Personal Finance Skills Solution Manual by Ace Test Banks

Personal Finance, 2nd Edition

By Vickie L. Bajtelsmit

CHAPTER 1 THE FINANCIAL PLANNING PROCESS THE LEARNING OBJECTIVES 1. To be able to recognize and internalize the importance of studying personal financial planning. 2. Ability to describe the five steps in the personal financial planning process. 3. Be able to identify the factors that influence personal financial planning decisions. 4. Understand how the elements of a comprehensive financial plan fit together. 5. Use analytical tools that consider opportunity costs and marginal effects in making personal finance decisions. 6. Understand when and how to select qualified financial planning professionals. CHAPTER OUTLINE AND SUMMARY I. Why study personal financial planning? A. What are the benefits of personal financial planning? 1. It will help you make better decisions. 2. Personal finance is a specialized area of study that focuses on individual and household financial decisions, such as budgeting, saving, tax planning, financing major purchases, buying insurance, and investing to achieve long-term goals.. 3. Personal financial planning is the process of developing and implementing an integrated, comprehensive plan designed to meet financial goals, to improve financial well being, and to prepare for financial emergencies. 4. The primary goal of personal financial planning is to develop and achieve financial goals. B. Why do people avoid financial planning? 1. Surveys suggest that most people recognize the need to manage their finances, but admit that they do not do an adequate job of it. 2. Variety of reasons including fear of failure, lack of interest, expect someone else to take care of it, aren’t interested, don’t have the math and finance skills, too busy, and don’t know whom to trust. C. What problems are associated with lack of financial planning? 1. Psychological problems can include stress, worry, embarrassment, anxiety or depression. 2. Unable to handle financial emergencies or unexpected job loss. 3. Victims of “get rich quick” scams. II. The five steps in the personal financial planning process. A. Step 1: Analyze your current financial position. 1. Need to determine your income and expenses. 2. You must collect and organize all of your financial information. 3. Then you must create personal financial statements and establish a baseline against which you measure improvement.

B. Step 2: Develop short-term and long-term financial goals. 1. Must identify and prioritize specific goals and objectives. 2. Must assess why you have the goals you do. 3. Short-term and long-term goals change over time. C. Step 3: Identify and evaluate alternative strategies for achieving your goals. 1. May need to reduce spending, increase earnings, or do both. 2. Necessary to compare costs and benefits of alternative strategies. D. Step 4: Implement a plan for achieving your goals. 1. Acquire fundamental knowledge and master analytical tools. 2. Make a personal financial plan. E. Step 5: Regularly reevaluate and revise your plan. III. Factors that influence personal financial planning. A. Changing needs over the life cycle. B. Value and attitudes. 1. People have different values and attitudes regarding money. 2. Values are fundamental beliefs about what is important if life. 3. Attitudes are opinions and psychological differences between people that affect their decisions. 4. Risk is your attitude toward uncertainty and is very important in financial planning. C. Life situations. 1. Family make-up and demographic characteristics – such as age, marital status, income, and wealth - significantly affect financial planning. 2. College-educated individuals tend to have higher incomes with more benefits. D. General economic conditions. 1. Economic factors that affect financial planning include inflation, interest rates, employment conditions, political unrest, and global issues. 2. Inflation is the change in the prices of goods and services over time. 3. Inflation is measured by the change in the consumer price index (CPI), reported monthly by the Bureau of Labor Statistics. a. The CPI is a measure of the price of a representative basket of more than 400 household goods and services in the United States market. b. It includes food, housing, consumer goods, gasoline, and clothing. c. Inflation is the percentage change in the CPI from one period to another. d. Calculated as: New value – Old value / Old value. 4. An interest rate is the cost of money or return on invested money. a. Usually expressed as a percentage of the amount lent or borrowed. b. When you borrow money, the interest rate is a cost to you. c. When you invest money, it is a measure of your earnings or return on that investment. d. Interest rates are driven by supply and demand. 1) When there a lot of demand for something (lots of buyers) relative to supply (not as many sellers), the price tends to rise. 2) When there is a lot of supply (lots of sellers) relative to demand (not as may buyers), competition will cause the price to fall.

e. Federal Reserve Bank (FRB) is the central bank of the United States. f. The FRB (The Fed) controls the money supply and sometimes takes actions to increase or decrease the supply of money. g. The federal funds rate is the rate that banks charge each other for short-term loans. h. The Fed controls monetary policy for the U.S. by taking actions that cause the “Fed Funds Rate” to increase or decrease. 1) When the Fed wants to stimulate the economy, it takes action to decrease interest rates. 2) When the Fed wants to slow the economy, it takes action to increase interest rates. 5. The economic cycle and employment conditions. a. The U.S. economy has historically experienced a pattern of ups and downs that is called the business cycle or economic cycle. 1) A recession is a phase in the economic cycle characterized by reduced business investment and increased unemployment. 2) Economic expansion is a phase in the economic cycle characterized by increasing business investment and employment opportunities. 6. Political unrest and global factors can affect your personal finances. IV. Elements of a comprehensive financial plan. A. Foundation. Acquire necessary tools and skills: Chapters 1-4. B. Securing basic needs – short-term planning: Chapters 5-10. C. Wealth building – long-term planning: Chapters 11-15. D. Wealth protection – insurance and estate planning: Chapters 16-17. V. Making effective decisions. A. Make reasonable assumptions. 1. Should be based on sound reasoning. 2. Should take risk into account. B. Apply marginal reasoning. 1. Marginal reasoning is a method of analysis that considers the increased benefit which would result from a particular decision. 2. Term “marginal” refers to the change in outcome, or the additional benefit, that will result from the decision you make. C. Opportunity cost is a measure of what you have to give up in order to take a particular action. D. Sensitivity analysis is an estimation of the change in outcome that results from a change in assumptions. VI. Selecting qualified financial planning professionals. A. As your life and finances become more complicated, you may need to get some professional help with financial matters. B. What are the factors to consider in choosing a planner? 1. Education. 2. Certification(s). 3. Experience. 4. Reputation. C. How are planners paid?

1. Fee only – planner charges based on services provided. 2. Commission only – planner receives no payment for financial plan, but receives a commission when you buy a financial product. 3. Fee plus commission – planner charges a fee for financial plan and receives commissions on any financial product sold to you. Fee may be lower than for a fee-only arrangement. 4. Fee offset by commission – planner charges a fee for services but will offset some of the fee for commission earned on products. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.money.cnn.com: Create a chart for a stock that provides data for the last month, quarter, year, three years, and five years. Determine the ticker symbol for a stock. Look up today’s closing prices for the Dow Jones Industrial Average (DJIA) and determine the 30 stocks that make up this index. 2. www.yahoo.com: Compare ratios for a firm you select and other firms in that industry. 3. www.cfp-board.org: Determine what schools in your state offer the course work that is required in order to take the test for the CFP certificate. 4. www.napfa.org: Click on the box entitled, “How to Choose a Financial Advisor” and compare the criteria in your textbook to this advice. 5. www.afcpe.org: Read about this association of financial planning educators and practitioners. 6. www.nefe.org: Read about collaborative efforts to improve financial literacy in the United States. ADDITIONAL MINI-CASES 1. Case 1 – Over My Head in Debt! Joe is a senior in college, majoring in engineering, and is considering proposing marriage to his girlfriend of three years. He is concerned about his credit card debt of $20,000 and his student loans of $20,000. His girlfriend Jane, has no loans because her parents are paying for her college tuition and books and she is working part-time to pay her other expenses while she is in college. a. Why is it important for Joe to talk to Jane about his debt before he proposes marriage? b. What do you think Joe should do about his debt? c. Should Joe propose to Jane? Why? 2. Case 2 – Will I Have to Support My Parents in Their Old Age? Jill is an only child and her parents have paid all her college expenses and still help her now that she has a full time job as an accountant. Her parents are getting ready to retire and are concerned about inflation because they are both going to be 62 years old and may face 30 or more years of being retired. They have Social Security and each of them has a fixed defined

benefit pension plan from teaching for 30 years. a. Should Jill be concerned about having to help them in the future because of the impact of inflation on their retirement income? b. How can she analyze the risk of her parents needing help in the future? c. What factors should she consider in determining if her parents may have a problem supporting themselves in the future? 3. Case 3 – Does College Pay? Jim is starting his junior year in college and is wondering if it makes sense to continue his studies. During his first two years he played on the school’s nationally ranked football team and paid very little attention to his studies during the fall semesters and had low grades. He loves playing football and would like to make that his career for the next 5-10 years. a. How can Jim use marginal analysis to help him make this decision? b. How much weight should Jim put on his poor academic performance? c. Should he talk to his coach and academic advisor about his decision? TEACHING SUGGESTIONS 1. Have students do the Learning Styles exercise in the text preface during the first class and use it to involve the students in a discussion about different approaches to learning. 2. Use the “Myth or Fact” quiz at the beginning of the chapter as a first quiz to allow students to gauge their knowledge of personal finance. Use it as a springboard for starting the discussion of the chapter. 3. Have students list five benefits they think they can derive from learning more about personal financial planning. Ask them to keep the list until the last week of classes and compare it to a list they make at the end of the semester. 4. Have students list three reasons why they think individuals avoid financial planning. Determine which reason the class thinks is most important and why. 5. Have students list three short term goals they would like to achieve in the next year and three long-term goals they would like to achieve in the next five years. Put the class in two, three, or four person groups and have them compare and discuss the goals they have written down. Prepare a list of common goals and have them present it to the class. 6. Have students discuss the concept of “life cycle” and how it will affect their financial plans. 7. Break the class into groups to discuss the concepts of values, attitudes, and risk and provide at least three examples of each to offer to the class. Discuss reasons why individuals have differences in values, attitudes, and risk and how it will affect their lives. 8. Have students go the www.bankrate.com to explore interest rates on a variety of different types of loans and discuss their findings in class. Ask them to bring to class a copy of the rates they find. 9. Have students complete the activities at the end of the chapter entitled, “Assessing Your Values and Attitudes Toward Money” and “Talking About Money With Your Family” and discuss their findings in class during the second class period.

CHAPTER 1 THE FINANCIAL PLANNING PROCESS SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Page 24 in Textbook Case 1-1. And Then There Were Three – A Baby Changes Everything. Re-evaluate the honeymoon plans. - Perhaps a cheaper honeymoon. In addition to the expenses of a new baby, they are going to have new expenses connected with work. - Employee health care coverage on the new jobs needs to be checked, particularly for preexisting conditions. - Company policy concerning family leave should also be examined. - A family decision needs to be made concerning Ellen’s return to work after the baby is born. - Living arrangements may need reexamination. The baby and associated equipment takes space. - Should project two to three year expenses for the baby. Case 1- 2.

Living on the Edge – What Happens If the Car Breaks Down? - Is the car essential? Public transportation would save much more than $400 a year. - If the car is essential, use the present money for repairs. Saving $40 per month will give her $130 for Christmas presents. - She needs an emergency fund of at least three to five months take-home pay. - She needs to reexamine her budget for cutting expenses to allow more savings.

Case 1 – 3.

Costs and Benefits of Graduate School. Consider how certain is a promotion to a management position. Would company provide financial support for studies? How much of a pay increase comes with a management position? Part-time Program. - Longer to complete. - Will continue to receive salary Full-time program - Less time to complete - Earlier promotion - Possible change in corporate needs for management. - Loss of salary Opportunity Costs - Costs of Tuition, Fees and Books. - Initial promotion delay for two year program. - Future salary differences due to one year delay for the two year program

CHAPTER 1 THE FINANCIAL PLANNING PROCESS SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 22-23 in textbook SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 22-23 in Textbook 1. Personal Financial Planning Process -Analyze need / use of the car -Analyze current financial condition - Liquidity, Cash Flow, Credit Score, Assets, Liabilities -Budget an affordable down payment -Estimate loan amount, interest rate, and monthly payments -Obtain an insurance quote on the make, model, and year of interest -Estimate gas and maintenance costs 2. Inflation Current expenses are $20,000, inflation of 3 percent Current amount*(1+inflation rate) = Next years amount $20,000 x (1.03) = $20,600 An increase of $600. 3. Inflation January 2004 CPI = 185.2

January 2005 CPI = 190.8

(CPI 2005/CPI 2004) -1 = Inflation Rate (190.8/ 182.2) -1 = Inflation Rate 1.0472 -1 = .0472 or 4.72% 4. Percent change Raise Salary = Change $5,000 $30,000 = 0.167 or 16.7% 5. Annual Percentage change: Home in 2000 = $100,000 , in 2005 = $250,000 Percentage change = (New value – Old value) Old value = ($250,000 - $100,000) $100,000

= $150,000 $100,000

Annual percentage change = (1 + 1.5) 1/5 -1

=1.50 or 150% = 1.201124 – 1

= .201124 or 20.1124%

6. Federal Reserve. The Federal Reserve may increase short term interest rates to: moderate risk of future inflation. maintain or moderate sustainable economic growth. 7. Interest Rate and Risk Highest to lowest interest rate with explanation 1. Credit card - unsecured 2. Car loan - Secured by car 3. Student loan (government backed) 4. Bank Savings account 8. Changing Life Circumstances. • Pay back student loans. • Housing arrangements – buy / rent, more room. • Investment plans – 401k, IRA, mutual fund, stocks, bonds... • Moving expenses for new job. • New or better clothing for job 9. Opportunity Cost Time cost – driving 60 miles and traffic around the airport will probably take two hours or more. Minimum wage is about $5/Hr. Missing class – difficult to quantify. Tuition is probably about $11 per class contact hour. Vehicle costs - $0.35 per mile = $21. She should take the shuttle bus and save money, it’s cheaper! 10. Life Cycle Effects – two important areas of financial planning for each stage. Single college student - Short-term planning – cash budget for expenses - Long-term planning – current position of assets and liabilities. Think about investment strategy for retirement Young married couple with two children - Short-term planning - budget for expenses - Long-term planning – college expenses, weddings, retirement Double income couple with children in college - Short-term planning - budget for expenses, college expenses, weddings - Long-term planning – retirement, grandchildren funds Recently retired couple - Short-term planning – expenses, travel, medical - Long-term planning - estate

CHAPTER 2 FINANCIAL PLANNING TOOLS: PERSONAL FINANCIAL STATEMENTS AND THE TIME VALUE OF MONEY THE LEARNING OBJECTIVES 1. Develop a system for organizing and maintaining your financial records. 2. Learn how to calculate your net worth using a personal balance sheet. 3. Learn how to identify your current inflows and outflows of cash using a personal cash flow statement. 4. Use personal financial ratios to evaluate your current financial position. 5. Understand and apply the basic principles of time value of money. CHAPTER OUTLINE AND SUMMARY I. Collecting and organizing your financial information. A. Why do you need to save bills and documents? 1. There should be a particular purpose for everything you save and file. 2. Possible reasons include: a. Paying bills. b. Tracking your budget. c. Preparing for tax reports. d. Making investment decisions. e. Making insurance or warranty claims. f. Ensuring prompt access to essential records. B. How long should you save documents? 1. It depends on what you will use it for. 2. Receipts for ATM withdrawals and deposits and for cash or credit purchases need only be saved until you receive a statement. 3. Bills for utilities, telephone, car expenses, and other irregular expenses that are not tax deductible should be kept for a full year so that you can accurately reflect the costs in your budget and personal cash flow statements. 4. Any documents that support tax deductions should be filed with your tax records and kept for seven years. C. Where should you keep documents? 1. You can keep them anywhere, as long as they are easily accessible. 2. Important personal documents and valuables include passports, birth and marriage certificates, social security cards, stock certificates, and wills and deeds should be kept in a safe deposit box or fireproof lockbox. a. A safe deposit box is a secure private storage area maintained in a remote location, often at a financial institution’s place of business. b. A lockbox is a fireproof keyed safe kept in your home, that is not as secure as a safe deposit box because it can be taken by thieves. II. Summarizing your current financial condition. A. Personal financial statements summarize your financial information. 1. Personal balance sheet. 2. Personal cash flow statement.

B. Preparing a personal balance sheet. 1. A personal balance sheet is a financial statement that details the value of what you own and what you owe to others to arrive at an estimate of your net worth at a given point in time. a. Net worth is the amount of wealth you would have left after paying all your outstanding debts. b. Everything you own, including liquid assets, real and personal property, and investments are called assets. c. Everything you owe to others, including unpaid bills, credit card balances, car loans, student loans, and mortgages are called debts. 2. Organization of the personal balance sheet. a. Start by making a list of everything you own, starting with short-term and going to long-term. b. Begin with the most liquid assets – cash and near-cash assets that can easily be converted to cash without loss of value. c. Liquid assets include checking and savings accounts. d. Your auto and home assets are not liquid, since it would take time to sell them and they may have a loss in value. e. Next, make a list of all of your debts. 3. Valuing your assets and debts. a. Your most recent bank financial statements will give you the value of your checking and savings accounts. b. For other assets, try to estimate the true market value, which is the price that something can be sold for today. c. The market value is not the amount you originally paid. d. For some of your assets, such as your car, there may be a corresponding debt. 1) If so, enter the market value of your vehicle on the asset side of your balance sheet. 2) Enter the loan balance on the debt side. e. If you lease a car, your payment obligations are a debt, but you do not own the car, so you should not include it as an asset. f. The market value of your car can be estimated using the Blue Book or www.edmunds.com on the Internet. g. Real estate values are determined by the values of comparable properties in the area. h. An insurance policy is counted as an asset only if it is a policy that accumulates cash value over time. 1) If you cancel an insurance policy that has a cash surrender value, the insurer will return that amount of money to you. 2) This is an available source of cash to you that should count as an asset. 4. Calculating your net worth. a. Once you have entered all the required information on your personal balance sheet, you can calculate your net worth using the following equation: Net worth = Value of your assets – Value of your debts b. Net worth measures what you would have if you had to sell all of your

assets to pay back your debts. c. If your net worth is positive, it represents how much you would have left over after you’ve paid everything. d. If your net worth is negative, it represents how much you would still owe after you sold all of your assets. e. The inability to pay debts as they come due is called insolvency. C. Preparing a personal cash flow statement. 1. A personal cash flow statement is a summary of income and expenditures over a period of time, such as a month or a year. a. It is used to evaluate the relationship between your income and expenditures. b. It is prepared on a “cash basis” which means that cash flows are recorded when they are received or paid. 2. Income includes all cash inflows you receive during the period. It can include: a. Wages, salaries, tips, and commissions. b. Scholarships. c. Loan proceeds. d. Gifts. e. Alimony and/or child support. f. Proceeds from the sale of your assets. g. Government benefits such as welfare, unemployment, or social security. h. Investment earnings. i. Gambling winnings. 3. You record all sources of gross income (income before taxes and expenses). 4. Expenses can be fixed or variable. a. Fixed expenses are a constant dollar amount each period. Examples include rent and car payments. b. Variable expenses are different from period to period. Examples include groceries, gas, and utilities. 5. Your net cash flow measures how much you have left over after paying all of your expenses. Net cash flow = Total cash inflows – Total cash outflows. a. If there is a negative net cash flow, than you are spending more than you earn. b. Those who have higher incomes tend to spend more. c. However, just because you have a higher income does not mean that your finances are in good shape. III. Using financial ratios to evaluate your financial standing. A. Financial ratios provide another important tool for evaluating your financial condition. 1. You can calculate your financial ratios from the information on your personal financial statements. a. Can compare your ratios to recommended targets. b. Track your ratios over time as a measure of your progress toward achieving your financial goals. 2. Examine ratios designed to measure three aspects of your finances:

a. Liquidity. b. Debt management. c. Adequacy of savings. B. Measuring liquidity. 1. The liquidity ratio tells you how many months you could pay your monthly expenses from your liquid assets. Liquidity ratio = Liquid assets / Monthly expenses 2. It measures your ability to pay household expenses out of liquid assets in the absence of regular income because of a layoff, illness, or disability. 3. Liquid assets should be enough to last 3-5 months. C. Measuring debt usage. 1. Debt ratio measures the percent of your total assets that is financed with debt and is calculated as: Debt ratio = Total debt / Total assets 2. The debt ratio will generally declines as you get older, since your financial assets and home equity will increase in value. 3. Debt payment ratio and mortgage debt service. a. Both of these ratios measure your ability to pay your financial obligations. b. In determining your creditworthiness, lenders commonly compare these or similar ratios to maximum values. 4. Debt payment ratio measures the percentage of disposable income required to make debt payments. Debt payment ratio = Total monthly debt payments / AT monthly income a.. The after-tax income (disposable income) is used in the denominator because the purpose of the ratio is to assess ability to pay. b. Minimum debt payments include mortgage loans, student loans, car loans, and credit card payments. 5. Mortgage debt service ratio is the percentage of gross income used for mortgage debt service. Mortgage debt service ratio = Monthly mortgage debt service / Gross monthly income a. The mortgage debt service is the total dollar amount of monthly mortgage principal, interest, property taxes, and homeowners insurance. b. Most individuals find that their housing costs, rent or mortgage payments, are their largest monthly expenditure. D. Measuring savings. 1. The savings ratio measures the percentage of your disposable income that is being allocated to savings. Savings ratio = Monthly savings / Monthly disposable income 2. It is possible to have a negative savings ratio, which means you are accumulating more debt. IV. Understanding the time value of money. A. Personal financial planning is all about making choices. 1. The principle that money received today is worth more than money to be received in the future because of the power of compounding is known as the time value of money (TVM).

2. Compounding occurs when you earn interest on your investment balance and then leave the interest in the account so that you earn future interest on the original balance plus the accumulated interest earnings. 3. Money that is not invested in interest-earning or growth assets will actually lose value over time because of the eroding effects of inflation. B. There are four types of TVM problems: 1. Future value of a lump sum. 2. Present value of a lump sum. 3. Future value of a series of payments. 4. Present value of a series of payments. C. There are three different ways to solve each TVM problem. 1. Method 1: mathematical formula. a. Formula alone. b. Formula with TVM tables located in Appendix A. 2. Method 2: financial calculators. 3. Method 3: Excel spreadsheet. 4. All three will give the same answer (with minor rounding errors in some cases). D. You will find TVM problems easier to visualize if you draw a time line that shows each of the cash flows for the problem you are attempting to solve. E. Future value of a lump sum. 1. The future value (FV) of a lump sum is its value at a particular time in the future if invested today at a given rate of interest. 2. If you have a $1,000 today and plan to put it in a bank account that earns 5% per year, how much will you have at the end of one year and the end of two years. 3. TVM assumes annual compounding, which means that the interest on the balance is calculated at the end of each year. 4. If the mathematical formula is used, as shown on the Powerpoint slide, then: a. After one year, the FV = $1,050 b. After two years, the FV = $1,102.50 c. Using the formula with the table in Appendix A-1, we find the future value interest factor for 5% interest and n = 2, the FV = $1,102.50. 5. If the financial calculator is used, the same answer is shown on the Powerpoint slides, with N = 2, I/YR = 5, PV = -$1,000, and FV = $1,102.50. 6. And by using the Excel spreadsheet, as shown in the Powerpoint slides, the answer is the same at $1,102.50 F. Present value of a lump sum. 1. The present value (PV) of a lump sum is the amount of money that you would have to invest today in order to have a desired amount in the future over a specified period at a specified interest rate. 2. Another use of PV is to determine how much an amount to be received in the future is worth today. Since PV will always be less than its FV, the word discounting is used to describe the process of calculating the PV. 3. If you expect to receive $1,000 in one year or two years in the future, but could get it today, how much would you be willing to pay if you assume 5%?

4. The three approaches provide an answer pf $952.38 for one year and $481.01 for two years. G. Future value of an annuity. 1. The future value of an annuity (FVA) is the amount to which a regular series of payments will grow, with compounding, if invested at a given rate of interest for a particular period of time. 2. An annuity is a series of equal payments made at regular intervals for a period of time. a. An ordinary annuity is an annuity with end-of-period payments. b. An annuity due is an annuity with beginning-of-period payments. 3. Example given on the Powerpoint slide, is a car payment. 4. You deposit $1,000 each year (end of year) into a savings account. a. How much would this account have in it at the end of 2 years if interest were earned at a rate of 5% annually? b. Answer is $2,050. H. Present value of an annuity. 1. The present value of an annuity (PVA) is the lump-sum amount that must be deposited today to provide for equal periodic payments for a given number of periods in the future. 2. How much would $1,000 cash that you would receive at the end of the next two years be worth today if you could earn 5% on your deposits? a. It would be worth $1,859.41. b. Answers are approximately the same for all three methods shown on the Powerpoint slides. 3. The original amount will be less than the total of the payments because the account will continue to earn interest each period on the gradually declining balance. 4. A 30-year mortgage or a 5-year level payment car loans are good examples. I. Computing payments for loans using time value principles. 1. Amortization is the process of calculating equal payments on a loan that includes principal repayment and interest on the declining balance. 2. By the time you make your last payment, you have paid off the total loan balance. 3. Instead of solving for the PV of an annuity, you solve for the payment. J. What if payments are not equal? 1. Most loans have monthly payments and interest is compounded monthly. 2. Need to solve problems for monthly payments. 3. Convert your interest to a monthly rate by dividing by 12 and enter the number of months as n. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.edmunds.com: Find the value for your current vehicle(s) and any vehicle you plan on buying in the next year. Because card dealers tend to use one source for valuing their vehicles and a different one for valuing your trade-in, compare your findings by getting the same values from www.kbb.com and www.nadaguides.com.

2. www.womansdivorce.com: To obtain information on financial implications of divorce for women go to the Divorce and Money section of this site. Determine what steps need to be taken before and after the divorce. 3. www.bls.gov: Go to the U.S. Bureau of Labor Statistics website to the section on Wages by Area & Occupation and then for over 700 occupations to find average annual salaries for a wide variety of business occupations. 4. www.hp.com/calculators: If you have an hp calculator go to this website to obtain more information on your calculator and how to operate it. 5. www.ti.com: If you have a ti calculator go to this website to obtain more information on your calculator and how to operate it. 6. money.ccn.com/2003/09/30/pf/millionaire/networth/: This will take you to a good article on net worth that allows you to calculate your net worth and then compare it to others who make the same income. The net worth calculator is not as detailed as the one in this chapter, but provides a good alternative view. ADDITIONAL MINI-CASES 1. Case 1 – I Can Not Find Any of My Financial Records! Sam has decided that he wants to get his financial life in order. He has committed to constructing a personal balance sheet and cash flow statement. Only he has no idea where any of the bills he has paid in the last year are or what he really earned in the last 12 months. a. Should he estimate what he thinks he has earned and spent in the last 12 months or wait for another year until he has records? b. Can he go to his bank or other financial institution where he has his checking account and get a record of the checks he has written in the last 12 months? c. Can his credit card(s) company provide information on how much he has charged this year and how much he has paid each month? d. Will his employer be able to tell him his gross and net income and the benefits he has received during the year? e. If he can not obtain any records, is their any value in estimating what he thinks he has earned, spent, and has as assets and liabilities? Why? 2. Case 2 – How Are We Doing Compared to Other Couples Our Age? Ron and Jennifer are a couple in their late 20s. They have been married for five years and have one two year old child. They want to know how they are doing compared to other young families their age. a. After they prepare their personal balance sheet and cash flow statements, which personal financial ratios should they compute? Why? b. When they have completed their ratio analysis where can they find other families’ ratios to compare to theirs? Recommend specific websites. c. Should they be concerned if their ratios look very different from other young families? Why? 3. Case 3 – Why Should I Care About Time Value of Money Calculations? Kuntal is an undergraduate student who is majoring in music. He has been introduced to time value of money calculations in the personal financial planning

course that he is currently taking. He does not understand why his professor thinks it is so important to learn the time value of money concepts. a. Can you provide any reasons that would make time value of money concepts important for a music major? b. What salary can he expect to make if he lands a position in a major city’s symphony? Should he expect that they will provide a pension plan? c. Kuntal’s father is an engineer and is very disappointed that he is majoring in music. However, his grandfather has provided a trust fund for him that he can start to draw funds from when he turns 30 in another nine years. If the fund currently has $500,000 in it can you suggest some time value of money analysis that Kuntal may want to use? TEACHING SUGGESTIONS 1. Use the “Myth or Fact?” quiz at the beginning of the chapter as a springboard for starting the discussion of the chapter. In particular, have the class discussion focus on the third statement that “People whose incomes are in the top 5 percent are happier than other people”. 2. Have students calculate what it would cost for dinner and a movie if they come back to campus for the 10th reunion and inflation has averaged 4% a year. Assume the current cost is $13.00 for two movie tickets and dinner out is $40. 3. Have students discuss their methods for saving financial documents. Do they use file folders and a file cabinet? Is everything stuffed in a drawer? Do they throw it all out? Do they shred financial documents that could lead to identity theft? 4. Allow students time in class to complete 2-1, Assessing Your Personality Type on pp. 62-63 and then solicit their opinion of the questionnaire. 5. Have students develop their own personal financial statements using Worksheets 9, 10, and 11 in their Personal Financial Planner. Do it effective at the end of last year and project results at the end of this year. 6. Divide the class into small groups and have them discuss the cost of obtaining an undergraduate degree. How much more is the tuition this year than when they started? What has happened to the cost of textbooks and other material that they have to purchase for classes? How have they dealt with the increased costs? What do they think the rate of inflation on their costs has been since they started college? 7. Ask students to check with their bank and find out how much it cost to rent a safe deposit box for a year. Survey the results in class. 8. Ask students which financial ratio they think is most important to calculate. Why? 9. Talk about future plans with students in class. Ask them to write down what they expect their net worth to be in ten years. Then ask them what they expect their income and expenditure to be. How realistic do they think these estimates are and why?

CHAPTER 2 FINANCIAL PLANNING TOOLS: PERSONAL FINANCIAL STATEMENTS AND THE TIME VALUE OF MONEY SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 61-63 in Textbook Case 2 – 1. Homer and Marge Evaluate Their Personal Finances 1a. Determine value of car by using the internet, call a car dealer, or ask an auto loan officer at their financial institution. 1b. Determine value of home by looking at homes being sold near where they live, newspaper ads,or their real estate tax bill. 2. Net Worth = Assets – Debts = $237,000 - $119,200 = $117,800 Net Cash Flow = Net inflow – Net outflow = $5900 – 5735 = $165/Mo or $1,980/Yr 3. Homer is spending $165 Month at Moe’s They should add an expense category for “Moe’s” The net cash flow will fall to $0. “Moe’s” expenses are already reflected in cash balance of $3,000. It will impact cash balances in the future. 4. Financial Status Liquidity Liquid Assets = $3,000 = 0.5 Months Monthly Expenses $5,735 Debt Payment Ratio Total Monthly Debt Payments = $750 + $240 + $215 +$190 + $60 After Tax Monthly Income $5400 + $2,000 $1,455 = 42.79% $3,400 Debt Service Monthly Debt Service = $750 + $190 + $60 = $1,000 = 18.52% Monthly Gross Income $5,400 $5,400 Savings Monthly Savings = $165 or $0 after Moe’s = 4.85% Monthly Disposable Income $5,400 -$2,000 or 0% after Moe’s 5. They are completely unprepared to send Lisa to college in four years. There are no savings or investments to help pay for college. There is no room in their present cash flow for savings. Suggestions Marge could consider going to work. Evaluate after tax income possibilities and impact upon the family Lisa should consider part time work to help pay college costs. After school, weekends, summers, and/or school holidays Try to reduce expenses Groceries Reduce or eliminate visits to Moe’s.

Use lower interest rate loan for credit cards Tap into home equity Vacations Entertainment Other Expenses Case 2 – 2. Can Christopher Stevens Afford to Purchase a Car? 1. Annual Net Cash Flow Annual inflows - Annual outflows = Summer work + school job – school expenses = $2,600 + ($50 * 40 weeks) – ($60 * 40 weeks) = $2,600 + $2,000 - $2,400 = $2,200 2. Monthly Payment Car = $5,000 – Down Payment of $500 = Loan of $4,500 @ 6% for 3 years $4,500 = Payment * (1- (1/(1+(.06/12))))36 /(.06/12) $4,500 = Payment * 1-.8356/.005 = payment * 32.871 Payment = $136.90 per month or $1642.80 per year 3. He needs to consider Car Insurance, Gas, Maintenance, and Repairs 4. Net cash flow = $2,200 Annual car loan payments = $1,643 $ 557 This amount may cover car insurance, but probably not enough to cover the other expenses. He should also think of the possibilities of school expense increases and earning potential for the next three years.

CHAPTER 2 FINANCIAL PLANNING TOOLS: PERSONAL FINANCIAL STATEMENTS AND THE TIME VALUE OF MONEY SOLUTIONS TO END OF CHAPTER APPLICATIONS PROBLEMS Pages 59-60 in Textbook 1. Keeping records. a. Visa Bill – Budgeting & cash flow 1 Year b. Apartment rent receipt - Budgeting & cash flow 1 Year c. Bank checking account Budgeting & cash flow 1 Year statement – d. Tax return Tax records 7 years e. Tuition, Fees, Housing Budgeting & cash flow 1 Year 2.Personal Balance Sheet. a. Credit card balance b. Weekly employment earnings c. Car d. Rent paid to landlord e. Checking account

Debt Neither - inflow Asset Neither - outflow Asset

3. Evaluating personal balance sheet. a. Net Worth: Total Assets – Total Liabilities = Net Worth $10,000 - $14,500 = -$4,500 b. Liquid Assets: Cash = Bank Accounts = $3,000 c. Debt ratio = Liabilities / Assets $14,500 / $10,000 = 1.45 or145% d. Liquidity Ratio = Liquid Assets / Monthly Expenses $3,000 / $1,200 = 2.5 4. Valuing assets and debts a. Borrow $1,000 – Liability – long term. b. Unrealized tax refund – Current asset c. Trust fund – Income d. Apartment rent – Expense of $800, rent due from roommate – Income 5. Net Cash Flow Net cash flow = Total cash inflow – Total cash outflow Total cash inflow = Gross cash inflow – Taxes = $30,000 – Taxes @ 30% or $9,000 = $21,000 Total cash outflow = Fixed expenses + Variable expenses Fixed expenses = $750 X 12 = $9,000 Variable expenses = $900 X 12 = $10,800 $19,800 NCF = $21,000 - $19,800 = $1,200

6. Personal Finance Ratios a. Liquidity Ratio = Liquid Assets / Monthly Expenses = $5,000 / $6,200 = .81 b. Debt Ratio = Total Debt / Total Assets = $166,000 / $180,000 = .92 or 92% Total Debt = Current Debt + Short Term Debt + Long Term Debt = $1,500 + $4,500 + $160,000 = $166,000 c. Mortgage Debt Service Ratio = Monthly Mortgage Service / Gross Monthly Income =$1,300 / $10,000 = .13 or 13% d. Debt Payment Ratio = Total Debt Payment (mortgage + monthly debt payment) After Tax Income (Monthly Disposable Income) $1,300 +$450 =.25 or 25% $7000 e. Savings Ratio = Monthly Savings / After Tax Income = $700 / $7,000 = .1 or 10% f. Net Worth = Total Assets – Total Debts = $180,000 - $166,000 = $14,000 g. Net Cash Flow = Total Inflows – Total Outflows (Savings + expenses) = $7,000 – ($700 - $6,200) = $100 7. Present Value of a Lump Sum a. PV = FV / (1+i)n $200,000 / (1+.12)30 = $200,000 / 29.96 = $6,675.57 b. PV = FV / (1+i)n $200,000 / (1+.10)30 = $200,000 / 17.45 = $11,461.32 The higher the discount rate, the lower the present value of the lump sum. 8. Present Value of a Lump Sum a. PV = FV / (1+i)n $50,000 / (1+.08)10 = $50,000 / 2.16 = $23,148.15 b. PV = FV / (1+i)n $50,000 / (1+.08)5 = $50,000 / 1.47 = $34,013.61 The longer the time period until the lump sum is received, the lower the present value. 9. Future Value of a Lump Sum a. FV = PV x (1+i)n $5,000 x (1+.04)10 = $5,000 x 1.48 = $7,400 b. FV = PV x (1+i)n $5,000 x (1+.06)10 = $5,000 x 1.79 = $8,950 The larger the rate, the larger the future value of the lump sum 10. Future Value of a Lump Sum a. FV = PV x (1+i)n $2,500 x (1+i)6 = $2,500 x 1.19 = $2,975 b. FV = PV x (1+i)n $2,500 x (1+i)8 = $2,500 x 1.27 = $3,175 The longer the investment period, the larger the future value of the lump sum.

