3.

List two ways to finance a real estate investment.

Answer: There are three mechanisms to finance a real estate investment: conventional fixed-rate mortgage, adjustable-rate mortgage, and seller financing. The conventional mortgage has the most predictable costs and outcome, so it presents less uncertainty (risk) to the buyer.

LO16.4 Assess the disadvantages of investing in real estate. 1.

Summarize why foreclosures and illiquidity are disadvantages in real estate investing.

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Answer: In communities where there are many foreclosures, other sellers must lower their home prices to compete. This depresses the values of all comparable housing, thus making it more difficult for anyone to sell at a reasonable price. Illiquidity is a disadvantage because the investor will have difficulty getting out of the investment and may have to take a loss if cash is needed quickly. 2.

Briefly comment on why interest rate risk is dangerous to real estate investors.

Answer: Rising interest rates make it more difficult for people to afford housing. These pressures force prices and rents down and decrease revenue for real estate investors. 3.

Comment on why real estate investors often have time-consuming management demands.

Answer: Managing a real estate investment requires time for conducting regular inspections of the property, dealing with insurance companies, making repairs, and collecting overdue rents. It needs to be treated like a job— because it is one.

LO16.5 Summarize the risks and challenges of investing in the high-risk investments of collectibles, precious metals, and gems. 1.

Identify one collectible that might be an interesting investment and explain why it might be difficult to make a profit.

Answer: Student answers will vary. Many will have very unrealistic expectations of how a collectible they find interesting would really do well as an investment. Acknowledgment of the speculative nature of all collectible investing is important. All funds can easily be lost in these types of deals. 2.

Explain why some investors buy gold and other precious metals and tell why choosing one type of investment might be appealing or unappealing to you.

Answer: Gold and other precious metals are primarily a hedge against inflation as they go up in value significantly in inflationary periods. The appeal of certain metals will vary among students. Fear of continued inflation and worsening economic and political conditions typically drives demand for precious metals. 3.

Identify some risks of investing in precious stones and gems.

Answer: The primary risk of precious gems is that most investors buy at retail and sell at wholesale, reducing the ability to buy low and sell high. Transaction costs are also very high, thereby reducing the potential for a positive return. Moreover, valuation of gems is not an exact science, leading to wide variation in value at any given time.

LO16.6 Explain why options and futures are risky investments. 1.

Distinguish between a call and a put for the options investor.

Answer: A call is a contract allowing the holder to purchase an asset (usually a stock) at a price established in the contract even if the current market price is higher. A put is a contract allowing the holder to sell an asset (usually a stock) at a price established in the contract even if the current market price is lower. One would

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purchase a call option if the expectation were for rising prices in the underlying stock, and a put option might be used to protect an investor worries about steep declines in the underlying stock price. 2.

Summarize one way a person with a conservative investment philosophy can profit in options.

Answer: Certain types of options can serve as a hedge against undesired price movements. One way is by writing a covered call option. This is when the seller of the call option owns the stock so if the price increases, they have it ready to sell to the option buyer. The second is by purchasing a put option as a form of insurance. As with the covered call, the option is paired with owning the stock. In this case, purchasing the option to sell at a set price. This protects the investor from a steep decline in prices for a stock in which they may be heavily invested. This is a common way to protect a portfolio when heavily invested in one stock. Unfortunately, this often happens when individuals hold too much of their employer’s stock. 3.

Explain how a speculative options investor can make a lot of money.

Answer: Most speculative investments are usually purchased with considerable leverage, and since they are zerosum games, it is entirely possible to lose not only the entire investment but the value of the investment itself. However, if we are on the winning side of a zero-sum game, profits can be quite high. Owning an option ―naked‖ is a highly leveraged way to control the price movement in more shares of stock. One can purchase a call option, and if the price of the underlying stock goes above the strike price, the speculator profits. However, most options expire worthless, and the premium is typically lost equaling a 100 percent investment loss. 4.

Offer reasons why futures contracts are not appropriate for the long-term investor.

Answer: Futures are not appropriate for the long-term investor because of their volatility, the fact that they are a zero-sum game, the fact that their market is dominated by large investors who know what they are doing, and the fact that the amateur investor really does not want to buy the commodity and must then sell the contract at some point regardless of the profit/loss that will result. Futures are the best fit for individual with a genuine business need to hold the contract. Farming and home construction companies are good examples.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on real estate and high-risk investments, what do you recommend to Brittany on: 1.

Investing in real estate?

Answer: Brittany should first consider the pluses and minuses of real estate investing. It is difficult to estimate risk and return in real estate. Since it requires substantial funds, Brittany may have to find cash by selling the securities in her brokerage accounts or use the balance of her monthly savings. Also, the returns from an illiquid real estate investment may not provide her with the same returns or thrills she obtains now as a frequent stock trader. Brittany is uniquely positioned to invest in real estate given her position as a licensed agent. She may be able to benefit from unique access to properties and conduct transactions at reduced fees. 2.

Putting some money into collectibles or gold?

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Brittany has no experience in these forms of speculative investments, so it is not worth the effort to get started, especially if taking on new real estate ventures. Brittany should, of course, not invest too much of her portfolio in any one of the high-risk investments introduced in this chapter. If Brittany has a special attachment or level of knowledge about any one collectible, this may be something she could dabble in with minimal funds. The pure pleasure of the activity would be the main justification, not the promise of future financial gain. 3.

Investing in options and futures contracts?

Answer: Brittany enjoys making aggressive investments, and the world of options and futures offers such opportunities. However, she may not want to spend the time required to become an expert in options and futures. With assistance from an experienced investment professional, there are strategies where options might be used to lower the risk of her many investments in stocks. Using covered calls or protective puts might fit will within her overall investment plan.

LET’S TALK ABOUT IT 1.

Invest in Real Estate. Describe what would encourage you to invest in real estate given that real estate prices have been extremely volatile in certain locations. Answer: Volatility in prices of real estate properties may present a good opportunity to buy or sell at a profit, but it is not something for the conservative investor to consider. There may be more opportunity for the average investor in stable neighborhoods and communities that will grow, in a growing economy, but the bottom line is that real estate is a high risk, high engagement investment. Real estate investors work hard at the ―job‖ of investing in and maintaining a profitable property. It is difficult to predict future cash flows from rent, expenses, and the ultimate sale price for the property.

The Two Ways to Make Money in Real Estate Investing. Which of the two ways to make money (cash flows from rent or price appreciation) in real estate investing is more important? Explain why. Answer: Student answers will vary. Cash flow is the most important because you can start losing money from day one of the investments, and these funds come early, depreciated at a lower rate when we calculate the present value of any investment property. If cash flows are negative, we might be forced to sell quickly at a loss completely ruling out the possibility of making money in price appreciation or capital gains.

Beneficial Tax Treatments of Real Estate. Review the five beneficial tax treatments of real estate and explain which one seems most important to a real estate investor. Answer: Student answers will vary. The ability to take depreciation on the asset and the very low taxes on capital gains may surprise many students. The tax system is favorable for business owners, and investors in real estate are essential running a business.

Reasons to Invest in Real Estate. Assume one has $50,000 in cash. Give reasons why one might want to invest that money in a real estate. Offer two reasons why others might not be willing to invest in real estate. Answer: The main reason that individuals may give as a reason to invest in real estate is personal and tied to the tangible aspects of real estate investing. There is an actual property that one can see, unlike ―paper‖ investing in stocks, bonds, and mutual funds. When students graduate from college, they may want to buy a home after they establish their career, so the join reason to own real estate (consumption and investment) might be important. Some students may have considered investing in real estate if they are familiar with real estate investment trusts or REITs. Others may say that they want to invest in financial assets with

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higher potential rates of return and less work. Real estate returns are difficult to predict, and the market is highly volatile in some locations. 5.

Disadvantages of Real Estate. Review the list of ―Disadvantages of Real Estate Investing,‖ and identify one that is of most importance. Explain why. Answer: Students may cite any of the nine reasons, but two of the more likely reasons would be the large initial investment and dealing with tenants. There are many challenges to investing in real estate, and the nature of the challenge will vary from person to person.