11. Present Value of an Annuity a. PVA = $1,000 x 1- (1/1.05 )10 = $1,000 x 7.722 = $7,722.00 .05 b. PVA = $1,000 x 1- (1/1.1 )10 = $1,000 x 6.145 = $6,145.00 .10 The higher the discount rate, the smaller the present value of the annuity 12. Future Value of an Annuity a. FVA = $2,000 x [(1.08)6 -1 ]/0.08 = $2,000 x 7.3359 = $14,671.86 b. FVA = $2,000 x [(1.12)6 -1 ]/0.12 = $2,000 x 8.1152 = $16,230.38 The higher the interest rate, the larger the future value of the annuity 13. Annual Versus NonAnnual Compounding a. $40,000 = Annual Payment x [ (1+.10)10 -1 ]/0.1 = Annual Payment x 15.9374 Annual Payment = $40,000 / 15.9374 = $2509.82 b. $40,000 = Monthly Payment x [ (1+.10/12)120 -1 ]/(0.1/12) = Monthly Payment x 204.8450 Monthly Payment = $40,000 / 204.8450 = $195.27 Note: 120 months in 10 years. 14. Time Value of Money a. Present Value of Annuity b. PVA = $800,000 x [ 1 – ( 1/ 1.08)25 ]/0.08 = $800,000 x 10.675 = $8,540,000 The annuity has a slightly larger present value than the $8 million lump sum 15. Time Value of Money a. Loan = $300 x { 1 – [ 1/ (1+(0.06/12)]36 }/(0.06/12) = $300 x 32.88 = $9,864 b. Total cost = Loan + Down payment = $9,864 + $2,000 = $11,864 c. 0% Financing Loan = $300 x 36 = $10,800 Total cost = Loan + Down payment = $10,800 + $2,000 = $12,800 Difference is $936.00

CHAPTER 3 GOAL SETTING, CAREER PLANNING, AND BUDGETING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 94-95 in Textbook Case 3 -1 Katie Stewart Confronts Her Spending Habits a. Before taking a new job for less money, she needs to understand the cash flow situation under her current circumstances. Once she can establish a budget, she could modify it to evaluate her cash flow if she changes jobs. Some considerations include: Lower gross salary – is there lower income tax in New Jersey? Save $2,600 in commuting expenses -$50 week, for 52 weeks Save on shopping sprees in New York b. Establish a budget that limits her spending. Set a clothing allowance and stick to it. Go shopping less often. Use the savings from these to pay down the credit card debt. c. To pay off credit card debt in four years at 14% interest $4,500 = Payment x 1- {1/[1+(0.14/12 )}48 = 1 – .5730 = 36.5895 0.14/12 0.01167 Payment = $4,500/ 36.5895 = 122.99 / Month d. Katie should compare her net salary after tax, especially state and city taxes. She will probably save most but not all of her commuting expenses and the shopping sprees. She will also have to consider the expense of looking for a new job. Case 3 – 2 Ron Herrington Faces a Layoff. a. Ron and Nancy need to establish a budget to understand their current cash flow. Then, they need to analyze expenditures that can be cut or eliminated to 1. increase their liquidity during the remainder of the time Ron still has a job, and 2. help offset the impact of Ron’s reduced salary. b. 1. Evaluate, a) Their assets, liabilities, and net worth. b) Their present cash flow situation to help them understand their current situation. 2. Estimate Ron’s lower future gross salary and tax impacts. Revise expenses to reflect their new situation. 3. Increase savings / investments to provide a safety net. c. Take steps to evaluate job skills demanded for software engineers and update his skills. Update his resume, establish references, and do practice interviews. Start looking for a job now by letting friends and acquaintances know he is looking and use job listing services. d. Pros: Increase family income Provide funding for children’s college expenses. Cons: Marketing skills may need updating. Impact on the children’s lives. Less time to spend with family. Now, she needs to evaluate her life experiences, update her resume, establish references, and start looking for a job.

CHAPTER 3 GOAL SETTING, CAREER PLANNING, AND BUDGETING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 93-94 in Textbook 1. Setting Goals. a. Determine increased annual expenses for raising a child during the early years. b. Estimate costs of college education for children and strategy for saving / investing. c. Increased need for adequate life and health insurance. d. Changed priorities – more time at home with child, revised sleeping schedule, less entertainment that is more child centered, more frequent visits to doctors for well baby and sick baby. 2. Breaking Goals into Quantifiable Subgoals. a. Jamal will need to save the down payment. Assume a saving interest rate of 3%. PV = 0, FV = $1,200, N = 12Mo. I = 3%/12 Monthly savings = $98.63 b. Determine length of time acceptable for the car loan. c. Determine available loan interest rates. d. compute monthly loan payments for the term and rate determined. 3. Present Value of Education. Education expense = $60,000 / yr. for 3 yrs. + $35,000 = $215,000 [ 1 – ( 1/1.04)45 ] PV= $20,000 x 0.04 PV= $20,000 x (1- 0.1712) / 0.04 PV= $20,000 x 0.8288 / 0.04 = $414,400 PV – Education Expense = $414,400 – 215,000 = $199,400 4. Budgets and Family Type.

Housing Transportation Entertainment Health Care

Rent or Mortgage Car Loan & Insurance Gas, Oil, & Maintenance Insurance Unreimbursed expenses

Fixed Fixed Variable Variable Fixed Variable

Age 27 Larger Larger Larger Larger

Age 70

Larger Larger

5. Developing a Budget. Income $1,000 Rent & Utilities Auto & Insurance Cell Phone Health Insurance Entertainment Monthly Net Cash Outflows

$450 $300 $ 25 $ 50 $150 $975

6. Determining Budget Variance. Budget Variance September Housing 0 Auto -20 Cell Phone 25 Health Insurance 0 Entertainment 70 Net Flow $75 over budget

October 20 20 0 0 25 $65 over budget

He needs to watch more closely his monthly spending. Entertainment is most consistently over budget, followed by Housing (probably utilities), Auto, and Cell Phone. 7. Effects of Inflation. Monthly Budget * Inflation = New Budget $1,000 * (1+.025) = $1,025 $1,000 * (1+.04 ) = $1,040

CHAPTER 3 GOAL SETTING, CAREER PLANNING, AND BUDGETING THE LEARNING OBJECTIVES 1. Identify your short-term and long-term personal financial goals. 2. Evaluate your skills, abilities, and interests to establish a career plan. 3. Develop and implement a household budget. 4. Monitor and control your expenses through a system of regular evaluation. 5. Understand how money attitudes affect budgeting. CHAPTER OUTLINE AND SUMMARY I. Setting Short-Term and Long-Term Personal Financial Goals. A. Why goals are important. 1. The key to successfully accomplishing a set of tasks is to establish a set of specific objectives or goals and persistently work at achieving them. 2. Achieving financial success requires a similar approach. 3. If you have a prioritized list of specific goals with measurable outcomes and a plan for how to achieve them, you’ll make progress toward financial success. B. Steps to identifying goals. 1. There is no magic formula for identifying and prioritizing your goals because they are unique to each individual and household. 2. Common goals include: a. Consumer spending and borrowing. b. Career advancement. c. Education for yourself, your spouse, and your children. d. Home purchase and maintenance. e. Managing risk. f. Retirement planning. g. Vacations and recreation. h. Charitable giving. i. Estate planning. 3. To be effective, your goals should be realistic. a. They should be within your control. b. Be stated precisely and in measurable terms so you can track your progress. C. Steps in setting goals. 1. Make a wish list. a. The first step in establishing a set of goals is to make a “wish list”. b. Short-term goals are those that can reasonably be accomplished within the next year, such as buying a car or taking a vacation. c. Intermediate-term goals, like paying off debt or saving for a down payment on a home, which may take up to five years to accomplish. d. Long-term goals which may take your entire lifetime. e. Goals will differ depending on your stage in the life cycle and your family makeup. f. The important part of making a wish list is to put it down on paper.

g. State goals in positive terms with projected dates and estimated dollar costs. 2. Prioritize. a. Prioritize your list to focus on those goals that are most important to you. b. There will be inevitable tradeoffs. 3. Break big goals into smaller steps. a. By breaking your bigger goals into smaller, more manageable steps, you’ll more quickly see progress towards your goal. b. The more frequently you see rewards from your endeavors, the more motivated you’ll be to stick with your plan. c. You will need to use the time value of money calculations from Chapter 2 to estimate the amounts that you will need to set aside to achieve your goals. 4. Reevaluate regularly. a. Your personal financial plan must be flexible to accommodate changes that you will face in the future. b. As your life progresses, your priorities will change, as will your strategies for achieving your goals. c. You will need to revisit your goals regularly, at least once a year. II. Career Planning. A. Career decisions throughout your life will not only influence your choice of goals, but also will affect the probability of your achieving them. 1. The time and effort you invest in your career will affect your earnings level and your future advancement opportunities. 2. The present value of your future earnings is sometimes referred to as your human capital. 3. If you don’t invest in your human capital by keeping your skills and abilities current, you may find that your income will stagnate as your skills and knowledge decline in value or become obsolete. 4. You can calculate the value of your college education by determining the present value of the increased income potential realized from your degree(s) based on average salary differences for a variety of occupations. 5. Can calculate an even more realistic estimate of the benefits of a college degree by determining the costs in lost wages and the cost of the education and subtract that cost from the benefits of a higher income. 6. Probably your human capital is your most valuable asset. B. Choosing a career. 1. Your choice of career is perhaps the most important life decision you will make. 2. You should apply good decision-making skills to the process. 3. Assess your abilities and interests. a. Studies show that people who are working in careers that support their intrinsic interests are happier and more successful. b. Your college or university career services office has tests you can take that will fit your interest and abilities to career options. Tests include: 1) Myers-Briggs Type indicator. 2) Strong Interest Inventory. 3) Keirsey Character and Temperament Sort. c. Ask yourself the following questions to develop a pattern that will help you

link your activities, hobbies, or interests to possible careers. 1) What activities do you enjoy most? 2) When you’re doing what you want, what are you doing? 3) What do you like to do in your leisure time? 4) What are your hobbies? 5) Are you a “people person”? 6) What courses have you enjoyed the most in college? 7) What projects or assignments did you enjoy the most in college? 4. Identify alternatives that fit your interests. a. Make a list of characteristics that describes your ideal job. b. Research how your unique interests fit careers you have identified. c. Be willing to change if you decide the career choice you have made is not right for you. 5. Evaluate the costs, benefits, and risks. a. Evaluate what it costs to prepare for your chosen career. b. What are the tradeoffs in terms of benefits of the career and negative factors. c. How likely will it be that you can succeed in this career? 6. Research employment trends. a. Aging of the population. b. Increasing importance of the service sector. c. Continued globalization. d. Concentration of the population in coastal regions and near transportation centers. C. Preparing yourself for the job market. 1. Acquire skills. a. Many careers today require familiarity with computers and well developed written and oral communications skills. b. Extracurricular organization membership provides the opportunity to develop leadership skills. 2. Get experience. a. Summer jobs. b. Internships. 3. Network. a. The process of developing contacts with people who might be helpful in your career is called networking. b. If you approach individuals in your network for an informational interview, you will learn about a potential career or job. D. Conducting an effective job search. 1. Use available resources. a. Classified ads in newspapers. b. Job fairs. c. Internet job websites. 2. Perfect your resume and cover letter. a. A resume is a summary of your education and experience and should be carefully written to present you in the best possible light. b. A resume should include:

1) Contact information. 2) Education and certifications. 3) Experience. c. Optional additional information on the resume can include: 1) Career objectives. 2) Summary of skills and abilities. 3) Honors, awards, and extracurricular activities. d. A cover letter is a letter of introduction, no more than one page in length, sent with a resume to prospective employers. 3. Applications, follow-up, and interviews. a. Prepare for an interview by becoming familiar with the firm and the job description. b. Dress appropriately. c. Try to do practice interviews before you apply for jobs. 4. Planning for the long term. a. Furthering your education. b. Moving up into a management-level position. c. Changing careers later in life. d. Starting your own business. III. Developing and Implementing a Budget. A. A budget is a plan for spending your money in the future so that you can achieve your financial goals. B. Four steps in the budgeting process include: 1. Forecasting. 2. Implementing. 3. Monitoring. 4. Evaluating. C. Forecasting future income and expenditures. 1. Need to forecast your future income and expenditures in setting up the budget. 2. Need to ask several questions: a. What time period will your budget cover? b. How will you keep your records? c. How will your income and expenses change over time? D. Reconciling your budget and applying funds to your goals. 1. Reconciling a budget is the process of adjusting income and spending so that your expenses do not exceed your income. 2. You want to be sure to include money for your prioritized financial objectives. IV. Monitoring and Controlling Your Budget. A. A money spending plan will help keep your actions consistent with your goals. 1. You can track your budget monthly by using a computer spread sheet. 2. Each month you can see how your spending varies from your projections. 3. You can then revise your budget based on what you learn. B. There are two main reasons for tracking budget variances: 1. To identify small cash leakages as soon as possible so that you can change your behavior before you have a major budget shortfall. 2. To ensure that large irregular cash expenses do not cause financial hardships.

C. You can provide for irregular cash expenses by: 1. Building a fund for large expenses by putting away some money each month. 2. Have an emergency fund. 3. Obtain a short-term loan. D. Revising your budget. 1. Discretionary spending can cause you to exceed your budget. 2. You will know why you do not meet your projected budget by keeping track each month. 3. You then need to go back and revise your budget. V. Money Attitudes and Household Budgeting. A. Individual differences in money attitudes and spending behavior can be a major cause of conflicts in relationships. B. Before combining household finances, the following issues should be considered: 1. How will you manage the finances in the household, pay regular bills, and make investment decisions? 2. Will each person retain individual control over some of the money? 3. Which household discretionary expenditures require joint agreement? 4. What are your individual attitudes about spending and borrowing? 5. What are your individual attitudes about planning and saving for the future? 6. What are your attitudes toward gift giving? 7. Who pays for the debt that precedes the marriage? 8. How will you pay for expenses associated with children from previous marriages? 9. Should you have a prenuptial agreement? ADDITIONAL WEBSITE ASSIGNMENTS 1. http://www.econlib.org/library/Enc/HumanCapital.html Read the article by Dr. Gary S. Becker on human capital. He won the 1992 Nobel Prize in Economics for his work in this area. What do you think about his views on how to increase your human capital? 2. http://apps.collegeboard.com/fincalc/college_cost.jsp Use the college cost calculator to determine your costs for going to college or to project the cost of your children going to college. Also provides a good set of articles on how to pay for college and available help. 3. http://keirsey.com/ This website discusses the four temperaments that are classified in the Keirsey Character and Temperament Sort. You can take an on-line version of the test and try to determine what your type of temperament you have and compare it to famous individuals who have been classified by type. 4. www.acinet.org This site is recommended in the chapter and provides excellent career information. Select educational level, then receiving a bachelor’s degree or higher and and end to find fastest growing occupations. Select an occupation and then compare wages and number of jobs in at least three different states. 5. www.practicalmoneyskills.com This site is recommended in the chapter and provides an excellent lesson for college students. Go to lessons for College Students and do the first lesson entitled, The Art of Budgeting. It will walk you through lots of questions

about setting goals and putting a dollar amount on those goals. 6. http://www.campuscareercenter.com/ Go to this site to investigate the idea of an internship as well as look at firms that offer internships. Decide if this is a legitimate site and if there are real opportunities here. Look at other sites that are listed in your favorite search engine for internships and compare to this site. ADDITIONAL MINI-CASES 1. Case 1 – How Much Will Our Budget Change? Elizabeth and Dennis are expecting their first child after both of them have pursued full-time professional careers for the last 10 years. They have enjoyed purchasing their first home and traveling widely. Before the baby arrives, they want to determine the impact of having a child on their budget. a. What additional expenses will they have before the baby arrives? b. What additional expenses will they have during the baby’s first year? c. How can they determine the cost of child care? d. How can they determine how much they will need to have to send their child to college? 2. Case 2 – How Do I Know What Intermediate-term Goals I Want to Have During the next Five Years? Tom is a senior majoring in Finance and plans on being a financial planner. He can determine his short-term goals, but is having trouble visualizing his intermediate-term goals. a. Can you suggest three intermediate-term goals he might want to consider? b. How can he determine how long it will take to achieve these goals? c. How can he determine what it will cost to achieve these goals? d. How likely will it be that his goals will change? Why? 3. Case 3 – How Do I Cultivate a Network for My Career? Bryan graduated from college with his bachelor’s degree four years ago. He is interested in finding another career opportunity as he is working for a small family business that does not seem to have much upside potential. a. Bryan has been advised to read Richard Bolles’ book entitled What Color Is Your Parachute?. It talks about deciding on careers. Look on the author’s website at www.jobhunterbible.com and evaluate the advise he offers. Do you think Bryan should look at this site? b. How can Bryan meet people who will form his career network? c. Does he need to know someone to get an informational interview? d. Should he consider going back to school for a master’s degree? Why? TEACHING SUGGESTIONS 1. Have students make a wish list of short-term and intermediate-term goals they would like to achieve. They should provide both a time line to achieve the goals and a dollar amount that is necessary to reach the goal.

2. After students have determined their short-term and intermediate-term goals, have them prioritize them over the next year. 3. Divide students into two groups, with each group searching the Internet for career websites. Ask them to find and evaluate at least five sites and present their results in class. They can use the job sites suggested in the box “ask the expert” on p. 81. 4. Have students go to the federal government’s Occupational Outlook Survey that is provided in a website listed on p. 78 and select one occupation to investigate. They should provide a one-page written summary of their evaluation of the career and why they think it might interest them. 5. Ask students to arrange an informational interview and report the results of both the efforts necessary to set it up and their findings on the interview in an oral presentation to the class. 6. Have students prepare a one-page resume that they can use to search for either a summer internship or their first professional job. 7. Ask students to prepare a budget for the next year. 8. Divide the class into four groups. Have each group discuss the following questions and suggest possible careers for the individuals in the group. a. What activities do you enjoy most? b. When you’re doing what you want, what are you doing? c. What are your hobbies? d. What courses have you enjoyed the most in college? 9. Discuss the four employment trends identified in the chapter. What impact, if any, do students think these trends will have on their career choice?

CHAPTER 4 INCOME TAX PLANNING THE LEARNING OBJECTIVES 1. Understand major features of the federal income tax system. 2. Know when and how to file your taxes. 3. Calculate taxable income and determine your tax liability. 4. Establish strategies to legally minimize the taxes you pay. 5. Understand how the tax system is enforced, and be aware of recent trends in the system. CHAPTER OUTLINE AND SUMMARY I. The Federal Income Tax System. A. Your income tax obligation is one of your household’s largest cash outflows. 1. Individuals work more than four months of the year to pay federal income taxes. 2. Average taxpayer spends more than ten hours filling out the required forms. B. A brief history of U.S. income taxation. 1. The 16th amendment to the U.S. Constitution was passed in 1913 and allowed Congress to impose a tax on income. 2. Federal income taxes are used to finance the national defense, education, social programs, drug safety, transportation, and road maintenance. C. The progressive nature of the U.S. tax system. 1. A progressive tax is a tax that requires higher-income taxpayers to pay proportionately more in taxes, through either higher tax rates or other rules. 2. A regressive tax places a disproportionate financial burden on lower income taxpayers. a. The tax that finances Social Security and Medicare is a regressive tax. b. The amount withheld for FICA (Federal Insurance Contributions Act) is the tax paid to help finance Social Security and Medicare. D. Marginal tax rates. 1. A marginal tax rate is the rate that is applied to your next dollar of income. 2. Our current tax rules assess taxes on taxable income, which is the amount of income that is subject to taxes under the law. E. The tax rate schedules. 1. Tax rate schedules tell you how much income tax you’ll pay for particular ranges of income. 2. There are separate schedules for five different household types. 3. A tax bracket is the range of taxable income to which a particular marginal tax rate applies. 4. You pay lower tax rates on your first dollars of income and higher rates on later dollars of income. F. Marginal versus average tax rates. 1. Much of tax planning is aimed at minimizing your average tax rate, which is the proportion of a taxpayer’s total taxable income that goes to paying taxes. 2. It is calculated by dividing taxes paid by taxable income.

3. Your average tax rate will always be less than your marginal tax rate because of the progressive nature of income taxes. G. Inflation indexing of tax brackets. 1. The federal income tax rates can only be changed by Congress. 2. However, the levels of income that trigger each successive increase in tax rate are automatically increased each year for inflation. H. Considering the marginal tax effect in making financial decisions. 1. The marginal tax effect is the reduction in taxes owed as a result of a financial decision. 2. You must evaluate your alternatives based on the changes in your financial circumstances that will result from the decision. I. The Internal Revenue Service. 1. The Internal Revenue Service (IRS) is the U.S. government agency responsible for collecting federal income taxes and enforcing tax laws and regulations. 2. There are sometimes ambiguities in the laws as written, so the IRS also writes regulations and makes rulings that interpret the laws. 3. When there are disputes about how to interpret and apply these laws and regulations fairly, the federal tax court hears cases and makes rulings. 4. The Internal Revenue Code is a compilation of all tax laws passed by Congress, along with the IRS regulations and tax court judicial decisions, making up the totality of tax laws in the United States. II. Filing Requirements. A. Who must file a federal income tax return? 1. Filing a tax return involves reporting income to the IRS on official tax forms and paying any outstanding taxes owed. 2. Your filing status identifies your household type for tax filing purposes. a. Single – unmarried or legally separated from your spouse. b. Married filing jointly – married couple filing a single tax return, even if only one spouse has income... c. Married filing separately – each spouse files an individual tax return, reporting his or her own income and allowed deductions from income. d. Head of household – single person who lives with and pays more than half of the support for a dependent child or relative. e. Qualifying widow(er) with dependent child – person whose spouse died within two years of the tax year and who lives with and pays more than half of the support for a dependent child. 3. Income. a. Adjusted gross income (AGI) is the total of your earned income (salaries, wages, tips, bonuses, and commissions) plus unearned income (interest, dividends, capital gains, rents, royalties, and net business income) minus certain allowed adjustments. b. Exemptions are the dollar amount per household member that is subtracted from adjusted gross income in calculating taxable income. 1) Personal exemption for each qualified person in your household. 2) A standard deduction is the dollar amount based on filing status that is subtracted from adjusted gross income in calculating taxable income.

3) An itemized deduction is an alternative to the standard deduction in which the taxpayer reports and deducts actual expenses in certain allowed categories to arrive at taxable income. c. You can also use a tax credit to reduce the taxes you owe. 1) Does not represent adjustments to your income. 2) Are subtracted directly from the taxes you owe. B. When and where to file. 1. Filing deadlines. a. Tax returns must be postmarked by midnight on April 15 of the year following the tax year. b. You can extend the deadline to August 5th, by filing Form 4868. a. You can get an additional extension to October 15th. b. Must still pay estimated taxes by April 15 or face penalties and interest. c. If you made a mistake on a prior year’s taxes, you can file an amended return. 2. Where to send your return. a. IRS maintains several service centers around the country based on zip code. b. The IRS e-file is a system allowing electronic filing of federal income taxes. 3. IRS forms. a. You have a choice of three primary tax forms: Form 1040, known as the long form, and two short forms, Form 1040 EZ and Form 1040A. b. Which form you use depends on your filing status, your income (type and amount), and the deductions and credits you can claim. c. Tax software packages such as TurboTax and TaxCut can often make it easier to complete your return and identify the appropriate forms to file. III. Calculating Taxable Income and Taxes Owed. A. Reporting income. 1. The first step in doing your taxes is to calculate your income. 2. Gross income is your income from all sources. 3. Some categories of income are excluded to arrive at total income on your tax forms, an amount that can be thought of as gross taxable income – income from all sources less allowed exclusions. 4. Employers and financial institutions are required to report the amounts that they pay you each year on Form W-2 for employment income and Form 1099 for other types of income. 5. Tips must be report but do not appear on your W-2. 6. You must report profits from business, and you may sometimes be able to subtract losses from business. 7. Gross income also includes any capital gain, or increase in value, of taxable investments that you sold during the year. a. If you hold an investment longer than a year, subject to 5% for taxpayers in the 10- 15 percent tax brackets and 15% for those in higher tax brackets. b. These same rates also apply to most dividend income. c. For the sale of your primary residence, if you have lived for two out of the last five years in the home before the sale, then you: 1) Can exclude $250,000 of the gain if you are single. 2) Can exclude $500,000 of the gain if you are married.

B. Adjusted gross income. 1. Certain expenses can be subtracted from total income to arrive at adjusted gross income (AGI). 2. Some adjustments include: a. Teachers of kindergarten-grade 12, unreimbursed expenses up to $250. b. Deductible individual retirement account contributions up to $4,000. c. Interest paid on student loans during the year. d. Tuition and fees for higher education up to $3,000. C. Standard versus itemized deductions. 1. The amount of the standard deduction increases annually with inflation and depends on your filing status. 2. If your deductible expenses are greater than the standard deduction, report itemized deductions on Schedule A. D. Medical and dental expenses. 1. Total your medical and dental expenses and then subtract 7.5 percent of AGI. 2. The remainder is your deduction. 3. You can only deduct medical expenses that your insurance has not reimbursed. E. Taxes you paid. 1. You’re allowed to deduct state and local income taxes you paid during the year. 2. Also allowed to deduct real property taxes paid on your primary residence and personal property taxes. F. Interest you paid. 1. You can deduct interest paid on your mortgage and home equity loans as well as certain charges paid by borrowers to obtain their home mortgage. 2. Interest paid on credit cards, personal loans, and car loans is not deductible. G. Gifts to charity. 1. You can deduct contributions made to charitable organizations. 2. Separate lines to report cash and noncash donations. H. Casualty and theft losses. 1. Can claim unreimbursed loss. 2. Deduct the amount of the loss that exceeds 10% of your AGI, less $100. I. Job expenses and miscellaneous deductions. 1. Expenses that are required for employment but are not reimbursed by employer. 2. Deductible to the extent that they exceed 2% of your AGI. J. Other miscellaneous deductions. K. Totaling your itemized deductions. 1. Use itemized deductions if they exceed standard deduction. 2. Unusually large deductions may raise scrutiny by the IRS. L. Exemptions. 1. The last step in calculating your taxable income is to subtract exemptions. 2. Each exemption can only be claimed on one tax form per year. M. Final calculation of taxes owed. 1. Subtracting deductions and exemptions from adjusted gross income gives you taxable income. 2. IRS provides taxes owed for taxable income up to $100,000. N. Applying available credits.

1. Current tax credits include credit for foreign taxes paid, child and dependent care expenses, elderly and disabled status, education expenses, retirement contributions, dependent children, and adoption. 2. Some credits have income limitations and require the use of a separate form. O. Alternative minimum tax. 1. The alternative minimum tax (AMT) was originally designed to ensure that people who receive certain tax breaks pay their fair share of taxes. 2. Recent years impacted many middle-income taxpayers. IV. Paying taxes. A. Withholding. 1. Money regularly withheld from employees’ pay by employers for payment of the employees’ taxes are called payroll withholding. 2. Amount of taxes withheld is determined by a calculation based on expected income and number of exemptions as indicated on your W-4 form. B. Estimated tax. 1. If you are self-employed or have investment income that hasn’t been subject to withholding, you must pay your taxes in advance of the April 15 due date. 2. Pay tax in quarterly estimated tax installments. C. Additional taxes on the self-employed. 1. Must file a Schedule SE with their tax forms. 2. It determines the amount of Social Security and Medicare payroll taxes owed on any business income. V. Tax Planning Strategies. A. Tax evasion versus tax avoidance. 1. Tax evasion is the deliberate nonpayment of taxes legally owed and is against the law. 2. Tax avoidance is the strategic use of knowledge of tax rules to avoid overpayment of taxes. B. Strategies for minimizing taxes. 1. Tax planning is the ongoing process of using the provisions of the tax law to reduce your taxes or defer them to later years. 2. Reduce taxable income. a. Many employers allow pretax contributions for employee benefit and retirement plans that reduce both taxes and Social Security payments. b. A flexible spending account is a reimbursement account for qualified medical and child-care expenses. 3. Defer taxable income. a. Employer retirement plans may allow you to make investment contributions on a pretax basis and avoid current income taxes on that income. b. These plans also allow you to defer paying taxes on the investment earnings in the plan. c. A traditional IRA is an individual retirement account that allows the holder to subtract current contributions from taxable income and to defer income tax until withdrawal at retirement. d. A Roth IRA is an individual retirement account to which contributions are made with after-tax dollars, but investment earnings and withdrawals at

retirement are tax-free. e. Postpone receiving income until a future tax year. 4. Receive income that is subject to lower tax rates. a. Long-term investments in capital assets. b. Primary residence. c. Shift some income to children. 5. Increase deductions and exemptions from incomes. a. Consider timing of expenses. b. Keep track of charitable contributions. c. Mortgage interest and property taxes are deductible for primary residence. d. Interest paid on home equity loans up to $100,000 is deductible. VI. Enforcement of the Tax System and Recent Trends. A. Enforcement of tax laws. 1. The IRS employs several levels of scrutiny to investigate tax returns for errors and intentional omissions. 2. A tax audit it the process by which the IRS more carefully examines particular tax returns for errors and omissions. B. Complexity of the tax system. 1. IRS and tax system is complex. 2. It can be beneficial and is worth learning about. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.irs.gov Go to the IRS official website to obtain Form 1040, Schedule A, Schedule C, Schedule SE, Form 1040EZ and Form 1040 A and compare the information requirements for filling out the long-form and accompanying schedules and the short forms. What do you need to do in order to have the expenses necessary to use Form 1040? 2. http://www.dinkytown.net/java/TaxMargin.html This site provides information on the latest federal income tax law changes and a calculator to determine your marginal and effective tax rates. Use it to determine your marginal and effective tax rates and you tax bracket. 3. http://www.taxadmin.org/fta/link/forms.html Use this site to find your state’s tax forms. Then go to the heading State Comparisons to see how your state taxes compare to everyone else’s state taxes. 4. http://www.brookings.edu/es/urban/eitc.html The Brookings Institution provides data on the IRS Earned Income Tax Credit for low income workers for all 50 states by urban and rural areas in map form. Use the site to find the percentage of low income households in your state and community. 5. http://taxes.yahoo.com/guide/buystock/ This site on Yahoo!Finance provide a basic explanation of capital gains. Read “Capital Gains and Losses 101” and then try reading some of the “Basic Questions About Capital Gains”. 6. http://www.principal.com/grouplh/selffunded/fsacalculator.html Principal Financial Group provides a calculator to determine how much you will save in taxes by using a flexible spending account. Use it to determine if you should use it.

ADDITIONAL MINI-CASES 1. Case 1 – I Don’t Know Anything About Federal Income Taxes Because My Parents Do My Taxes for Me. Erin is a 20 year old college student taking a course in Personal Financial Planning. When the class discussed federal income taxes, she didn’t have a clue about the subject. a. Should she ask her parents about how they do their taxes? Why? b. When will she have to fill out a federal tax form? c. Suggest two or three websites she can use to learn about taxes and their income on her future earnings. 2. Case 2 – Why Does the Government Tax My Tips? John is a working as a waiter until he can establish his acting career. He does not understand why the government taxes his tips as they are different each work day and he seems to get more tips than his co-workers. a. Why do you think the federal government taxes John’s tips as a waiter? b. How should John keep track of his tips, as most of them come in the form of cash and he simply spends the money. c. What are the benefits of recording his tips and reporting them to his employer? What are the disadvantages of recording his tips? d. Go to IRS Publication 17 on line to determine how tips are to be reported and taxes and advise John what to do about his tip income. 3. Case 3 – Can My Parents Use the Hope Scholarship Credit? Eric’s parent’s adjusted gross income is $70,000. He is wondering if they can use the Hope Scholarship Credit on their federal income taxes as he is a 19 year old college student. a. What is the Hope Scholarship Credit? How did it get that name? b. Do you think his parents can use it? Why or why not? c. How is the Hope Scholarship credit different than the Lifetime Learning Credit? d. Will the Hope Scholarship Credit affect Eric’s college scholarship? TEACHING SUGGESTIONS 1. Have students look up the 16th Amendment to the United States Constitution. What does the amendment state? Why did Congress pass this amendment? 2. Have two students debate the following questioning in class: The Federal Government Takes Too Much of My Income in Income Taxes. 3. Have students go the IRS website to determine career opportunities with the IRS. What are the qualifications necessary to be an IRS agent? What are the advantages and disadvantages of this career? 4. As stated in your textbook on p. 108, filing federal taxes electronically is becoming a very popular option. Have class discuss the pros and cons of filing taxes electronically. How accurate do they think the IRS projection is that 60% of individual tax returns will be filed electronically by 2009?

5. On page 113 of the textbook there is a list of income that is included and not included in Gross Taxable Income. Have students discuss why they think the income listed in the not included category is not taxed. 6. Ask students to report on which tax form, if any, they file. Discuss how long it takes to complete the form. Have them ask their parents about which form they file and what their parents think about filing federal, state, and local income taxes. Remind them that not all states have state and/or local income taxes. 7. Have the class discuss why interest on mortgages can be deducted by individuals but not interest on car loans, credit cards, or personal loans. Do they think the tax law should be changed to allow for deductions for these types of interest? Why or why not? 8. Have students calculate the potential value of an IRA when they turn 65, if they start one today, in 10 years, or 20 years. Does it make more sense to use a traditional or a Roth IRA ? Why? 9. It is important understand the strategies that can be followed to minimize taxes. Have students discuss the advantages and disadvantages of owning a small business in terms of minimizing their taxes.