Timeshares as an Investment. Explain why timeshares should not be considered an investment. Why do some people buy timeshares? Answer: A timeshare is never an investment, even though some persuasive salesperson might suggest differently. A timeshare is a prepaid vacation. For non-deeded timeshares, ―ownership‖ runs out after 20 or 25 years since it really is a leased property. At any point in time, half of all timeshares are for sale. That’s too many sellers and too few buyers, again demonstrating that these are not investments, only a way to precommit to a vacation.

Put Some Money into High-Risk Investments. What percentage of an investment portfolio, if any, should be invested in high-risk investments? Explain. Answer: Most people should have nothing invested in alternative investments, or 5 or 10 percent of their portfolio at the most. Medium- and long-term investors, and that is most people, do not need to add risk to their portfolio. Besides, high-risk investment techniques are complicated and time consuming. Most investors are better served to focus on their careers and keep their investment program simple. Beginning investors need to learn investment fundamentals and follow them, rather than getting into risky alternatives. Some alternative investments seem like gambling rather than investing. For most of these speculative investments, there is a real chance of losing 100 percent (even more) of our funds.

Invest in Gold? Would someone invest in gold today? Explain why or why not. Answer: Student answers will vary. Many will see gold as a hedge against uncertain times. Others will be put off by the volatility of gold prices. Fear during a period of unrest (e.g., high inflation, high unemployment, political turmoil) often drives investors to choose gold and precious metals which have the longest history as a store of value.

Options and Futures. Both options and futures are risky investments. Identify one that seems like an unwise idea and explain why it is unappealing. Answer: The futures market is an economic necessity for those businesses that will use the products, such as oranges for orange juice companies and pork bellies for sellers of pork and beans. There seem to be so many ways to lose money in the futures market, including not being able to control such things as the weather and overseas competition. It appears that the only people who consistently profit in futures trading are the dealers in the contracts themselves. The market works more like that seen in insurance than investing.

DO THE MATH 1.

Price-to-Rent Ratios. Calculate the price-to-rent ratios for the following properties arranged by price of home followed by annual rental income: (LO 16-1) (a) $700,000/$40,000; (b) $300,000/$36,000; (c) $200,000/30,000. (d) What do these ratios tell us about their potential as an investment property?

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Solution: This is a potential ―Class Activity‖ exercise related to page 522 in the text. a. 17.5 = $700,000/$40,000 b. 8.22 = $300,000/$36,000 c. 6.67 = $200,000/$30,000 d. Properties ―b‖ and ―c‖ are the better investment properties where the current price is low when compared to annual rental income. Property ―a‖ is more expensive relative to the expected annual rent, and the risks to an investor are higher. 2.

Real Estate Investment Returns. Marianne Mooney, a benefits manager, and her sister, Laureen, a middle-school teacher from Columbus, Ohio, are interested in the numbers behind real estate investments. They have reviewed the figures in Table 16-2 on page 495 and are impressed with investing together on a 50/50 basis to earn the potential 50.12 percent return after taxes. Assume that they bought the property with each contributing half of the down payment and financed with a 7 percent $175,000 30-year mortgage loan with annual interest costs of $11,900. Answer the following questions to help guide their investment decisions: (LO 16-2) a. Substitute the Marianne’s 25 percent combined state and federal marginal tax bracket in Table 16-2 and calculate her taxable income and return after taxes. b. Substitute Laureen’s 15 percent combined state and federal tax rate in Table 16-2 and calculate her taxable income and return after taxes. c. Why does real estate is a favorable investment for Marianne and Laureen? d. What one factor might be changed in Table 16-2 to increase their returns? Solution: This is a potential ―Class Activity‖ exercise related to page 525 in the text. a. In the 25 percent tax bracket, Marianne’s taxable income, return after taxes, and yield after taxes, based on Table 16.2, would be as follows: One-half of the gross rental income Less one-half annual depreciation deduction Subtotal Less one-half of the interest expense on the $175,000, 7.0 percent mortgage loan. Taxable income Cash flow after interest expense ($12,000 − $5,950) Minus income taxes (0.25  $6,050) After-tax return After-tax yield [$4,538 ÷ ($100,000 − $87,500)] b.

$2,959 6,050 1,512 $4,538 36.3%

In the 15 percent tax bracket, Laureen’s taxable income, return after taxes, and yield after taxes, based on Table 16.2, would be as follows: One-half of the gross rental income Less one-half annual depreciation deduction Subtotal Less one-half of the interest expense on the $175,000, 7.0 percent mortgage loan. Taxable income Cash flow after interest expense ($12,000 − $5,950) Minus income taxes (0.15  $6,050) After-tax return After-tax yield [$5,143 ÷ ($100,000 − $87,500)]

$12,000 3,091 $8,909 5,950

$12,000 3,091 $8,909 5,950 $2,959 6,050 907 $5,143 41.1%

Real estate would be a favorable investment for the sisters because the rate of return is very competitive with returns on savings or alternative investments. They could also expect additional

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profits through price appreciation. The depreciation expense, which is not an out-of-pocket expense, makes the tax burden lower and thus increases the after-tax return. When the property is sold, the accumulated depreciation would be taxed at what might be lower capital gains rates. Ways to increase the sisters’ yield using the factors in Table 16.2 would be to increase rent income, lower the tax rate (by moving to a state with not income tax), shop for a loan with a rate below 7 percent, or place less money down on the property—further increasing the leverage in the investment.

Review the math in Table 16-3, on page 529. Discounted Cash Flow to Estimate Price and provide an opinion on which part of the assumptions (rent or sales price) is more important in influencing the price estimate (LO 16-3). Solution: This is a potential ―Class Activity‖ exercise related to page 528 in the text. In Table 16-3, there are two assumptions; that rent will increase 2 percent per year and that the property would appreciate $20,000 over the five years. Both estimates could be overly optimistic, especially the $20,000 appreciation. However, the payments received in the early years are discounted at a lower rate than those received in later years. If the property were held for 20 years, the sales price would be discounted by a factor of 0.3769 (from Appendix A-2). Rental payments received early in the life of the investment are the most important in determining value.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Consider a Real Estate Investment Harry and Belinda Johnson are considering purchasing a residential income property as an investment. The Johnsons want to achieve an after-tax total return of 7 percent. They are considering a property with an asking price of $190,000 that should produce $27,000 in gross annual rental income and $15,000 in net operating income annually. a. Calculate the price-to-rent ratio on the property. b. Calculate the present value of after-tax cash flow for the property, assuming that the after-tax cashflow numbers are $8,000 for the first year, $8,400 for the second year, $8,800 for the third year, $9,200 for the fourth year, and $9,600 for the fifth year, and that the selling price of the property will be $210,000 in five years. Prepare in a format like Table 16-3 on page 496, using Appendix A-2 to discount the future after-tax cash flows to their present values. c. Give the Johnsons your advice on whether they should invest in the property at its current price of $190,000. Solution: a. 7.04 price-to-rent ratio ($190,000/$27,000), relative to other rental properties, this is low implying the property is priced lower relative to gross annual rent. b. Present value of after-tax cash flow = $44,000 Discounted Cash Flow to Estimate Price for Johnson Investment Property After-Tax Cash Present Value of $1 Present Value of AfterFlow at 7 Percent* Tax Cash Flow 1 year $8,000 0.9346 $7,477 2 years 8,400 0.8734 7,337 3 years 8,800 0.8163 7,183 4 years 9,200 0.7629 7,019 5 years 9,600 0.7130 6,845 Sale price of property in 5 years $210,000 0.7130 149,730 Present value of property $185,591

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The $190,000 asking price of the investment property is a bit too high to earn the Johnsons a 7 percent annual return. Their choices are to negotiate the price down, accept a return of less than 7 percent, increase rents, hope that the sale price of the property will be higher than $210,000 five years from now, or consider another investment.

CASE 2: Victor and Maria Consider Selling Maria’s Mother’s Home Victor and Maria Hernandez are thinking about selling her mother’s home, which she recently inherited, and use the proceeds to enhance their investments for retirement. Its current estimated value is $300,000. The home is fully paid for. a. If the rent is $1,800 a month, what is the rental yield? b. If they sold the home, should they invest the proceeds into any high-risk investments, such as gold? Solution: a. 3.6% = ($21,600/2)/$300,000 b. It would not make sense for Victor and Maria to invest the proceeds into any high-risk investments. The whole point for selling the home is to avoid the high risk associated with owning a rental property. Alternative investments would be even riskier. If Victor and Maria do like the idea of some high-risk investments, they should limit their exposure there to no more than 10 percent of what they might get by selling the home, and the rest can be added to their long-term investment portfolio.

CASE 3: Julia Price Wants to Try High-Risk Investments Julia continues to be a diligent worker and, at age 60, has saved and invested wisely for her planned retirement. She has an extra $15,000 in a cash management account beyond what she needs for emergency savings. She rejected options and commodity futures as too risky but is considering gold. Julia wonders if the price volatility of gold over the past few years will continue, and she has always thought about investing in antique furniture. Offer your opinions about her thinking. Solution: If Julia is a normal rational investor, she will realize that the gold price fluctuates around a flat line, promising no real long-term gains for the investor and that she should avoid gold as an investment. If she wants to speculate in the short term, she might invest some funds in gold. She should not risk more than 5 percent of her funds for this effort. If she is particularly enthusiastic about antique furniture, then this might give her an opportunity to experience both financial and quality of life gains. The pleasure gained from owning these collectibles may offset many of the risks of investing. If the investment is only a small portion of the portfolio, such quality-of-life gains is worth consideration.

CASE 4: Real Estate or Stocks? Keisha Williams, a senior research analyst in San Bernardino, California, has bought and sold technology stocks profitably for years. Lately, some of her stock investments have done quite poorly, including one company that went bankrupt. Emily, a longtime friend at work, has suggested that the two of them invest in real estate together because property values in some neighborhoods have been rising in anticipation of a large manufacturing company’s plans to increase its workforce. Keisha has looked at three small office buildings and some residential duplexes as investments. a. Contrast the wisdom of investing in commercial office buildings versus the attraction of investing in residential properties. b. List three of the advantages associated with real estate investments. c. List three things that can go wrong for real estate investors. Solution: a. Commercial properties carry more risk of remaining unrented than residential units, especially since the shock of the COVID-19 pandemic. Business tenants usually expect more extensive and costly

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services. Commercial buildings have a greater likelihood of obsolescence. However, one can charge higher rents on commercial properties to offset the higher risk involved. Residential properties may be easier to finance at lower rates because of the lower overall level of risk. Often, real estate investments appreciate. As such, they serve as a hedge against inflation. Real estate investment also gets beneficial tax treatment about capital gains, depreciation deduction, interest expense deduction, and tax-free exchanges. Real estate is tangible, appealing to many who want to see where their money goes. It is quite possible, and even likely, to lose money in real estate investments. Property values may fall, and if that happens, rents will fall. Managing a real estate investment takes time, money, and hard work. Investors must collect overdue rent, conduct regular property inspection, deal with insurance companies, and make repairs.

CASE 5: From Real Estate to Options and Futures Jonathan Clark and Cody Adams, longtime dental partners in Basking Ridge, New Jersey, have bought and sold real estate properties for 10 years. They have profited on many transactions, although they did have some substantial losses during the last recession. Their portfolio of real estate is worth about $4.7 million, on which they owe $2.9 million. Jonathan has read about investing in options and futures contracts, and last week, he talked with a stockbroker about the possibilities. a. Offer some reasons why Jonathan may want to invest $100,000 or more in options and futures contracts. b. List some of the risks of options trading for Jonathan and Cody. c. From an investor’s point of view, contrast trading in futures contracts with buying real estate. Solution: a. Jonathan and Cody have a large portfolio. They can afford the risk involved with investing in futures and options. They undoubtedly can afford to lose based on the value of his existing portfolio, but cash flows are not clear. Real estate is not a liquid investment, and the partners might need to borrow to make the investments in options and futures. Borrowing further increases the risk of investing. b. Some of the risks involved in investing in options and futures include a rather large risk of loss. Even speculative investors, like Jonathan and Cody, should limit their exposure to 10 percent of their portfolio. If they invest in naked options (not owning the underlying assets), as opposed to covered options, they are investing in a highly speculative activity. c. When one invests in real estate, typically a small down payment is made. The same is true when one invests in futures contracts. An investor can put down as little as 5 to 15 percent. In some cases, only a small deposit is required. In real estate investing, putting down a small down payment means the investor is using a lot of debt financing to purchase the property. The same is true for futures. An investor will have to use their own funds to put down money on a futures contract that may move the opposite way from expected. In this way, buying highly leveraged real estate is like trading in futures. In both cases, the leveraged returns are appealing when prices go in the desired direction. Similarly, the losses can be unimaginably large if prices do not move as expected.

EXTENDED LEARNING 217. Community Real Estate Prices. Interview local real estate brokers to determine if the prices of singlefamily dwellings in your community have been decreasing or increasing over the past four or five years and ask why. Inquire about homes located near you as well as those in other parts of the state or country. Prepare a brief report of your findings and include reasons for the change in prices. Solution: Student responses will offer reasons for changes in prices over the past four or five years in student’s community as well as cite the opinions of real estate brokers.

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218. Tax Consequences of Real Estate Investment. Using a website like Realtor.com or Zillow.com select a possible commercial real estate investment in your community and make a ―first attempt‖ to prepare an analysis similar in format to that in the Did You Know? box titled ―The Tax Consequences of an IncomeProducing Real Estate Investment.‖ Make any reasonable assumptions you desire and calculate the numbers. Prepare the table and a brief report of your findings. Solution: Responses will be an attempt to create a table like the one in the book on an imaginary real estate investment property. Some narrative should accompany the table. Students should realize and report on the many assumptions that are needed to create such estimates. 219. History of Gold Prices. Search the Internet for the history of gold prices in U.S. Dollars. How far back can you find prices for an ounce of gold? How have prices changed over time? When adjusting for inflation, how have prices changed over time? Solution: Students should be able to find multiple sources and charts showing the history of gold prices expressed in U.S. dollars. It might be fun to see who found the earliest price in dollars. While prices that are not adjusted for inflation might indicate a steady rise, adjusting for inflation will yield flatter trend in prices implying that long-term real gains have not been earned through gold investments. The significant fluctuation yearover-year does imply that there is some opportunity for short-term speculation in gold. 220. Protective Puts and Covered Calls. Conduct some research on the Internet on the terms ―protective puts‖ and ―covered calls.‖ Explain what both terms mean and how the strategy might be appealing to a conservative investor. Solution: A protective put is the combination of stock ownership with the purchase of put options matching in number of shares. If the stock price falls below the strike price, then the option gains value to offset the loss in the stock value. The protection or insurance lasts only if the option. If the stock price rises, then the option expires worthless, and the premium paid for the option is lost. This premium can be viewed as an insurance premium and of particular importance to anyone with a large portion of their portfolio in one stock. A covered call is when the stock owner sells a call option on the same stocks in their portfolio. If prices rise, then the stock owner has the options to sell at the strike price. If prices remain the same or fall, the owner keeps the premium. Investors who are willing or wanting to sell at the strike price can use a covered call to make a bit of extra money when liquidating a stock position.

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Solution and Answer Guide GARMAN/FOX , PERSONAL FINANCE 14E; CHAPTER 17: RETIREMENT AND ESTATE P LANNING

TABLE OF CONTENTS Answers To Chapter Concept Checks .................................................................................................. 202 What Do You Recommend Now? .......................................................................................................... 208 Let’s Talk About It ................................................................................................................................. 209 Do the Math ............................................................................................................................................. 211

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Financial Planning Cases ....................................................................................................................... 213 Extended Learning.................................................................................................................................. 218