CHAPTER 4 INCOME TAX PLANNING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 131-133 in Textbook Case 4-1.Yenni Oey Figures Her Taxes. a. Itemize Deductions? Standard deduction = $4,750 Health insurance $2,000 Unrembursed medical expenses $ 500 less Adjusted gross x 7.5% $2,500 $22,300 x .075 = $1,675.50 deductible medical expenses $ 827.50 State tax withheld $ 600 Church offering $250 Salvation Army $150 $ 400 Total Deductions $1,827.50 She is better off to take the standard deduction b. Taxable Income Wages $22,300 Student loan interest $ 50 Adjusted gross income $22,250 Standard deduction $ 4,750 Personal Exemption $ 3,050 Taxable income $14,450 c. No tax credits d. Marginal tax bracket is 15% e. It is almost always a good idea to put money in an IRA. It would reduce her taxable income and she would save 15% in taxes for every dollar put into an IRA. The time value of money makes much larger potential earnings for IRA investments now rather than later in her career. f. Tax due Tax = $700 + ($14,450 - $7000) x .15 = $700 + ($7,450) x .15 = $700+$1,117.50 = $1,817.50 Withheld = $1,200 Tax Due $ 617.50 She should have more withheld for next year. Case 4-2.Christine and Rich Schaeffer Prepare to File Their Taxes. a. Total Salaries $65,000 Gambling Winnings $ 600 Total Income $65,600 IRA Contribution $ 4,000 Student Loan Interest $ 100 Adjusted Gross Income $61,500 Itemized Deductions $16,620 Personal Exemptions $18,300 (6 x $3,050) Taxable Income $26,580

Schedule A Medical expenses $2,500 $ -0(0.075 x $ 61,500= $4,613) Mortgage Interest $10,500 State Tax Withheld $ 2,750 Property Taxes $ 2,300 Unreimbursed Job Expense $2,300 $ 1,070 (0.02 x $61,500= $1,230) less $1230 Total Itemized Deductions $16,620 b. Tax = $1,400 + (($26,580 - $14,000) x 0.15) = $1,400 + ($12,580 x 0.15) = $1,400 + $1,887 = $3,287 Tax Withheld =$5,750 Tax Refund =$2,463 Case 4-3. Carlos Santiago Determines His Estimated Tax Payments. a. Estimated Business Revenue $95,000 Materials Cost $30,000 Labor Cost & Taxes $15,000 Gross Income $50,000 Taxes and Insurance $ 1,700 Advertising $ 2,000 Other Business Expenses $ 3,000 Net Business Income $43,300 b. Less Social Security Deduction $ 3,312 Estimated Taxable Income $39,998 c. Standard Deduction for Single $ 4,750 Personal Exemption $ 3,050 Estimated Taxable Income $32,188 d. Estimated Taxes = $3,910 + (($32,188 - $28,400) x 0.25) = $3,910 + (($3,788) x 0.25) = $3,910 + $947 = $4,857 e. Minimum Estimated Tax Due Each Quarter = $1214

CHAPTER 4 INCOME TAX PLANNING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 130-131 in Textbook 1. Taxable Income Adjusted Gross Income Standard Deduction Personal Exemptions (2) Taxable Income

$25,000 9,500 6,100 $ 9,400

2. Marginal Verses Average Taxes a. Marginal tax rate = 15% b. Tax = $700 + .15($24,000 - $7,000) = $700 + .15($17,000) = $700 + $ 2,550 = $3,250 c. average tax rate on taxable income = $3,250 / $24,000 = 13.54% average tax rate on adjusted gross income = $3,250 / $35,000 = 9.29% 3. Tax Effects in 25% marginal tax. a. Itemized deduction of $200 = $200 x .25 = $50 tax reduction b. Tax credit of $200 =$200 tax reduction 4. Capital Gains Tax on interest income = $1,000 x .35 = $350 tax Tax on capitol gains = $1,000 x .20 = $200 tax - a difference of $150 5. Marginal benefit of deductions. Top marginal tax bracket = 35% Tax saving on contribution = $1,000 x .35 = $350 Actual cost = $1,000 - $350 = $650 6. Medical expenses. 7.5% of Adjusted Gross Income $20,000 x .075 = $1,500 Medical expenses not covered = $2,400 Deductible medical Expenses = $900 7. Taxable Income a. Standard deduction – single = $4,700 Medical deduction $4,500 less 7.5% AGI $45,000 x .075 = $3,375 $1,125 Mortgage interest $7,500 Property tax $1,800 State income tax $1,000 Charitable contributions $ 500 $11,925 This is more than double the standard deduction, therefore she should itemize.

b. Taxable income Adjusted Gross income Personal exemption Itemized Deductions Taxable income

$45,000 $ 3,050 $11,925 $30,025

CHAPTER 5 CASH MANAGEMENT AND FINANCIAL INSTITUTIONS SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 167-168 in Textbook Case 5-1. Erica Swanson Gets into Cash Flow Trouble. a. Each retailer will charge $20. Three retailers = $60 Her bank charges $25 for each check Four checks = $100 Total Cost = $160 b. Returned Check totals = $126.82 Bank negative balance = $119.40 Retailer returned check charges = $ 60.00 She needs to deposit $306.22 c. Her current balance is -$119.40 Returned check fees = $100.00 Total in account was -$ 19.40 d. To prevent overdrafts she needs to keep close track of her account balance. She should also enquire about overdraft protection from the bank that would pay checks and charge a fee. Case 5-2. Weighing Liquidity Needs Against Higher Returns on Savings. a. Monthly expenses average $3,000 / Month Two months expenses = $3,000 x 2 = $6,000 Six months expenses = $3,000 x 6 = $18,000 Their emergency fund should be between these two amounts. The emergency fund does not all have to be in a savings account, but should have some level of liquidity such as laddered CDs. Some questions to be asked include how secure are their jobs? What are future plans for a family? Would both work if there were children? b. Risks in CDs: Early withdrawal penalty Loss of interest income if rates rise over the time period of the CD. Risks in stocks: Transaction costs for buy and sell. Loss if stock declines. Single stock loses portfolio effect of mutual funds. Unusual liquidity risk Both work for the same company. A company problem requiring layoffs could cost both their jobs. Are their retirement funds tied to the company? A downturn in the company could reduce their value. c. At the present time, they have relatively low monthly expenses compared to their earnings. Given that average expenses are $3,000 and earnings are $5,200, they should have much more savings than $14,000. They need to establish a monthly budget and an investment plan for their savings. They will also need to examine their attitude towards risk to determine the types of investments they are willing to make.

Case 5-3. Felicia Kobayashi Seeks a New Bank. Some considerations for accounts: Locations that are convenient for home and work. Account fees, minimum balances, and limits on numbers of checks Interest percentages On-line banking options and fees Ease of transferring money between accounts Costs for blank checks and services Time required for closing and shifting accounts Maturities, interest rates, and early withdrawal fees for CDs

CHAPTER 5 CASH MANAGEMENT AND FINANCIAL INSTITUTIONS SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 166 in Textbook 1. Opportunity Cost Amount above minimum = $2,500 - $1,000 = $1,500 ($2,500 x 0.035) – ( $1,500 x 0.02) = $57.50 2. Emergency Fund She should have emergency funds to cover five or six months of expenses. Monthly expenses = $1,100 x 6 = $6,600 She should consider other sources of liquidity, estimate possible expenses, job security, and consider unexpected expenses that have occurred in the past. 3. After Tax Yield a. After Tax Yield = yield x (1 – tax rate) = .05 x (1 - .25) = 3.75% b. Risks - May need some of the money during the term of the CD and the interest penalty would apply to the entire amount. - If interest rates rise causing a loss of chance of higher return. - Should consider laddering several CDs in smaller amounts with differing maturities 4. After Tax Yield a. After Tax Yield = yield x (1 – tax rate) = .04 x (1 - .20) = 3.2% b. With 5% inflation, the cost of goods is rising by 5% each year. The after tax return on the CD is only 3.2%. This means that 1.8% of purchasing power is being lost each year since inflation is that much higher than the after tax returns. 5. Establishing an emergency fund. Monthly savings = $300 Account value = $300 x FVIFA for 13 months @ .03/12% = $300 x ((1+.0025)12 -1) / .0025 = $300 x ((1.0304-1) / .0025 = $300 x 12.1664 = $3,649.91 Total savings for 1 year = $1000 x (1+.0025)12 +$3,649.91 = $1030.40 + $3,649.91 = $4,6803.31 6. Rule of 72 Tax Yield = yield x (1 – tax rate) = .07 x (1 - .20) = 5.6% Rule of 72 72 / 5.6 = 12.86 or 12years 10 1/3 months 7. Comparing account alternatives. “Free” is not free. You must keep $200 minimum daily balance. Write no more than 20 checks. If either term is violated, there will be a $10.00 service charge. Additionally, you will lose a small amount of interest depending on current rate.

CHAPTER 5 CASH MANAGEMENT AND FINANCIAL INSTITUTIONS THE LEARNING OBJECTIVES 1. Apply the objectives of cash management to assessing your need for cash management products and services. 2. Explain the rules of effective cash management and why it is important to regularly balance your checkbook. 3. Understand the differences among providers of cash management products and services. 4. Identify cash management products and services that are important to your financial plan. 5. Compare cash management account options based on liquidity, safety, costs, and after-tax annual percentage yield (APY). 6. Select appropriate tools for dealing with cash management errors. CHAPTER OUTLINE AND SUMMARY I. The Objectives of Cash Management. A. Cash management includes all your decisions related to cash payments and short-term liquid investments. 1. Liquid investments are usually one year or less in duration. 2. Cash accounts pay less interest and increase the risk of overspending. B. Managing monthly transactions. 1. To pay your bills, you need to have sufficient cash in a transaction account. 2. Most individuals use a checking account for their transaction account. 3. Checking account allows you to regularly make deposits, write checks, withdraw funds, or make electronic payments in a timely fashion and at minimal cost. C. Preparing for cash emergencies. 1. A cash reserve is liquid assets that are held to meet emergency cash needs. 2. Options include checking and savings accounts, home equity lines of credit, and credit cards. D. Cash is necessary for meeting short-term investment goals like a vacation. E. How much should you hold in cash? 1. As part of your personal financial plan, you should assess your cash needs for transactions and emergencies. 2. Consider alternative sources you can tap in the event of emergency. II. Rules of Effective Cash Management. A. Balance your checkbook every month. 1. Objective is to reconcile the balance reported by the bank. 2. Do so because: a. Use of checks, debit cards, and ATMs, makes it easy to lose track of how much you spend each month. b. May exceed you budget or bounce a check. 3. Steps in balancing your checkbook: a. Adjust the bank balance for any additional checks and deposits that do not

appear on the bank statement. b. Adjust your check register to reflect checks and deposit transactions at aren’t yet recorded, as well as any bank charges or interest. c. If the statement still doesn’t balance, may sure you have not missed any withdrawals or deposits and check your math. B. Pay your bills on time. 1. Reduces your costs and minimize risk of damaging your credit rating. 2. Avoid getting annoying phone calls from your creditors. C. Pay yourself first. 1. Save money for achieving personal goals before you do anything else. 2. Pay yourself first by automatic funds transfer. 3. Use automatic bill paying through your creditor or service provider. D. Evaluate alternative accounts and providers. III. Providers of Cash Management Services. A. Depository institutions. 1. Depository institutions are financial institutions whose primary source of funds is customer deposits and primary source of income is interest earned on loans. 2. Includes commercial banks, savings institutions, and credit unions. 3. A commercial bank is a depository institution offering a wide variety of cash management services to business and individual customers. a. Personal accounts are insured for up to $100,000 per depository by the Federal Deposit Insurance Corporation (FDIC). b. FDIC is a government-sponsored insurance agency. 4. Savings and loan associations (S&Ls) are depository institutions that receive funds primarily from household deposits and must use 70% of their funds to make home mortgage loans. a. A mutual savings institution is one that is owed by its depositors. b. A stock-held savings institution is owed by stockholders. 5. A credit union is a nonprofit depository institution owned by its depositors. 6. Web-only financial institutions must be checked out at the FDIC website to make sure they are legitimate. B. Non-depository institutions. 1. Non-depository institutions include mutual fund companies, life insurance companies, brokerage firms, and other financial services firms. 2. A mutual fund is a non-depository financial institution that sells shares to investors and then invests the money in financial assets. 3. A life insurance company is a non-depository financial institution that obtains funds from premiums paid for life insurance, invests in stocks and bonds, and makes mortgage loans. 4. A brokerage firm is a non-depository financial institution that helps its customers to buy and sell financial securities. 5. Financial service firms have evolved from mutual funds, life insurance companies, and brokerage firms into multi-product firms like Merrill Lynch. C. Evaluating financial institutions. 1. Products. a. Does the financial institution offer the selection of products you need.

b. Do the products have the features you need? 2. Price – Are the financial products competitively priced? 3. People – Does it provide the desired level of customer service? 4. Place – Is the financial institution located conveniently for your needs? IV. Cash Management Products and Services. A. Checking accounts. 1. Demand deposits are deposit accounts, such as checking accounts, from which money can be withdrawn with little or no notice to the financial institution. 2. A regular checking account is one that does not pay interest and requires the payment of a monthly service charge unless a minimum balance is maintained. a. Advantages are highly liquid, if offered by bank or savings institutions is insured by FDIC, and no monthly fee if minimum balance maintained. b. Disadvantages are no interest is paid on balances, may limit number of checks that can be written per month, and may impose higher fees for services. 3. A negotiated order of withdrawal (NOW) account is a type of checking account that pays interest. a. Advantages are highly liquid, interest paid on balance, may include other services such as debit cards, certified checks, and fund transfer, if offered by bank or saving institutions is insured by FDIC, and no monthly fee if minimum monthly balance maintained. b. Disadvantages are interest may be reduced or eliminated if account drops below minimum balance and may require a minimum balance. 4. A money market account is a savings account which pays interest that fluctuates with market rates on money market securities. a. Advantages are highly liquid, pays higher interest than other checking alternatives, and if offered by a bank or saving institution, insured by FDIC. b. Disadvantages are limited to a small number of checks per month, higher minimum balance than other checking alternatives, and usually does not include other banking services. B. Savings accounts. 1. A demand deposit savings account allows you to withdraw your money at any time. Less risky, but pay a lower return. 2. A time deposit account is a savings account from which the depositor may not withdraw money, without penalty, until after a certain amount of time has passed. C. Savings alternatives. 1. Regular savings accounts – low minimum balance account that is highly liquid. 2. Certificate of deposit (CD). a. An account that pays a fixed rate of interest on funds left on deposit for a stated period of time. b. Maturity date for a CD is the date on which the depositor can withdraw the invested amount and receive the stated interest. 3. Money market mutual fund is a fund that invests in short-term, low-risk financial assets, such as short-term debt securities issued by the federal government, federal agencies, and large public corporations and pays investors a rate of return that fluctuates with the interest earned on the portfolio.

4. Government savings bonds. a. U.S. savings bonds are issued by the U.S. Treasury and pay interest that fluctuates with current Treasury security rates and are exempt from state and local taxes. b. Series EE bonds were renamed “Patriot Bonds” after September 11, 2001. 1) Known as discount bonds because they sell for less than face value. 2) Redeemable at face value when interest increases to that value. 3) Rule of 72 is a method of calculating the time for a sum of money to double by dividing 72 by the rate of interest earned on the funds. 4) Interest accrues semiannually on May 1 and November 1. 5) Exempt from federal, state, and local income tax until cashed in. 6) For lower- and middle-income families, the interest income is exempt if it is used to pay for qualified higher education expenses. c. Series HH bonds could only be purchased with series EE bonds through August, 2004. d. Series I bonds are similar to EE bonds but provide protection from inflation. D. Other cash management products and services. 1. Electronic banking services. a. A debit card is a plastic card that effects immediate electronic withdrawal of funds from a bank account. b. Automated teller machines (ATMs) are computer terminals used to obtaining account balances, making deposits and withdrawals. c. Other electronic banking services. 1) Financial institutions accept automatic deposits of paychecks and allow you to authorize automatic electronic withdrawals for payments of bills. 2) Can also pay bills through a private service. 2. Specialized checks. a. Traveler’s check – issued in specific denominations by large financial institutions and accepted worldwide. b. Certified checks – a personal check drawn on your own account and guaranteed by the financial institution in which you have an account. c. Cashier’s check – check drawn on the account of the financial institution itself and made out to the party you specify. d. Money order – a legal request for a company to pay a particular sum of money to a person or business that you designate. E. Evaluating cash management account choices. 1. Liquidity – can you withdraw money without incurring fees or losing any of your original investment? 2. Safety – is the account guaranteed or insured? 3. Costs and after-tax interest – Truth in Savings law requires that financial institutions report the annual percentage yield (APY). a. APY is the amount of interest paid each year, given as a percentage of the investment. b. Compare interest rates across accounts with different compounding periods. V. Resolving Cash Management Problems. A. If you bounce a check…

1. Overdraft protection is an arrangement by which a financial institution places funds in a depositor’s checking account to cover overdrafts. 2. A bounced check is reported to one of the check approval companies, that collects the amount owed on the bounced check and assess penalties. 3. Financial institution will also assess a penalty. B. If you receive a bad check… 1. You will pay a penalty and may bounce your own checks. 2. Take checks only from reliable sources and don’t write checks until the funds have been credited to your account. C. If you discover fraudulent activity on your account… 1. Must check the source of wrong electronic payments right away. 2. Call to contest the charge – bank must list number. D. If you want to stop payment on a check… 1. A stop payment order is an order by which a financial institution promises not to honor a check that a depositor has written. 2. Order should be in writing. E. If you need money in a hurry… 1. A wire transfer is an electronic transmittal of cash from an account in another location, for a fee. 2. Also cash-delivery by Western Union, Money-gram, and American Express. ADDITIONAL WEBSITE ASSIGNMENTS 1. http://www.creditlovers.com/personal-finance/cash-reserve.html This site is provided by a credit card organization. Read the article entitled “Cash Reserve” and decide how much you should keep in a cash reserve based on this discussion. 2. http://www.moneycentral.msn.com/articles/banking/saving/1317.asp Read the suggestion for paying yourself first and decide which ones may most sense, if any, for you. 3. http://www.fdic.gov/consumers/consumer/index.html This FDIC website (listed on p. 146 of the textbook) has three interesting articles on topics covered in this chapter. Try reading “Correcting Bank Account Errors”, “Safe Internet Banking”, and “FDIC Consumer Alerts – Phishing Scam”. 4. http://www.ny.frb.org/education/interest_rates.html This is the website for the Federal Reserve Bank of New York. It provides an excellent discussion of interest rates and many of the topics covered in this chapter as well as charts of current short-term interest rates. 5. www.bankrate.com As suggested on p. 154 of the textbook chapter, check this site for the best current rates on CDs and money market funds. Compare the rates on CDs and money market funds to determine which maturity on CDs provides approximately the same return as money market funds. 6. http://www.ricksteves.com/plan/tips/moneytip.htm Read Rick Steves travel advice on how to change money when traveling in Europe, including the use of ATMs, using credit cards, and traveler’s checks.

ADDITIONAL MINI-CASES 1. Case 1 – How Much Money Should Diane Keep as a Cash Reserve? Diane is a divorced woman in her mid-30s who has a successful career as a lawyer. Her before-tax annual income is $75,000. She owns a condo valued at $180,000 on which she has a $150,000 mortgage. Diane wants to know to know how large a cash reserve she needs. a. What is the purpose of a cash reserve? b. What questions should Diane answer to determine how large a cash reserve she should have? c. What dollar amount is generally recommended for a cash reserve? d. How will her goals affect this decision? 2. Case 2 - Jonathan Wants to Pay Himself First – How Should He Do It? Jonathan graduated from college a year ago and is working for an engineering firm. They offer a 401(k) plan after you have worked for the company for a year. The plan offers a match on the first 6% of salary. During his first year with the company, he signed up for an automatic Roth IRA plan with Fidelity Investments and had $50 a month withdrawn from his checking account. a. Should he sign-up for the 401(k) plan at work? b. How much should he have taken out of his pay each month? Why? c. Should he still have the $50 a month withdrawn for a Roth account? Why? d. Should he have any funds automatically invested in savings bonds? Why? 3. Case 3 – Vanessa’s Debit Card Problem. A debit card allows the user to instantly withdraw funds from a checking account but does not provide a record of the withdrawal and therein lies a potential problem. To illustrate, Vanessa frequently uses her debit card and forgets to record the transaction in her check registry. During the last few months, she has bounced two checks. a. What suggestions can you offer her to remember to record her debit activity? b. Would it help her to electronically review her checking account once a week? c. Should she seek a checking account that offers overdraft protection? d. Why is it important for her to balance her checking account every month? TEACHING SUGGESTIONS 1. Ask students to write a one page memo on the advantages and disadvantages of their checking account and attached the material from their financial institution that lists all of the provisions of their account. They should be prepared to discuss their checking account in class. 2. Using the instructions on p. 143 on how to reconcile a checkbook with a bank statement, have students reconcile their checkbook for the month. Discuss in class, what problems, if any, they had in doing so. 3. Have students visit a local commercial bank, S&L, and credit union and report their impressions of the products offered, price of the products, level of service, and location. They should indicate which one they would be likely to choose.

4. Career opportunities at the Office of the Comptroller of the Currency and the Office of Thrift Supervision are discussed on the websites listed on p. 146. Students should investigate potential careers to determine qualifications and opportunities. 5. Have student compare three web-only financial institutions that they find on-line. Discuss the pros and cons of using this type of institution and why they think it would be a good or bad idea to use one for some of their accounts. 6. Select at least one mutual fund website and report the types of funds that are offered and what the potential risk, returns, and costs that are reported. Do the same for TIAA/CREF and a brokerage firm. Compare and contrast the mutual funds offered at each of these institutions. 7. Have students check the interest rates being paid for 3-month, 6-month, 12-month, 2-year, 3-year, and 5-year CDs. Compare these rates to government T-bills and T-notes and discuss the differences, if any, that they find. 8. Have students investigate the ATM machines (manufacturer) that their financial institution has, the costs for using it, which networks it is connected to, and what getting cash from another institutions’ ATM will cost. 9. Calculate the APY at three different financial institutions for savings accounts with the same maturity. How easy is it to obtain this information? Is it prominently displayed? Do the people working at the institution able to readily able to provide this information?

CHAPTER 6 PURCHASING STRATEGIES AND CREDIT CARDS SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Page 195 in Textbook Case 6-1.

Ray Martinez Buys a New Microwave. Consumer purchase considerations. 1. Identify alternatives. 2. Research alternatives 3. Consider new verses used. 4. Comparison shop. 5. Evaluate warranty. 6. Buy best alternative. Features Price Features Warranty Consumer ratings Compatible with other equipment

Case 6-2.

Microwave 1 Microwave2 Microwave3

Cash Verses Credit. Checking Account $250 -$50 = $200 Target Card – Owe $1,000; Credit limit $1,500 = $ 500 Will work over semester break. For Use of Card - Allows more to be spent on presents (up to $500) - Working over the semester break will provide some money to pay off part (or possibly all) of the cost of the presents. Against Use of Card - Already owe $1,000 on the card. At 18% interest, that will cost up to $180 in interest next year. - Should use semester break salary to partially reduce $1,000 balance and increase liquidity in the checking account. - Relatives would probably appreciate a nice holiday card just as much as a gift. Everyone knows students lack money.

Case 6-3.

Impact of Credit Card Debt on Household Financial Ratios. a. Debt payment ratio = Total monthly debt payments / After-tax monthly income = $340+$35+$110+$37+$122 / $4,000 = $644 / $4,000

= .161 or 16.1% b. Mortgage debt service = (Gross monthly income X 28%) = ($5,000 X .28) = $1,400 c. Total debt payment = Total monthly debt payments / After-tax monthly income =16.1% Bank wants ratio of at least 36%, therefore no problem. d. Total debt payment with $1,000 monthly mortgage service. = (Mortgage debt service + Total monthly debt payments) / After-tax monthly income = $1,000 + $644 / $4,000 = .411 or 41.1% This is more than the 36% ratio required by the mortgage lender. Paying off the car would reduce monthly debt payments to $304 and: = $1,000 + $304 / $4,000 = .326 or 32.6% which is within limits.

CHAPTER 6 PURCHASING STRATEGIES AND CREDIT CARDS SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 193 – 194 in Textbook 1. Consumer purchase decisions Will this purchase help me to achieve one of my financial goals No Do I need to reevaluate my goals? / \ No Yes Don’t buy \

/ Yes /

Yes Is it consistent with my priorities? \ No Don’t buy

Can I afford it With current cash flow? / Yes

\ No

In budget

Reduce contribution to savings

Reduce current spending

Withdraw from savings Finance it Reduce monthly Reduce new CFs for loan term savings for loan term

Incur interest costs

2. Annual Percentage Rate APR = ($200 +$50) / $1,000 = .25 or 25% 3. Calculating Finance Charges 31 days in billing cycle (31 days in March) (5/31) x $5,000 = $ 806.45 (5/31) x $5,500 = $ 887.10 (12/31) x $4750 = $1,838.71 (9/31) x $5,750 = $1,669.35 a. Average Daily Balance = $5,201.61 x (.15/12) = $65.02 Finance Charge b. With grace period (10/31) x $5,000 = $1,612.90 (21/31) x $4,250 = $2,879.03 Average Daily Balance = $4,491.93 x (.15/12) = $56.15 Finance Charge The finance charge would be $ 8.87 less 4. Cost of credit Annual 20% = 1.667% Monthly $100 = Payment x PVIFA12, 1.667 = Payment x (1-(1 / (1+.01667))12)/ .01667

$100 = Payment x (1-.8200) / .01667 = Payment x 10.7978 Payment = $100 / 10.7978 = $9.26 Monthly x 12 months = $111.13 $100 = Payment x PVIFA60, 1.667 = Payment x (1-(1 / (1+.01667))60)/ .01667 $100 = Payment x (1-.3709) / .01667 = Payment x 37.7385 Payment = $100 / 10.7978 = $2.65 Monthly x 60 months = $158.98 5. Effect of Bad Credit. It seems unfair to link auto insurance and credit rating. However insurers claim they have increased expenses collecting premiums and that poor credit risks have more claims. 6. Cost of credit. Credit card processors charge merchants 3 to 5% for processing the transaction. Cash is a risk only from counterfeit or robbery. If the check writer is known to the merchant, risk is minimized. 7. Opportunity Cost of Credit. Interest = $8,000 x 16% = $1,280 + $60 = $1,340 with average fees for two cards. Future Value = $1340 x FVIFA40, 6% = $1,340 x ((1+ 0.06)40 -1) /.06 = $1,340 x (10.285 – 1) / .06 = $1,340 x 154.762 = $207,381.03 8. Identity Theft. If she suspects unauthorized use of her credit card she should notify the card issuer immediately. She should probably get a new card account and stop using the old card. Her maximum liability is $50 if she reports the unauthorized usage promptly.

CHAPTER 6 PURCHASING STRATEGIES AND CREDIT CARDS THE LEARNING OBJECTIVES 1. Apply the personal financial planning process to making consumer purchase decisions. 2. Be able to identify the advantages and disadvantages of using credit to make consumer purchases. 3. Understand the various types of consumer credit. 4. Evaluate credit card alternatives, including terms and costs. 5. Be able to recognize the hazards of credit card use, including the risk of identity theft. CHAPTER OULINE AND SUMMARY I. Consumer purchases and your financial plan. A. When you decide to buy something today, you’re also deciding not to spend the money on something else or not to save or invest the money. B. Purchases that are for necessities - things you need in order to live, such as food, clothing, and shelter, must come first. 1. Luxuries, things you want but can live without like a new car, are discretionary. 2. Using credit to buy something now only delays the inevitable cash outflow and entails the additional cost of interest on the borrowed funds. C. Is the purchase consistent with your prioritized goals? 1. Before making any purchase, particularly a large one, ask yourself whether the item you are considering purchasing is consistent with your financial plan. 2. If it is not, then do you need to reevaluate your prioritized goals? 3. Is this the best choice out of my alternatives? D. Can you afford it? 1. Do you have sufficient funds to pay for it? 2. If not, then you will either reduce your current contributions to savings, withdraw money from savings, or borrow money. E. Cash or credit? 1. Any time you receive cash, goods, or services now and arrange to pay for them later, you are buying on credit. 2. If you use credit for personal needs other than home purchases, you using consumer credit. 3. The most common types of consumer credit are credit card accounts, auto loans, home equity loans, and student loans. 4. You must consider the tradeoffs between the cost of borrowing and the lost earnings on savings. F. Making the consumer purchase decision. 1. The first step is identifying your alternatives. 2. Research the alternatives in hardcopy and Internet information searches. 3. Consider new versus used.

4. Research alternatives and comparison shop. a. Evaluate the pros and cons of each. b. Set up a table that summarizes the key features of each alternative, including price and specific product attributes of interest. 4. A warranty is a promise or guaranty made by the manufacturer or seller, which may include repair or replacement of defective or damaged merchandise. a. New products have implied warranty that they are suitable for sale and will work as intended. b. An express warranty is a written promise of more extensive protection. c. An extended warranty is an optional (for a fee) extension of implied or express warranties. 5. The last step in the purchase decision is to actually buy the product. II. The advantages and disadvantages of consumer credit. A. The advantages of credit include: 1. Buy now, pay later. a. You essentially enjoy the use of the produce while paying for it. b. Advantageous as long as: 1). You can afford the payments without sacrificing other financial goals. 2) Product lasts at least as long as the time period of payments. 2. Convenience and safety. 3. Source of emergency cash. B. The disadvantages of credit include: 1. Negative impact on household finances. a. Reduces net worth. b. Reduces liquidity. c. Limits financial flexibility. 2. Cost of borrowing money is the interest rate, which makes the purchase more expensive. 3. Increased risk of overspending. 4. Increased insurance premiums. III. Types of consumer credit. A. Closed-end credit is credit that a lender approves for a specific purpose, 1. Requires the borrower to pay it back in full with interest. 2. Repaid either in a single payment or as an installment loan with equal payments ending at a specific time. Called a consumer loan. B. An open-end credit (also called revolving credit) provides a preapproved continuous loan that can cover many purchases. 1. The credit limit or credit line is the preapproved maximum amount of borrowing for an open-credit account. 2. Most common examples are credit cards and equity lines of credit. IV. Credit cards. A. A credit card is a plastic card printed with an account number and identifying the holder as a participant in a revolving credit agreement with a lender. 1. A cash advance is a cash loan that can be made from a credit card account. 2. A convenience check is a check supplied by a credit card lender for the purpose of making a cash advance.

B. Types of “plastic”. 1. Bank credit cards. a. A bank credit card is issued by a financial institution. b. Allows the holder to make a purchase anywhere the card is accepted. c. Service providers include Visa, MasterCard, Discover, and Optima. d. Financial institutions pay transaction fees to the service provider for managing payments to retailers and billing of account holders. e. Nonfinancial companies and affinity groups such as alumni associations collaborate with a financial institution to issue credit cards. 2. Retail credit cards. a. For use only at the retail store’s own outlets. b. Sears, JCPenney, and Home Depot. 3. Travel and entertainment cards. a. Designed primarily to allow business customers to delay payment of certain travel and entertainment expenses to coincide with their firm’s reimbursement system. b. Require payment in full each month. 4. Debit cards. a. Withdraw money directly from your checking or savings account. b. Those that have overdraft protection, allow you to borrow funds with terms similar to a credit card. 5. Smart cards. a. A smart card stores identification and electronic money in a computer chip on the card. b. Cards can store much more electronic information than credit cards. c. Commonly used on university campuses. d. Also take the form of store gift cards or digital wallets. C. Common credit card contract terms. 1. Annual fees. a. Some credit cards charge an annul fee for the privilege of being a cardholder. b. Fees range from zero to $300. 2. The annual percentage rate (APR) is the standardized annual cost of credit, including all mandatory fees paid by the borrower, expressed as a percentage rate. a. The APR is calculated by adding the annual fee to the total annual finance charges and dividing by the average loan balance for a year. b. The teaser rate is a short-term below-market interest rate intended to encourage new customers to apply for a credit card. 3. Credit card statements are issued once per month. a. The date on which a credit card purchase is made is called the transaction date. b. The last day of a billing cycle is called the billing date, and credit card transactions made after that date appear on the next month’s bill. c. The due date is the date by which payment must be received if the holder is to avoid late penalties and, in some cases, interest on new transactions. d. The grace period is the time before interest begins to accrue on new

transactions. e. The minimum payment is the minimum amount that must be paid by the due date to maintain good credit standing and avoid late payment penalties. f. A late payment penalty is a penalty fee charged to an account for making a payment after the due date, and can range from $10 to $50. g. An overlimit charge is a penalty fee charged to an account for exceeding the credit limit. D. Calculation of finance charges on open-end credit. 1. The finance charge is the dollar amount of interest charged by the lender in a particular billing cycle. 2. It is calculated by multiplying the periodic rate by the account balance owed. 3. The monthly periodic rate is found by dividing the nominal interest rate by 12. 4. The periodic rate is know, but the amount borrowed is not, and issuers use different methods for calculating this amount. 5. Average daily balance method without a grace period. a. The most common method for calculating the account balance. b. Interest on average daily balance including new charges. c. Lender calculates the balance owed on each day of the billing period, adding any new charges and subtracting any payments received during the period. d. Lender adds these daily balances together, determines the average, and uses this value to calculate the finance charge for the period. 6. Average daily balance method with a grace period. a. The finance charge is applied to the average daily balance, including payments received but excluding new purchases. b. Cardholder gets “free credit” from the date of purchase until the beginning of the next billing cycle. 7. Two-cycle average daily balance method. a. Used when the balance has not been paid in full. b. Finance charge is applied to the average daily balance for the previous two billing cycles, including payments received and new purchases. 8. Previous balance method. a. Finance charge is assessed on the balance owed at the close of the last business cycle, without consideration of payments made during the current billing cycle. b. Pay interest on credit you have already paid back. 9. Adjusted balance method. a. Finance charge applied to the balance owed at the close of the last billing cycle less a credit for payments made during the current billing cycle. b. Preferable to the previous billing method. E. There are two important rules to remember in comparing credit card terms. 1. First, always compare the rates based on APR rather than the nominal, or stated rate. 2. Second, read your credit agreement carefully to determine how finance charges are calculated. V. The advantages and disadvantages of credit card use. A. Advantages of credit cards.

1. Method of identification. 2. Means of record keeping for business expenses. 3. Ability to make purchases by phone or Internet. 4. Easier to return merchandise. 5 Free credit if you pay the bill in full each month. 6. Other advantages may include travel insurance, rebates, frequent flier miles, and discounts on specific merchandise. Card may have one-time or monthly fee or higher interest rate. B. Disadvantages of credit cards. 1. Negative impact on personal financial statements. 2. Increased risk of overspending. 3. Increased cost of purchases. 4. Most expensive way to borrow. 5. Loss of privacy of financial information. 6. Higher insurance premiums. 7. Interest not tax deductible. 8. Risk of fraud and identity theft. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.ebay.com: Go to the eBay website and pick an item to bid on that you think should sell for no more than $20 and bid on it. Follow Pat Brill’s direction in the “ask the expert” box on p. 180. Write a one page write-up of your experience and what you thought of e-Bay. 2. www.bankrate.com: Go to the credit card section under bankrate.com directory and read the answer to the question, “How do I choose the best card?” 3. www.bankrate.com: Use the calculator on bankrate.com that allows you to compute the question, “What will it take to pay off my credit card?”. 4. www.cccsintl.org: Use the Consumer Credit Counseling Service’s website to found information on their debt counseling service. 5. www.consumerworld.org: Look in the content column on the left side of the webpage for the category shopping and review a product that you are considering purchasing. 6. www.ftc.gov: Look in the content column on the left side of the webpage for the category For Consumers and examine one of the choice after go to that part of the site. ADDITIONAL MINI-CASES 1. Case 1 – How Should Josh Decide Which Credit Card to Pick? Josh’s new job involves traveling two weeks of the month. He is being given a credit card at work to use for travel expenses, but also wants a personal credit card. a. How should he decide which credit card to select? b His new bank offers him a Visa card and his alumni association is offering him a MasterCard. What other sources of credit cards should he consider? c. He has been averaging one new credit card offer each week in the mail and does not know whether he should consider any of them. What would you advise him to do? d. Should he put any of his travel expenses on the personal credit card? Why?

2. Case 2 – What Advise Can You Give Brian About His Credit Card Debt? Brian has six credit cards with total debt of $14,000. He is 28 years old, owns his own home and has a stressful job that pays him $40,000 a year. He bought his home two years ago and took a 30-year mortgage with a very low down payment and has almost no equity in the home and would find it difficult to qualify for a home equity loan. He also has a car loan on his 2002 Ford Focus that still has a balance of $5,000. a. Should he take a second job to help pay off the debt he has acquired? Why? b. Ask him about his financial plan. If he does not have one, how should he develop one? What information should he gather? c. Where can he go for help in solving his credit card debt problem? d. Would it help to know how long he has had the credit card debt and why he thinks he has built up this much debt? e. His parents are financially comfortable. Should he ask them for a loan? Why? 3. Case 3 - Should Anita Apply for a Credit Card? Anita is a high school senior and she has an opportunity to obtain a credit card that offers a $300 credit limit with an interest rate of 18%. She has a part-time job that pays her minimum wage and she works 15 hours a week. Should she apply? Why? TEACHING SUGGESTIONS 1. Have students complete the “Are You in Debt Danger?” questionnaire (6-2) on p. 196 that allows them to determine if they are in financial trouble. Discuss the questions in class and help them to understand why these facts are warning signs of financial difficulties. 2. Have students construct questions for a survey with no more than five multiplechoice questions that allows them to collect data on college student’s use of credit cards. Once the class selects the questions they think are most appropriate, have them each use the questionnaire in paper format with at least ten students that are not in the class. Tally the results and discuss their findings. 3. Ask each student to list their largest purchase in the last 12 months. Then ask then to explain how they decide on the item they purchased and why they purchased it. 4. Ask students to keep a paper record of all items that they purchase in the next week that cost less than $5.00. The record should include day and time of purchase, item purchased, and reason for the purchase. Use the records as a basis for discussing the psychological reasons that might have influenced items that are purchased and how they feel about the purchases now. Be sure to have students submit their records as a homework assignment. 5. Invite a local bank representative or credit union representative to class and discuss their institution’s credit cards and consumer loans. Ask the individual to provide guidance on how to best use their credit cards and what to do if individuals get in trouble with too much debt. 6. Have students go to three garage sales and/or estate sales and report on their opinion of the items that are for sale and the prices that are charged. Ask them to describe their shopping experience and if they would do it again.

7. Discuss the reasons why manufacturers offer their customers a warranty on their products. Have students discuss one item they have purchased that came with a warranty and if they needed to use the warranty. If so, what happened? 8. Discuss the recent decision by insurance companies to base premium costs for car and homeowner’s insurance on an individual’s consumer credit history. Do they know if their insurance company uses their credit history? Why do they think insurance companies do this? 9. Discuss the use of smart cards on your campus. How many students are using these cards if your university offers them? What do students like and dislike about them? Do they think that it is a good idea to use smart cards to store consumer information such as driver’s licenses, credit cards, checking and savings accounts, and health club membership? Why or why not?