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ANSWERS TO CHAPTER CONCEPT CHECKS LO17.1 Distinguish among the two types of employer-sponsored tax-sheltered retirement plans. 1. Distinguish among after-tax money put into investments, pretax money, and vesting. Answer: After-tax money is money that has already been taxed. Thus, if we were in the 25 percent combined federal and state bracket and wanted to put $4,000 away for retirement, we would first have to pay tax on the money and, thus, would really need $5,333 in income to be able to have $4,000 [$5,333 × (1 − 0.25)] after taxes to invest. If we invest in a pretax manner, we can put the full $4,000 in income away without paying taxes first. Vesting is a worker’s right to have permanent access to employer contributions made to an employer-sponsored retirement account. 2. Explain what is meant by tax-sheltered investment growth on money invested through qualified retirement accounts. Answer: All qualified retirement plans have tax-sheltered investment growth. This means that the earnings each year off our investments do not have to be reported to the IRS and we do not have to pay tax on them as we would through a typical investment account. What this means is that more money stays in the account to grow to an even higher amount over time. 3. Summarize the main differences between defined-contribution and defined-benefit pension plans. Answer: A defined-contribution retirement plan, also known as a salary-reduction plan, is an employersponsored retirement plan. The plan has three variations: (1) the employer contributes to the plan (a noncontributory plan), (2) the employer and employee make contributions, or (3) the employee solely makes contributions (both are contributory plans). The money in the account is in the name of the worker. At retirement, the worker can begin withdrawing money from the plan. The employer does not pay the retirement benefits during retirement. Instead, the employer and employee provide the funds during the working years to build the fund that the employee owns. Thus, the level of benefits is unknown and depends on the success of the investments that the employee chooses to make with the contributions. Only the level of contributions is known in advance—hence the name. In a defined-benefit plan, no account is set up for an individual worker. Instead, the employer puts money into one account that is invested and then is used by the employer to pay retirement benefits to retired workers. Thus, it is the employer that pays the retirement benefits during retirement. The level of the benefit is based on some formula such as 2 percent of the employee’s final salary level for each year worked for the employer. Thus, the benefit is defined—hence the name. 4. Offer your impressions of working for an employer who offers a sizable matching contribution compared with one that does not. Answer: Most employers offer a full or partial matching contribution to each participating employee’s account. Thus, an employer who makes a generous match is, in effect, paying a higher level of

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compensation. Never compare salary offers for prospective jobs without knowing the level of matching contributions an employer might make into a defined-contribution plan. A higher match is the same as a higher salary. In fact, the match may be even better than the equivalent salary as the investments in the retirement account are expected to benefit from compounding over time. 5. Why is it best to invest retirement money in low-cost funds? Answer: Investment fees are a drag on the growth of an investment over time and are especially problematic when investing for the long-term such as for retirement. An 8 percent return with a 2 percent fee is only 6 percent. If we invest $4,000 per year for 35 years at 8 percent, we will have about $760,000. At 6 percent, we will have only $475,000. That’s more than a 2 percent difference! Try to invest only in options where the expense ratio is less than 0.5 percent. 6. Review Figure 17-1, Monte Carlo Simulation, and provide impressions of the current and new strategies. Answer: Student answers will vary. Hopefully, they will appreciate the value of the recommendations for making it easier to select the appropriate portfolio of investments in their retirement plan accounts. The big differences between the strategies are in the amount of retirement contributions, level of investment risk, and planned age of retirement. In taking more investment risk, the assets are distributed more heavily in stocks within the ―investment advice‖ section of the illustration. LO17.2 Explain the various types of personally established tax-sheltered retirement accounts. 1. Why should workers choose to save for retirement through a personally established retirement account? Answer: One reason is that many employees who can participate in their employer’s qualified retirement plan have limits placed on the number of tax-sheltered deposits they can make into the plan and may wish to save additional amounts. A second reason applies to employees of employers that do not offer employer-based plans and, thus, the employee would need to establish their own plan. 2. Is investing in a Roth IRA account a good idea? Why or why not? Answer: Roth IRAs are an excellent way to save for retirement, especially for younger savers expecting to be in a higher tax bracket in the future. They offer both tax-free growth and tax-free withdrawals. Roth IRAs do have a disadvantage of not having an upfront tax break. However, when investing for the long term, such as for retirement, this initial disadvantage is always overcome by the advantage of the tax-free withdrawals, especially when tax rates are expected to be higher in during the period of withdrawal. 3. List two differences between a Roth IRA and a traditional IRA. Answer: One, the deposits into a Roth IRA are not tax sheltered in the year they are made, whereas those into a traditional IRA can be. Two, withdrawals from a Roth IRA after age 59½ are tax free.

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Withdrawals from a traditional IRA are always fully taxable at ordinary income tax rates. With a traditional IRA, one has simply deferred payment of the income taxes. 4. Who would use a Keogh or Solo Individual 401(k) plan rather than a SEP-IRA to save for retirement? Answer: Keogh’s and Solo 401(k)’s are used primarily by self-employed workers who have no other employees. A SEP-IRA allows self-employed individuals to set up a retirement plan for both them and their employees. LO17.3 Plan for the realities of retirement. 1. Why should retirement savings be a priority over education savings? Answer: Saving for the kids’ education is an honorable goal; however, funds can be borrowed for education, and they cannot be borrowed for retirement. Students have many options when paying for education. Retirees have, as best, a pension, retirement savings, and Social Security. 2. What does life expectancy have to do with retirement? Answer: Life expectancy is key in retirement planning. Longevity has increased over the last century. Many of today’s 80- and 90-year-olds never expected to live so long and have outlived much of their nest egg. Planning on a long retirement of 30 years is solid financial management. 3. What does RMD mean and what does it have to do with retirement? Answer: RMD is the acronym for ―required minimum distribution.‖ This feature of the tax laws applies to tax-deferred accounts such as 401(k) accounts and tradition IRAs that allow for pre-tax deposits into the account during one’s working years. Because the taxes were not paid initially, they must be paid as the funds are withdrawn. To facilitate this, retirees must begin making withdrawals at age 72. Amounts are determined in accordance with life expectancy tables produced by the IRS. 4. What can happen if we do not save for retirement? Answer: Not saving for retirement is a big mistake. We will have to work longer, have poorer living conditions, may need to rely on relatives for support, not be able to afford quality health care, and not have the enjoyable retirement for which we had hoped. LO17.4 Estimate Social Security retirement income benefit. 1. Summarize how workers become qualified for Social Security retirement benefits. Answer: The typical employee pays 6.2 percent of current income for FICA taxes, up to maximum taxable yearly earnings of $160,200 (for 2023; adjusted upward for inflation each year). In addition, there is a 1.45 percent Medicare tax on all employment earnings. In exchange for these contributions, the employee receives a retirement benefit until they die, the size of which depends on the employee’s lifetime earnings and age at retirement. To qualify for benefits, workers earn credits © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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and can earn up to a maximum of four credits in any one year. One credit is earned for each $1,640 (adjusted upward for inflation each year) in Social Security taxable earnings. To qualify for Social Security retirement benefits, a worker needs to have attained forty credits. Most people working regularly out of school have done so by their mid-to-early thirties. 2. Distinguish between the benefits provided under Social Security for a worker who is fully insured and a worker who is currently insured. Answer: A worker who is fully insured is fully qualified for all benefits. The amount of the benefit will depend upon the worker’s earnings history. Currently insured means that the worker does not have sufficient credits for retirement benefits but can receive survivor’s and disability benefits if they have attained six credits out of the most recent 13—possible, six credits in the past three years.

3. Explain what happens if we choose to retire earlier than full retirement age, which is sixtyseven. Answer: If we choose to begin collecting Social Security retirement benefits before full benefit retirement age, our benefits are permanently reduced. The reduction depends on the number of months early that we begin to take benefits but can be as high as 30 percent if we begin collecting benefits at age 62 (the earliest possible age) and our full retirement age is sixty-seven. Full retirement age is sixty-seven for all those born after January 1, 1960. LO17.5 Calculate the amount needed to save for retirement in today’s dollars. 1. List the steps in the process of estimating a retirement savings goal in today’s dollars. Answer: First, we must estimate the level of income we will want during retirement. Then we subtract an estimate of the Social Security benefits we might receive and any pension benefits from an employer for which we are already qualified. The difference will be the amount of additional income needed per year to meet the level of retirement income desired per year. Based on our estimated return on retirement investments and the number of years we want to be able to withdraw funds from our nest egg, we can calculate the total nest egg needed at retirement. This can be reduced by amounts we have already saved for retirement such as in an employersponsored retirement account or an IRA and any other savings we can use for retirement. 2. In the section titled ―How to Get the Money to Save,‖ pick three that you think Erik might be willing to accept. Why did you pick these three? Answer: Erik can cut back on some of his expenses and try to put another $440 per month into his 401(k) account at work in an investment that will earn him at least 3 percent over the rate of inflation. A stock index mutual fund should be able to achieve this rate of return and should be one of the options in his plan. Otherwise, the items selected by Erik should require the least effort. Automatic payroll deduction is easy to start and then nothing else needs to be done. The

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probability of success is high! Saving half of future raises can also be done automatically in some retirement plans. In the moment, Erik can make a good decision for his future self. If he waits until he gets the raise, he may be more tempted to raise his level of living and spend the raise.

LO17.6 Describe how to avoid penalties and not outlive retirement money. 1. What are some of the negative impacts of taking early withdrawals from retirement accounts? Answer: The first disadvantage—and the biggest one—is that the funds will no longer be available to grow into the needed retirement nest egg. It is like starting over and time is what builds wealth. The second disadvantage is that we must pay taxes on the withdrawn funds, and there is a taxwithholding provision so that we get only 80 percent of what we withdraw, and the rest is held to pay the taxes. The third disadvantage is the 10 percent penalty for early withdrawal. We lose a portion of our money directly to the IRS. 2. Give two examples of penalty-free withdrawals from retirement accounts. Answer: Early penalty-free withdrawals from certain types of tax-sheltered retirement accounts include when the funds are used for college expenses, housing purchases, and medical expenses. It may also be possible to withdraw funds for early retirement between the ages of 55 and 59½. Early withdrawal allowances are more generous with Roth-type accounts as the taxes are considered to have already been paid on Roth-type accounts. 3. Summarize how long one’s retirement money will last given certain withdrawal rates. Answer: If a retiree withdraws 3 percent of their nest egg each year during retirement, it is 99 percent likely that the money will last 20 years and 93 percent likely that the money will last 40 years. Withdrawing at a 6 percent rate reduces that likelihood to 74 percent if retirement lasts 20 years and only 18 percent if retirement lasts 40 years. These figures are pulled from the illustration provided in Table 17-4. 4. Offer some positive and negative observations on the wisdom of buying an annuity with some of a retirement nest egg when retired. Answer: At retirement, one can choose to buy an annuity with a portion of the nest egg accumulated. How big a portion to put into an annuity depends on one’s concerns about outliving the income that can be withdrawn from the nest egg. Annuities can provide income security, but it comes at a cost. Annuity products are complicated combinations of investment and insurance. The fees are often difficult to discern and are always higher than traditional investment products like mutual funds and exchange-traded funds.

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LO17.7 Plan for the distribution of estate, including advance directive documents. 1. What is probate? Give three examples of how people may transfer assets by contract to avoid probate. Answer: Probate is the court process for distributing the probate assets from a deceased person’s estate. Probate can be a costly and time-consuming process, and therefore many people try to avoid it. Transfers by contract include accounts/assets held with others by joint tenancy with right of survivorship, accounts with a payable-on-death clause, property in trusts, and assets for which there is a beneficiary designation. 2. Distinguish between probate and nonprobate property. Answer: Non-probate property is property owned by a deceased person that will transfer by contract at death such as through a trust, by a form of joint tenancy or by having a beneficiary designation on the asset. It is a relatively easy process to transfer the asset to the designated person. All other property is probate property and will be distributed by the probate court in accordance with the decedent’s will or, if there is no will, by the laws of the state in which the deceased had legal residency. Typically, when there is no will, the property will go to a surviving spouse, surviving children if there is no surviving spouse, surviving parents if there is no surviving spouse nor surviving children, and surviving siblings if there is no surviving spouse nor surviving children or parents. 3. List three examples of the types of topics that go into a properly drafted will. Answer: A properly drafted will lists all non-probate assets and names a specific heir for each. Sign the will in front of witnesses who also will sign. Witnesses cannot be potential inheritors such as family members. Identify an executor. Choose a guardian for minor children and select someone to manage minor children’s inherited assets. See the simple illustration of a will for Harry Johnson on page 582. 4. Distinguish between an irrevocable living trust and a testamentary trust. Answer: An irrevocable living trust is established while the grantor is still alive and takes effect immediately upon signing. The grantor can make no changes to the trust once it is established. A testamentary trust is written while the grantor is alive but does not take effect until the grantor’s death. The trust may or may not be amendable by the grantor after it is written depending on whether it is revocable or irrevocable. 5. What is the likelihood of average middle-income families paying federal estate taxes? Answer: The likelihood of the average person paying federal estate taxes is extremely low. First, the basic exclusion amount is $12.92 million and because spouses have an unlimited exclusion on estates they share, the effective exclusion amount is $25.84 million. Inheritance taxes are also extremely rare because only six states levy them and, typically, one’s usual heirs—immediate family members—are exempt. © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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6. Offer one major reason people should create advance directive documents. Answer: The major reason for creating advance directive documents is to provide guidance to family caregivers over decisions that may need to be made concerning health care and finances should one become unable to make these decisions. 7. What does a durable power of attorney provide, and can it be changed? Answer: A durable power of attorney gives a designated person absolute power to manage personal financial affairs should one become unable to do so. A durable power of attorney can be changed so long as the individual remains able to do so.

WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on retirement and estate planning, what do you recommend to Chrisanna and Fernando about retirement and estate planning regarding: 1. In which types of retirement plans might Fernando invest for retirement? Answer: Fernando does not work as an employee for an employer so has no access to an employersponsored retirement plan. However, Fernando could open a spousal traditional IRA and a Keogh plan. Both his contributions and the growth in investments would accumulate tax free. 2. What withdrawal rate might they use to avoid running out of money during retirement? Answer: Chrisanna and Fernando should withdraw about 4 percent of their nest eggs annually once they retire. This will give them about an 86 percent likelihood that their money would last 30 years, or until age 95 if they retire at age 65. As they move through retirement, they will know more about actual levels of return, inflation, and necessary spending for unexpected things like healthcare; allowing them to adjust the withdrawal rate. 3. How much in Social Security benefits can each expect to receive? Answer: Both Chrisanna and Fernando have a long work history and earn good salaries. They will collect near the maximum in Social Security retirement benefits if they wait until their full benefit retirement age of sixty-seven. If they want to retire at age 65, their benefits will be permanently reduced by about 12 percent. To get an accurate estimate, they can contact the Social Security Administration and review their individual statements. 4. How much do they each need to save for retirement if they want to spend at a lifestyle of 80 percent of their current living expenses? Answer: Chrisanna should estimate annual income needed, in today’s dollars, based on the 80 percent figure and subtract the retirement income expected from Social Security. She should then

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determine the future value of that level of income based on an assumption for inflation over the next 17 years. That amount can be used to calculate the total nest egg Chrisanna will need at retirement given an assumption about her and Fernando’s life expectancies. From that nest egg, she can subtract the future value of amounts of savings and investments already available. This will give Chrisanna an estimate of the additional nest egg she will need to build. Fernando should do the same. Getting a firm estimate of the amount to save for retirement takes some work but can be done with the help of online calculators or the Run the Numbers worksheet on page 571 A good starting estimate is to confirm that both are saving at least 15 percent of gross income for retirement. 5. What two actions might they take to go about transferring their assets by contract to avoid probate? Answer: If they are committed to avoiding the passing of assets using a will and probate court, Chrisanna and Fernando should make sure that as much of their property as possible will be nonprobate property. They can do this via joint ownership of assets or setting the assets up with a payable at death designation. They should also write their wills with the assistance of an attorney. Whoever dies first should then amend ownership and payable at death designations and should also write a new will.

6. What advance directive documents should they complete? Answer: Chrisanna and Fernando each need a living will, health care proxy, and durable power of attorney. These documents will allow for efficient health care decisions in line with their individual wants and financial decisions and management can continue under the direction of a trusted individual identified in the durable power of attorney document.