CHAPTER 7 CONSUMER LOANS AND CREDIT MANAGEMENT SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Page 230-231 in Textbook Case 7-1. Rob Mayor Works on Improving His Credit. a. - Be certain to pay all debts on time every time. - Make a statement on his credit record concerning his immaturity at the time the poor record was established. b. Rob needs to reduce or, if possible, pay off his credit card debt. - Investigate a debt consolidation loan at a lower rate. - Sell assets and use proceeds to pay down debt. - Work more hours or find a job that pays better and use increased earnings to pay down debt. - Develop a zero based budget to reduce unnecessary expenses. - Consider moving in with parents to reduce living expenses. Case 7-2. Assessing the Impact of Debt on the Payment Rate. a. Payment ratio = Current debt payments / Net earnings = $315 / $1,500 = .21 or 21% b. Payments on $10,000 simple interest at 6% for 6 years = PVIFA72, .0050 = (1- (1 / (1 + .0050))72) / .0050 = 60.3400 Monthly payment = $10,000 / 60.34 = $165.73 c. Payment ratio = Current debt payments / Net earnings = $480.73 / $2,000 = .24 or 24% d. With the credit card debt the payment ratio is slightly higher than the 10 – 20% recommended by financial planners. Lenders may ask a higher interest on the car loan. Therefore, paying down or paying off credit card debt looks like a good idea. It would bring the payment ratio into line with recommendations and reduce interest expenses. - Set up a budget and follow it closely - Reduce monthly expenses - Postpone purchase of the car for four months alone would provide sufficient revenue to pay off the credit card debts Case 7-3. Recognizing the Early Warning Signs of Credit Problems. a. Andrea exhibits several of the warning signs. - Credit card purchases denied - Lack of concern about being denied, must have happened before - Spends too much - Late payment cause for joke instead of concern - Use new card to make payments on existing cards b. Sources of information. - Her own credit report to verify information and see what creditors are saying. - Visit web sites such as -debtsmart.com - consumercredit.com - debtadvice.org - nfcc.org - profina.org She may need professional help from consumer credit counseling. c. She needs to list all of her indebtedness to determine where she stands.

- Create a budget and follow it. - Cut expenses and reduce clothing expenditures. - Consider debt consolidation Case 7-4. Dealing With Financial Problems. a. Risks facing Jack and Allison. - Inability to make monthly debt payments in addition to living expenses and private schools - No safety net, very little equity in the home - Debt ratios and payment ratios estimates are much too high, and even higher because of the $15,000 in credit card debt. - If Jack lost his job - Children would have to be pulled out of school immediately - Large reduction in monthly expenses - Consider sale of home and / or other assets - Allison would need to obtain a full time job b. They are in severe financial trouble now that will impact their family for years. Jack must stop his gambling and if necessary seek counseling. They need a debt consolidation loan to reduce the credit card interest rates. Credit counseling services are essential. c. Consolidation Loan problems. - There is too much debt and not enough equity or assets. - Monthly expenses are not managed very well. Earnings should be sufficient to more than cover them. d. Other strategies: - Zero based budget - Reduce monthly expenses - Move children to public school - Allison should seek employment

CHAPTER 7 CONSUMER LOANS AND CREDIT MANAGEMENT SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 229 in the Textbook 1. Payment Ratios. Payment Ratio = Debt payments / Monthly income = $300 / $1,200 = 25% This is too high. The maximum recommended by financial planners is 10 to 20 %. 2. Opportunity Costs. You should use the savings to pay off the card. It would save you about 10% or a little less than $300 in interest in one year. The 15% interest is not tax deductible, but the 5% interest income is taxable. Withdrawing the $3,000 would reduce your liquidity, but if you deposit the monthly payments, in less than four years the money will be replaced. 3. Payments Necessary to Achieve Debt Reduction Goals. (Using Exhibit 7-7) a. $48.49 b. $118.95 c. $228.08 d. $368.04 4. Payments for Loans. a. 6% / 12 = .0050 PVIFA36, .005 = 1 – (1 / (1+.005))36 / .005 = 32.880 Payment = $10,000 / 32.880 = $304.14 b. 6.5% / 12 = .005417 PVIFA48, .005417 = 1 – (1 / (1+.005417))48 / .005417 = 42.1636 Payment = $10,000 / 42.1636 = $237.17 c. 7% / 12 = .005833 PVIFA60, .005833 = 1 – (1 / (1+.005833))60 / .005833 = 50.5057 Payment = $10,000 / 50.5057 = $198.00 d. 7.5% / 12 = .00625 PVIFA72, .00625 = 1 – (1 / (1+.00625))72 / .00625 = 57.840 Payment = $10,000 / 57.840 = $172.89 5. Finance Charges. $1,000 @ 10% / 2 years a. Simple interest, single payment $1,000 x 10% = $100 annual interest / average loan balance = $100 / $1,000 = 10% b. Simple interest monthly payments 10% / 12 = .00833 PVIFA24, .0083 = 1 – (1 / (1+.0083))24 / .0083 = 21.6687 Payment = $1,000 / 21.6687 = $46.16 average monthly balance = $786.01 APR = Total annual finance charge / Average loan balance over the year. =78.6 / 786.01 = .099 or 10% c. Add-on installment loan Payment = Amount of loan + (Amount of loan x Nominal rate x number of years) / number of payments = $1,000 + ( $1,000 x .10 x 2) / 24 = $50 APR approximation for add-on loan = total annual finance charges / Original loan amount x 0.5 = $100 / ($1,000 x 0.5) = .2 or 20%

6. Finance Charge. $3,000 for 3 years. a. 8%, Simple interest, single payment annual interest / average loan balance = $240 / $3,000 = 8% Total interest = Principle x interest x number of years $3,000 x .08 x 3 = $720 b. 8%, Simple interest installment loan 8% / 12 = .006667 PVIFA36, .0067 = 1 – (1 / (1+.0067))36 / .0067 = 31.9034 Payment = $3,000 / 31.9034 = $94.03 Total interest = payment x number of payments – Principle $94.03 x 36 - $3,000 = $385.08 APR = Total annual finance charge / Average loan balance over the year. =206.63 / 2583.00 = .080 or 8% c. 6% Add-on, using N-Ratio method, Box 7-3 APR = (12 x ((95 x 36)+9) x ($3,000 x .06 x 3)) / ((12 x 36) (36+1) x ((4 x $3,000) + ($3,000 x .06 x 3)) = (12 x $3,429 x 540) / (432 x 37 x $12,540) = 22,219,920 / 200,439,360 = .1109 = 11.09% Total interest = Principle x interest x number of years $3,000 x .06 x 3 = $540 d. 7% Discount APR = ($3,000 x .07) / ($3,000 – ($3,000 x .07 x 3)) = $210 / ($3,000 - $630) = $210 / $2370 = 8.86% Total interest = Principle x interest x number of years $3,000 x .07 x 3 = $630 7. Decision Factors in Loan Choice. Unsubsidized Student Loan Now 6%, Variable - Accrues interest from date of award - Repayment deferred until six months after graduation - Helps student liquidity while in college - Tax deductible interest starting with loan repayment - Possibility of rising rates in the future? - Owed by student Home Equity Loan, Fixed at 7% - Payments start now - Tax deductible interest starting now - Possibility of falling rates in the future? - Reduces parents current liquidity - Increases parents debt ratio - Owed by parents 8. Loan Payoff for Simple Interest Loan $13,000 @ 6% 48 months, simple 6% / 12 = .0050 PVIFA48, .005 = 1 – (1 / (1+.005))48 / .005 = 42.5803 Payment = $13,000 / 42.5803 = $305.31 Remaining balance after 24 payments = $6,888.45 (See accompanying spreadsheet) 9. APR and Loan Payoff for Add-on Loans $13,000 @ 6% 48 months, add-on a. Total interest = Principle x Rate x Time = $13,000 x .06 x 4 = $3,120 Monthly payment = (Principle + Interest) / Number of payments = ($13,000+ $3,120) / 48 = $335.83

b. APR = (12 x ((95 x 48)+9) x ($13,000 x .06 x 3)) / ((12 x 48) (48+1) x ((4 x $13,000) + ($13,000 x .06 x 3)) = (12 x 4,569 x 3120) / (576 x 49 x 55,120 = 171,063,336 / 1,555,706,880 = .1100 = 11.00% c. Loan payoff using rule of 78’s Sum of digits for 48 payments = (N/2) x (N+1) = (48/2) x (48+1) = 24 x 49 = 1176 Sum of digits for 24 payments = (N/2) x (N+1) = (24/2) x (24+1) = 12 x 25 = 300 Proportion of finance charges avoided = Sum of remaining digits / Sum of all digits = 300 / 1176 = .2551 or 25.51% Finance charges avoided = Original finance charge x Proportion of finance charges avoided = $3,120 x .2551 = $795.91 Loan payoff = (Number of payments left x Payment amount) - Finance charges avoided = (24 x 335.83) - $795.91 = $7,264.01 d. Loan payoffs are so different because add-ons have higher APR than simple interest and more interest is allocated to the earlier payments by the rule of 78’s. 10. Consumer Credit Rights. a. Unlawful. You have the right to be treated fairly and civilly. b. Lawful. There is no credit history. There is no way to judge your ability and willingness to pay. A small loan at a higher rate successfully paid off may be necessary. c. Lawful. However, You have the right to fair and accurate reporting by the credit bureau. You should immediately inform the credit bureau of the error. Creditors are responsible for the accuracy of information they provide. d. Lawful. Probably was a “teaser“ rate, but not actually available without perfect credit. 11. Improving Creditworthiness. - Obtain a credit card with a low limit. Use it for a few small items and make payments on time. Paying off the balance each month would save finance charge. - Perhaps a phone in her name, and / or other utilities if she is renting, making sure all payments are on time. - A consumer loan on something like a car with great care to make timely payments. Perhaps her parents would cosign if necessary. - Discuss the importance of a monthly budget and keeping track of expenses. 12. Home Equity Loan Amounts. Home value = $120,000 90%Loan-to-value ratio $120,000 x .9 = $108,000 Less Mortgage = $80,000 Maximum Loan=$28,000

CHAPTER 7 CONSUMER LOANS AND CREDIT MANAGEMENT THE LEARNING OBJECTIVES 1. Identify the most common types of consumer loans and lenders. 2. Compare consumer loans based on terms and costs. 3. Assess your creditworthiness and know how to improve it. 4. Understand your consumer credit rights. 5. Establish a plan for managing your consumer credit and reducing outstanding balances. CHAPTER OUTLINE AND SUMMARY I. Consumer loans. A. Characteristics of consumer loans. 1. Interest rates. a. A fixed-rate consumer loan is a loan for which the rate of interest remains the same throughout the term of the loan. b. A variable-rate consumer loan is a loan for which the rate of interest varies periodically with a changing market rate, such as the prime rate. c. Fixed-rate loans are used for automobile and home equity loans. d. Variable-rate loans are used for home equity loans and credit cards. 2. Payment arrangements. a. A single-payment loan requires that the balance be paid in full at some point in the future, including the principal and the interest owed. b. An installment loan allows the borrower to repay over time, usually in monthly installments that include both principal and interest. c. An installment loan is in default whenever a required payment is overdue. d. An acceleration clause makes the entire balance due and payable in the event that the borrower falls behind in payments. e. A prepayment penalty is a fee charged for early repayment of a loan. 3. Secured and unsecured loans. a. A secured loan gives the lender the right to take certain assets or property in the event that the loan is not repaid according to its terms. b. The pledged property can be an auto, home, or business property and is called the collateral. c. When real property is used as collateral, as in the case of a home mortgage, the lender will record a lien against the property at the county courthouse, putting the public on notice of its potential right to the property. d. An unsecured loan has no collateral and the lender must suffer the full loss. B. Types of consumer loans. 1. Home equity loans. a. Home equity - market value of a home minus the remaining mortgage balance. b. Lender of a home equity loan’s right to the home is secondary to the primary mortgage lender.

c. When home equity loans are established as lines of credit, they usually have a term of 5-10 years and a variable interest rate. d. When home equity loans are taken as a lump sum, they have fixed-rates of interest and a term of 5-15 years. e. Interest on home equity loans is tax-deductible up to a maximum of $100,000. 2. Car loans. a. The loan is limited to some percentage of the current market value of the car, and the borrower must pledge the car as security. b. Loan maturities are usually two to six years. 3. Student loans. a. A student loan is a loan made for the purpose of paying educational expenses. b. About two-thirds of all student financial aid comes from federal programs, including loans and grant programs. c. The Student Guide is available from the federal Department of Education that tells you about federal aid programs and how to apply for them. d. The four major student loan programs are: 1) Subsidized Stafford loan. 2) Unsubsidized Stafford loan. 3) PLUS loan. 4) Federal Perkins loan. e. Can defer loan payments for up to three years for economic hardship, postsecondary study, unemployment, or service in the military or the Peace Corps. f. Perkins loans can be forgiven in the event the borrower dies, is disabled, or takes permanent employment in certain professions. C. Sources of consumer loans. 1. Depository institutions. a. Includes banks, savings and loans and credit unions. b. Offer the widest variety of consumer loans and, on average, the most favorable interest rates. c. Accounts for nearly half of all consumer lending. 2. Consumer and sales finance companies. a. A consumer finance company is a non-depository institution that makes loans to riskier consumers and has higher interest rates. b. A sales finance company is a non-depository institution that makes consumer loans to buyers of products offered through its parent company. 3. Other sources of consumer loans. a. Investment accounts at brokerage firms. b. Cash-value life insurance policies. c. Retirement plans. d. Pawnshops. D. Terms and costs of consumer loans. 1. The promissory note is the legal contract that specifies the terms and conditions of the borrower’s agreement to repay a sum of money. 2. A down payment is usually required on a consumer loan and is the amount of the purchase price that a buyer pays in cash.

3. The loan term is the amount of time in which the loan must be repaid. 4. Lenders usually charge higher rates of interest on loans with longer terms. 5. The promissory note for a secured loan will include a description of the collateral pledged for the loan and specify the conditions under which the lender can take possession of the collateral. 6. APR is the total annual finance charges divided by the average loan balance over the year. 7. Lenders must state the APR in the loan agreement and in advertising. 8. The simple interest method to determine finance charges on a consumer loan is based on the outstanding balance on the loan. a. The actual amount of interest owed in each payment period is the remaining balance of a loan times the nominal rate divided by the payments per year. b. Each payment includes both principal and interest. c. As you make payments, the remaining balance goes down and so does the interest you pay and the payment remains the same. 9. When the add-on interest method is used, the interest is added to the amount borrowed before the payments are calculated; the total is then divided by the number of payments to determine the payment amount. a. With add-on interest, you’re paying the nominal rate on the original balance even after you’ve repaid most of the loan. b. An approximation of the APR can be found by calculating the total annual finance charge and dividing it by the original loan amount x 0.5. c. The N-ratio method is used to calculate the APR for add-on interest loans. 10. The discount interest method is usually used for single-payment loans. a. The lender subtracts the interest due from the principal amount before the borrower gets the money and at maturity, the entire principal amount is due. b. Pay interest on funds not available to you. c. APR is found by calculating the total annual finance charges divided by the average loan balance over the year. 13. Lenders offer credit life and disability insurance to pay off the loan if you die or become disabled. Very expensive and profitable for lender. 14. Lender has right to obtain funds from you if you default, even if they repossess your collateral which may not sell for enough to repay loan. 15. Early repayment of installment loan depends on how interest is calculated. a. For simply interest loan, simply use your calculation function with the daily rate of APR/365. b. The Rule of 78s is a mathematical formula used to calculate the amount of interest remaining to be paid on an add-on installment loan and is also known as the sum of the years’ digits method. 16. A balloon loan is a loan for which the regular installment payments are calculated using a longer amortization period, but a single large payment is required after a shorter period of time to repay the loan in full. II. Building your creditworthiness. A. The five C’s of credit. 1. Capacity. a. Do you have sufficient income?

b. How big are your current payment obligations? 2. Capital. a. How much are your assets worth? b. How much are your total debts? c. What is your net worth? 3. Collateral. a. Are you pledging any assets as security for the loan? b. Do you have money in checking, savings, and investment accounts? 4. Character. a. Have you used credit before and do you have a clean credit record? b. Have you ever filed for bankruptcy? c. How long have you lived at the same address and worked for your current employer? 5. Conditions. a. Do you have a secure job? b. Is the company you work for in good financial condition? c. Are general economic conditions favorable? d. Cosigner is a person who agrees to take responsibility for repayment of a loan if the primary borrower defaults. B. Applying for consumer credit. 1. Do not be tempted by application received in the mail for a credit card. 2. Sample application for consumer credit appears on p. 218. C. If you are denied credit. 1. Lender must notify you want you are denied credit. 2. Try to correct the problem before apply again for credit. III. Understanding your consumer credit rights. A. Rights in obtaining credit. 1. True cost of credit is required in the APR. 2. Equal Credit Opportunity Act prohibits lenders from discriminate against you based on race, sex, marital status, religion, age, national origin, or receipt of public benefits. B. Credit reporting. 1. Credit bureaus are companies that collect credit information on individuals and provide reports to interested lenders. a. Equifax Credit Information Services. b. Experian. c. Trans Union. 2. What information is included in your credit report? a. Previous, current, and future credit history that includes average balances, late payments, and overlimit charges; employment and income history; and home mortgage amounts and payments. b. List of every request for your credit report in the last two years. 3. Your credit score. a.. FICO is a credit scoring system developed by Fair, Isaac and Company. b. Uses statistical models to calculate your probability of repayment. c. Scores range from 300 to 850, and a good score is 700-800.

4. Correcting errors on credit reports. a. You have the right to be notified if negative information is added to your file. b. Negative information is removed after 7 years and bankruptcy after 10 years. 5. Billing statements. a. Lenders are required to provide you with full information related to all charges made to the account and clearly explain any finance charges and how they are calculated. b. If you find an error, you have 60 days to contest it in writing. 6. Debt collection practices. a. Past-due notices in the mail, phone calls, and a debt collection agency. b. Fair Debt Collection Practices Act of 1978 gives you the right to be treated fairly and civilly by debt collectors. IV. Managing consumer credit. A. When and how to use consumer credit. 1. Only buy items on credit if you have a specific plan to repay the debt. 2. If possible, pay your credit card balance in full by the due date. 3. Limit the number of credit card you have. B. Reducing outstanding credit. 1. Regular evaluate your credit usage. 2. If necessary, take action to reduce outstanding debt. C. Meeting payment obligations if you are having difficult doing so. 1. Obtain a debt consolidation loan at a lower interest rate. 2. Take a second job specifically earmarked to pay down the debt. 3. Develop a zero-based budget. 4. Live with your parents or other family members to cut your expenses. 5. Sell assets. D. Avoiding bankruptcy. 1. Contact your creditors directly. 2. Consumer credit counseling. a. Avoid firms that advertise and charge for this service. b. National Foundation for Consumer Credit (NFCC) offers free credit consumer counseling through local nonprofit branches called Consumer Credit Counseling Services (CCCS). 3. Bankruptcy as a last resort. a. Bankruptcy is the legal right, specified under the U.S. Bankruptcy Act of 1978, to ask a court of law to relieve you of certain debts and obligations. b. Chapter 7 Bankruptcy requires the liquidation, or sale, of most of your assets. 1) Doesn’t dismiss alimony and child support, student loans and debts not declared in court. 2) Sale of assets used to paid creditors. c. Chapter 13 Bankruptcy is a method of protecting you from creditors’ claims while you develop a plan to repay your debts. 1) New payment arrangement for reduced balances and payments. 2) Generally keep all of your assets.

ADDITIONAL WEBSITE ASSIGNMENTS 1. http://studentaid.ed.gov: This site is mentioned on p. 205 of the textbook. Go to the left side of the page and click on College under the school attending. After you get to the college page, scroll down to Attention College Senior where there is a discussion of the four repayment plans for college loans. Read the choices, decide which one is right for you and then provide a write-up of the plan and why you choose it. 2. www.econsumer.equifax.com: This is the website for one of the three major credit bureaus listed in your text on p. 220. Compare the information about credit reports on this site with the other two major credit bureau sites. Which one do you think is easiest to use? Which one is most helpful? Which one has the most useful calculators? Which site to you like best? 3. www.myfico.com: This site explains the FICO credit score system. Read the section on Credit Education to learn more about credit scores and how they are used. 4. www.nfcc.org: This is the stie for the National Foundation for Consumer Credit listed and discussed on p. 226. Find the local branches that are in your area. Call to determine the services that are offered and what the charge is for these services. 5. http://www.salliemae.com: This is the website for SallieMae, the organization that buys student loans and offers consolidation of all of your loans. Read through the section on the left hand side of the page on borrowing for credit. Compare this information with that provide on the government site http://studentaid.ed.gov. 6. http://www.chicagofed.org/consumer_information/abcs_of_figuring_interest.cfm: This is the Federal Reserve Bank of Chicago’s article on the ABCs of Figuring Interest. It provides a discussion of interest rates on credit and how to calculate them with examples of several different methods. Read the article and compare to the discussion in your textbook. ADDITIONAL MINI-CASES 1. Case 1 – What Should Stephanie Do About Her Student Loans Now That She Is Graduating? Stephanie has her first teaching job as a special education teacher. She has Perkins loans she used to pay for some of her college expenses. a. Where can she find information on her options for repayment? b. What options does she have for repayment? c. What happens if she decides she does not like teaching special education? 2. Case 2 – Should Walter and Louise Take Out a Home Equity Loan? Walter and Louise purchased their first home four years ago. They have now gotten themselves in trouble by maxing out their credit limit on four different credit cards. They realize they are in trouble and are considering a home equity loan. They only put down 10% when they purchased their home and it has not appreciated since they bought it. a. Should they consider a home equity loan for more than 100% of their homes value? b. What risks do they face in taking this type of home equity loan? c. What other actions should they take if they decide to take the home equity loan?

3. Case 3 – What Should Ryan Do About a Mistake He Found on His Credit Report? Ryan Smith has found mistakes on his credit report from each of the three major credit bureaus and each one has different mistakes. a. What should Ryan do to correct the mistakes? b. What can he do in the future to reduce the mistakes? c. How often should he check his credit reports? TEACHING SUGGESTIONS 1. Have students complete 7.2 – Develop a Plan for Managing Consumer Credit on p. 232-233 to help them analyze their current credit situation. 2. Students should complete 7.3 – Evaluate Your Credit Report on p. 233 to determine if there are any errors on their credit reports from the three major credit bureaus and obtain their credit scores. 3. Check with the financial institution where you have your checking account and/or credit card to see what their interest rates, application costs, and terms are on their home equity loans. 4. Click on the Financial Aid office on your school’s website. What information on school loans, if any, do they provide? Is it easy or difficult to get help on your campus with financial aid? What type of aid besides loans are available? 5. Go to a local pawnshop and see the type of merchandise that they have for sale. Ask about their terms for their loans and what interest rate they are charging. What type of information do they ask for before they will make a loan? What type of assets do they accept as collateral for a loan? What assets do you have that you could offer for collateral? 6. Go to the Federal Trade Commission site on the Internet to find information on the Equal Credit Opportunity Act and it provisions. What does it recommend you do if you think you have been discriminated against in obtaining credit? 7. Why do you think lawyers advertise their services if you think you want to file for bankruptcy? What do you think the impact of filing for bankruptcy will have on your credit record and your ability to obtain employment and insurance? What other options are there to solve a credit problem besides bankruptcy? 8. Divide students into groups with four persons in each group. Ask them to develop a list of costs associated with obtaining a college degree. Determine how many are receiving help with college costs from family and how many are putting themselves through college. Are any of them receiving help from their employers or their parents’ employers? How much do they estimate it will cost them to obtain a bachelor’s degree? How long will it take them to get a bachelor’s degree. Be prepared to share the group’s results with the class. 9. Ask a representative from a bank, S&L or credit union to come to class and discuss the consumer lending business. Also ask them o discuss which of the Five C’s of Credit are most important in obtaining consumer credit.

CHAPTER 8 AUTOMOBILE AND HOUSING DECISIONS THE LEARNING OBJECTIVES 1. 2. 3. 4. 5. 6.

Evaluate your automobile needs and determine what you can afford. Decide between automobile financing alternatives. Be an informed automobile consumer. Evaluate your housing needs and determine what you can afford. Select a home that meets your needs and negotiate an acceptable price. Choose between financing options and know how to apply for and qualify for a mortgage.

CHAPTER OUTLINE AND SUMMARY I. The automobile decision A. Do you need a car? 1. The purchase should be analyzed against other luxury and convenience expenditures. 2. You should consider alternatives such as biking, walking, and using public transportation. B. Does the purchase fit into your budget? C. Recognizing the costs of automobile ownership 1. Fixed expenses: a. Finance charges b. Depreciation is the decline in value of an asset over time. c. Incremental auto insurance cost d. Other fixed costs: car registration, licenses, and taxes. 2. Variable Operating costs a. Increase with miles driven. b. Examples: gas and oil exchanges. 3. Evaluating affordability in light of total costs a. Consider the total annual cost or the cost per mile. D. Evaluating vehicle choices 1. Price a. Sticker price is the manufacturer’s suggested retail price (MSRP) for new vehicle, including manufacturer installed accessories and options. b. Dealer’s invoice price is the price that a dealer pays to purchase a new vehicle from the manufacturer. 2. New versus used a. Market values of used cars declined substantially in the last several years. 3. Equipment a. Vehicles can differ substantially in standard equipment, options, and accessories. 4. Size and fuel efficiency 5. Safety should be a factor in any automobile purchase.

6. Reliability a. Some makes and model are notorious for their lack of reliability. b. Express warranties are written or oral promise by seller. c. Implied warranties are legal obligations that the product for sale be suitable for intended use. d. Limited warranties are less than a full promise to repair or replace, often covering parts and labor for specifically identified types of problems. e. Extended warranties are service contract agreements that, for a set price, extend an original warranty or add services or coverage. II. Auto financing alternatives A. The lease versus buy decision 1. The up-front and monthly costs of buying are higher than they are for leasing. 2. A person who leases will have no equity at the end of the lease. B. What is a lease? 1. A lessor is an owner of an asset, commonly a vehicle or real property, who charges money for the use of that asst for a period of time. 2. A lessee is a person who pays money for the privilege of using someone else’s vehicle or real property for a period of time. 3. Close-end leases are leases in which the lessor bears the risk that the value of the car at the end of the term is less than originally estimated. 4. Open-end leases are leases in which the lessee is responsible for the additional depreciation at the end of the lease term if the value of the car is less than originally estimated. C. Important lease technology 1. Gross capitalized cost is the value of the vehicle at the beginning of the lease. 2. Up-front fees are the fees paid for credit report and lease application. 3. Capitalized cost reduction is the amount the gross capitalized cost will be reduced by the down payment, rebates, or trade-in. 4. Residual value is the expected depreciated value of the vehicle at the end of the lease term. 5. Rent charge is the total dollar finance charges for the term of the lease. 6. Lease term is the number of months in the lease. 7. Excess wear and mileage limits relate to the penalty you are charged for excessive wear and use of the vehicle. 8. Purchase options allow you to purchase your leased vehicle at the end of the lease term. 9. Early termination relates to the penalty you are charged for ending the lease early. 10. Disposition fee is the charge for the disposition of the vehicle at the end of the lease if you choose not to purchase the vehicle. III. Getting the most for your money A. Understanding the sources of auto dealer profit 1. The difference between what dealers pay for the car and what they sell it for. 2. Profit on dealer-installed options, dealer delivery and preparation, and undercoating. 3. Manufacturer incentives

4. Extended warranties and service contracts 5. Finance charges and application fees 6. Expected profit on traded vehicle. B. Making consumer complaints 1. If you have a problem with an automobile purchase, you have the following options: a. Warranty work from service department b. Manufacturer c. State Consumer Affairs Department. 2. All complaints should be made in writing and should be documented. 3. Lemon laws are state laws that protect consumers against chronically defective vehicles. IV. The housing decision A. Housing needs analysis 1. Changing housing needs over the life cycle 2. Housing as a component of your financial plan a. Make this decision in light of your other priorities. b. Consult your budget to determine what you can afford to spend on housing. B. Rent versus buy 1. Depends on your preferences, your budget, and creditworthiness. 2. It usually costs more to buy than rent equivalent space. 3. Homeowners experience long-tern financial advantages to ownership. C. Advantages of Renting 1. Lower monthly payments 2. Mobility 3. Less responsibility D. Disadvantages of Renting 1. Increasing costs over time 2. No investment value 3. No tax deductions 4. Restrictions on the use of the property 5. Uncertainty E. Legal issues for tenants 1. Leases a. Leases should be in writing, but don’t have to be if less than one year. b. Leases are negotiable. c. All states have laws that govern landlord-tenant relations. d. A security deposit is the dollar amount required at the beginning of a lease to cover the costs of any damage to the property over the lease term. F. Calculating how much house you can afford 1. Estimate the monthly amount you can allocate to total housing costs consistent with your budget and financial goals. 2. Estimate the nonfinancing costs of home ownership and subtract them from your total budgeted amount. 3. Estimate the amount you can borrow with that level of payment.

4. Add other sources of funds and subtract closing costs to calculate the house price you can afford. G. Cost of home ownership 1. Principal and interest 2. Property taxes a. Property tax rate is local tax assessed on real estate proportionate to value b. Property tax = (Assessed Value / 1000) x Tax Rate c. Assessment ratio is a proportion of market value used to calculate assessed value of real estate on which the property tax rate will be assessed. d. Assessed value = Market Value x Assessment ratio 3. Homeowner’s insurance 4. Repairs and maintenance 5. Association dues 6. Offsetting tax benefits H. Estimating what you can allocate to the monthly mortgage payment 1. Estimating principal and interest payments a. Use time value of money principles to estimate the amount you can borrow. b. The appropriate interest rate is the monthly rate, annual rate divided by 12. 2. Maximum mortgage amount = Affordable payment x Mortgage factor I. Understand limits set by lenders 1. Lenders commonly use ratios to evaluate your ability to pay a. Mortgage debt service ratio = Monthly mortgage debt service / gross monthly income 1) Lenders commonly require it to be less than 31% b. Debt payment ratio = Total monthly debt payments / After-tax monthly income 1) Lenders commonly require it to be less than 41% J. Maximum affordable house after including other sources of funds 1. Down payment amount a. Consider the minimums imposed by lenders, your available cash, and the opportunity cost of using cash for this purpose. b. You must make a 20% down payment to avoid paying a mortgage insurance premium (MIP), which insures the lender against your default on principal and interest payments. 2. Closing costs are transaction costs paid at the closing of a home purchase. a. Closing is the meeting at which participants sign the required paperwork to finalize a home purchase and mortgage agreement. V. Buying a home A. The determinants of real estate market values 1. Location, location, location. This includes many related factors: the town, the values of surrounding properties and their use, proximity to schools and transportation, and zoning laws. 2. Other factors: the type of structure, age, characteristics of the structure and land, curb appeal, and asking price relative to value.

B. Real estate brokers are professionals who help homeowners find buyers for their homes and assist in the purchase transaction, in return for a fee, which is paid by the seller. 1. Factors in choosing a broker: a. Experience: How long has the broker been selling real estate? b. Focus: Is this the broker’s primary profession? c. Track record: What is the average price of homes the broker has sold? d. References e. Size: How big is the office the broker works out of? 2. How is a broker paid? a. Commission is the percentage of sales price paid to broker(s) who assist in the sale of a home. b. Listing brokers are brokers who originally contracted with the seller of the house you’re buying. c. Cooperating brokers are brokers who originally shoed you the house and helped you negotiate the sales price. 3. Your legal relationship with a broker a. An agent is a person who is acting on behalf of another through a contractual agreement. b. A principal is a person who has delegated responsibility to an agent and to whom the agent has a duty. c. A buyer broker is a real estate broker who works exclusively for the buyer and owes not legal duty to the seller. C. Negotiating the contract 1. Buyers usually make an offer that is less than the asking price expecting a counteroffer from the seller. 2. Terms of the contract: a. Price b. Conditions c. Other terms VI. Mortgage financing A. A mortgage is a long-term amortized loan that is secured by real property. If you don’t make your mortgage payments, the lender has the right to foreclose. B. Mortgage market 1. The primary mortgage market is the market in which lenders originate mortgage loans with borrowers. 2. The secondary mortgage market is the market in which lenders sell mortgages after initial origination. C. Types of mortgages 1. A conventional mortgage is a fixed-rate, fixed term, fixed payment mortgage loan. 2. Insured mortgages are insured by the Veterans Administration and the Federal Housing Authority 3. An adjustable-rate mortgage (ARM) has an interest rate that, by contract, varies over time with market conditions.

a. Interest rate caps are caps on annual and lifetime increases in an ARM interest rate. b. Negative amortization is an addition to loan balance that occurs when the monthly payment is insufficient to cover the monthly interest cost. 4. Balloon mortgages are loans for which the final payment is much larger then the earlier, regular payments. 5. Graduated payment mortgage allows for gradually increasing payments over the life of the loan, resulting in negative amortization during the early years. 6. A lender buy-down mortgage is a mortgage that imposes a schedule of increasing interest rates over the life of the loan, resulting in gradually increasing payments. 7. A growing equity mortgage is a mortgage whose payments increase over time, with the increase applied to reduce the balance owned on the loan. 8. A bi-weekly mortgage is an arrangement in which mortgage payments are made every two weeks in an amount equal to half the required monthly payment, resulting in extra month’s payment over the course of a year. 9.A shared appreciation mortgage gives the lender a right to a proportion of the increase in the value of the home in return for a lower rate of interest. 10. A reverse annuity mortgage is an arrangement in which the homeowner sells equity in a home in return for a stream of income but retains the use of the home. B. Factors affecting mortgage payments 1. The longer the term, the smaller the mortgage payment. 2. The higher the interest rate, the larger the mortgage payment. 3. Discount points reduce your loan interest rate. a. Discount point, equals one percent of the mortgage loan amount, paid up front to a lender in return for a reduction in annual rate on a mortgage. 2. Economic factors 3. Location 4. Your default risk 5. The property C. Mortgage application 1. Once you have applied for the loan, the lender must provide you with a good faith estimate of the costs associated with the transaction. 2. Mortgage rates may change after the time of application a. A lock-in is an agreement with a lender that guarantees a particular mortgage interest rate at closing. D. Refinancing is obtaining a new mortgage to pay off a previous, usually higher rate mortgage. 1. Reasons to refinance: a. To save money b. To access your home equity c. To reduce the term of your mortgage 2. Costs of refinancing are similar to original mortgage costs 3. Divide the non-escrow closing costs by the monthly payment savings to determine the number of months it will take to recoup the closing costs.

VI. Completing the real estate transaction A. The closing 1. Date of closing is set by mutual agreement of the buyer, seller, and lender. 2. Inspect the property prior to closing. 3. All the necessary legal documents to transfer property ownership to you, record the transaction, and finalize the mortgage are signed at closing. B. Closing costs 1. Mortgage costs 2. Escrow accounts are reserve accounts held by the mortgage lender in which it collects a monthly prepayment of property taxes and insurance and then pays these bills as they come due. Two to three months of escrow paid at the closing. 3. Title insurance ADDITIONAL WEBSITE ASSIGNMENTS 1. www.ebay.com: Ebay, the largest Internet auction site, now sells cars and well as all the other new and old items in its vast inventory. Search on that site for your dream car and compare that to the Blue Book value. Does it appear that this is a good way to buy a car? What additional costs for delivery would you expect? Does the price differential make those costs worthwhile? 2. www.intellichoice.com: Many dealers offer certifications for used cars. Check this site to find the ratings on these programs. On what criteria are the certification programs rated? Which dealer ranks highest? 3. www.consumerreports.com: Go to the Consumer Reports website and find the most recent research on new car models. How much better is the gas mileage on the hybrid Ford Escape compared to its gas powered alternative? 4. www.realtor.com: Pretend that you are interested in purchasing a home in your area. Go to this website and search to find available housing based on your needs and wants. 5. www.Realtor.com: Find a home of your choice in a community in which you would like to live. Print a picture of the property and the description of the house including number of rooms, features of the home, and local schools. Provide a map of its location. What is the listing price of the home and what would the mortgage payments be if you put a 20% down payment on the home. Attach the material to a write-up of your selected home and why you choose it. 6. www.homepath.com: This website, sponsored by Fannie Mae, is designed to help first-time homebuyers. Click on “Home Starter Path” and follow the directions. 7. Use www.kbb.com and www.edmunds.com to compare the sticker price, dealer’s invoice price, current selling price, and price for a three year old version of a vehicle of your choice as suggested on p. 239. Attach the information that you obtained to a one page memo that discusses the information you found and whether or not it changed your opinion of the vehicle. 8. Use the Internet to find your local tax assessors office and the assessment ratio and property tax rate (mil rate) for property in your area. Find the median home value

in your area by calling the local Board of Realtors and calculate the annual property tax on the median home in your area.

ADDITIONAL MINI-CASES 1. Case 1 – Should Yassar Trade in His Gas Guzzler? Yassar has a 1998 SUV that gets less than 10 miles per gallon. He drives about 15,000 miles per year between work, school, and offroading with his friends. He currently owns his vehicle outright but could afford to make a monthly payment on a newer vehicle. Discuss the decision process that Yassar should follow in making this decision, being sure to identify any information he will need to have to make an informed decision. 2. Case 2 – The Costs of Being “Extreme Green” Chris Robinson prides himself on being environmentally conscious. He and his wife Cherie live in a rural community, raise their own vegetables (they are vegetarians), they do not own a car, preferring to bike or walk everywhere, and their home is a passive solar design. Recently they were delighted to discover that Cherie is pregnant with their first child and they are wondering if having a baby is going to make it more difficult to maintain their previous “green” lifestyle.” Help them make a list of the potential problems they might face with respect to housing and automobiles once their baby is born. TEACHING SUGGESTIONS 1. By a show of hands, determine how many students rent versus lease their current cars and how many students rent versus lease their current homes. Ask them to identify the reasons they have chosen to lease versus buy. Then ask how many expect they will lease versus buy after they graduate from college. Assuming there is a substantial difference for the home decision, have them discuss why they expect that decision to be different in the future. 2. Discuss the pros and cons of buying cars from different sources, including new car dealers, used car dealers, directly from owners in response to an ad, or online. 3. Ask a student to share a car buying experience that was uncomfortable, such as one in which a salesman was pushy or attempted to make them agree to less favorable terms. Use this to motivate a discussion of the sources of dealer profit. 4. Lead a short class discussion on the factors you should consider in deciding whether to trade in your old vehicle versus sell it on your own. 5. Have the students create a list of factors that would make a house more attractive to a potential buyer. Discuss whether it would be worthwhile to make major or minor repairs/ renovations prior to putting a house on the market. 6. Have the students research the housing market in your area, either on line or by looking in newspapers. What is the lowest price for a single family detached home? How much cheaper is it to by a condominium of a similar size?

7. Have the students call several lenders in the area to find out their maximum ratio guidelines. Share this information in class and discuss why lenders do not all use the same criteria. 8. Have students calculate the fixed and variable operating costs for a vehicle assuming they buy it new or buy a three year old model and write a report that discusses the following questions. What is the difference in costs? What are the trade-offs in buying a new or used vehicle? What is the effect of buying a three year old model on the warranties for the vehicle? Which vehicle do you think you would buy? Why? 9. Call three local real estate offices and ask them what their commission rates are for selling a home that should sell for $150,000. Compare the rates and ask if any of their agents are buyer brokers. If you were selling a home, which real estate office would you choose. Why? 10. Visit a local car dealership and/or their website. Find out what it would cost to lease a new vehicle versus buying one over a three-year period. How do you explain the differences in cost? Do you think all dealers have the same terms in their offers? Test by visiting more than one dealership in person or on-line. What information do you have to provide to get an estimate? Which offer would you choose? 11. Investigate apartment or condo rentals in your area for at least three different units that are similar in size and rent. What is the monthly rent? What is the required security deposit? What are the features of the apartment or condo and what amenities are available? Which apartment or condo would you choose? Why?

CHAPTER 8 AUTOMOBILE AND HOUSING DECISIONS SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 269 in Textbook 1. Total Costs of Automobile Ownership N =48; I =8/12; PV = 12,000; Compute PMT = 292.96 Annual Loan Payment = 292.96 x 12 = 3,516 Gasoline = (5,000/22) x 1.70) = 386 First year depreciation 3,000 Incremental insurance 200 Registration and license 250 Sales tax = 14,000 x 4% = 560 Oil changes 120 Total Cost of Ownership 8,032 Cost per mile = 8,032/5,000 = $1.61 2. Costs of Automobiles Number of gallons per year = 16,000/20 = Change in cost per gallon = 1.95 – 1.65 = Additional cost per year = 800 x 0.30 =

$800 $0.30 $240

3. Finance Charges a. 48 month loan: N=48; I=6/12; PV=6,000: Compute PMT = $140.91 36 month loan: N=36; I=5/12; PV=6,000; Compute PMT =$179.83 b. 48 month 36 month Total Payment = 140.91 x 48 = 6,763.68 = 179.83 x 36 = 6,473.88 Less original loan amount 6,000.00 6,000.00 Total interest paid 1,763.68 1,473.88 c. The longer term loan requires a lower monthly payment, so you need to consider your other uses for those funds. Even if the total interest paid on the shorter loan is less, you should consider your opportunity costs. You may also consider the depreciation of the vehicle since you don’t want to be in a situation where you owe more on it than it is worth. 4. Car Loan Payments and Balance Owed a. N=60; I=6/12; PV = 16,000; Compute PMT = 309.32 b. After 36 months, you have 24 payments of 309.32 left, so the remaining balance is the present value of that stream of payments: N=24; I=6/12; PMT=309.32; Compute PV = 6,979 5. Auto Lease Versus Buy Decisions. Conditions where a lease would make sense: • When you don’t have enough money for a down payment to buy • When you want to have smaller monthly vehicle expenses

• When you don’t need a vehicle at the end of the lease • When you think the market value of the vehicle won’t exceed the loan balance after two years. • When manufacturer lease incentives make leases more attractive financially. • When you don’t think you will exceed the mileage limits on the lease. 6. Mileage Penalties Three year maximum mileage = 12,000 x 3 = 36,000 Excess mileage = 40,000 – 36,000 = 4,000 miles Mileage penalty = 0.25 x 4,000 = $1,000 7. Rent Versus Buy Cost of renting Annual rent 800 x 12 Renter’s insurance After-tax interest lost on sec. dep. Total Cost of Renting

9,600 140 24 9,764

Cost of Buying Mortgage payment Property tax Insurance and maintenance Down payment and closing costs After-tax interest lost on clos. costs Subtotal costs

7,200 1,300 500 5,000 100 14,100

Less savings on repaying principal 1,234 (7,200 – 5,966) Less house appreciation 4,000 Less tax savings on interest 1,492 (5,966 x 25%) Less tax savings on property tax 325 (1,300 x 25%) Subtotal savings 7,051 Total Cost of Buying 7,049 (14,100 – 7,051) Recommend that Maria buy the home since the total costs are less than the costs of renting. Since rental costs will increase each year, but the mortgage payment is constant, it is likely that her cost savings will be greater in later years. 8. Mortgage Payments a. N=30x 12=360; I=8/12; PV=75,000: Compute PMT = $550.32 b. N=15 x 12 = 180; I=8/12; PV = 75,000; Compute PMT = $716.74 c. N=15 x 12 = 180; I=6/12; PV = 75,000; Compute PMT = $632.89 9. Adjustable-Rate Mortgages a. N=30x 12=360; I=6/12; PV=100,000: Compute PMT = $599.55 Balance owed at end of 2nd year. 360 – 24 =336 remaining payments: N=336; I=6/12; PMT = 599.55: Compute PV = 97,468.15

b. First year payment (Rate =4%) N=30x 12=360; I=4/12; PV=100,000: Compute PMT =477.42 Balance after first year: N=360-12=348; I=4/12; PMT = 477.42; Compute PV=98,239.03 Second year (Rate = 5%) N=348; I=5/12; PV=98,239.03: Compute PMT = 535.27 Balance after second year: N=336; I=5/12; PMT=535.27; Compute PV =96,693.50 c. Maximum interest on the ARM is 9% (original 4% plus the lifetime cap of 5%)

CHAPTER 8 AUTOMOBILE AND HOUSING DECISIONS SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 270-272 in Textbook Case 8-1 Rami and Sara Sayed Decide Whether to Rent or Buy a. Total monthly housing maximum $1,500 Monthly Non-financing Housing Costs: Property tax (1,800/12) 150 Insurance (600/12) 50 Maintenance 150 Utilities 60 Total 410 Available for mortgage costs (1,500 – 410) 1,090/month Assuming loan at 6%, amount they can borrow with 1,090 payment: N=360; I=6/12; PMT = 1,090; Compute PV = 181,803 Plus available funds 20,000 Less expected closing costs 4,000 Maximum house Sayeds can afford $197,803 b. Debt payment ratio = (1,090 + 150 + 50 + 550 + 150 + 230)/6,000 = 37% Mortgage debt service ratio = (1,090 + 150 + 50)/6,000 = 21.5% Both ratios are less than the lender’s maximum, so the Sayeds could qualify for the $181,803, assuming that they meet other lender requirements. c. You can calculate interest paid by taking the total mortgage payments in the first year (= 1,090 x 12 =13,080) and subtracting the change in the mortgage balance over the year. Remaining balance at the end of one year: N=348; I=.5; PMT=1090; Compute PV = 179,570. This means that they repaid 181,803 – 179,570 = 2,233 in equity. Interest paid = 13,080 – 2,233 = 10,847. Deductions Interest: 10,847 Property tax 1,800 12,647 Standard deduction 9,500 Net deduction 3,147 x tax rate 25% = 787 incremental tax savings. d. The Sayeds can afford to buy the house but their current liquidity and future cash flow situations could be tight. They should do a detailed cash budget for the family for a few years. If they plan to have children over the next few years, they need to anticipate the additional costs. If Sara needed to take off time from work, would they be able to make the mortgage payments and their other expenses. Case 8-2 Carrie and Brad Crenshaw Consider Refinancing Costs a. The payment on their current loan: N=360; I=7.5/12; PV=130,000; Compute PMT =908.98

They have 360 – 48 = 312 payments to go. Calculate remaining balance: N=312; I=7.5/12; PMT=1,255,58; Compute PV = 124,619 b. N=360; I=6/12; PV = 124,619; Compute PMT = 747.15 This saves them 908.98/747.15=161.83 per month. The cost of this loan is 250 + 500 in closing costs = 750. They can recoup this cost in just 750/161.83 = 4.7 months. c. N=360; I=5/12; PV = 124,619+15,000 = 139,619; Compute PMT =749.50 d. Both of the alternative loans will result in the Crenshaws having greater monthly cash flow to apply to other financial goals. In both cases, however, they will be financing the loan for an additional four years relative to the remaining term on their current loan. The interest they will pay on this extra loan term will partially offset the other interest savings. With the loan from Bank B, the Crenshaws will face much higher closing costs (total $1,946 compare to $750 for the Bank A loan) because they have to pay a discount point and they will be borrowing an additional $15,000 as well. However, their payment on that loan is almost the same as the loan from Bank A. IF they opt for this loan, they should attempt to use the extra funds to build their financial condition, make investments, or add value to their property. Otherwise, the additional debt will adversely impact their household financial ratios. e. By extending their loan for four years, they will be paying more interest and they will be committing themselves to making the payment for a longer time than originally intended. It isn’t appropriate to compare payments on the old and new loans over different terms. When you compare the total payments on the old and new, the difference is not as great as it would appear to be by comparing the monthly payment amounts (312 x 908 =283,296 whereas 360 x 747 =268,920, for a difference of 14,376). Case 8-3 Is an ARM Worth the Risk? a. The mortgage markets are competitive, so it is unlikely that a lender will charge 1.5% when others are charging 4.5%. In fact, it is highly likely that the lender’s cost of funds is higher than 1.5%, so it will likely make up for the low rate in other ways. However, rates ARMs start low and increase over time. b. ARM lenders often offer attractive “teaser rates” but then have fairly unfavorable increases over the term of the loan. With such a low initial rate, the loan is likely to have steep rate hikes each year to make up for the early losses to the lender. c. The year 2 rate will be 3% + 2% = 5%. The lifetime cap after the first year is 7% so the maximum rate is 12%. d. N=360; I=1.5/12; PV = $77,579; Compute PMT = 267.74 His previous payment was: N=360’ I=5/12; PV=80,000; Compute PMT =429.46 He will save 429.46 – 267.74 = 161.72 per month, or 1,940.64 in the first year. e. Financing costs are 2% x 77579 = 1,551.58. Therefore it will take less than a year to recoup those costs with his new lower payment. f. He should consider how long he plans to stay in the house. The rate will remain lower than his current rate for only two years, assuming that rates are rising overall. After the first year, it could adjust to 5 %, 7% in the second year, and so

on. Assuming that his credit remains sound, he might consider taking this loan and then refinancing with a fixed rate loan later if the rates go up too much. At the moment, he has a very attractive loan-term fixed rate loan (5%), so he should keep it if he thinks he will stay in the home for a long time. g. Jonas should estimate his cost savings over his expected holding period. In doing so, he should consider a best case and worse case scenario and determine whether he can take the risk of the bad outcome. Case 8-4 Annette Decides Whether to Lease or Buy a. N=48; I=7/12; PV = 13,000; Compute PMT = $311.30 b. Cost of leasing for two years Capitalized cost reduction $2,000 Security deposit (2 x 199) 398 2,398 Foregone interest (2,398 x 2%) Total lease payments (199 x 24) End of lease charges Less: Return of security dep. Plus: Purchase option Total Cost of Leasing

96 4,776 0 398 6,872 12,000 18,812

Cost of Buying: Down payment Foregone interest (3,000 x 2%) Total loan payments Total Cost of Buying

3,000 240 14,941 18,181

Buying is the lower cost option by $691. c. The dealership may get incentives from the manufacturer. They might have thought she was concerned about the size of the payment or the down payment so that the lease option would clinch the deal. They might think that the market value of the vehicle at the end of the lease would be higher than the residual value in determining the lease, or that the purchase option was higher than the actual market value.

CHAPTER 9 PROPERTY AND LIABILITY INSURANCE PLANNING THE LEARNING OBJECTIVES 1. 2. 3. 4. 5.

Apply the risk management process to developing an insurance plan. Understand how insurance works. Identify your homeowner’s or renter’s property and liability risk exposures. Know how to select the right homeowner’s or renter’s insurance for you. Identify your automobile insurance coverage requirements, options, and costs.

CHAPTER OUTLINE AND SUMMARY I. Risk Management A. What is risk? 1. Pure risk is exposure to the risk of loss. a. Happens at random. b. Insurance available to help spread out the risk across the population. 2. Speculative risk is exposure to risk of loss or gain. B. The risk management process 1. Identify your risk exposures a. If you own something, you have a risk of losing it or having it damaged. b. Liability risk is the risk that you will be held financially responsible for losses to another person or the person’s property. 2. Evaluate your potential exposure a. Frequency of loss is the probability that a loss will occur. b. Severity of loss is the dollar value of loss. c. Expected loss = Expected Frequency x Expected Severity 3. Choose the most appropriate risk management tool a. Avoid the risk. b. Reduce the risk 1) Loss control is action taken to reduce the frequency or severity of expected losses. c. Transfer the risk to another party, usually an insurance company. d. Risk retention is when you decide to pay for losses out of pocket instead of purchasing insurance against the risk of those losses. 4. Implement your risk management plan 5. Periodically reevaluate your risk management plan II. How insurance works A. Risk pooling and insurance 1. Law of large numbers is a principle holding that, for large pools of identical risks, the risk that actual losses per person will be greater than predicted decreases as the size of the pool increases. B. Fair insurance premiums 1. A premium is the price an insurer charges a policyholder for insurance protection.

2. Risk classification is the categorization of policyholders by characteristics that affect their expected losses. Insurers use risk classification to price policies fairly. a. If insurers can accurately classify policyholders and predict the losses of a pool, premiums can be fairly close to individual expected loss. 3. Three types of risk make it difficult to estimate expected losses. a. Correlated risk is risk that affect large numbers of policyholders at once in the same area. b. Nonrandom risk is risk that is within the control of the policyholder. c. Unpredictable risk is risk with potentially unlimited severity. C. Insurance policies and terminology 1. An insurance policy is a contract between an insured and an insurer in which the insured agrees to pay a premium in return for the insurer’s promise to pay for certain covered losses during the policy period. 2. An exclusion is a potential loss that is expressly excluded from coverage by an insurance policy. 3. A rider is an addendum to an insurance policy that requires payment of additional premium in return for additional specified insurance coverage. 4. The principle of indemnity implies that insurance should only reimburse the policyholder for actual losses. 5. A deductible is the amount of loss that must be paid by an insured before the insurance company will pay any insurance benefit. III. Managing homeowner’s risk A. What risks are covered by homeowner’s insurance? 1. Homeowner’s insurance is insurance purchased by a homeowner to cover property and liability losses associated with a home. a. Damage to the building or its contents caused by a covered event or peril. b. Damage or theft of personal property. c. Liability for another person’s losses on your property. 2. Renter’s insurance is insurance purchased by a renter to cover personal property and liability losses but not damage to the building itself. B. What is liability risk? 1. Negligence is a failure to fulfill a legal duty to another that causes injury to that person or to his or her property. 2. Defenses to negligence: a. Contributory negligence is a defense to a claim of negligence available when the injured party contributed to his or her own injury. b. Assumption of risk is a defense claim of negligence available when the injured party voluntarily took on the risk. 3. Strict liability is a rule of law that holds a person liable for damages without proof of negligence. IV. Homeowner’s Insurance A. Homeowner’s coverages 1. Section I property coverage 2. Section II liability coverage 3. Umbrella policy is a supplemental personal liability insurance policy.

B. Pricing of homeowner’s insurance depends on 1. Amount of coverage purchased. a. Face amount is the value of assets insured under a policy. 2. Limitations on coverage: a. A schedule is a list of otherwise excluded valuables that are to be covered under a homeowner’s or renter’s policy for additional premium. 3. Characteristics of the insured such as credit and previous loss history. 4. Discounts on your premium for factors that limit expected claims costs. 5. Characteristics of the property: location, age of structure, construction material, proximity to fire house V. Automobile insurance A. Managing automobile risks 1. Driving an auto exposes you to both property and liability risks. 2. Compulsory automobile insurance laws are state laws that require proof of liability insurance as a prerequisite to auto registration. 3. Financial responsibility laws are state laws that require proof of ability to cover the cost of injury to persons or property caused by an auto accident. B. The Personal Automobile Policy (PAP) 1. Auto insurance includes coverage for both property and liability risks. 2. East state has a standard automobile insurance contract form. 3. Bodily injury includes: a. Part A protects you from legal liability for auto accidents by covering your financial cost, your legal defense costs, and court costs. b. Part B covers medical costs for you and any passengers injured in an accident. c. Part C covers injuries you incur in an accident caused by an uninsured motorist. 4. Property damage (optional): a. Collision coverage is insurance that covers loss or damage to your vehicle caused by an automobile accident. b. Comprehensive physical damage coverage is insurance that covers loss or damage to your vehicle caused by any peril other than an automobile accident. C. No-fault automobile insurance is a type of automobile insurance system in which each insured driver in an accident collects his or her claim from his or her own insurer regardless of who is at fault. 1. Intended to provide prompt compensation of accident victims and to reduce litigation costs. 2. The concept has fallen short of these goals. D. Auto insurance premiums depend on: 1. How much you drive 2. How well you drive 3. Your risk characteristics 4. Where you drive 5. Type of vehicle you drive 6. Your insurer’s financial performance

E. What to do if you have an auto accident 1. Stop your vehicle and wait at the scene of the accident for a police officer. 2. Call 911 to report the accident and seek medical assistance injuries. 3. Exchange names, addresses, phone numbers, and insurance information with the other drivers. 4. Obtain contact information for any witnesses. 5. When police officers arrive, provide information that they request but do not admit fault. 6. Obtain a copy of the police report. VI. Buying insurance and filing claims A. Finding agents and insurers 1. Exclusive or captive agents sell products for only one insurer. 2. Independent agents sell products for multiple insurers. B. Getting price quotes 1. Call local agents and insurers. 2. Use the Internet. C. Making a claim on your insurance 1. Promptly notify your insurance agent or insurer and follow their directions. a. A claims adjuster is a person designated by the insurer to assess whether a loss is covered by your policy and to assign a dollar value to the loss. 2. Document your losses. 3. Document the progress of the claim. 4. Refrain from signing anything that limits your ability to receive further payment form the insurer until you’re satisfied that the entire claim has been paid. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.car-accidents.com: Read the information here on what to do if you are in a car accident. Write a short summary of your legal rights and responsibilities. 2. www.iii.org: At the Insurance Information Institute website, find the automobile limits by state and compare them to those listed in Exhibit 9-6. Report to the class on any changes that have occurred since 2004. 3. www.progressive.com: Progressive Insurance has implemented an aggressive marketing campaign centered around the fact that it provides prospective insurance buyers with price quotes from its competitors alongside its own. Discuss the logic of doing this. How can Progressive actually know the prices that would be charged by its competitors? Do you think those quotes are reliable? Why or why not? Would this advertising campaign make you more likely to get a price quote from the company? 4. www.nhtsa.gov: The National Highway Safety Administration recently ranked all vehicles based on their probability of having a fatality. Find the latest rankings. Which vehicle has the highest number of fatalities and which has the lowest? Do you think that the reason for these results is that the high fatality car is more dangerous? IF not, how can you explain the extreme difference in fatality rates?

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5. www.fema.gov/nfip: The Federal Emergency Management Association operates the National Flood Insurance Program. Find out if you need flood insurance and where you can get it. 6. www.actuary.com: If insurance seems like it might be an interesting career area for you, visit this site to find out more about actuarial career options. ADDITIONAL MINI-CASES 1. Case 1 – How Much Homeowner’s Insurance? Karen and Mike have recently built their dream retirement home on a nice five acre lot. The land cost $100,000 and building costs were $350,000. They went a little nuts on the “extras” such as nicer kitchen cabinets and countertops, a built in Jacuzzi tub in the master bath, and high grade carpeting, so the resale value of the home right now is actually less than what they spent on it. They don’t mind, since the point was to build what they wanted. However, they are now unsure about how much homeowner’s coverage they should buy. Their agent tells them that since the value of the home is only $375,000 and $100,000 of that is the land, they should only insure it for a face value of $275,000. Should they take their agent’s advice on this? What type of coverage should they buy? Do they run the risk of being underinsured in the future? How can they avoid that problem? 2. Case 2 – Reducing the Risk of Teen Automobile Fatalities Jill and Chuck have a daughter who is about to get her driver’s license. They have recently read a lot about teen fatalities and are considering placing some restrictions on their daughter’s driving privileges. Based on what you know about auto fatalities, recommend some risk management strategies for this family. Will these strategies also reduce the risk of less severe auto-related losses? 3. Case 3 – The “Total” Risk Marian has always believed in having adequate insurance. For this reason, she has paid for higher limits on her auto coverage and she still has property damage coverage on her beloved 1994 Suburu at a cost of $200 per year. She recently was in a “fender bender” with a gigantic Ford Expedition—the SUV basically ran over her little car—and the insurance company notified her that they would be totaling her car. The amount they would pay her was the depreciated value of the vehicle, which they said was only $1,000. Marian was distraught. She had always kept her vehicle in perfect running order and she didn’t have that many miles on it. She had assumed it would last her for several more years. Now, she can’t possibly replace it with only $1,000. What mistake did Marian make? Can she negotiate the claim amount with the insurer? Why did the insurer total the vehicle? What would have been the financial consequences and risk of dropping the property damage coverage three years ago? TEACHING SUGGESTIONS 1. Have students survey their friends about the types of insurance they carry, their limits of coverage, and any additional insurance they are considering.

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2. Point out the results in the News You Can Use on p.g 294 that indicate wide price dispersion in auto insurance. Ask the class to try to think of any other products that seem equivalently uncompetitive. How can one insurer charge twice as much for basically the same product (these were all highly rated companies, so risk isn’t the issue). You can illustrate the answer to this question by the following exercise that show how little insurance consumers comparison shop: Ask your class, by a show of hands, to indicate how many insurers they called before buying their current coverage (start with 5 or more and work down). Find out how many have had their current coverage for at least two years and ask how many of that group priced alternative coverage before renewing for the year. If your class is typical, this casual survey will reinforce the decision inertia that is typical among insurance buyers. Ask the class to think about how that information can help to explain the price dispersion phenomenon. 3. After presenting the different types of risk management tools (avoid, control, transfer, retain), give several examples of risks and ask the class to suggest the best method for each one. Examples could include: running into a tree while skiing (control by wearing a helmut); dying while sky diving (avoid); having your car stolen while you’re in the grocery store (control by locking the car; transfer with insurance if the car is valuable enough); having a car accident (control by careful driving); going through the windshield in a car accident (control by owning a car with air bags); losing your pen (retain). 4. Ask the class why they think that you can’t buy insurance for investment losses and businesses can’t buy insurance to cover them for earnings that are lower than expected. Remind them about the principle of pooling. 5. Have a debate about the pros and cons of no fault automobile insurance. 6. In Chapter 2, a personal balance sheet was explained. Given the personal balance sheet you estimated for this past year, what is the value of your assets? Discuss any property or liability insurance that you have to protect these assets? Does your insurance cover the entire value of your assets? Why or why not? 7. Discuss your car insurance policy. What company issued the policy and how much does it cost? Describe the types of protection you have and how each type costs. What deductible have you chosen and why? Are there any discounts that you are eligible for, and do you take them? 8. Call at least three insurance agents in your community to determine what it would cost for renter’s insurance on an apartment. What factors determine the cost of the insurance. Do you think it is a good idea to have renter’s insurance? Why? What does this type of insurance cover? 9. Determine if your community has a list of “known dangerous animals”. If so, what animals are included? Does your insurance company exclude insurance for certain breeds of dogs? How do you think insurers decide which breeds should be considered a bigger risk for biting someone? If a breed is considered risky, would that stop you from owning that type of dog? Why? 10. Have you ever been involved in an car accident? If so, what happened to cause the accident? What happened as a result of the accident? Did your insurance cover the costs? Did you change your insurance coverage after the accident? Why? 11. When you rent a car at an airport or in your home town, is it necessary to have insurance? Should you take the insurance that the rental company offers? Why? What are your alternatives?

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CHAPTER 9 PROPERTY AND LIABILITY INSURANCE PLANNING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 299-300 in Textbook 1. Risk Management Process a. Identify the risk exposure. In this case, the risk exposure is that her son might be injured by the BB gun or may injure someone else or their property. b. Evaluate your potential losses. Although it is difficult to measure this precisely, Zelda could search on the Internet for any statistics on BB gun injuries. If her son is young, there might be a higher probability of loss. The potential severity could be very large, for example if another child was seriously injured. c. Choose the most appropriate risk management tool. Given the potential severity, avoiding the risk by not buying a BB gun would seem to be advisable. If she does decide to do it, she should reduce the risk by requiring her son to take a gun safety class and she should provide supervision for the gun’s use. She may want to increase her liability coverage by purchasing an umbrella policy. d. Implement your risk management plan. e. Periodically reevaluate your risk management plan. She may be willing to give her son more freedom to use the gun after he has shown himself to be responsible in its usage. 2. Risk Pooling a. Estimate the total expected losses and charge each student at least 1/100 of that total. b. Not necessarily. It may be the case that some of the students are higher risk than others. They may live in a more dangerous neighborhood, they may have more property that is at risk, they may not practice very safe risk management (by not locking their doors when they are away). If you tried to assess individual risk of loss in order to charge differential premiums, people might not tell the truth about their risk of loss. c. You would have to assess each member of the pool the additional pro-rate share of the losses. d. Some students might not take steps to reduce risk. Some students might not want to pay the additional amount at the end. It might be difficult to agree on the amount of the losses that will be paid. There may be fraudulent claims made on the pool. Who will manage the money during the year? Students have different risk of loss. It may be difficult to estimate the losses for the pool up front. 3. Estimating Expected Losses a. Expected frequency = .50 b. Expected severity = 0.25 x 3,000 + 0.75 x 500 = $1,125 c. Expected total loss = (0.50 x 0) + 0.50 x 1,125 = $562.50

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d. Patrick should buy the collision coverage. The expected loss is only $62.50 more than the $500 deductible, but he is subjected to a fairly high risk of a large ($3,000) loss. With the insurance, he can better budget for the possible outcomes. 4. Homeowner’s Coverage a. Maximum personal property coverage = 50% of face value = 0.5 x $200,000 = $100,000 b. Maximum living expenses = 20% of face value =0.2 x $200,000 = $40,000 5. Effect of Underinsuring a. If the face value of your coverage is less than 80% of the value, then the amount you can recover for the loss is reduced proportionately. If his home is now worth $210,000, the value of the dwelling is estimated to be 80% of that amount, or $168,000. He is carrying $120,000 face value insurance on a property worth $168,000 so the proportion he has insured is 71.4%. If his home is completely destroyed, resulting in a loss of $168,000, his recovery will be limited to $120,000. b. If he had $160,000 face value, his entire loss would be covered, but the amount would not necessarily be sufficient to replace the old dwelling. That will depend on the cost of construction in the area and the type and size of his former home. 6. Auto Insurance Coverage a. The total personal injury claims are 3 x 20,000 = 60,000, but she has a limit of $40,000 per accident on her policy, so she will be responsible for the other $20,000. The total vehicle damage is within the limit so the insurer will pay it. b. Bonita must personally pay the deductible of $250. The remaining damage is covered by her collision insurance.

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CHAPTER 9 PROPERTY AND LIABILITY INSURANCE PLANNING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Page 301 in Textbook Case 9-1 The Zumwalts Buy Homeowner’s Insurance a. HO-3 All-risk form is the most appropriate for the Zumwalts. b. They should have $400,000 in dwelling coverage. Although they could carry slightly less since the face value has to be at least 90 percent of the actual value, they wouldn’t want to risk a loss that was greater than their coverage. If, they insured less than 90 percent, the amount of their indemnity would be reduced accordingly in the event of a loss. c. The standard policy will provide them with sufficient coverage for their personal property since it automatically will provide coverage at 50% of the face value. However, it will not be sufficient for the jewelry since policies typically limit unscheduled jewelry coverage to a small dollar amount. They may want to buy additional coverage for the jewelry, but it might be too expensive to be worth it. d. The Zumwalt’s net worth is $250,000. They may want to have umbrella liability coverage if they anticipate potential liability that is greater than their homeowner’s and auto liability limits. e. Since they are in a high wildfire risk area, they should take steps to minimize their risk of loss. Given the large losses in that area in recent years, it might make sense to move to a lower risk area (avoid the risk). To minimize the severity of losses in the event of a fire, they should clear brush away from the house, make sure the house is made from fire resistant materials, install a larger sprinkler system or pool so that water will be easy to access in the event of a fire. They might also consider a replacement value policy since this would protect them against rising construction costs. Case 9-2 Actual Cash Value Versus Replacement Cost a. Furniture 750 Carpet 350 Motel 300 Total 1,400 Less: Deductible 250 Total Paid by Insurer 1,150 b. With replacement cost insurance Furniture & carpet 7,000 Motel 300 7,300 Less Deductible 250 Total Paid by Insurer 7,050

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c. The $5,900 in uninsured losses paid by the Costanzas is much greater than the additional premium for a replacement cost policy. However, they could have reduced their premium if they opted for an increased deductible or if they qualified for any discounts for safety equipment or building materials.

Case 9-3 Limits of Liability a. Carrie has $65,000 in home equity and savings and owns her car outright. If she caused an automobile accident, her assets would be at risk to cover any property or liability judgement that was not paid by the insurance. Her current liability imits of 25/50, while within the legal limits, are not likely to be sufficient if anyone is seriously injured. Furthermore, the vehicle damage limit of $15,000 is quite low, given the costs of vehicles today. At a minimum she should carry 150/300/30. b. Uninsured motorist coverage would pay for any injuries she incurred in an accident with an uninsured driver or hit and run. Since she probably has health insurance coverage and she also carries comprehensive on her vehicle, she probably doesn’t need additional uninsured motorist coverage. c. Since her car is only a few years old and is worth $10,000, she probably should carry the property damage insurance on it. Most auto accidents involve some sort of property damage and repairs can be fairly expensive relative to the value of the car. However, she should make this decision based on how expensive the coverage is. She could budget for this expense instead since she has sufficient savings to pay for the actual losses as they occur. If she does buy this coverage, she should also take a fairly large deductible.

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CHAPTER 10 ANALYZING JOBS AND EMPLOYEE BENEFITS: HEALTH, DISABILITY, AND RETIREMENT PLANS SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 338-339 in Textbook Case 10-1 Anna Trebuca Considers a Cafeteria Plan a. Individual health insurance is often less expensive than group coverage for those you are young and healthy. The problem is that the insurer can drop your coverage if you develop a health condition that makes you a bad risk. If that happened, Anna would have to wait until the next open enrollment period to add back into her employer’s plan. If Anna stays with the employer, she will remain insurable at the regular group rate, even if she becomes a greater health risk. She also benefits from being able to pay for the insurance premiums with pre-tax dollars. If she buys the individual policy, the premiums will only be deductible on her schedule A if she itemizes deductions and the health costs are more than 7.5% of AGI. b. The PPO limits choice of physicians but has the advantage of a low deductible and no copy for in-network providers. The FFS plan is less expensive by $600 per year but has a higher deductible by $100. c. The FFS cost would be (12 x $150) + $250 + (20% x 9,750) =$4,000 The PPO cost would be (12 x $200) + $150 = $2,550 In this circumstance the PPO provides the least out of pocket expense. d. A married couple should consider the combined costs of the two decisions. If Anna can keep any unused benefit dollars as cash compensation, it makes sense to buy the health insurance from the employer which offers the best coverage and price. She can buy the dental insurance and the disability insurance and take the remainder as cash compensation. e. Her premium costs would be $480 per year, but she would receive a benefit of only the $150 checkup and cleaning. For this insurance to be a good deal for Anna, she would need to have expected dental costs of at least $660 in addition to her cleaning. In that case, her insurance would pay the $150 cleaning plus 50% of the $660, or $330, and she would just break even. Case 10-2 Juan Morales Analyzes His Disability Risk and Coverage a. If Juan were to become disabled, he would need to be able to cover the family’s household expenses, currently $3,000 per month, but possibly $2,200 per month. b. His sick and paid leave will provide him with his usual take-home pay for the first three weeks (15 work days), but the short-term disability doesn’t pay until he has had 30 days of continuous disability, which is one additional week. At that point he would receive 55% of his current salary or 0.55 x 4,000 = $2,200, for 12 months. If Juan has enough savings to cover the one week of the waiting period ($3,000/4 = $750) then he will have sufficient income, assuming that he can cut down his expenses to $2,200 during the period he is receiving the short-term disability payments. If not, then he will need to have an additional $800 x 12 =

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$9,600. Since he currently earns $4,000 before taxes and expenses are $3,000, it is doubtful that the family is saving much at present. c. Disability definitions vary so it is possible that Juan might be unable to work his job, but still not qualify for disability income. The short-term policy is likely to be “own occupation” insurance, but the long-term policy might have a more restrictive definition. d. Probably not. The definition of disability for Social Security is that you must be unable to work at any job, not just unable to work at your previous occupation. A back injury normally would not preclude all types of work, although it is likely that Juan’s post-injury employment would pay less than his current employment. If Juan were disabled sufficiently to receive Social Security benefits, his other disability benefits would be offset by this amount, so it shouldn’t make a difference in his planning. Since it is less likely that he would qualify anyway, Juan should do his planning on the assumption that he would not. Case 10-3 Clare Deluna Compares Job Offers a. First compare the two jobs in terms of cost of living. The Seattle equivalent to the Denver salary is (40,000 x 1.1)/1.05 = $41,905, which is $6,095 less than the Seattle offer. The expected bonus in Seattle dollars is (5,000 x 1.1)/1.05 = $5,238, which partially offsets the salary difference but isn’t guaranteed. Clare should consider the bonus, but not assume that it will be given, since the firm could decide in the future to give more or less (or none). b. Although both firms provide 3% matching, the Brandis salary is higher, so the potential contribution amount will be 3% x $48,000 = $1,440 as compared to the Matheson 3% x $40,000 = $1,200. Clare should also take into consideration that the Matheson plan is cash contributions and the Brandis plan is employer stock, which is considerably riskier. She needs to know whether the employer stock can be sold, whether there are time limits on doing so, and how well it has performed in the past. If the Brandis stock is not publicly traded, the value to Clare is much lower. Clare will also be fairly undiversified if she has all her retirement money invested in a single company. c. Comparison Worksheet:

Salary purchasing power Bonus purchasing power Health insurance (assumes employer cost is the same) 401(k) contribution

Brandis 48,000

Matheson 41,905

Difference +6,095

5,238

-5,238

200 x 12 = 2400

240 x 12 =2,880

-480

1,440 (employer stock)

1,200 (cash)

+240

Net Difference

+617

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Brandis is a slightly better offer based on the money alone. Brandis is less attractive in that it provides the retirement benefit in employer stock, but Matheson is less attractive in that the bonus is not guaranteed. e. If Clare needed employee + 1 health coverage, the difference between the two would change since the contribution by Brandis would still be 2,400, but the value of the benefit provided to Clare by Matheson would be 12 x 420 = 5,040, for a net difference of 2400 – 5040 = 2,640. This would make the Matheson offer better by 2,160.