LET’S TALK ABOUT IT 1. Why Calculate? Do you know anyone who has estimated their retirement savings goal in today’s dollars? Offer two reasons why many people do not perform those calculations. And offer two reasons why it would be smart for people to determine a financial target. Answer: Some people fail to make calculations because they assume that a combination of Social Security benefits and their employee’s pension will take care of their retirement needs. Other people may depend on their employed spouses to take care of their retirement needs. Yet, those who prepare well for retirement will find that Social Security will provide about 20–30 percent of preretirement income, with savings making up a large portion of the remaining 70–80 percent. Those who do not perform the appropriate calculations and fail to prepare well may find that Social Security provides 80 percent of retirement income because that income is much smaller than © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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expected as there is little saved to supplement income. The irony is that for people with similar lifetime earning patterns, the amount of Social Security benefits is the same, but the retirement income will be quite different. What this means is that workers need to use a strong employerbased plan or their own investments to maintain their level of living during retirement. It is important to perform the appropriate calculations to know just how much one should be saving for retirement. These calculations can never be exact, but they get us all going in the right direction. With a savings goal calculated and written down, we are all much more likely to save and invest for our future selves. 2. Retirement Planning Mistakes. Of all the mistakes that people make when planning for retirement, which one do you expect to negatively affect your retirement planning the most? Review the items discussed in Section 17-3 and give reasons why. Answer: Students may mention several mistakes. Waiting too long to start saving is the biggest mistake people can make. Second, people invest too conservatively while saving for retirement. Further, taking money out of one’s retirement accounts for whatever reason during one’s working year is a big mistake. It is like starting over and carries the same impact as waiting too long to start saving. Believing they do not have money to save for retirement is the most common excuse not to save at least something for the future each year. 3. Retirement Investing Today. What are your thoughts on this comment? ―Younger workers today face some serious challenges in deciding where to invest their retirement funds.‖ Answer: Younger workers should not shy away from addressing the challenges when deciding where to invest their retirement funds. Their focus should be long term with investments in a welldiversified portfolio dominated by stocks using mutual funds and ETFs. Over the long run, this is the portfolio that provides the greatest overall return on investment with the least amount of risk. Young investors have the major advantage of time and Time Value of Money is the most important concept in personal financial planning. Though market conditions may be a cause for concern, what is guaranteed is that things will change over their investing lifetimes, there will be difficulties, and the only real mistake that a young investor can make is waiting too long and losing the advantage of having time on their side. 4. Monte Carlo Advice. What do you think of the Monte Carlo approach to analyzing and formulating an investment strategy? What is good about it? Answer: Student answers will vary. The key is to understand that Monte Carlo Advice simplifies investment decisions rather than make them more complicated. While the math and science behind the calculations may be complex, the basic idea is simple. Based on many repeated random draws of past performance and the basic characteristics of the investor (age, risk tolerance, contribution levels, and retirement needs), a recommended efficient portfolio can be generated that maximizes the chance for successfully attaining an investment goal. The output of a Monte Carlo analysis shows the likelihood of success, something most investors and understand and respond to.

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5. Wills for College Students. Do college students really need a will at this point in their lives? Why or why not? What would happen to the typical college student’s assets if they died without a will? Answer: College students may especially need a will if they are married, employed, or have children. But all people need a will if they have assets that they want to have a say in ultimate distribution should they die. If a student dies without a will, the laws of their state of official residence would dictate how the probate court would distribute their assets. Making a simple will is easy and can even be done for free with some of the resources linked in the chapter. Having a will in college, when one’s financial and personal life may be simpler, sets a good starting point for estate planning documents needed in the future. All college students should have advance directive documents to avoid causing undue burden on loved ones should they not be able to make their own healthcare and financial decisions. 6. Writing a Letter of Last Instructions. Identify topics that you would cover in your letter of last instructions. Answer: A letter of last instruction may contain information on funeral and burial instructions, organ donation wishes, material to be included in the obituary, contact information for relatives and friends, and any special bequests of money or possessions. The letter is a good first step in thinking about what one want to have happen after they die.

DO THE MATH 1. Tax-Sheltered Returns. Ashley Travis, of Phoenix, Arizona, is in the 22 percent marginal tax bracket and is considering the tax consequences of investing $2,000 at the end of each year for 30 years in a tax-sheltered retirement account, if the investment earns 9 percent annually. (LO 17-1) a. How much will Ashley’s account total over 30 years if the growth in the investment remains sheltered from taxes? b. How much will the account total if the investments are not sheltered from taxes? (Hint: Use Appendix A-3 by rounding the after-tax rate of return to the nearest whole number.) Solution:

a. $2,000 × 136.3075 = $272,615; the factor 136.3075 comes from Appendix A-3, 30-year row and 9% column. b. The after-tax yield will be only 7.02% [0.09 (1 − 0.22)]. $2,000 per year invested at 7.02 percent will be worth about $188,922 (2,000 × 94.4608) at the end of 30 years. 2. Withdrawal Amount. Over the years, Ahmed and Aamina El-zayaty, of Berkeley, California, have accumulated $200,000 and $220,000, respectively, in their employer-sponsored retirement plans. If the amounts in their two accounts earn a 6 percent rate of return over Ahmed and Aamina’s anticipated 20 years of retirement, how large an amount could be withdrawn from the two accounts each year? (Use the Appendix A-4 to perform calculations.) (LO 17-6) Solution:

Ahmed could withdraw $17,437 = $200,000/11.4699.

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Aamina could withdraw $19,181 = $220,000/11.4699. 3. Savings Amount Needed. Brenda and Dan Domico, of Olympia, Washington, desire an annual retirement income of $40,000. Given that their parents all lived into their nineties, they each expect to live for 30 years past retirement. If the couple could earn a 3 percent after-tax and afterinflation rate of return on their investments, what amount of accumulated savings and investments would they need? Use Appendix A-4 to solve the answer. (LO 17-5) Solution:

$40,000 × 19.6004 = $784,016 4. Annual Earnings. Jose and Gabriela Perez, of Raleigh, North Carolina, hope to sell their home and net $380,000 and then retire to a smaller residence in a rural community that is valued at $150,000. After they sell the property, they plan to invest the $230,000 in stock mutual funds and ETFs and earn a 4 percent after-tax return. How much will this nest egg be worth in 5 years when they retire? Use Appendix A-1 to solve the answer. (LO 17-3). Solution:

This is a potential ―Class activity‖ exercise related to page 570 in the text. $230,000 × 1.2167 = $279,841; discuss in class and focus on the realities of downsizing the home and adjusting to a new lifestyle in a more rural environment. 5. Twins Invest. Janet Brooks, of Lubbock, Texas, plans to invest $3,000 each year in a mutual fund for the next 40 years to accumulate savings for retirement. Her twin sister, Rebecca, who lives in nearby Amarillo, plans to invest the same amount for the same length of time in the same mutual fund. However, instead of investing with after-tax money, Rebecca will invest through an employer sponsored tax-sheltered retirement plan. If both mutual fund accounts provide an 8 percent rate of return, how much more will Rebecca have in her retirement account after 40 years than Janet? How much will Rebecca have if she also invests the amount saved in income taxes? Assume both women pay federal and state income taxes at a 25 percent rate. Use Appendix A-3. (LO 17-1) Solution:

Janet will be receiving a 6 percent after-tax return [0.08 × (1 − 0.25)], and her account will be worth $464,286 ($3,000 × 154.7620) at the end of 40 years. If Rebecca invests $3,000 plus her $750 tax savings ($3,000 × 0.25) and earns 8 percent annually, her account will be worth $971,462 ($3,750 × 259.0565). Rebecca’s account could be more than double Janet’s in 40 years. 6. More Aggressive Investing. Alima Brown, of Harrisburg, Pennsylvania, wants to invest $4,000 annually for her retirement 30 years from now. She has a conservative investment philosophy and expects to earn a return of 3 percent in a tax-sheltered account. If she took a more aggressive investment approach and earned a return of 5 percent, how much more would Alima accumulate? Use Appendix A-3 to solve the answer. (LO 17-5) Solution:

At 3 percent, Alima would have $190,302 ($4,000 × 47.5754) after 30 years. At 5 percent, Alima would have $265,756 ($4,000 × 66.4389). Thus, Alima would have $75,454 more if she earned 5 percent rather than 3 percent. It is wise, and safe, to accept more risk when investing for long periods of time. © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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7. Federal Estate Taxes. Sandra Hampton of Burlington, Vermont, remained single all her life and died in 2023 on her 105th birthday. She was an active investor in equities and real estate for decades and had the goal of leaving behind significant wealth for her extended family members. (LO 17-7) a. If Sandra's total taxable estate is valued at $11,550,000, what will be the federal estate tax due? b. If Sandra's total taxable estate is valued at $12,920,500, what will be the federal estate tax due? Solution:

a. $0. The amount is below the federal estate tax exemption level for deaths in 2023. b. $90. With a total estate that is $500 above the exemption amount of $12,920,000, there would be a small estate tax due equaling 18 percent of $500 or $90. The federal tax rates rise quickly, and the highest marginal rate is 40 percent once the size of the estate hits $13,920,000 or $1,000,000 above exemption.