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CHAPTER 10 ANALYZING JOBS AND EMPLOYEE BENEFITS: HEALTH, DISABILITY, AND RETIREMENT PLANS SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 337 in Textbook 1. Deductibles and Coinsurance Total charges $20,000 Family deductible $ 1,000 $19,000 Coinsurance 20% 3,800 Total out of pocket = $1,000 + $3,800 = $4,800 2. Comparing Health Insurance Plans a. FFS HMO Annual Premium 1,200 2,400 Annual physical (200) 200 10 ($10 copay) 2 doctors visits (200) 100 20 ($5 copay) 10 prescriptions (500) 300 5 Total out of pocket 1,800 2,480 b. Annual premium 1,200 2,400 Annual physical (200) 200 (ded) 10 Skiing injury (3000) 100 (ded) 10 580 (coins.) 4 prescriptions (200) 120 40 Total out of pocket 2,200 2,460 3. Defined-Benefit Plans a. (15 years x 1.0%) + (15 x 1.5%) + (15 x 2%) = 67.5% of final salary Benefit = 67.5% x 100,000 = $67,500 per year b. 5 x 1% x 40,000 = $2,000 per year. But since you are only 60% vested (because of the 3 to 7 year vesting schedule) at that time, you are only entitled to 60% of 2,000, or $1,200 per year. 4. COBRA Coverage a. The total cost of coverage is $400 per month, or $4,800 per year. Your COBRA coverage is the best option if you are unable to qualify for inexpensive individual health insurance, either because of a health condition or otherwise. You will also want to consider how long you expect to need the coverage. You must notify your employer within 60 days of being laid off. b. 400 x (1.02) = $408/month c. An individual health insurance policy may be less expensive than the employer’s group coverage if you and your family are young and healthy. You may also have the option of being added to your spouse’s employer coverage, but there is likely to be a waiting period so you may need to use the COBRA coverage until then.

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5. Comparing Salaries in Different Areas (40,000 x 1.05)/0.85 = $49,412 This implies that Urban City pays $588 more in purchasing power than Rural Town even though the cost of living is substantially higher there. 6. Disability Income Needs a. She needs enough to cover the 25 days of potential disability before the employer’s short term disability insurance kicks in. Assuming 20 workdays per month, she will receive take-home pay of (5/20) x 2,300 = 575. Since her expenses are $2,000, she will be short by $1,425. In addition, in each month of her disability, she will receive 60% of her $3,000 salary, or 1,800, which is $200 less than her expenses. To cover a full year of disability, she will need $1,425 + (11 x 200) = 3,625 to cover her costs. b. She needs enough to cover 2,000 per month in expenses. This is 2,000/3,000 = 67% of her pretax income. She should probably opt for 70% coverage.

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CHAPTER 10 ANALYZING JOBS AND EMPLOYEE BENEFITS: HEALTH, DISABILITY, AND RETIREMENT PLANS THE LEARNING OBJECTIVES 1. Understand and value the components of a compensation package that includes employee benefits. 2. Evaluate your expected health-related expenses and incorporate health insurance funding in your financial plan. 3. Identify the types of health insurance plans and understand their features. 4. Calculate your disability income needs and select appropriate insurance. 5. Incorporate employer-sponsored retirement plans in your financial plan. 6. Compare job offers according to geographic location, salary, and benefits packages. CHAPTER OUTLINE AND SUMMARY I. Components of employee compensation A. Tangible versus intangible benefits 1. Tangible benefits: a. Wage or salary compensation b. Cash-equivalent benefits, including contributions to retirement plans, health and life insurance, paid vacation, sick leave, personal leave, and education reimbursement. c. Noncash benefits, such as the use of a company car, unpaid vacation, sick leave and personal leave, wellness programs, and access to child-car facilities or health club memberships. 2. Intangible benefits: a. Flexible working hours b. Opportunities for training and advancement c. Job location d. Working environment e. Quality and personality of coworkers B. How employee benefits vary 1. Benefits are sometimes completely paid for by the employer. Contributory plans are employee benefit plans for which the employee pays some or all of the costs. 2. Cafeteria plans are an employee benefit plan in which the employer provides a sum of money and allows employees to choose the benefits they want from a menu. 3. The reasons for differences across firms are largely due to costs. C. Why benefits are preferable to cash compensation 1. Advantages of group insurance a. Group insurance is insurance purchased on a group basis by an employer for the benefit of employees.

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b. Group underwriting in which the premium is based on the risk of the group as a whole rather than on characteristics of individual group members. c. Members of the group are also protected from the risk of policy cancellation due to changes in their individual group members. d. Offers some cost advantages. 2. Limitations of individual insurance a May not always be available to you. a. May not be renewable. c. Everyone in the group has access to the insurance regardless of his or her health status. 3. Tax advantages of Employee Benefits a. No real tax difference to the employer. b. Tax law allows you to receive certain noncash benefits without reporting the value as taxable income II. Health insurance and your financial plan A. Heath insurance needs analysis 1. Health insurance provides protection against unexpected costs due to illness, accident, or disability. 2. More than 40 million people in the U.S. have no insurance. 3. Even regular, predictable medical expenditures can rapidly deplete household resources. 4. Children will increase health care costs. 5. Medical care and health insurance has been increasing over time. B. Strategies for controlling health-care costs. 1. Invest in your own health: Stay healthy. 2. Choose an employer that offers generous health insurance benefits: The best situation is when the employer pays the full cost. 3. Budget for small expenditures: You are better off to opt for the lower-cost, higher-deductible option and pay the deductible out of pocket instead of the extra premium. a. Take advantage of beneficial tax rule: Take advantage of pretax earnings. 1) Flexible spending accounts (FSA) are accounts maintained by an employer in which the pretax earnings of an employee are set aside for qualified medical and child-care expenses. 2) Health savings accounts (HAS) are investment accounts in which an employer deposits pretax dollars allocated for payment of an employee’s health-related expenses. b. Take advantage of opt-out rules: Good idea if you can have better or cheaper coverage through your spouse’s employer. III. Types of health insurance A. Fee-for-service plans are health insurance plans that reimburse the insured for medical expenses incurred or pay the provider directly. 1. Basic health care insurance is health insurance that covers hospital, surgical, and physician expenses.

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2. Major medical insurance is insurance that covers the costs of most medical services prescribed by a doctor, subject to deductibles and coinsurance. a. Maximum limit is the lifetime maximum paid by the insurer to an insured person. b. Annual deductibles c. Coinsurance is an arrangement providing for the sharing of medical costs by the insured and the insurer. d. Stop-loss limit is the maximum out-of-pocket cost to be paid by an insured in a given year, after which the insurer pays 100% of covered charges. e. Copay is the dollar amount of medical cost paid by the insured under a coinsurance provision after meeting the annual deductible. B. Managed-care plans are health insurance plans that attempts to reduce costs through contractual arrangements with providers and financial incentives for lowcost alternatives. 1. Health maintenance organizations (HMO) are managed-care plans that attempt to control health care costs by encouraging preventive care and limiting participants to providers with whom the plan has contracted. 2. Preferred provider organizations (PPO) are managed-care plans that provide participants with financial incentives to use certain providers. 3. Point of service plan (POS) are health-car plans in which participating providers are affiliated with an HMO, but participants can still use nonparticipating providers if they are willing to pay a bigger share of the cost. 4. Exclusive provider organization (EPO) is a health-car plan that only covers medical costs from participating providers. C. Consumer choice plans are health plans that include financial incentives for preventive care and cost reduction. 1. Attempt to make you more sensitive to the cost of medial care and wiser in deciding what care to receive. D. Government-sponsored plans 1. Workers’ compensation insurance is state-run program requiring employers to pay lost wages and medical costs associated with job-related illness or injury. 2. Medicare is a federal health insurance program for people age 65 and over. a. Social security is much more than just a public retirement plan. b. Part A is mandatory hospital insurance, prescription drugs, and posthospitalization extended-care services up to 100 days. c. Part B is supplemental medical insurance for which you pay a monthly premium. 3. Medicaid is a state-run program providing health-care coverage for the poor. a. Medigap policies are insurance policies designed to pay deductibles and other costs that are not covered by Medicare. b. Currently in financial difficulty. E. Special circumstances 1. Continuation coverage under COBRA

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a. The consolidated Omnibus Reconciliation Act of 1986 is a federal law that applies to all employers with 20 employees or more. b. If you lose or quit your job, you are eligible to purchase coverage through your previous employers’ plan for a period of 18 months. 2. Health insurance continuation should be a factor in divorce settlements. 3. Students must look into options when they lose their dependent status. 4. A preexisting condition is an illness or injury that significantly increases your expected claims costs under an insurance policy and that began before you were covered under that policy. a. The Health Insurance Portability and Accountability Act of 1996 (HIPPA) provides that you can’t be subject to a preexisting condition waiting period when you move from one plan to another. F. Additional Types of Insurance 1. Dental Expense Insurance 2. Vision Care Insurance IV. Planning for disability income needs A. What is disability? 1. A disability is an illness or injury that prevents you from earning your regular income or reduces how much you can earn. B. Disability income needs analysis 1. If you were disabled tomorrow and were unable to earn your regular income, how much money would you need to meet your basic needs? C. Sources of disability income 1. Disability income insurance is insurance that replaces the policyholder’s lost income during a period of disability. 2. Government-sponsored disability income protection a. Most states require that some type of workers’ compensation insurance be carried on all employees. b. If your injuries are serious enough, you may be eligible for Social Security disability insurance. 3. Employer-sponsored disability income protection a. Employers may provide disability income protection in several ways: 1) Personal days 2) Paid vacation time 3) Sick leave 4) Group short- and long-term disability income insurance. b. Short-term disability insurance pays a portion of your predisability earnings after you’ve exhausted your sick days and you’ve been unable to work for a specified waiting period. c. Long-term disability income insurance specifies the definition of disability that qualifies you for income replacement, the waiting period before you’re eligible to receive benefits, the percentage of predisability income replacement, and the length of time benefits will be paid. 4. Individual disability insurance a. You can purchase coverage in the individual market

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b. The best types are those that replace lost income if you’re unable to perform the duties of your particular job. c. Key features to look for: 1) Waiting period 2) Benefit duration 3) Income replacement 4) Renewability V. Employee-sponsored retirement plans A. Employee Retirement Income Security Act (ERISA) in 1974 B. Tax advantages of qualified plans 1. Tax-qualified retirement plans are retirement plans that qualify under federal law for tax deferral; taxes on contributions made to the plan and earnings on plan assets are not due and payable until withdrawal at retirement. a. Entitles you to tax benefits: 1) Contributions are tax-deductible by your employer in the year in which contributions are made. 2) Your own contributions to the plan are made on a pretax basis and are not subject to taxation. 3) Taxes on your contributions to the plan, benefit accruals, and any income or capital gains you earn are deferred until withdrawal. C. Defined-benefit versus defined-contribution plans 1. Defined-benefit (DB) plans are retirement plans in which the employer promises employees a retirement benefit determined by a formula, commonly based on pre-retirement earnings and years of service. 2. Defined-contribution (DC) plans are retirement plans in which the employer promises to make regular contributions to employees’ retirement accounts but does not guarantee the benefits that will result. 3. Cash balance plans are defined-benefit retirement plans that include an investment component similar to a defined-contribution plan. D. Important features of defined-benefit plans 1. Benefit formula likely based on salary and service. 2. Vesting rules are rules that define employees’ rights to accrued retirement plan contributions and benefits. a. Under ERISA, employer must have vesting rules that are at least as favorable as: 1) 5 year cliff vesting 2) 3 through sever year graded vesting 3. Portability is an employee’s right to take retirement plan assets from one place of employment to another when the employee changes jobs. 4. Nominal retirement age: a. Minimum age of 59 ½ 5. Guaranteed benefits: a. The Pension Benefits Guarantee Corporation (PBGC) guarantees pension benefits. 6. Disability, survivors, and retirees health insurance E. Features of defined-contribution plans

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1. Types of DC plans: a. Money-purchase plan is a retirement plan to which the employer contributes a set percentage of the employee’s salary. b. Profit-sharing plan is a retirement plan in which employer contributions are discretionary. c. Cash-or-deferred arrangement (CODA) is a retirement plan in which employees can contribute some of their salary to the plan on a tax-deferred basis. d. Employee stock ownership plans (ESOPs) are profit-sharing plans that make contributions to employee accounts in the form of employer stock. 2. DC plans are designed to allow participants to specify how they want their account balances invested. 3. Limits on employee and employer contributions a. Maximum tax-deductible employer contribution of 25% of compensation, with a maximum of $40,000. b. Your own contribution is limited to $14,000. 4. Plans for small business a. A simplified Employee Pension Plan (SEP) is a type of plan that has a simplified administrative rules and doesn’t lock the employer into a particular contribution level. b. Savings Incentive Match Plans for Employees of Small Employers (SIMPLEs) are for small employers that don’t offer another qualified plan. VI. Comparing compensation packages A. Comparing salary offers 1. It is more expensive to live on the East or West Coasts than in the middle of the country. 2. It is more expensive to live in urban areas. 3. Equivalent high-cost salary = (Index of high cost area x Salary)/(Index of lowcost area) B. Comparing benefit packages 1. Consider only the benefits that are valuable to you at your current stage in the life cycle. 2. Use marginal analysis by focusing on the differences between job offers rather than trying to value all the benefits. C. Developing a comparison worksheet 1. Summarize the differences between your offers. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.aarp.org/hcchoices: Read what the American Association of Retired Persons has to say about the Health Insurance Portability and Accountability Act (HIPAA). 2. www.hiaa.org: The Health Insurance Association of America represents health insurers in the United States. Go to the consumer section and read what they recommend for disability insurance. Based on what you find out, write a short report describing how you plan to prepare for potential disability costs in the future.

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3. www.claims.org: This website is sponsored by the Alliance of Claims Assistance Professionals. When a family is dealing with a serious illness, they sometimes become overwhelmed with medical bills and insurance claims at a time when they are emotionally and financially incapable of handling them. Investigate how and why you might want to hire a claims assistant and write a short report about what you find. 4. www.statehealthfacts.org: Compare the Medicaid coverage offered in your state to that of other states. ADDITIONAL MINI-CASES 1. Case 1 – Brianna Farr Develops an Employee Health Plan Brianna Farr is a small business owner and she wants to provide her employees with access to group health insurance. She has discovered that the cost of health insurance is very high and it is increasing at a faster rate than wages. As a small business, Brianna knows that she will have to required her employees to pay a large share of their own insurance premiums. In deciding between different plan alternatives, one of Brianna’s criteria is that the plan design include features that will help to keep future costs down. a. Explain how preventive care features can be included to reduce future costs. Can Brianna do anything to encourage her employees to have a healthier life style? b. What level of deductible would you recommend Brianna incorporate in her plan and why? c. Why might it be a good idea for Brianna to allow employees to have flexible spending accounts? How would they work? Would a Health Savings Account be preferable? Why or why not? 2. Case 2 – Jenna Hallahan Considers Alternatives to an Employer Health Plan Jenna works for an employer who offers employees the option to purchase health insurance through a group plan. The insurance is very comprehensive, has only a $250 annual deductible, and is very expensive ($300 per month). Jenna is 20 years old and in good health. She has investigated some other alternatives for individual health insurance and has found a plan that will cost only $150 per month. The annual deductible is $500. a. Discuss the advantages and disadvantages of purchasing group insurance versus individual insurance. What risks is Jenna exposed to if she opts for the individual insurance? b. Assuming that Jenna could afford to pay the higher monthly premium for the group coverage, what is the opportunity cost of doing so? What would you recommend she do with the extra funds if she opts for the cheaper insurance? c. Discus the pros and cons of taking a higher deductible. If the employer offered a second plan with a $500 deductible, how much less would the monthly premium have to be to make it a better deal? Does it matter how much Jenna expects her annual health care expenditures to be? 3. Case 3 – Quinn Considers His Retirement Plan Options

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Quinn is 55 years old and has worked for the same employer for his entire 30 year career. He has a defined benefit retirement plan that pays 2% of final salary for every year of service. His current salary is $70,000 and he expects it to increase at a rate of 3% per year if he continues working. He is trying to decide whether to retire early or wait until he can qualify for Medicare at age 65. His employer currently provides health insurance, but if he were to retire, he would have to pay the premium himself. a. What would his retirement benefit be if he retires now? b. What would his retirement benefit be if he retires in ten years? c. If he expects to live to age 80, what is the present value of the future benefits to be received under each scenario? (Note that, for simplicity, you should assume benefits are the same over time, when in fact there will usually be cost of living adjustments each year.) d. Explain why it’s important for Quinn to consider retiree health insurance in making this decision.

TEACHING SUGGESTIONS 1. Begin the class by asking students to identify all the components of compensation, including intangible benefits that make a difference to your overall job satisfaction. Since most will initially focus on the easily quantifiable components of compensation, this will start them thinking about how they might take the other elements into consideration. 2. The placement of this chapter immediately following the property and liability insurance material makes it possible for you to make the connection to the topics previously covered. Ask the students to think about how risk aversion, identification of risk exposures, and various risk management methods can be applied to their health and disability risk decisions. 3. Ask students to pretend that they are starting up a small business that will have some employees. What benefits would they want to be able to offer to their employees? Would they be contributory or noncontributory? Why? How will this decision affect company profitability? Why would they offer any benefits at all? 4. Discuss the rising costs of health insurance. Why are these costs increasing at a faster rate than inflation? 5. Have the students break into small groups to brainstorm ways to reduce the costs of health care from the point of view of different constituents: individuals, employers, health care providers, insurance companies, government. Have the groups report back to the class. 6. Poll the class to find out what kinds of health insurance they have. Ask them if they are satisfied with their insurance coverage. 7. Invite a human resource manager from a local firm, ideally one that hires a lot of students from your school, to come to your class and explain the benefits package offered by the firm. 8. Have students contact their family dentist to ask about the advisability of purchasing dental insurance. Is the coverage comprehensive? Which type of dental insurance is

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best? What is the average annual cost of dental care for a person your age? (Note that those areas with fluoridated water often have very low incidence of tooth decay, so this cost is limited to the annual cleaning and checkup.) 9. Ask students whether they would prefer to have a defined benefit or a defined contribution retirement plan and why. Provide a numerical example that illustrates the difference in outcomes. For example, consider a hypothetical 22 year old who works to age 67 (45 years), beginning at $40,000 salary and averaging a 3% salary increase per year (so salary is $151,264 at retirement). A DB plan might provide 70% of final average salary, or $105,885. If that same person’s employer contributed 3% of salary for his entire working career (the average employer contribution), the account would have $1,184,724 in it at retirement if the account averaged a fairly optimistic 10% return on investment. That would buy a 20 year annuity of about $95,000 (assuming 5%). You can use this to note that the DB benefit probably will have COLAs. 10. Have the students interview graduating seniors about their job offers. What benefits were offered? How well was the benefit package explained? How difficult was it to decide between competing job offers?

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CHAPTER 11 FUNDAMENTAL CONCEPTS IN INVESTING THE LEARNING OBJECTIVES 1. Develop realistic investment goals that are consistent with your financial plan, risk tolerance, and life stage. 2. Identify your investment alternatives. 3. Understand the risk-return tradeoff. 4. Recognize the importance of asset allocation and diversification of your portfolio. 5. Decide whether you will be an active or passive investor and what your primary investing strategy will be. 6. Invest successfully by incorporating taxes in your investment decisions and using available information resources. CHAPTER OUTLINE AND SUMMARY I. Developing realistic investment goals A. First things first: Establishing a firm foundation 1. Set specific goals that are realistic and within your control. 2. Before you begin to develop an investment plan, you should make sure that you have a secure foundation to build on. 3. Questions you must answer “yes” to before you start investing: a. Have I established my financial goals? b. Am I living within my budget and meeting my basic needs? c. Have I reduced my outstanding high-interest credit? d. Do I have an emergency fund in cash or liquid savings accounts? e. Do I have adequate insurance coverage? f. Have I bought a home or established a plan for doing so? B. Investing to meet your prioritized goals 1. Prioritize in order to know which ones you’ll focus on first. 2. The amount to invest depends on expected return on investment. 3. Must also consider risk relative to your preferences and time horizon. C. Estimating your target and investment contribution D. Getting the money to invest. Strategies include: 1. Pay yourself first. 2. Save your raise: 3. Set aside bonuses, tax refunds, and other lump sums 4. Continue a payment plan: Shift the dollars that went to the car or student loan over to your investment plan. 5. Participate in an employer-sponsored retirement plan. 6. Stop up a cash leak 7. Go on a financial diet once or twice a year 8. Take a second job. II. Understanding your investment alternatives A. Investing by lending and by owning

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1. A debt investor is an investor who lends money to an individual, a government entity, a financial institution, or other business. 2. An equity investor is an investor who has an ownership interest in a business. 3. The return on your investment will come from: a. Regular cash flows b. Capital gain is the growth in the value of an investment over time. 4. Advantage of Lending a. Fixed-income investments are debt investments that provide a fixed interest payment to the investor over the term of the investment. b. Certainty of payment 5. Disadvantages of Lending a. Risk that the borrower might default b. You have no right to any of the additional profits. 6. Advantages of Owning a. You can share in the profits of a business b. No obligation to manage. 7. Disadvantages of Owning a. Cash flows are much less certain b. Company is not obligated to make payment to its owners. B. The major asset classes 1. Asset classes are broad groups of investments that have certain characteristics in common. 2. Securities are investments in which the investor contributes a sum of money to a common enterprise with the intention of making a profit though the effort of others. 3. Common stock is investment security that represents a proportionate ownership interest in a corporation. a. Dividends are periodic distributions of profits to equity investors. 4. Bonds are investments representing a loan to a government or business entity, which usually pays a fixed rate of interest for a fixed period of time. 5. Preferred stock is a type of stock that pays a fixed dividend. 6. Mutual funds are a collection of investments, managed by a professional investment firm, in which investors can buy shares. 7. Real estate offers investor the opportunity to receive cash flows from net rental income and capital gains from the growth in the property’s value. 8. Derivative securities are investments that derive their value from some underlying security’s changes in price over time. a. Speculative investments are high-risk investments made in the hope of making a short-term profit. b. Commodities are contracts to buy or sell raw materials or agricultural products in the future. c. Futures contracts are contracts to buy or sell financial securities in the future. d. An option is a contract that gives the holder the right, but not the obligation, to purchase or sell a specified investment at a set price on or before a specified date.

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9. Indexed securities are investments whose cash flows mimic the returns and risk of a broad class of securities. III. The risk-return tradeoff A. Riskier investments provide you with higher average rates of return over time. B. Two kinds of risk: 1. The risk that you won’t receive expected cash flows from the investment. 2. The risk that the value of your investment will decline over time. C. Evaluating your risk tolerance 1. Risk aversion is a tendency to dislike risk and to be unwilling to invest in risky securities unless they earn higher investment returns. 2. Most people are risk-adverse to some extent, but are willing to take on a little risk to get a little bit more benefit. D. Factors affecting risk tolerance 1. Life cycle effects: 2. Demographic differences: a. Wealthier people are more willing to take risk. b. Families with children tend to be less willing to take financial risk. 3. Education and Experience 4. Consumer confidence. E. Measuring risk and return for individual securities 1. The real risk-free rate is the minimum return required for you to invest. 2. Rate of return is the total income earned on an investment over a period of time, including interest or dividends and capital gains, divided by the original amount invested. a. = Current yield + Capital gain yield b. = (Current income + End price – Beginning price) / (Beginning price) 3. Risk premiums: investors will require a certain amount of return for each type of risk to which they’re exposed. a. Inflation risk is the risk that inflation will erode the purchasing power of investment returns. b. Nominal risk-free rate is the expected return on a short-term risk-free investment such as a Treasury bill, equal to the real risk-free rate plus an inflation risk premium. c. Interest-rate risk is the risk of price changes due to changes in interest rates. d. Reinvestment risk is the risk that short-term investments will have to be reinvested at lower rates when they come due. e. Default risk is the risk of not receiving promised cash flows from an investment. f. Liquidity risk is the risk of not being able to convert an asset to cash without losing value. g. Market risk is investment risk associated with general market movements and economic conditions. IV. Diversification and asset allocation A. How diversification works

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1. Diversification is an investment strategy that involves spreading money across a range of investments in order to reduce the overall risk of the portfolio. 2. As you increase the number of investments in your portfolio, the variability of the returns your portfolio will decline. B. The importance of asset allocation 1. Asset allocation is the process of deciding what proportion of a portfolio to invest in each asset class. a. A method by which you achieve diversification. b. Your allocation of funds between broad asset classes should change over your life cycle to be consistent with your investment objectives. V. Establishing your investment strategy A. Active versus passive investing 1. Active investors actively buy and sell, attempting to make short-run gains. a. Portfolios actively managed by professional money managers achieve lower annual returns, on average, than the market as a whole. b. You may be better off to buy shares of indexed securities. 2. Passive investors invest to make long-run returns and don’t actively engage in buying or selling. 3. Market efficiency is a theory that suggests prices immediately adjust to reflect all publicly available information. a. Related to how quickly prices react to news. b. The increasing efficiency of the market makes it riskier than ever to be an active investor. B. Passive investing strategies 1. Buy-and-hold is a strategy in which the investor identifies his or her target asset allocation and then selects appropriate securities to hold for the long run. 2. Dollar cost averaging is a strategy in which you invest in equal dollar amounts at equal intervals regardless of fluctuations in price. 3. Direct investment program is a program offered by a publicly traded company to allow investors to automatically purchase shares of the company’s stock on a regular basis without incurring a brokerage fee. 4. Dividend reinvestment plan (DRIP) is a program that allows investors to receive dividends in the form of additional shares of stock instead of cash. 5. Timing is an investment strategy in which you attempt to shift your asset allocation to capture upturns and avoid downturns in specific markets. VI. Key strategies for investment success A. Take advantage of favorable tax rules 1. Current income from investments held in taxable accounts may be taxable as ordinary income. 2. Tax on capital gains depends in part on how long you hold the investment before selling it. 3. The increase in an asset’s value isn’t taxed until the asset is sold. 4. A tax-deferred investment allows you to delay paying taxes on both income and capital gains until the money is withdrawn for a specific allowed purpose. 5. A tax-exempt investment’s returns are not subject to certain taxes at all.

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B. Take advantage of investment information resources, including company annual reports, Internet resources, business and financial periodicals, brokers and financial advisors, investment clubs C. Follow some simple rules 1. Start early. 2. Keep good records 3. Do your homework 4. Stick to the plan over the long term. ADDITIONAL WEBSITE ASSIGNMENTS 1. finance.yahoo.com: On the main finance page, read the top news stories. Select one and write a short summary of what information is reported and why it is important to investors. 2. www.winninginvesting.com: The Internet has so many different sources for investment information that individuals can find it difficult to separate the good from the bad. This portal, “An Opinionated Guide to the Web’s Best Investing Sites,” provides links to other pre-screened investing sites. Follow several of the links and write a short summary of your top choices. 3. www.fool.com: Find out why Motley Fool recommends that you practice a “buy and hold” investment strategy. 4. www.zacks.com: Check out the Zack’s Investment Research site, walk through the tutorial “Investing 101” and use the glossary of financial terms to look up a term you don’t know. Would you recommend this site to other novice investors. Is the primary purpose of the site to sell you something? Why does that matter? ADDITIONAL MINI-CASES 1. Case – Melody Considers a Life Cycle Approach to Investing Melody is 25 years old and she doesn’t know a lot about investing. Her financial advisor has suggested that she consider a life cycle approach to managing her investments. a. What does he mean by that? b. In a life cycle approach to investing, what allocation strategy would you expect him to recommend to Melody? Do you think this is a good idea? c. What are the tradeoffs that Melody should consider? d. How would you expect her allocation to change as she gets older? 2. Case 2 – Eric Summers Gives Up on Being an Active Investor Eric Summers is 50 years old and recently inherited $600,000 when his mother passed away. At first, he thought that it would be fun to try investing the money on his own so he invested a lot of time and energy into becoming a more informed investor. In addition to reading as much as he could about the subject, he became and avid listener of a talkradio show on investing, hosted by Jonathan Sherman. After several months of lackluster performance, he began to realize that being an active investor was harder than he thought, so he began to consider some other options. Because he thought the Jonathan Sherman

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was so knowledgeable about stock investing, he searched on the Internet and discovered that Jonathan, along with several other investment managers in his firm, managed funds for other people. He contacted Jonathan and found that he was very interested in managing the estate for him. a. What are some possible reasons that Eric didn’t achieve the investment success that he had hoped for. b. What elements of being an active investor do you think are the most difficult? c. Is Eric’s approach to solving his problem a reasonable one? If not, what would you have done differently? d. What questions should Eric ask Jonathan Sherman and what kinds of information should Sherman provide to Eric before they enter into an agreement? 3. Case 3 – Should Nancy Ammons Use Her Home Equity to Start Investing? Nancy Ammons owns a home that has appreciated substantially in value since she bought it. She estimates that she could get a 4% interest-only home equity loan in the amount of $50,000. Since she has heard that stocks average about 12% per year, she figures she can borrow the money, invest it in stocks, pay the interest, and bank the rest. It seems like a no-lose idea to her. a. Before undertaking an investment program, what should Nancy do? b. Is borrowing the money to invest in stocks a good idea? Why or why not? c. If Nancy puts her money in stocks, what risks does she expose herself to? d. If Nancy put her money in bonds instead, what risks does she expose herself to? TEACHING SUGGESTIONS 1. Take a poll of the class to see how they answer the risk aversion question from the Survey of Consumer Finances (in the Money Psychology box on p. 356). Discuss how they think their parents and grandparents would answer the same question. Do they think their own answers will change over time. You can also use this question to see if there are observable gender differences in your class. 2. Have the students decide whether they are “bullish” or “bearish” about the prospects for the stock market over the next 12 months. Ask them to write a short explanation of their reasoning. 3. Discuss the long-term investment results from investing $1 in 1933 in either T-Bills or the S&P500 and leaving it there until 2004, as reported in The News You Can Use Box on p. 361. If you could always perfectly predict which of these two asset classes would outperform the other in a given year and move all your money to that asset class at the beginning of the year, your portfolio at the end of 70 years would be 20 times greater in value than if you left it in stocks the whole time. You can use this story to illustrate several important facts: 1) information is very valuable; 2) noone is very good at timing the market; 3) just missing a few of the bad years or a few of the good years can also make a big difference. 4. Play your own version of “Who Wants to Be a Millionaire?” Have the students calculate how much they would need to invest each year to have $1 million accumulated by the time they are age 67. For example, if your students are, on

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average, 19 years old, they will invest for 48 years. Make a chart on the board that shows how much a typical student will need to invest if they can earn 4%; 6%, 8%, or 10% annually on their investments. (Answers: 4%: 7,181; 6%: $3,897; 8%: $2,040; 10%: $1,041). Answers will differ depending on the age of the students. Select one of these goals (e.g. $2,040) and have the students brainstorm on ways that they can get that much money each year to invest. Some ideas are given on p. 350-351. You can also use this example to discuss the reasonableness of the investment return assumption. 5. Use the previous example to illustrate how important it is to start early on an investment program. Have the students recalculate the amount they need to save annually if they wait until they are ten years older to begin investing. Ask them why the required saving amount is so much greater, given that they still have most of their lives ahead of them. 6. Ask students why they think it’s important to have investment goals. What are some of the possible problems that can result if an investor doesn’t have a particular goal in mind? 7. Discuss how the Internet has changed the investment process. 8. Tell the class about Warren Buffet and the incredible success he has had in choosing investments for his company’s portfolio (Berkshire Hathaway). Buffet has been quoted as saying that investors should be greedy when others are fearful and they should be fearful when others are greedy. Ask the class to explain what he means by this and to evaluate whether they think it is good advice. 9. Discuss the proliferation of self-help gurus who sell books, seminars, and television shows based on their “secrets” to successful investing. To illustrate the problems with listening to these folks, it might be helpful to explain what happened to the Beardstown ladies: A small investment club of retired ladies sold millions of copies of their books (The Beardstown Ladies Guide to Investing) on how their common sense approach to investing caused their portfolio to beat the market even though none of them really knew much about investing. The books have since all been recalled by their publisher since it was discovered that they had counted their monthly additional contributions to the fund as part of their return on investment. After calculating the returns correctly, it turned out that their portfolio had not beaten the market, but of course they already had made millions on their books.

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CHAPTER 11 FUNDAMENTAL CONCEPTS IN INVESTING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 374-375 in Textbook Case 11-1 Income Versus Growth a. No, they have not completed the foundation components of her financial plan. Before investing, they need to develop a budget, pay off their credit, establish an adequate emergency fund, and purchase adequate property and liability insurance. Their $4,000 emergency fund is only enough to meet their expenses for a little more than a month, so that part of their plan still needs some work. They also have outstanding credit balances that need to be taken care of. b. One they have established adequate liquidity, they need to diversify their investments into stocks and debt securities. There is no guarantee that stocks will give them the greatest return, so a more balanced strategy would be preferable. They have a long investment horizon for retirement, but will need access to college funds sooner. c. They should increase their contributions to their employer retirement plans. This would reduce taxable income and taxes. Although they currently spend all of their after-tax earnings, they could use some of the $35,000 to offset the drop in pay, or they could revise their budget to find the extra money to invest. d. Jeff is correct that the debt reduction goal should precede the investment goal. The interest paid is not tax deductible and they are unlikely to earn 18% return on their investments after taxes, so they will have a net gain in after-tax income by paying off the credit card debt. Case 11-2 Benefits of Diversification a. Stock fund: Average return = 7.6% Bond fund: Average return = 6.2% 50/50: Average return = 6.9% The stock fund was the riskiest since it had the largest variation in annual returns over the five years. b. Year Winken Blinken Nod 1 10,000 x 1.05 10,000x1.08 5,000 x 1.05 + 5,000 x 1.08 2 10,500 x .92 10,800 x 1.1 5,325 x .92 + 5,325 x 1.1 3 9,660 x 1.18 11,880 x 1.02 5,378 x 1.18 + 5,378 x 1.02 4 11,399 x .98 12,118 x 1.07 5,916 x .98 + 5,916 x 1.07 5 11,171 x 1.25 12,964 x 1.04 6,064 x 1.25 + 6,064 x 1.04 End Amount 13,964 13,483 13,887 Diversifying provided Nod with the advantage that her portfolio never declined in value during the entire period, but she still ended up with almost as much ending wealth as the all-stock portfolio.

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Case 11-3 Life Cycle Differences a. Great-Grandma Anna is probably typical of someone in their 90s who has lived through the Great Depression. The large number of bank failures during that period in history made people distrustful of financial institutions. At this stage in her life, she needs liquidity with no risk of loss since she has little time to make up any losses. Grandpa seems to be a bit of a risk-taker relative to his age. At age 70, most people are reducing their allocation to stocks, but an offsetting factor is that his mother has lived to be 96, which could imply greater-than-average longevity in the family. His success at doubling the inheritance has perhaps made him more optimistic about stock investing than he should be. The adult children seem to have too little invested in stocks, given their time horizon. This is possibly due to their individual cash flow situations and the number of children who are currently in college. Kristopher’s attitudes are consistent with his life cycle stage. He doesn’t have any money, but he understands that it’s a good idea to go for growth when you’re young. He has plenty of time to make up any shortterm losses. b. Great-Grandma didn’t avoid inflation risk. Although inflation has been relatively low over the last decade, she may have had money in her freezer during the early 1980s when it would have lost about 10 percent per year in purchasing power. In addition, she didn’t earn the real risk free rate on her funds, as she could have in an insured savings account. c. Grandpa Herring is right, but the allocation shouldn’t be the same for everyone. The fact that he has a government pension is an important factor in his household investment allocation. It reduces his need for liquidity and ensures that he will have a lifetime income, so he doesn’t need to worry about outliving his assets. d. Kristopher’s long time horizon for investing makes it possible for him to take more investment risk. However, he hasn’t yet experienced any investment losses, so it may be difficult for him to stick with his plan if he has some early losses. He has probably also been influenced by his grandfather’s investment success so he may have unrealistic expectations of doubling his investment in a short period of time. He should take a more diversified approach to investing than 100% stocks.

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CHAPTER 11 FUNDAMENTAL CONCEPTS IN INVESTING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 373 in Textbook 1. Rate of Return a. Pretax rate of return = (1 + 32 – 30)/30 = 10.0% b. Capital gains tax rate will be 15%. After tax rate of return = 10% x (1-0.15) = 8.5% 2. Rate of Return a. Pretax rate of return = (90 + 1,000 – 1,000)/1,000 = 9.0% b. Interest is taxable at the ordinary income tax rate. After tax rate of return = 9% x (1-0.25) = 6.75% 3. Saving for a Goal N=48; I=5/12; FV=6,000; Compute PMT = 88.23 per month 4. Investment Growth N=72; I=4/12; PMT = 150; Compute FV=12,183.38 5. Investment Growth a. N=20; I=5 x (1-0.25)= 3.75; PV = 100,000; Compute FV = 208,815 b. N=20; I=10; PV=100,000; Compute FV =672,750. Unless this is in a Roth IRA, she will have to pay tax on this amount when she withdraws the money at retirement. 6. Capital Gains Tax Stock A Gain = (10 – 5) x 100 = 500 Stock B Gain = (23 – 25) x 50 = -100 Net Capital Gain = 400 Taxes = 400 x 15% = $60 7. Components of Risk Nominal Risk Free 3.0% + Interest Rate Risk Premium 2.0% + Default Risk Premium 1.5% + Liquidity Risk Premium 1.0% =Yield on Debt Security 7.5% 8. Asset Allocation a. She should not invest the entire $50,000. She should first pay off the $5,000 credit card debt which has a high interest rate. She should consider paying off the $3,500 car loan since its interest rate is higher than what she can earn on a lowrisk investment. She needs to increase her emergency fund to at least 6 months since she is at risk of being laid off.

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b. Probably not since her funds available for investing will be substantially less than $50,000 and her investment flexibility is quite limited due to her lack of liquidity and her risky job situation. c. Since her current circumstances make it inadvisable to risk losing any money, she probably shouldn’t invest any in stocks at this time. If she makes it through the next two years without getting laid off, it might be a good idea for her to use the money toward the purchase of a home. Not only would she be able to build home equity, but she would have some tax advantages as well. Until she has developed a more detailed financial plan, she should put her money in short term debt securities.

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CHAPTER 12 INVESTING IN STOCKS SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Page 414 in Textbook Case 12-1 Jeff Goldberg Considers Stock Investing a. After tax = 5% x (1 - 0.15) = 4.25% PMT = 3,000; I = 4.25; N=5; Compute FV = $16,330 b. After-tax = 10% x (1 – 0.15) = 8.5% PMT = 3,000; I = 8.5; N=5; Compute FV = $17,776 c. His investment horizon is relatively short which doesn’t allow him much time to recover from a stock market decline. The difference in outcomes isn’t large enough (17,776 – 16,330 = 1,446) to take the risk. d. If he decides to invest in stocks, he should pick lower-risk stocks that don’t expose him to as much downside risk. He might consider dividend-paying stocks and those with lower betas. He may not be able to diversify sufficiently since $3,000 per year doesn’t allow him to by very many shares and he will have to pay commissions on each transaction. Another alternative that will be covered in the following chapter is to purchase indexed stock mutual funds or exchange traded funds to achieve greater diversification at lower transaction cost. Case 12-2 The Morinis Evaluate Their Stock Portfolio Performance a. Use PFP Worksheet 46. b. Stock A: (100 x 26) + 25 = $2,625 Stock B: (100 x 35) + 25 = $3,525 Stock C: (100 x 40) + 25 = $4,025 Stock D: (100 x 15) + 25 = $1,525 Total Invested =$11,700 c. (100 x 29.00) + (100 x 33) + (100 x 41) + (100 x 18) = $12,100 d. Dividend Yield Capital Gains Yield Stock A 0.16/26 = 0.6% (29-26)/26 = 11.5% Stock B 0.60/35 = 1.7% (33-35)/35 = -5.7% Stock C 0.50/40 = 1.25% (41-40)/40 = 2.5% Stock D 0 (18-15)/15 = 20% e. Dividends received = (100 x 0.16) + (100 x 0.6) + (100 x 0.50) = $126.00 Portfolio Annual Return = (126 + 12,100 – 11.700)/11,700 = 4.5% f. Since they are holding large-cap stocks, they should compare their performance to the S&P500. This index reflects a more diversified view of the overall market for large stocks. By this measure, the Morinis portfolio did poorly relative to the index. The 4.5% return was much lower than the 12% market return. g. Stocks B and C did much worse than the market. The Morinis should consider their sector and industry diversification. They have only four stocks in their portfolio, which isn’t enough to diversify the risk of poor performers. They might also consider purchasing stock mutual funds or indexed securities to get better diversification.

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CHAPTER 12 INVESTING IN STOCKS SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 412-413 in Textbook 1. Risk and Return a. Stock L: Large-cap Stock M: Mid-cap Stock S: Small-cap b. Stock L: Income Stock M: Growth and Income Stock S: Growth c. Stock S is best for aggressive investors since it will have the greatest risk and growth potential and will not provide investors with any income to offset short – term losses. d. Stock L is best for conservative investors since it will have less variability over time and its dividend will provide a stable income. e. If you have a 5 year time horizon, stocks are all a bit risky since they could experience short-term declines in value. Of these three, Stock L will expose you to the least risk of loss of principal. You definitely wouldn’t want to invest in Stock S since it currently has negative income and its has already experienced large price appreciation. 2. Classify Stocks a. KMart: Value; Mid-cap; Services; Retail (Department & Discount) b. Intel: Growth, Large-cap; Technology; Semiconductors c. General Motors: Value; Large-cap; Consumer Cyclical; Auto & Truck Manufacturing d. Level 3 Communications: Growth; Mid-cap; Services; Communications. 3. Stock Split a. 3:1 x 150 = 450 shares b. 90/3 = $30 per share c. You would expect the share price after the split to be slightly higher than $30 on the expectation of future good performance. 4. Margin a. $3000/50 = 60 shares. $5 profit per share Percent return = (60 x 5)/3,000 = 10% b. Margin allow you to earn the $5 per share with an investment of only 55% of the original $3,000 cost. 55% x 3,000 = $1,650. Percent return = (60 x 5)/1,650 = 18.2% The net return on investment in this scenario will be lower by the amount of interest paid on the margin loan. 5. Types of Orders a. Total cost = (100 x 25.50) + 20 = $2,570, or $25,70 per share.

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b. Total cost = (100 x 25.50) + 20 = $2,570, or $25.70 per share. c. This order would not be executed since the market price has risen above your maximum. If the market price later fell to $25.25 within the time period of the order, the total cost would be (100 x 25.25) + 20 = $2,545, or 25.45 per share. 6. Ratios a. EPS = 2,000,000/1,000,000 = $2 per share b. P/E = $30.00/$2.00 = 1.5 times c. Dividend yield = $1.00/$27.00 = 3.7%. Note that investors who buy the stock today will expect a dividend yield of $1.00/$30.00 =- 3.3%, if dividends don’t rise this year. d. Total return = ($1 + $30 - $27)/$27 = 14.8% 7. Market Risk a. Vixen Inc. has the most market risk since its beta (2.5) is the highest. The lowest beta stock (0.5) is Luke Enterprises. b. Vixen Inc would be expected to experience an increase of roughly 2.5 x 10 = 25%. c. Luke’s expected change in value would be about half of the market’s loss, or -5%. d. The portfolio beta is the weighted average of the betas of the individual stocks = 1.25 8. Dividends a. 400 x 0.90 = $360.00 this quarter. b. If you are in the 15% bracket for federal income taxes, your dividends will be taxes at the capital gains tax rate of 5%. c. $3.60/$65.00 = 5.5% 9. Locking in Profits a. Her cost to buy the shares was (100 x 20) + 35 = 2,035. Because of her limit order, her stock would have been sold at $26.00, generating (100 x 26) – 35 = $2,565 to Ariel. Her return on investment was (2,565 – 2,035)/2,035 = 26% b. If she had placed a market order instead, she might have had it executed at $25.50, in which case she would have gotten (100 x 25.50) – 35 = $2,515. Her return on investment would have then been (2,515 – 2,035)/2,035 = 23.6%

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CHAPTER 12 INVESTING IN STOCKS THE LEARNING OBJECTIVES 1. 2. 3. 4. 5. 6.

Know the basic terminology used by stock investors. Classify stock according to their characteristics. Describe how stocks are bought and sold. Understand how the regulation of securities markets is beneficial to investors. Analyze investment alternatives and evaluate portfolio performance. Identify sources of information for stock investors.

CHAPTER OUTLINE AND SUMMARY I. Common Stock A. What is common stock, and why is it used? 1. Common stock represents a share of ownership in a corporation. 2. A corporation is a form of business organization that exists as a legal entity separate form its owners who have limited liability for corporate losses. a. Private corporations have few shareholders and their stock isn’t bought and sold. b. When you purchase shares of common stock in a public corporation, you’re buying an ownership interest in that company. c. A residual claim is a common shareholder’s right to the firm’s assets and income after all other claimholders are paid. 3. Companies sell shares of stock to the public to get funds they need to grow their companies. B. What are the stockholder’s rights and obligations? 1. Investors share in the future income and growth opportunities of the firm. 2. Voting Rights a. Limited rights to influence management. b. Each common stockholder has the right to vote for members of the board of directors at tan annual election. c. A proxy is a written agreement in which a shareholder gives another person the right to vote in his or her place. 3. Limited liability is a statutory right given to corporate shareholders limiting their potential losses to the value of the shares held. 4. A common shareholder expects to share in the profits of the firm. a. A stock dividend is a dividend given to shareholders in the form of shares of stock instead of cash. b. Firms are not required to pay dividends to shareholders. 5. Preemptive rights are the right of a stockholder to maintain his or her proportionate ownership when the company issues additional shares of stock. 6. Stock splits provide each shareholder with a number of new shares in proportion to the number of shares already held. C. Advantages of stock investing

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1. No management responsibility since investors only contribute money. 2. Higher long-run returns since equity investors have more risk than debt investors. 3. Greater liquidity since stocks can be converted to cash quickly at a relatively low cost. 4. Low interest-rate sensitivity 5. Diversification if you have a variety of investments in your portfolios. D. Disadvantages of stock investing 1. Risk 2. Investors have little power to influence the actions of management. E. The stock market 1. The primary market is where stocks are sold to the public by the issuing corporation for the first time. a. The initial public offering (IPO) is a company’s first stock offering to the public. b. A tombstone ad is a formal advertisement of a stock issue in the financial press. c. A prospectus is a document that gives financial information about a stock issue and the issuing company to potential investors. 2. The secondary market is where stocks that have already been issued are traded between investors. a. A securities exchange is a physical location at which securities are traded; the largest is the New York Stock Exchange. b. An over-the-counter (OTC) market is an electronic network for trading securities through securities dealers. c. A listed security is a security that is approved to be bought or sold on a particular exchange. d. A seat on the exchange is a membership in an organized securities exchange, which allows the holder to transact business there. e. A bid price is the stock price offered by a potential buyer. f. An ask price is the stock price requested by a potential seller. g. A specialist is a person responsible for matching a particular stock’s buy and sell orders at a specific securities exchange. h. The National Association of Securities Dealers Automated Quotation System (NASDAQ) is an electronic reporting system for more frequently traded OTC stocks. II. Classifications of Common Stock A. Income versus growth stocks 1. Income stock is stock that compensates investors primarily through the regular payment of dividends and has less capital appreciation 2. Growth stock is stock that compensates investors primarily through increases in value of the shares over time. a. Issued by younger companies that are experiencing high growth. b. Firms tend to reinvest profits to meet capital needs rather than distribute profits as dividends. c. Expose investors to greater uncertainty.

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B. Blue chip stocks are stocks issued by a large, stable, mature company. 1. Firm’s earning tends to track the growth in the overall market. 2. Considered less risky than growth stock. C. Cyclical versus defensive stocks 1. Cyclical stock exhibits above-average sensitivity to the business cycle. 2. Defensive stock is relatively insensitive to the business cycle. D. Industry and sector stocks. Examples: 1. Airline: United Airlines 2. Automobile: Ford Motor Company 3. Banking: Bank America 4. Chemicals: Dow Chemical 5. Financial Services: Merrill Lynch 6. Food and Beverage: Coca-Cola 7. Industrial Goods and Services: General Electric 8. Media: Disney 9. Retail: Home Depot 10. Technology: Intel E. Market capitalization is the total outstanding value of a company’s stock at current market prices = Current Market Price x Number of Outstanding Shares 1. Large-cap is market capitalization in excess of $5 billion. 2. Mid-cap is market capitalization of $1 billion to $3 billion. 3. Small-cap is market capitalization of less than $1billion III. Buying and Selling Stocks A. You can look up the stock price to determine how much you’ll pay for shares on financial websites or in The Wallstreet Journal 1. Close price is the last price at which a stock sold at the close of the previous business day. B. Placing an order 1. Stock is normally traded in a round lot, which is 100 shares of stock. 2. A market order is an offer to buy stock at the current market price. 3. A limit order is a request to buy stock at any price up to a given maximum or to sell stock at any price above a given minimum. 4. A stop order is an order to buy or sell stock holdings when the market price reaches a certain lever. C. Long versus short 1. When you hold stock in your portfolio, you are said to be long in stock. 2. Selling short is a strategy in which an investor borrows stock from a broker, sells the stock, and later buys stock on the market to replace the borrowed stock. A short seller’s objective is therefore to sell high and buy low. D. Using a broker 1. A stockbroker is a licensed professional who buys and sells securities on behalf of clients. 2. A full-service broker is a broker that offers a full range of services to clients. 3. A discount broker is a broker that facilitates transactions but usually does not offer investment advice or research services to clients.

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A brokerage account is an investor’s account at a brokerage firm, from which the investor pays for purchases and into which the firm deposits proceeds from sales. a. Buying on margin is using borrowed funds from your broker to make a trade. You must pay interest on the borrowed funds. b. A margin call is a request from a brokerage firm that the holder of a margin account add money to the account to maintain the required minimum. c. Churning is excessive trading in a discretionary account. 5. Factors to consider in selecting a broker: a. Is the account insured by the SIPC? b. Does the brokerage firm have a useful website? c. What is the commission structure? d. Will the broker pay you interest on any uninvested cash in your accounts? e. What services does the broker provide in addition to executing trades? 6. A growing number of investors are choosing the convenience and reduced transaction costs associates with online investing. a. A day trader is an active investor who buys and sells many times during the day to make quick profits. IV. Regulation of the Securities Market A. History of Federal Securities Law 1. A “buyer beware” environment used to be prevalent since it was difficult for stockholders to obtain the necessary financial data. 2. Much of today’s regulation was an outgrowth of the 1929 stock crash and the Great Depression. B. Information disclosure requirements 1. The Securities Act of 1933 2. The Securities Act of 1934 3. Today all traded securities must be registered with the Securities and Exchange Commission (SEC) C. Anti-fraud provisions 1. Federal law protects investors by prohibiting fraud and misrepresentation in the sale of securities. 2. Insider trading is trading based on company information not available to the public, illegal under federal law. 3. Evidence suggests that fraudulent activities still persist. D. Other regulations 1. The Maloney Act of 1938 requires securities trade associations to register with the SEC and authorized the formation of the National Association of Securities Dealers (NASD). 2. The Investment Company Act of 1940 and the Investment Advisors Act of 1940 extended SEC registration and disclosure rule to mutual funds and mutual fund advisors. 3. The Securities Investor Protection Act of 1970 created the Security Investor Protection Corporation (SIPC) to which most brokers belong. 4.

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1) If insured, you are protected against losses of up to $500,000 in securities. 2) Protection does not extend to investment losses. 4. After stock market crash of 1987, the securities industry made some changes to its system of self-regulation to protect against extreme market volatility. a. Circuit breaker rules are securities industry rules that act to temporarily halt trading in the event of an unusually large drop in the market. V. Stock selection and performance evaluation A. Measuring expected stock returns 1. Investors look at historical rates of return, earnings per share, and the price-toearning ratios. 2. Dividend yield = Annual dividend / Market price of stock 3. Capital gains yield = Annual change in price / Market price of stock 4. Earnings per share = After-tax net income / Numbers of shares outstanding 5. Price-to-earnings (P/E) ratio = Stock price / Earnings per share B. Measuring stock risk 1. Quantifying the risk-return relationship a. A measure of investment risk is the variability of the returns you can expect from the investments. 2. Measuring market risk a. Beta is the measure of the market risk, or nondiversifiable risk, of a stock. b. A beta equal to 1 means that the stock has about the same degree of risk as the overall market. c. A beta <1 means that the stock is less risky than the average and will give a proportionately smaller return d. A beta >1 means that the stock is riskier than average and will you proportionally more return. 3. The time diversification debate a. Average risk of stock investing declines as the time horizon gets longer. b. But the longer you’re in the stock market, the greater the risk of experiencing a large loss. C. Valuation methods 1. Fundamental analysis involves comprehensive analysis of factors that influence the value of a stock and its risk. 2. The discounted dividend model focuses on expect future cash flows to investors and uses the concept of the time value of money. a. Value = D x (1 + g) / (r-g) b. Problems: it makes some very strong assumptions that often don’t true in practice. D. Evaluating Portfolio performance against stock indexes 1. A stock market index is an indicator that shows the average price movements of a particular group of stocks representing the market or some market segment. a. Tracks the performance of a particular group of stocks.

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2. The Dow Jones Industrial Average (DJIA): price weighted index of 30 large cap blue chip stocks considered representative of the overall U.S. stock market; the most widely watched and reported index in use today. 3. Standard & Poor’s 500 Index: market cap weighted index of 500 large cap stocks; benchmark most commonly used by mutual funds and money managers to assess performance. 4. Other indexes for different groups of stocks 5. Tracking your portfolio performance a. It is important to keep track of the investments you have. b. Keep good records of your stock purchases and sales c. Track performance relative to your objectives 6. Indexing a. If your objective is to closely mimic the performance of an index, you’ll save on transactions cost by simply buying an index security or shares in a indexed mutual fund. VI. Sources of information for stock investors A. National news related to general economic conditions B. Company information C. Industry information D. Internet resources. E. Self-help books ADDITIONAL WEBSITE ASSIGNMENTS 1. finance.yahoo.com. Go to this site and click on “Indices.” This will take you to a page where you can look at price histories for all the major market indexes and interest rate benchmarks. Compare the performance of the Dow Jones Industrial Average to that of the broader stock indexes such as the S&P500 and the NYSE. Do they appear to move together pretty closely? What was the annual rate of return on each of these three over the last year? The last five years? 2. www.stock-trak.com: This site allows individuals to set up a portfolio and trade stocks, bonds, derivatives, and other securities (with a 20 minute delay from realtime prices). Although there is a charge for this service, you can have the students evaluate the site for ease of finding trading directions and availability of current information for investors. 3. www.fool.com: The Motley Fool website provides a lot of valuable investment information for individual investors. Go to the “Fool’s School” and find out what investment strategies are recommended for individual stock investors. 4. www.smartmoney.com: Search this site for the “Map of the Market” and pull it up. This will allow you to view the performance of more than 500 stocks at once. Use the control panel to find out which were the biggest gainers and losers over the last month. 5. www.gomez.com: Use this site to identify a broker to meet your needs. Click on “Benchmarks” for rankings of financial services firms. What criteria are they ranked on? Identify the top three firms.

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ADDITIONAL MINI-CASES 1. Case 1 – Stocks for the Long Run? Rip Van Winkle wants to invest a sum of money for twenty years with the objective of using it to finance his retirement at that time. He has $100,000 to invest. He heard about time diversification and thinks that investing in stocks might be a good idea, but he wants to find out how much difference it will make if he invests more conservatively. Based on his research, he thinks that a diversified stock portfolio will earn 9% per year on average and a diversified bond fund will earn 6% per year. a. If he invests in stocks, how much will his nestegg grow to by the time he needs it in 20 years? b. If he invests in bonds, how much will his nestegg grow to by the time he needs it in 20 years? c. What tradeoffs should he consider in making this decision? d. Explain why people sometimes argue that the risk of stock investing is lower for long time horizons. e. Can he reduce the stock investment risk by his allocation decisions over the course of the next 20 years? If so, how? 2. Case 2 – What’s the Point of a Stock Split? Morris Bettah read an article in a personal finance magazine that suggested an investment strategy of buying stocks whenever the companies announce a stock split. The author argued that prices almost always rise after a stock split and therefore this strategy was a “no lose.” Morris decided to try this on his own. In the last three months, he has bought five different stocks right after he read about their splits. Unfortunately, most of them seemed to decline in value right after he bought them. The one that increased didn’t increase enough to cover his trading costs. a. Explain to Morris the reason that stocks might be expected to increase in value after a split announcement. b. If Morris is buying based on information he reads in a financial newspaper, what is the problem with his investment strategy? c. If Morris is buying relatively small numbers of shares, what is the problem wth his investment strategy? d. Even if stocks tend to rise in value after a split announcement, should Morris consider other information in making his investment decisions? If so, what would you recommend? 3. Case 3 – Should Keith Use a Discount Broker or a Full-Service Broker? Keith Ickes received a $10,000 bonus from his employer at the end of the year and wants to use it to start a stock investment portfolio. He has asked you to help him decide on a broker. a. What factors should he consider in deciding whether to use a discount broker or a full-service broker? What is the potential financial consequence of this decision? If Keith doesn’t know a lot about investing, would this make a difference in your recommendation?

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b. Assuming that Keith’s investment objectives are long-term in nature and that he is currently 30 years old, does a stock investment strategy make sense for him? Why or why not? What types of stocks should he invest in? c. Provide Keith with some suggestions for informational resources he can use to make his brokerage decision as well as his individual stock selection decisions. TEACHING SUGGESTIONS 1. Use the Anheuser-Busch and Dell comparison graph to illustrate how stocks of different types can have very different performance over time. Discuss the factors that influenced these two companies’ performance over that five year period. This can also be used to illustrate the beneficial effects of diversification. 2. Have students interview an account executive for a local brokerage firm (or have one come into your class as a guest speaker). Ask them to find out how the broker is paid, what he likes and dislikes about his job, whether he provides additional financial planning services to clients, whether discount brokers have affected his business over the last few years. 3. Without any prior research, ask students to identify companies that they would like to invest in and why. This type of question usually generates well-known companies and those that produce popular products (like Coke, McDonalds). Discuss the problems with assuming that a good product (or good prices) from a consumer’s perspective always makes a good company. You can ask students whether they think it costs the same to provide better service or better working conditions for employees. If not, then how will that impact profitability? 4. Ask the students to pick a company they are interested in (perhaps one that was identified in the previous activity) and research it at the library or online using reports from Value Line, Standard & Poors, and business periodicals such as Fortune and Business Week. Based on what they find, they should write a short report that provides their buy or sell recommendation. 5. Discuss the ethics of insider trading. You can motivate this discussion by giving an example that might seem to the novice investor to be legal. For example, your neighbor tell you to buy the stock of a company for which he is a member of the Board of Directors. He tells you that they are getting ready to announce a merger that will almost certainly result in a stock price increase. You can use this example to illustrate the definition of an insider and to explain how your acting on this information is unfair to whomever you buy the shares from (who doesn’t have the information). In conjunction with this discussion, you can have the students talk about prevalent attitudes toward other unethical behavior, such as cheating. 6. Ask students to comment on why investors react so strongly to company earnings reports. If possible, find an example of a recent unexpected earnings report and show the stock price graph for that day. This can be used to motivate the discussion of the dividend discount model. 7. Have students request a copy of the annual report of a company they are interested in or download one from the Internet. Ask them to carefully read the report and write an executive summary.

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8. Have students find out more about the Google IPO and how it differed from the normal type of public offering. Lead a discussion on the pros and cons of this type of stock sale procedure. Is it likely that other firms will follow Google’s lead? 9. If you have access to the Internet in your classroom, it is useful to demonstrate the investor tools that are available and easy to use on that website. For example, go to finance.yahoo.com and enter the ticker symbol for a stock that would be of interest to the class. You can show the stock price graph and you can have it graphed against an appropriate index. You can also demonstrate how to screen stocks based on predefined criteria, such as beta, P/E ratios, or dividends.

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CHAPTER 13 INVESTING IN BONDS AND PREFERRED STOCK THE LEARNING OBJECTIVES 1. 2. 3. 4.

Know the basic terminology used by bond investors. Classify bonds according to their characteristics. Analyze bond investment alternatives and evaluate performance. Explain how the features of preferred stocks are similar to those of both common stocks and bonds. 5. Identify sources of information for investors in bond and preferred stock. CHAPTER OUTLINE AND SUMMARY I. Bonds A. A bond is a type of financial security that represents your long-term loan of money to a company or governmental entity and gives you the right to receive interest payments and to have your loan repaid in the future. B. The purpose of bonds 1. An organization or government seeks outside investors when it doesn’t have enough current cash flow to support its needs. 2. Governments have no other financing source. 3. Businesses choose bonds due to following factors: a. Cost: Debt is cheaper than equity. b. Taxes: Interest payments are tax-deductible to the firm and dividends are not. c. Control: No more shares are sold, thus, no one has a diluted ownership interest. d. Leverage: Debt improves the returns to existing shareholders. C. Investors buy bonds when: 1. They want to diversify their portfolios. 2. They need a regular source of predictable income. 3. They hope to profit from future increases in the value of their bonds. 4. They want to lower their risk. 5. They want to match the term of their investment to their investment time horizon. D. Bond terminology 1. A prospectus is a document the bond issuer must provide all prospective investors with the pertinent information about the company and the security. 2. An indenture is a legal document that details the rights and obligations of the bondholders and bond issuers. 3. A trustee is the legal representative for the owners of a bond issue. 4. The face value is the dollar amount the bondholder will receive at the bond’s maturity date. 5. The maturity date is the date on which a bond comes due and the bond issuer must pay the face value to the bondholder.

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6. The coupon rate is the annual rate of interest on a bond, quoted as a percent of the face value. 7. The coupon payment (= Coupon rate x Face value) is the annual interest payment on a bond, equal to the coupon rate times the face value, usually paid to investors in two equal installments. 8. A call provision is a contract term that allows a bond issuer to buy back a bond issue before the maturity date. a. The purpose is to save costs on interest payments by refinancing. b. Most corporate bonds have call provisions. c. Investors are generally unhappy when the provision is exercised. 9. A sinking fund is a fund accumulated to pay an amount due at a specified time in the future, such as when a bond issue comes due. 10. Some bonds issues include a special provision that allows the bondholders to convert the bond to shares of common stock in the future. E. The bond market 1. Subject to similar regulation as the stock market 2. Less volume of trading II. Types of Bonds A. Classification by type of issuer 1. Corporate bonds: Long-term, interest-bearing debt securities issued by a corporation to help finance its long-term assets or operations. 2. U.S. Treasury Bonds: issued by the federal government when expenses exceed tax inflows; no default risk 3. An agency issue: bond issued by a federal agency backed by pools of mortgages or student loans; slightly riskier than Treasury bonds. 4. A municipal bond: long-term debt security issued by a state or local government entity. a. Interest payments are exempt from federal income tax. b. A general obligation bond is a municipal bond that will be repaid form the operating cash flows of the issuing entity; backed only by the full faith and credit of the issuer. c. A revenue bond is a municipal bond that will be repaid from income generated by the project financed by the bond issue. d. Can sometimes be fairly risky investments. B. Classification by bond characteristic 1. A debenture is an unsecured bond. a. The promise of payment of interest and principal in the future is backed only by the creditworthiness of the company or governmental body. 2. A secured bond is a bond for which interest and principal payments are backed by assets or future cash flows pledged as collateral (which makes it less risky). 3. Floating-rate bonds are bonds whose interest payments are adjusted periodically according to the current market interest rates. 4. An indexed bond is a bond whose interest payments are adjusted periodically according to a market index.

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5. A Treasury Inflation Protected Securities (TIPs) are federal government bonds that are adjusted for inflation. 6. A zero-coupon bond is a bond that doesn’t make interest payments but instead is discounted at the time of sale. a. Popular for buy-and-hold investors b. Disadvantages: Bad tax treatment and investors are exposed to greater interest-rate risk. 7. Investment-grade bonds are medium- and high-grade bonds with low risk of default on interest or principal. 8. Speculative-grade bonds or junk bonds are bonds with a high risk of default; sometimes called “high yield bonds.” 9. Catastrophe bonds are usually issued by insurance companies and give investors the opportunity to bet against the occurrence of a disaster. III. Evaluating and Selecting Bonds A. What is a bond worth? 1. The value of a bond is the discounted present value of the cash flows you’ll receive: a. The fixed semiannual coupon interest payments. b. The repayment of the face value at the fixed maturity date. B. Estimating bond yield 1. Yield is the annual return on investment including current yield and capital gains yield. 2. Current Yield is the component of total yield that is attributable to regular interest payments = Coupon / Current Price 3. Capital Gains Yield is the percentage gain or loss in value over a particular period = ( Ending Price – Beginning Price ) / ( Beginning Price ) 4. Holding-period return is the return on investment over a particular period of time = (Annual Interest Received + Ending Price – Beginning Price) (Beginning Price) 5. Yield to Maturity (YTM) is the annualized return on a bond, if it is held to maturity and all interest payments are reinvested at the same rate. Can use approximation to estimate YTM: = Annual Coupon Payment + [(Face Value – Price) / Years to Maturity] (Face Value + Price) / 2 6. Yields tend to track fairly closely with market interest rates, which vary over time. C. The risks of bond investing 1. Default risk: Bond investors need to be concerned with the risk that a firm will become less creditworthy over time. 2. Liquidity risk: Depends on existence of active secondary market. 3. Interest rate risk: Interest rates change over time and prices vary inversely with interest rates. 4. Inflation risk: Expected inflation is incorporated in the market rate of interest at any given time as a component of the nominal risk-free rate. 5. Maturity risk: Prices of securities with longer maturities are more sensitive to interest rate changes.

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D. Bond investment strategies 1. Diversification: Holding bonds from a number of issuers with differing risk characteristics. 2. Buy-and-Hold: You earn the yield to maturity that you calculated at purchase. 3. Dollar Cost Averaging: Requires that you make regular purchases over time rather than buying in a single larger installment. 4. Laddering: A buy-and-hold bond investing strategy in which you purchase a collection of bonds with different maturities spread out over your investment time horizon. 5. Maturity Matching: Requires that you purchase assets which have cash flows that coincide with the period in which you need the funds. 6. Timing: Time purchases of your assets based on market conditions. E. A bond transaction 1. Individual investors usually buy bonds through a broker and bonds are traded through a bond dealer, who profits on each trade. 2. The Wall Street Journal regularly reports prices and yields for Treasury issues and some municipal and corporate bonds (but these are before dealer costs). IV. Preferred Stock A. What is preferred stock? 1. Similarities to both common stock and bonds. 2. Issued by companies to raise capital for ongoing operations or expansion. 3. No set maturity date: company never repays the original investment amount. B. Expected cash flows from preferred stock 1. Usually pays a quarterly dividend based on a fixed percentage of its par value. 2. Par value is an arbitrary initial value assigned to shares of preferred stock at issuance and used to calculate the dividend payment. 3. Primarily an income investment. 4. The price is highly sensitive to interest rate movement. C. Contract terms that affect preferred stock cash flows 1. Cumulative preferred stock gives holders the right to receive past unpaid dividends before any dividends can be paid to common stockholders. 2. Call provisions allow the company to retain the rights to repurchase the stock from investors. 3. Adjustable-rate preferred stock pays a dividend tied to a market interest rate. 4. Participating preferred stock allows preferred stock investors to share with common stockholders in the profits that are left over after the normal preferred and common stock dividends have been paid. 5. A convertibility feature allows a preferred shareholder to convert to common stock under certain conditions. D. Valuation of preferred stock 1. The present discounted value of the cash flows it will generate. 2. A perpetuity is a constant cash flow stream that continues into infinity. a. PV of a perpetuity = Constant Cash Flow / Interest rate 3. Value of Preferred Stock = Dividend / Interest rate 4. Dividend Yield = Annual Dividend / Price

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E. Risks and rewards of preferred stock investing 1. Advantage: regular cash flow. 2. Disadvantage: dividends may be taxable 3. Important risks: interest rate risk, call risk, and default risk. V. Sources of information for bond and preferred stock investors A. Financial press B. Government sources ADDITIONAL WEBSITE ASSIGNMENTS 1. www.investinginbonds.com: Click on calculators and play with general-purpose bond calculator. 2. www.nyse.com: Go to the home page for the New York Stock Exchange and find out what bonds are traded at that exchange. Write up a short report explaining the requirements for listing bonds on the exchange as compared to those for listing stocks. 3. www.bondsonline.com: Click on “Research bond” and look up the bonds of General Electric. Are its bonds investment grade? How many different issues does GE have and when do they mature? 4. www.standardandpoors.com/ratings: Look up current rating of IBM and Dell. If they are not the same, how can you explain the difference between the two based on what you know about their products, their business risk, and recent technology sector performance? 5. www.fidelity.com and www.vanguard.com: Fidelity and Vanguard are two large investment firms and they each provide extensive information for investors. Go to the public access sections of both sites and compare what they have to offer. Which is easy to navigate? Which one appears to provide more “free” information? Find an interesting piece of information about bonds that you can share with the class. 6. www.averages.dowjones.com: Find the latest average yield on bonds on the Dow Jones Indexes website. Compare that yield to the S&P500 yield. ADDITIONAL MINI-CASES 1. Case 1 – Are Bonds Worth It? Raj and his girlfriend Sonja have just completed a course in personal finance. They are newlyweds and are currently working on a financial plan. Raj says he wants to put their investments 50% in stocks and 50% in bonds. Sonja tells him that the low returns for bonds make them unattractive, given their current age (21) and investment time horizon. a. What can you tell about Raj and Sonja’s degree of risk tolerance? Is it a problem when married couples differ in their risk attitudes? b. Is Sonja correct? If the average annual return on stocks has been 10% and the average return on bonds has been 6%, how much less will the couple have after 20 years if they follow Raj’s investment strategy? (In answering this part, think about the compound yield on the portfolio rather than the dollar amount in their account.)