FINANCIAL PLANNING CASES CASE 1: The Johnsons Consider Retirement Planning Harry Johnson’s father, William, was recently forced into early retirement at age 55 because of poor health. In addition to the psychological drawbacks of the unanticipated retirement, William’s financial situation is poor because he had not planned for retirement. His situation has inspired Harry and Belinda to look at their own retirement planning. Together they now make about $200,000 per year ($110,000 for Belinda and $90,000 for Harry) and would like to have a similar level of living when they retire. Harry and Belinda are both in their early forties, and they recently checked into their annual Social Security Benefits Statements, which indicated that they each could expect about $32,000 per year in today’s dollars as retirement benefits in 25 years at age 67. Although their retirement is a long way off, they know that the sooner they put a plan in place, the larger their retirement nest egg will be. a. Belinda believes that the couple could maintain their current level of living if their retirement income represented 90 percent of their current annual income after adjusting for inflation. Assuming a 4 percent inflation rate, what would Harry, and Belinda’s annual income need to be over and above their Social Security benefits when they retire at age 67? (Hint: Use Appendix A-1.) b. Both Harry and Belinda are covered by defined-contribution retirement plans at work. Harry contributes $5,400 to his plan and his employer puts in $2,700. Belinda contributes $6,600 and her employer puts in $3,300. Assuming a 7 percent rate of return, what would their combined retirement nest egg (now valued at $400,000) total 25 years from now if they keep contributing? (Hint: Use Appendix A-1 and A-3.) c. For how many years would the retirement nest egg provide the amount of income indicated in part (a)? Assume a 4 percent return after taxes and inflation. (Hint: Use Appendix A-4.) d. One of Harry’s dreams is to retire in his fifties. What would the answers to parts (a), (b), and (c) be if he and Belinda were to retire in 12 years? e. What would you advise Harry and Belinda to do to meet their income needs for retirement? Solution:

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a. This is a potential ―Class activity‖ exercise related to page 570 in the text. The Johnsons’ non–Social Security retirement income at age 67 needs to be $309,233 [((0.90 × $200,000) − $64,000) × 2.6658]. b. The Johnsons’ nest egg will be $3,309,442 in 25 years; $1,138,482 [($5,400 + $2,700 + $6,600 + $3,300) × 63.2490)] + $2,170,960 ($400,000 × 5.4274) c. This is a potential ―Class Activity‖ exercise related to page 577 in the text. The nest egg will provide the income called for in question (a) for about 14 years. ($3,309,442 ÷ $309,233 = 10.7); then see the 4% column in Appendix A-4 where the factor of 10.561 is close to 10.7 implying that the fund would last about 14 years. d. In 12 years at age 54, the Johnsons would not be able to receive Social Security retirement income and, thus, they would need to replace 90 e. percent of their income themselves. Their income need with a 4 percent rate of inflation would be $288,180; [(0.90 × $200,000) × 1.6010]. The Johnsons’ nest egg will be $1,222,873 in 12 years; $321,993 [($5,400 + $2,700 + $6,600 + $3,300) × 17.8885)] + $900,880 ($400,000 × 2.2522). The nest egg will provide the income called for in question (a) for about 3.7 years (or somewhere between 3 and 4 years). ($1,222,873 ÷ $288,180 = 4.2434); then see the 4% column in Appendix A-4. With current assumptions, retirement in 12 years is not feasible for the Johnsons. f. Harry and Belinda are clearly not saving enough money for either retirement age; 67 or 54. Their total contributions of $18,000 is 9 percent of their income. At their age, they should be contributing closer to 15 percent including their employer contributions. With their current combined employee and employer contributions, their nest-egg would last only a few years if they retired early and only 14 years if they retire at age 67. They certainly should reexamine their prospects for meeting their retirement goals. They need to pump up their investment program based on their maximum contributions to any salary reduction plans available through their employers and traditional IRAs to affordably retire at age 67. They might also consider a more aggressive investment plan, delaying retirement, or plan to spend less in retirement. CASE 2: Victor and Maria’s Retirement Plans Victor, now age 61, and Maria, age 59, plan to retire at the end of the year. Since his employer changed from a defined-benefit retirement plan to a defined-contribution plan 10 years ago, Victor has been contributing the maximum amount of his salary to several different mutual funds offered through the plan. Unfortunately, his employer never matched any of his contributions. Victor’s tax-sheltered account, which now has a balance of $300,000, has been growing at a rate of 7 percent through the years. Under the previous defined-benefit plan, today Victor is entitled to a single-life pension of $360 per month ($4,320 annually) or a joint and survivor option paying $240 per month ($2,880 annually). The value of Victor’s investment of $20,000 in Pharmacia stock some years ago has now grown to $56,000. Maria’s earlier career as a medical records assistant provided no retirement program, although she did save $10,000 through her credit union, which was later used to purchase zerocoupon bonds now worth $28,000. Maria’s second career as a pharmaceutical representative for Pharmacia allowed her to contribute to her retirement account over the past 9 years, which is now worth $98,000. Pharmacia matched a portion of her contributions, and that match is now worth $70,000; its growth rate has ranged from 6 to 10 percent each year. When Maria’s mother died

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last year, Maria inherited her home, which is rented for $1,800 per month; the house has a market value of $300,000. The Hernández’s’ personal residence is worth $260,000. They pay combined federal and state income taxes at a 30 percent rate. a. Sum up the present values of the Hernández’s’ assets, excluding their personal residence, and identify which assets derive from tax-sheltered accounts. b. Assume that the Hernández’s plan to liquidate and use all the assets listed in part (a) to fund their retirement. If funds earned a 7 percent rate of return over the Hernández’s’ anticipated 20 years of retirement, how large an amount could be withdrawn each year? c. How large an amount could be withdrawn each year if they needed the money over 30 years? d. How large an amount could be withdrawn each year if the proceeds earned 6 percent for 20 years? For 30 years? (Hint: Use Appendix A-4.)

Solution:

a. Tax-Sheltered Assets Victor’s Defined Contribution Plan Maria’s Pharmacia Retirement Account Maria’s Pharmacia Matching Retirement Account Victor’s Pharmacia Stock Zero-coupon Bonds Maria’s Mother’s Home Totals

Non-Tax-Sheltered Assets

$300,000 $98,000 $70,000

$468,000

$56,000 $28,000 $300,000 $384,000

b. $80,423 = $852,000 / 10.5940 (7% for 20 years) c. $68,660 = $852,000 / 12.4090 (7% for 30 years) d. $74,281 = $852,000 / 11.4699 (6% for 20 years) $61,897 = $852,000 / 13.7648 (6% for 30 years) CASE 3: Julia Price Thinks About Retirement Julia is now in her early fifties. She has had three jobs in her career so far and participated fully in the defined-contribution retirement plans offered by her employers. When she left her last position, she rolled her retirement account over to the account at her new employer, and it is currently worth about $480,000. Now she is about to change jobs again. But this time, she is taking a job with the Consumer Financial Protection Bureau in Washington, DC. She also will be taking about 4 months off from working before starting that government job. The federal government retirement program is a defined-benefit plan. That means she cannot transfer her private sector plan to the government plan and therefore must decide whether to leave the funds within her current employer’s plan or open a rollover IRA account into which to transfer the © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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funds tax and penalty-free. Another alternative available to her is to withdraw the $480,000 from her current account, pay income taxes on it this year (at the highest federal and state marginal tax rate), and invest the proceeds of approximately $300,000 ($480,000 less about $180,000 in taxes) into a new Roth IRA account. Offer your opinions about her thinking. Solution:

Julia’s situation involves two steps. First, should she roll her defined-contribution fund over into an IRA or leave it on deposit where it now resides? If she decides to leave the money on deposit, she foregoes the IRA option currently. Because she is over 10 years from retirement, she might be better off rolling the money over into an IRA. This will eliminate the need to continue to manage her funds through the previous employer’s plan and she can deal directly with the mutual fund into which she deposits the funds. The second step then is to decide between a traditional or Roth IRA. The tax-free withdrawals from the Roth IRA during retirement are tempting. However, she will lose over one-third of her current nest-egg to taxes, an amount she is unlikely to recoup, given that she is in her early fifties. These lost funds will not be able to continue to grow on her behalf. The issue comes down to the tax-bracket she will be in when she retires. If she is in a lower bracket than currently, the traditional IRA looks to be the better option. Since she is in one of the highest brackets now (due to the big jump in taxable income if she withdraws the funds) she will be in a lower bracket during retirement and should opt for the traditional IRA. Taking smaller distributions while in retirement should allow Julia to withdrawal the funds at lower marginal rates. CASE 4: Calculation of Annual Saving Needed to Meet a Retirement Goal Nicci Denny, age 42, single, and from Lansing, Michigan, is trying to estimate the amount she needs to save annually to meet her retirement needs. Nicci currently earns $80,000 per year. She expects to need 90 percent of her current salary to live on at retirement. Nicci anticipates receiving about $2,450 per month in Social Security benefits at age 67. Using the Run the Numbers worksheet on page 539, answer the following questions. a. What annual income would Nicci need for retirement? b. What would her annual expected Social Security benefit be? c. Nicci expects to receive $1,500 per month from her defined-benefit pension at work. What is her annual benefit? d. How much annual retirement income will she need from her retirement funds? e. How much will Nicci need to save by retirement in today’s dollars if she plans to retire at age 67 and live to age 92, like her mother? Assume a 3 percent rate of return after inflation for retirement assets during retirement. f. Nicci currently has $15,000 in a Roth IRA. Assuming a growth rate of 8 percent, what will be the value of her Roth IRA when she retires? (Hint: Don’t take out income taxes.) g. How much additional money will she still need to save annually for retirement? h. What is the amount she needs to save each year to reach this goal? Again, assume a rate of return for retirement assets of 3 percent above inflation. i. What if Nicci could earn 5 percent above inflation? Then how much will she need to save for retirement annually? Solution:

a. $80,000 × 0.9 = $72,000 b. $2,450 × 12 = $29,400

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c. $1,500 × 12 = $18,000 d. $72,000 − $29,400 − $18,000 = $24,600 e. This is a potential ―Class Activity‖ exercise related to page 570 in the text. Assuming an 8 percent return and 25 years of retirement, Nicci will need $428,362 by retirement ($24,600 × 17.4131). If she thinks she will live longer than age 92 or that she cannot earn 3 percent above the rate of inflation, Nicci will need even more by retirement. f. $15,000 × 6.8485 = $102,727 using Appendix A-1 to grow the Roth IRA investment at a rate of 8 percent over 25 years. g. $428,362 − $102,727 = $325,635 h. Again, assuming Nicci can earn 3 percent above the rate of inflation and saves annually for the next 25 years until she retires, she will need to save $8,931 per year ($325,635 ÷ 36.4593). i. If Nicci can average 5 percent above inflation, she would have to save $6,823 per year ($325,635 ÷ 47.7271). CASE 5: A Couple Considers the Ramifications of Dying Intestate Yvonne Moody of Cheyenne, Wyoming is a 34-year-old police detective earning $58,000 per year. She and her wife, Joanna, who is a public-school teacher earning $44,000, have two children in elementary school. They own a modestly furnished home and two late-model cars. Joanna also owns a bass fishing boat. Both spouses have 401(k) retirement accounts through their employers, and their employers also provide them with group term life policies that match their salaries. Yvonne also has a $100,000 term life policy of her own. The couple has about $5,000 in their joint checking account. Neither has a will. a. List four negative things that could happen if either Yvonne or Joanna were to die without a will. b. What would be the most important negative consequence of not having a will if both Yvonne and Joanna were to die together in a car accident? c. Which assets could be jointly owned so that they will automatically transfer to the other spouse if either Yvonne or Joanna dies? d. What qualities should Yvonne and Joanna look for when naming the executors of their wills? e. Once they have completed and signed their wills, where should they keep the original documents? Solution:

a. First, their estate would go through probate without any directions from them to the court as to how to distribute the assets. Second, this would add to the cost of the process thereby using precious resources in undesired ways. Third, there likely would be some distribution of assets to their children, who are too young to handle such matters. Fourth, they would have no control over who is appointed to serve as executor of their estates. b. They would have no say in who would be the guardian of their children should they both die in the same event such as a car accident. c. This is a potential ―Class Activity‖ exercise related to page 580 in the text. d. Their home, their vehicles, and their checking account could all be jointly owned. e. The person should be someone they trust and who has the time and expertise to handle the job.

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Ideally, the will can be filed with the probate court. Original copies can be kept in a safedeposit box or a safe so long as family and an executor can easily access. Duplicates should be given to their parents, the appointed guardians, and the attorney and executors, siblings.

EXTENDED LEARNING 1. Views Concerning Social Security. Talk to two fellow students who are not taking your personal finance class. Ask them to explain their feelings about the degree to which Social Security will meet their income needs during retirement. Then ask them how they plan to meet their retirement income needs beyond what Social Security might provide. Make a table that summarizes your findings. Then compare their views and plans with what you have learned from reading this chapter. Solution:

Students should prepare a summary of their findings from interviews. They will find that their friends are highly skeptical of the prospects for Social Security as a source of their retirement income. Nonetheless, they will find that their friends have not given much thought about preparing for retirement and the importance of Social Security for most workers. The information in this chapter shows that starting early with a nominal amount of retirement savings coupled with employer contributions can go a long way toward building a secure retirement and that their friends should not procrastinate. Social Security will be there for their peers and planning for it as a portion of income replacement in retirement is part of the retirement planning process. 2. What Is It Like to Be Retired? Survey two individuals or couples who have been retired for more than 1 year. Ask them how financially well prepared they felt before they retired. Then ask them to assess the financial realities of retirement at the current point in time. Include a discussion of how their investment mix (mutual funds, stocks, bonds, annuities) may or may not have changed since they have retired. Write a summary of their responses and how their experiences may affect your thinking about being retired. Solution:

Students should prepare a summary of their findings. The impact on their thinking will vary but should reinforce the benefits of planning for retirement. It is likely that they will find that current retirees are happy—especially if they feel financially secure. Freedom over their time is a theme to appear in responses. 3. Feelings About Approaching Retirement. Survey two individuals or couples who are about 10 to 15 years away from retirement. Ask them to explain what steps they have taken to prepare for retirement and how prepared they feel. Also ask them to describe what they will do financially in the next decade to get ready for retirement. Write a summary of their responses and how their experiences impact your own thinking about getting ready for retirement. Solution:

Students should prepare a summary of their findings. The impact on their thinking will vary but should reinforce the need to start young and invest through a diversified portfolio of securities. Ten years out from retirement is when the typical person become most focused on retirement planning. Themes such as adding to savings using the ―catch up‖ provisions in the tax code may emerge. This group may be most anxious about retirement if they have not started early. © 2024 Cengage. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. Retirement Savings Behavior Early in One’s Career. Survey two individuals or couples who are less than 10 years into their professional careers. Ask them if they have started saving for retirement, and if not, why not. Also ask them about the types of investments (mutual funds, stocks, bonds, annuities) that they are using or would use to save for retirement. Write a summary of their responses and how their efforts, or lack thereof, impact your thinking about saving for retirement. Solution:

Students should prepare a summary of their findings. The impact on their thinking will vary but should reinforce the need to start young and invest through a diversified portfolio of securities. Individuals early in their careers need to start on a strict savings plan to take advantage of the time they have before retirement. 5. Letter of Last Instructions. Create a letter of last instructions by giving your personal representative or family member the information needed concerning your personal and financial matters (funeral arrangements, location of will, insurance policies, location of documents, gifts etc.). Solution:

Response should be a letter of last instructions. Discussion about the difficulty of thinking about and planning for death is appropriate for the class. 6. Loss of Defined-Benefit Plans. What do you think of the long-term trend of employers moving away from offering employees defined-benefit retirement plans to providing them with definedcontribution plans? Write up your comments. Solution:

Students will have various responses. Some will lament the loss of a guaranteed pension and its effects on society. Others will feel that more emphasis on defined contribution plans gives workers much more control over their retirement planning efforts, leaving them less tied to employers over time. 7. Transfers. Make a short list of your assets and determine if upon your death they all will transfer to beneficiaries by contract, property ownership designations, or by payable-on-death designations. Write up your observations. What might need to be changed? Solution:

Students should prepare a summary of their findings. The impact on their thinking will vary but should reinforce the need to be conscious of how assets are owned and who their beneficiaries are and will be. They should have a plan on how to change the ownership of assets if necessary. [return to top]

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