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c. Assume that you invest $1,000 today in each in a stock indexed fund and a bond indexed fund and earn the average rate of return each year. How much would you have at then of 20 years? d. What differences in risk would the two portfolios be subject to? e. What advice would you give Raj and Sonja to help them resolve this disagreement? 2. Case 2 – Zero Coupons are Not Zero Taxes Yoko plans to retire in 20 years, so she decided to buy zero coupon bonds that would mature in 20 years. Her reasoning for this decision was that it would be much lower risk to match the maturity of her investment to her needs for cash. She paid a total of $300,000 for bonds that have a maturity value of $1,000,000 payable in 20 years. a. Based on the price she paid and the time to maturity, what is the yield to maturity? b. What are the tax consequences of this investment? c. Is this a good strategy? Why or why not? 3. Case 3 – How Can You Tell the Trash From the Treasure? Kerry’s broker called her recently to recommend that she buy “high yield” bonds to increase the average return on her investment portfolio. He argued that the stock market had been lackluster but that there were several bond issues that he felt were rated lower than was justified based on their financials. Kerry took his advice and bought some of the bonds. A few months later, the issuer declared bankruptcy and Kerry lost most of her invested dollars. a. Does Kerry have any recourse against the broker for giving her bad advice? Would it make a difference if the broker knew that Kerry had fairly high risk tolerance? b. Is it ever possible that a company’s debt rating is “incorrect,” as was suggested by the broker? If so, how could that happen? c. Assuming that you would have also recommended that Kerry have some of her money in junk bonds, what mistake did she (and her broker) make in this particular situation? d. What should Kerry have done before investing in the bonds recommended by the broker? TEACHING SUGGESTIONS 1. You may want to review some basic time value of money concepts and calculations before starting this chapter. Valuation of bonds is a great application of these principles. 2. Ask students about what they thought about the risks of bond investing prior to reading the chapter. Which investors are they most appropriate for? Did they think that bond investors were exposed to the risk of losing their principal investment? If they have an opinion at all, they probably think that bonds are reasonably safe investments. Show them a graph that bond price and yield variability over the last ten years and ask them whether they still think bonds aren’t risky. Why do they think that bonds have had a reputation as being fairly low risk when they appear to experience a lot of variability? Exhibit 13-4 in the text shows the minimum and maximum annual returns on several debt securities since 1994. (None of them had negative annual returns.)

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3. Photocopy and distribute the “Corporate Bonds” section from the Wall Street Journal and illustrate how you can use time value calculations to estimate the value. Have the students compare the bonds listed in Exhibit 13-7 to those listed in the current paper. What explanations can they cite for bonds that are more actively traded today compared with the date in the text? Find a bond that is listed on both tables and have them calculate the change in price over the time period. Ask them what has caused this change. 4. Ask the class to tell you why investors consider Treasury bonds to be “risk-free.” Are they truly risk free and, if not, what risks are Treasury investors still exposed to? 5. Discuss whether it’s possible to make money based on the inverse relationship between interest rates and bond prices. At first, students may be tempted to believe that they can anticipate interest rate movements (as in the case where the Federal Reserve is expected to increase or decrease rates) but you should encourage them to remember the implications of market efficiency—prices will already reflect anticipated interest rate movements so you could only profit if you knew something noone else did. 6. FACT #5 on p. 437 discusses a common individual investor error—selling low and buying high. In light of the relationship between interest rates and prices, have students explain how this can easily happen in bond investing (for less knowledgeable investors). 7. Have the students locate an advertisement for a bond issue in a financial newspaper. In groups or individually, ask them to research the issuing corporation or government entity and report back to the class regarding the financial condition of the company and how it plans to use the money raised from the bond issue. 8. Have the class break into groups and discuss which bond investment strategies, if any, identified in the text are most appropriate for themselves, given their life cycle stage and investment objectives. For any they have not selected, identify the type of person it would be most appropriate for. 9. Lead a class discussion on convertible securities. Why would an investor want to buy and why would a corporation want to issue convertibles? 10. Ask the class to discuss the impact they think the new tax rules for dividends will have on investors demand for preferred stock and bonds.

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CHAPTER 13 INVESTING IN BONDS AND PREFERRED STOCK SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 446-447 in Textbook Case 13-1 Ernie and Belinda Maxwell Evaluate Their Investment Plan a. The average coupon rate was $80,000/$1,000,000 = 8.00% b. The current average coupon rate is $60,000/$800,000 = 7.06% c. Market interest rates have declined from 8.0% to 5.5% over the past ten yearsa. As the Maxwell’s bonds matured, new ones with lower coupon rates were purchased. They also sold $150,000 worth of par value to cover living expenses, so they now have a smaller amount invested. d. Yes. They now only have $850,000 in face value which is providing them with only $60,000 in income. Since they seem to need more than that to maintain their current lifestyle, they will have to continue to sell bonds or to not reinvest them as they mature. This will further reduce their interest income. e. Given that the Maxwells anticipate living another twenty years, they need to make some changes if they want to support themselves that long. They probably should have some of their money invested for growth. Although this will increase the risk of their portfolio, it may be riskier for them to continue to erode their nestegg. They also need to think about whether they want to spend all their wealth or preserve some of it for their family. They probably will need to put together a financial plan that involves reducing their expenses. f. By choosing a fixed income investment portfolio in the 1990s, the Maxwells missed out on the tremendous gains experienced by stock investors during that period. If they had been invested in stocks for the latter half of the decade, their $1 million might easily have grown by 50%. Of course, they also avoided the downturn that occurred at the end of the decade, but a mixed strategy of bonds and stocks would have dampened their losses. Although they thought that they were opting for low risk, they are currently facing reinvestment rate risk. As they reinvest their maturing bonds, their options for new bonds are all at lower coupon rates, resulting in reduced income from their portfolio. They also face inflation risk. Although their interest income on existing bonds is fixed, the purchasing power of that income is declining over time. Case 13-2 Great Uncle Clyde Leaves Mike a Bundle a. (10 x 910.00) + (10 x 1,140.46) + (10 x 1,000) + (10 x 1,085.27) + (10 x 1,044.54) + (10 x 991.89) = $61,721.60 b. Although the average yield is fairly high, the reason is that most of these bonds are junk bonds (as indicated by their Moody’s ratings). Since their low ratings imply greater risk, the high yields are probably justified. Mike faces the risk of default by one or more of the issuers, which would leave him with bonds that are worthless. c. The two Aaa-rated bonds have yields of 6.0% and 5.2%. The reason for the difference is that the higher yielding bond has 25 years to maturity and the lower

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one has only 13. Since longer maturities imply greater risk, the yields are higher on such bonds. d. The difference between the 25 year Aaa (6.0%) and the 20 year Ba (7.5%) is 1.5%. The difference between the 13 year Aaa (5.2%) and the 10 year Ba (7.0%) is 1.8%, implying that the risk premium for increased default risk is similar for the two different maturity types. The risk premium difference between the 20 year Ba (7.5%) and the 17 year B (8.5%) is about 1%, which is similar to the difference between the 10 year Ba and the 5 year B bonds. e. Not very. Mike is very young and should be invested in some growth assets such as stocks. If he decides to remain invested in bonds, he should probably consider some reallocation. Out of his entire portfolio, two-thirds is invested in riskier bonds. f. He probably should invest some of his money in stocks. Since he only has ten of each bond, however, the transaction costs for selling will be fairly high. He should consider taking all his interest income and investing it in stocks as well as investing money in stocks as his various bonds mature. It would also be a good idea to do some homework on the bonds in his portfolio to see whether any of them subject him to high risk of default.

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CHAPTER 13 INVESTING IN BONDS AND PREFERRED STOCK SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 445-446 in Textbook 1. Reading Bond Quotations a. Coupon rate = 6.875% b. Years to maturity = how many years until May 1, 2012 (maturity date). c. Last yield = 5.424% d. Price = 109.10% of par. If par value is $1,000, the price is $1,091 2. Bond Coupon Payments 1,000 x 7.45%/2 = $37.25 every six months 3. Current Yield a. (1,000 x 5.6%)/850 = 6.59% b. (1,000 x 6.0%)/1,000 = 6.00% c. (1,000 x 6.28%)/1,100 = 5.71% d. The longer the time to maturity, the higher the current yield. 4. Approximate Yield to Maturity a. [80 + (90/10)]/(1910/2)=89/955 = 9/32% b. [80 +(-80/10)]/(2080/2) = 72/1040 = 6.92% c. PV = 910; N= 10 x 2= 20; PMT = 80/2 = 40; FV=1,000; Solve for I/2=4.704 x 2 = 9.41% 5. Effect of Interest Rates on Bond Price a. The increase in rate will cause the price to fall. b. Enter N=20; FV=1000; PMT=40; I=10.4/2=5.1; Solve for PV=864.07 c. (910-864)/910 =5% decline d. Longer maturity bonds have greater price risk, so the percentage decline would be larger. 6. Maturity Risk a. Longer term bonds require higher yields, all else equal, due to greater risk. b. Bond A: [60+(71.06/10)]/(1928.94/2) = 6.96% Bond B:[60 +(197.93/10)]/(1802.07/2) = 7.76% c. Bond A: N=18; I=8/2; FV=1000; PMT=60/2=30; Solve for PV=873.41 Bond B: N=38; I=9/2; FV=1000; PMT=30; Solve for PV= 729.25 d. Bond A fell (873.41-928.94)/928.94 =6% Bond B fell (729.25-802.07)/802.07 = 9% 7. After-Tax Interest Income 10 x $1,000 x 9% x (1-.25) = $675 8. After-Tax Yield

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a. Corporate bonds held in taxable account is fully taxable so after-tax yield is 8% x(1-0.30) = 5.6% b. Municipal bond not taxed, so after-tax yield is 7%. c. Treasuring is not taxable by the state, so after-tax yield is 5% x (1-0.25) = 3.75% 9. Holding Period Return a. Current yield = 80/850 = 9.41% b. Capital gains yield = (900-850)/850 = 5.88% c. Holding period yield = (80+900-850)/850 = 15.29% d. Market rates of interest probably fell, perhaps due to lower inflation or an economic slowdown. e. Holding period return = (80 +850-900)/900 = 3.33%. Market rates of interest probably rose due to higher inflation or faster economic growth. 10. Preferred Stock Dividends Divident = 7.5% x 25 = $1.875 per share 11. Value of Preferred Stock Price = (100 x 0.7)/.08 = $87.50 12. Interest Rates and Preferred Stock Price a. Yield = (110 x .082)/95 = 9.49% b. If yields rise to 10.49%, then price = (110 x .082)/.1049 = $85.99 As with bonds, interest rates are inversely related to price. 13. Zero-Coupon Bonds a. PV = 231.40; N=30; FV=1000; PMT = 0; Solve for I=5% b. The annual increase in price of $25.62 is taxable even though the money was not actually realized. If held in a tax-exempt or tax-deferred account, no money will be due in the current year to the IRS. 14. Tax-Equivalent Yield 6.5%/(1-0.30) = 9.29% 15. Bond Conversion 1,000/27 = $37.04 conversion price per share. The value of converting now = 27 x 30 = $810. He would lose $190 by converting now. He should wait until the stock’s price is above $37.04.

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CHAPTER 14 MUTUAL FUNDS, INVESTMENT REAL ESTATE, AND OTHER INVESTMENT ALTERNATIVES SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Page 481-482 in Textbook Case 14-1. Elena Musinski Evaluates Mutual Fund Options a. Elena’s investment goal is to develop a college fund for her two girls that will be sufficient to cover their future education costs. She needs to decide whether the fund is intended to pay for part or all of the expected costs. b. Assuming that the children start college at age 18, Elena has 12 and 13 years respectively for her investment horizon. She should consider diversified growth funds or diversified growth and value funds. As the time horizon gets shorter, she should shift to more conservative funds that will protect against loss of principal. c. Her taxable income will be quite low since the child support payments are not taxes. Tax-exempt securities will therefore not be that helpful to her. (Note that Section 529 plans are explained and discussed in Chapter 15, so students will not know how to use them yet.) d. Scenario (1) She earns 1% after taxes: Assuming that half the existing fund is allocated to each child 6-year old: PV = 10,600/2 = 5,300; PMT = $5,200; N= 12; I=1; Compute FV = 71,921 5-year old: PV = 5,300; PMT = 5,200; N=13; I=1: Compute FV=77,840 Scenario (2) She earns 4% 6 year old: FV = 86,620 5 year old: FV = 95,284 Scenario (3) She earns 6% 6 year old: FV = 98,388 5 year old: FV = 109,492 e. 2,000 x (1.05)15 = $4,158 Case 14-2. Gabe and Della Lopez Are Disappointed in Their Bond Fund a. Gabe and Della probably have too much in bonds. They have at least a 15 to 20 years time horizon for investing, so should have some growth investments. Under their current situation, they will get income from their bonds and eventually from Social Security, but they have little chance for price appreciation unless future interest rates fall to the low levels in 2003. b. Bond values have an inverse relationship with interest rates. Their AAA long-term bond fund values declined because bond yields increased about 1% a year during that time period. The prices of individual bonds fell and therefore the funds that hold them had lower NAV. c. Since their income is based on the total investment they have in the funds, their income will fall when the value of the funds goes down. If they had held individual bonds instead of bond funds, their income would not have declined, even though the value of their portfolio would still have declined. In the future, as interest rates rise, the bond fund will be purchasing new bonds with higher coupon rates, so the income from the fund will probably rise as well.

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d. They might consider shifting some of their money to a diversified stock fund (growth and income). They seem to be basing their expectations regarding the stock market on the recent decline, but the longer-term performance of equities has been much better than bonds. If they do decide to take more risk, however, they have to be prepared for short-term fluctuations in the value of their portfolio. The disadvantage of rebalancing right now is that the value of their bond funds is relatively low, so they will take losses on their investment. If the Lopezes are determined to invest in bonds, they would be better off laddering their investments—buying an equal dollar amount of corporate AAA debt securities that come due in each of the next 15 years. This would allow them to hold the bonds to maturity, ensuring that they will receive their expected yield to maturity. As each of the bonds mature, they could also reinvest the funds or spend them, as their needs dictated at the time. e. Probably not. A financial planner would have told that the prices of bond funds would fall when rates rose. Since rates were so low at the time Gabe retired, this was almost guaranteed to happen. The planner would also have likely recommended at least some investment in equities. Case 14-3 Christine McClatchey Considers a Real Estate Investment a. Loan amount = $145,000 – 29,000 down payment = $116,000 Payment on loan: PV = 116,000; N=360; I=8/12; Compute PMT = 851.17 b. Rental income 15,000 Expenses 2,500 Mortgage interest 9,250 (given in part d of problem) Net cash flow 3,250 before tax c. Unrealized capital gain = (160,000 -145,000 – 13,000) = 5,000 This is 5,000/158,000 = 3.2% on the original invested capital Note that the 13,000 includes the improvements and the closing costs. Alternatively, you can include the closing costs as an expense against cash flows in the first year.) d. Annual return = (160,000 – 145,000 -110,000 +15,000 – 2,500 – 9,250)/(29,000 + 10,000) = 0.212, or 21.2% e. Christine’s legal background makes this considerably risky for her than for the average investor. However, the answer to this depends on the location of the property, the demand for rentals, the employment environment, and interest rates. She also must take into consideration that the returns she makes on the property are not without costs. She must invest time in finding tenants and managing the property. f. Christine has about $50,000 invested in mutual funds and now she has nearly that much invested in a single real estate property. Most financial planners recommend that you not have more than 20% of your assets in any single investment. We also don’t know whether she also owns her own home, which would imply even greater allocation to a single asset class. If the real estate market were to experience a downturn, Christine would be hurt by her lack of diversification.

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CHAPTER 14 MUTUAL FUNDS, INVESTMENT REAL ESTATE, AND OTHER INVESTMENT ALTERNATIVES SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 480 in Textbook 1. Net Asset Value a. Net asset value = (240 – 10)/15 = $15.33 per share b. The price is $1.67 or 10.9% highet than the closed end fund’s NAV. Investors are willing to pay more than the current market price for the fund. Whether this is a good deal depends on if you expect the price of the fund’s shares to continue to rise in the future. If you think that prices might fall, it would be a good idea to sell and realize the difference. 2. Net Asset Value a. NAV=(50 – 5)/5 = $9.90 per share. b. The NAV has increased $9.90 - $8.00 = $1.90 per share. The annual change in value was 1.90/8.00 = 23.75% 3. Expense Ratio The expense ration = 1/40 = 0.025, or 2.5%. 4. Front-End Load a. Your total investment is 50 x $35 = $1,750. The sales charge is 0.04 x $1,750 = $70. b. $1,750 - $70 = $1,680. This is 1,680/50 = 33.60 per share. 5. 12b-1 Fees a. Since it’s a no load fund, you won’t pay the fee directly. b. The ½% 12b-1 fee will be taken out of the investment returns for the year on the entire fund, so you will earn ½% less than you would have without the fees. That will result in an indirect cost of $10,000 x 0.005 = $50 for the year. 6. Back-End Load If you sell in the third year, the back-end load will be 3 percent. The deferred sales charge will therefore be $1,000 x 3% = $30. 7. Matching Investment Objectives with Funds a. 20-year old saving for down payment: recommend money market fund, since she needs to preserve capital and she has a short time horizon. b. 60-year old retired couple: recommend corporate bond fund for income or a state municipal bond fund that would provide tax-free income. c. 30-year old couple saving for child’s college: recommend equity fund because they need capital appreciation and they have a fairly long time horizon. 8. One-Year Returns a. Percent return for the year is the increase in NAV plus the dividend yield.

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= 12% + (1.50/$50) = 12% + 3% = 15% Your return is lower because you must factor in the 5% front-end load you paid. Your return is therefore only 10% b. If the NAV fell by 15%, the loss would be offset by the 3% dividend yield, so the net for the year would be a loss of 12%. With your front-end load, you would have lost 17%. 9. Return on Investment a. Two year holding period return = (36+2+2-31)/31 = 9/31 = 29% b. Annual holding period return = (1.29)1/2 -1 = 13.6% 10. Return on Investment Real Estate a. Return on investment = (190,000 + 12,000 – 180,000)/180,000 = 12.2% b. Annual interest on the loan = 6% x 90,000 = $5,400 Return on investment = (190,000 +12,000 – 5,400 – 180,000)/90,000 = 18.4% c. You would have to pay a real estate commission and closing costs. This will reduce the net selling price and decrease the return on investment. 11. Return on Collectible Investment Annual return = (2,500/1,000)1/10 – 1 = 9.6% per year.

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CHAPTER 14 MUTUAL FUNDS, INVESTMENT REAL ESTATE, AND OTHER INVESTMENT ALTERNATIVES THE LEARNING OBJECTIVES 1. Describe the benefits and cost of investing in mutual funds. 2. Classify mutual funds by their investment objectives and portfolio composition. 3. Establish strategies for selecting among mutual funds and evaluating fund performance. 4. Identify the advantages and disadvantages of direct and indirect real estate investment. 5. Explain why investments in precious metals, gems, collectibles, and derivatives are speculative. CHAPTER OUTLINE AND SUMMARY I. What is a Mutual Fund? A. A mutual fund is an open-ended investment company that uses its investors’ funds to purchase stocks, bonds, or other financial assets. B. Net Asset Value is the market value of a mutual fund’s assets less the market value of its liabilities, per share. 1. = (Market value of assets – Market value of liabilities) / Number of Shares 2. The objective of fund managers is to invest in assets that will continue to grow in value over time. C. Mutual funds have grown substantially over the last 2 decades, in number of funds, total net assets, and the number of households with accounts. D. Types of investment companies 1. Investment companies are financial intermediaries that invest funds in securities or other assets. a. Open-end funds sell shares directly to investors and buy them back on request. b. Close-end funds issue a fixed number of shares that trade on a stock exchange or in the over-the-counter market. c. Exchange-traded funds (ETF) are professionally, but not actively, managed, often intended to track a market index. The shares are traded in the secondary market. d. Unit investment trusts (UIT) buy and hold a fixed portfolio of securities for a period of time determined by the life of the investments in the trust. e. Real estate investment trusts (REIT) are close-ended funds that invest primarily in real estate or mortgages. E. The advantages of mutual fund investing 1. Diversification a. Mutual funds are broadly invested in the financial markets. b. Look at the annual report of a mutual fund to determine asset allocation of a particular fund.

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2. Lower transaction Costs a. If you trade individual stocks, you must pay brokerage fees. b. Mutual funds make larger-volume trades; thus, the cost per trade will be substantially lower. 3. Professional Money Management a. Individual investment selection decision is taken out of your hands. b. Mutual fund investment decisions made by professional money managers. 4. Liquidity a. If you need access to your funds, it’s fairly easy to sell your shares. 5. Dividend Reinvestment a. Most mutual funds allow you to automatically reinvest dividends and capital gain distributions. 6. Beneficiary Designation a. You can designate where you want the funds to go when you die. 7. Withdrawal Options a. Set amount per month b. Redeem a certain number of shares per month c. Take only the current income d. Make a lump sum withdrawal of all or part of the account. F. The cost of mutual fund investing 1. Shareholder Fees a. A one-time sales charge b. A redemption fee to cover the costs c. An exchange fee when an investor transfers money from one fund to another within the same fund family. d. An annual account maintenance fee 2. Fund Expenses a. An annual management fee charged by the fund’s investment advisor b. Annual distribution fees c. Other operational costs 3. Comparing Costs a. The prospectus for each fund must include a standardized fee table so that investors can compare the costs of investing in different funds. 4. Load vs. No-Load a. Front-end load is a commission or sales charge paid by mutual fund investors at the time they purchase shares b. Back-end loan is a charge paid by mutual fund investors at the time they sell shares. c. No-load fund is a mutual fund that doesn’t’ charge a front-end or backend load. 1) Although this will save you money, you need to look carefully at what you’re giving up. 5. Expense Ratios a. = Total Expense / Total Assets in Fund 1) The lower this ratio the better

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b. All funds charge their investors for providing services, but some are more efficient in managing costs than others. 6. Mutual Fund Classes by Fee Structure a. A mutual fund can offer a menu of share classes that differ in load and expenses. II. Mutual Fund Investment Classifications A. Classification by investment objectives 1. Growth funds are mutual funds that focus on capital appreciation. 2. Income funds are mutual funds that focus on providing stable dividend and interest income. 3. Funds try to provide reasonable income to investors while still investing in companies that have good potential for growth in value. 4. Balanced funds provide investors with the opportunity to benefit from investments in both stocks and bonds. 5. Value funds are mutual funds that invest in companies perceived to be undervalued by the market. 6. Life-cycle funds are mutual funds that design its asset allocation to meet the needs of individuals in a particular life stage. B. Classification by portfolio composition 1. Asset Class a. Mutual funds commonly confine their investments to certain asset classes. b. The performance of the fund is likely to mimic the overall performance of that asset class. 2. Sector funds are mutual funds that invest primarily in securities from a particular industry or sector. 3. International funds are mutual funds that invest primarily in securities from countries other than the U.S. 4. Global funds are mutual funds that invest in U.S. and foreign securities. 5. Index funds try to mimic the performance of a particular index without necessarily buying every stock that is included in the index. 6. Socially responsible funds are mutual funds that limit their holdings to securities issued by companies that meet certain ethical and moral standards. III. Selecting and Evaluating Mutual Funds A. Matching fund classification with investment objectives 1. Factors to consider a. The outcome you’d like to achieve b. The time horizon you have for achieving it c. The amount of risk you’re will to take d. Minimizing taxes owed 2. Identify fund classifications that would be appropriate for their objectives. a. Debt versus equity b. Growth verses income 3. Consider whether fund income is taxable versus tax exempt B. Identifying fund alternatives: Use the graphic in Exhibit 14-7 to illustrate the process. C. Comparing funds based on key factors

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1. 2. 3. 4. 5. 6.

Ratings Expenses Net Asset Value Manager Tenure Services Provided Fund Family is an arrangement in which a single company operates several separately managed mutual funds with different investment objectives. D. How many funds? 1. Having more funds isn’t the same thing as diversifying. 2. Having more funds from different families reduces the risks related to investment company failure or wrongdoing and not market risk. 3. Diversify by buying shares in funds that focus on different areas. E. The mutual fund transaction 1. Find the current price from a broker, in newspapers and on a financial website. 2. Making the Purchase a. Although half of all fund shares are sold through brokers, you don’t have to use one. Many investment companies sell their shares directly to investors. b. The Financial Services Modernization Act pf 1999 made it possible for banks and insurance companies to create and market mutual funds. F. Tracking your portfolio 1. You must keep up with your portfolio and you should continue to make additional contributions to your investment fund. 2. Regularly review the performance of the fund relative to its investment objectives and the index that it tracks. IV. Real Estate Investment A. Your home as an investment 1. Real estate can add value to your investment portfolio, increase your diversification, and provide less volatile returns over time. 2. Requires a substantial amount of hands-on management and expertise. 3. You can’t access returns without substantial costs. 4. Real estate markets can help reduce the impact of the market decline. B. Direct versus indirect real estate 1. Direct real estate investment: investor hold title to the actual property. 2. Indirect real estate investment: investor owns real estate through a trustee or company that holds the title to the real estate C. Advantages of direct real estate investment 1. After-tax cash flow a. You’re allowed to depreciate the cost of your initial investment in the home over 27 ½ years. b. Other allowable deductions include interest expenses, property taxes, insurance, utilities, and expenses for repairs and maintenance, and other reasonable expenses that you incur in the management of the property. c. Negative taxable income can be deducted against other taxable income up to a maximum of $25,000 per year.

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d. If you have a vacation home, you are allowed to rent it out for up to 14 days per year without recording income. 2. Price appreciation a. The price of real estate has increased faster than other goods. b. The appreciation of any individual property depends primarily on its location. 3. Leverage a. If you borrow money to purchase investment real estate, your actual return on investment will be higher then if you pay cash. D. Disadvantages of direct real estate investment 1. Large initial investment 2. Lack of liquidity 3. Reduced diversification a. Real estate investments require so much money that you will have less money to invest elsewhere. 4. Transaction costs are very high for real estate. 5. Hassles of day-to-day management E. Indirect real estate investment 1. A limited partnership is a partnership in which limited partners provide investment funds, have limited liability, and participate in profits by a general partner manages the investment. 2. Real Estate Investment Trusts (REITs) are the most attractive for of indirect real estate investment. 3. Mortgage-backed securities are securities that are backed by pools of mortgages. Investors receive a share of the cash flows from the mortgages. V. Other Investment Alternatives A. Not recommended for novice investors. B. Precious metals and gems 1. High up-front cost and provides no regular cash flow. 2. Resale market for jewelry is relatively inefficient. 3. Investments in gold and other precious metals are not a good way to diversify because the returns are so low it drags down the overall portfolio returns. 4. Direct investment requires commission fees when buying and selling, and it is not safe to keep bars sitting around the house. C. Collectibles and art 1. This is a dual purpose investment because you can enjoy the asset today and they will have value in the future. 2. These do not provide a regular cash flow. 3. These are risky relative to other asset classes. D. Financial derivatives 1. A futures contract is one in which you promise to buy or sell the underlying security at some point in the future at a price that is determined today. 2. An options contract gives you the right to buy or sell in the future at a specified price but doesn’t require you to go through with the purchase or sale. a. A call option gives you the right to buy something in the future. b. A put option gives you the right to sell something in the future.

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3. The advantage is that you can participate in the price movements of the underlying security without buying the security itself. 4. Options are complex financial investments that require financial expertise, indepth understanding of the market, and the products. 5. Trading is often speculative, but it can also be used to reduce risk in your underlying portfolio. 6. Hedging is if you invest in a derivative contract that will increase in value when something else in your portfolio decreased in value. E. Should you consider alternative investments? 1. Before investing, take a close look at your financial plan. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.sec.gov: The Securities and Exchange Commission regulates mutual funds and provides protections for investors. Go to their website and look for educational material for new mutual fund investors. Would you recommend this website for others who are considering investing in mutual funds? 2. www.morningstar.com: Select a mutual fund that you would like to invest in by using the screening tools on the Morningstar website. Compare your fund’s performance over the last year to that of the S&P500. 3. www.irs.gov: Go to the Internal Revenue Service website and look up information on the taxation of mutual fund dividends. Make a short report to the class on the change that was put in place by the Bush Administration. Would this make investors more likely to invest in mutual funds outside of tax-deferred retirement accounts? Is this type of tax reduction good for the economy? Why or why not? 4. www.ici.org: The Investment Company Institute collects extensive data on investment companies. Go to their website and find their most recent Mutual Fund Fact Book. Compare the information in Exhibits 14-1 and 14-2 to the more recent statistics on number of households owning open-end funds, the number of open-end funds in existence, and the total net assets of open-end funds. Has there been a significant increase sine 2003? Why do you think that the growth slowed in the period 2000-2002? 5. www.nareit.com: The National Association of Real Estate Investment Trusts collects information on the REIT marketplace. Use the information on that website to write a short report on this investment class. What are the advantages of investing in real estate relative to other asset classes, according to this organization? How did REITs perform during the recent stock market downturn? What different types of REITs are there? ADDITIONAL MINI-CASES 1. Case 1 – Maintaining Optimal Asset Allocation Heather wants to allocate her $20,000 portfolio 50% to stocks and 50% to bonds. She therefore bought $10,000 of stock mutual fund shares and $10,000 of bond mutual fund shares. After one year, her stock fund has earned a return of 10% and her bond fund has earned a return of 5%.

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a. At the end of the first year, what is Heathers stock/bond allocation? b. If she wants to maintain the 50/50 allocation, what are her options? c. Is there any cost to rebalancing? d. If Heather continues to split her new investment dollars equally between stocks and bonds, but does not rebalance, what adverse effects will this have on her portfolio? 2. Case 2 – Load Funds versus No Load Funds Penn and teller have asked you to help them resolve a dispute. Penn thinks that it is always better to invest in no-load funds. “After all,” he says,” why should I pay a commission if I don’t have to?” Teller thinks that his brokerage firm more than makes up for the 3% front-end load by providing him with greater services and performance. a. If both Penn and Teller invested $10,000 at the beginning of the year and Penn’s fund averaged 10% return, how much would Teller’s fund have had to earn to be equivalent after taking the costs into account? b. What types of services do you think are being provided to Teller? Are these worth paying for? c. Many funds have high expenses and these expenses are often suggested as the reason that actively managed funds are less likely to beat the index they are tracking. Why would investors ever want to invest in load funds? 3. Case 3 – Barbie Mania Barbie is one of the most popular categories of collectibles. Although there are literally millions of normal Barbie dolls sold word wide, Mattel, Inc. regularly produces “limited edition” Barbie collectibles, many of which cost $200 or more. These are marketed to collectors as “investments.” Beverly has been collecting Barbies for the last ten years and estimates that she has more than 1,000 dolls. An investment advisor has suggested that she sell them all and invest in the stock market instead. Beverly shows him a Mattel, Inc. book that gives the current market values of her dolls and verifies that her “portfolio” has increased in value over time with no risk. a. Explain to Beverly why the Mattel, Inc. book is not an accurate measure of the value of her portfolio. Identify some of the risks she is exposed to. b. Search on ebay.com to find out how many Barbies are listed there. What is the most expensive one you can find (search on limited editions)? c. By looking at the listings, can you determine what characteristics make a doll worth more or less? Does this interfere with your enjoyment of the dolls while you own them? d. Assume that Beverly bought a Holiday Barbie in December 2000. Find out what it could sell for today. If she paid $50 in 2000 for that Barbie, what would her return on investment be? Did Beverly incur any transaction costs in the purchase? Will there be any for the sale? How do those costs impact her return on investment? e. What are the advantages and disadvantages of a large auction market like ebay.com? Before ebay was created, how would Beverly have sold her dolls? Do you think that they would have been worth more or less?

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TEACHING SUGGESTIONS 1. If you have access to the Internet in your classroom, you can easily demonstrate the use of the Morningstar screening tools for selecting mutual funds. You can also show the class how easy it is to download a prospectus for a mutual fund. Show the class a fee table for a particular fund as well. 2. Have the students do a dollar cost averaging comparison. Provide them with a set of monthly fund prices for a period of five years (from finance.yahoo.com or Morningstar.com, for example) and ask them to compare the outcome with annual lump sum investments versus monthly investments of smaller amounts. Have them write a short report that summarizes their findings. 3. Break the class into groups and assign half the groups to identify arguments in favor of investing in exchange traded funds and the other half to identify arguments in favor of investing in actively managed funds that track the same indexes. When each group is finished, facilitate a classroom debate on the subject. You can use this to revisit the issues of market efficiency and transaction costs. 4. Illustrate the advantages of leveraged real estate investments by giving a simply home purchase example. 5. Have the students ask their parents or another homeowner for information on the price they paid for their home, any improvements made over time, and the current value. Ask them to calculate the annualized return on investment (without leverage). Using the current average mortgage rate, ask the students to estimate the leveraged return on investment. (You could have them use actual mortgage information, but with so many refinances and home equity loans in recent years, this is overly complex.) 6. Find out if any of the students or their parents have purchased homes for them to live in while they are going to college. Use this to motivate a discussion of the pros and cons of making this type of investment. What are the disadvantages of living in your investment property? If you are renting the property to others, what is it like to be a landlord? 7. Find out how many students have ever purchased collectibles with the objective of investment gains. If the class is large enough, it is entertaining to find out how many have purchases certain types: Barbies; Beanie Babies; action figures; comic books; sports memorabilia. Discuss the pros and cons of investing in collectibles. Check in advance on ebay for the current value of an interesting collectible for which you know the original price. Have the class do a quick calculation of investment return. Be sure to bring up the issues of storage costs, potential for damage or breakage, and fads.

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CHAPTER 15 SAVING FOR DISTANT GOALS: RETIREMENT AND EDUCTION FUNDING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 512-513 Case 15-1 Choice of Annuities a. She will receive nothing. b. It would have been reasonable if Henry had outlived his wife. However, it was probably selfish on his part, since he didn’t consider the potentially devastating financial impact on his wife if he died first. c. She won’t be able to receive Social Security benefits until she is at least 62, but will then qualify to receive benefits based on her husband’s earnings history. d. Hopefully she was the beneficiary of Henry’s life insurance policy. If the family home has significant value, she can sell it and live someplace cheaper. If she can’t work due to poor health, she may have to rely on relatives for support or she will have to apply for public assistance. Case 15-2 An Older Widow Plans for Retirement a. $250,000 x (1.06)12 = $503,049, an increase of $103,049 b. If post retirement expenses are 80% of preretirement expenses, she will need ncome of $18,000 x 80% x 1.04 = $14,976. c. 35,000/12 = 2,917 = AIME PIA = [90% x 606] + [32% x (2,917-606)] = 1,285 per month. d. She will have enough in the early years at least. Her Social Security benefit (1,285 x 12 = 15,420) will be enough to cover her income needs calculated above. Since these benefits are inflation indexed, they should increase over time. If her expenses rise due to medical costs or otherwise, she can use her investments or sell her home to fund those costs. Case 15-3 Getting a Late Start on College Planning a. Expected Education Costs: Amount Needed Current Age of Children In Year 10 7 6 Total 8 18,476 18,476 9 18,476x1.04 19,215 2 10 18,476x1.04 19,984 11 18,476x1.043 20,783 41,565 12 20,783x1.04 21,614 43,228 2 13 20,783x1.04 21,614x1.04 44,957 14 20,783x1.043 21,614x1.042 46,756 15 21,614x1.043 24,313 b. 10-year old: In 8 years, need 18,476 x 4 x 50% = 36,952 7-year old: In 11 years, need 20,783 x 4 x 50% = 41,566 6 year-old: In 12 years, need 21,614 x 4 x 50% = 43,228

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c. 10-year old: FV = 36,952; N=8;I=6; Compute PMT =$3,733 7-year old: FV= 41,566; N=11; I=6; Compute PMT =$2,776 6-year old: FV = 43,228; I=6; N=12; Compute PMT = $2,562 Their annual total investment would need to be 3,733+2,776+2,562 = 9,071, or $756 per month. With Rosanne’s income they should be able to meet this goal. They may want to set aside more than this in the children’s education funds in the event that one or more of the children want to attend an out-of-state school or a private school. It is also possible that the children will not be realistically able to pay for 25 percent of their college costs. Perhaps as Rosanne’s income grows, she can increase her allocation to these accounts accordingly. d. Section 529 investment plans are a good idea because of the tax advantages. However, the large amount of funds they are saving will reduce the children’s ability to qualify for financial aid. e. Unless the family income grows substantially, they should be able to use the Hope Scholarship Credit and Lifetime Learning Credit to reduce taxable income while the children are in college. If they use a 529 plan, they will be able to reduce their state taxes. f. They will have trouble funding their retirement needs since most of their extra funds will be going to the education fund. They need to develop a long-term budget to see what expenses they can reduce or additional ways they can earn income in order to work on their retirement goals as well. Case 15-4 Defined Benefit Versus Defined Contribution Plans a. If Ernie works for 40 years and his salary grows 45 per year, his salary will be: $50,000 x (1.04)10 = $74,012 in 10 years $50,000 x (1.04)20 = $109,556 in 20 years $50,000 x (1.04)30 = $162,170 in 30 years $50,000 x (1.04)40 = $240,051 in 40 years b. Maximum benefit under the DB plan would have been $240,051 x 70% = $168,036. c. His first year contribution is 8% x 50,000 = $4,000 and his employer’s contribution is $4,500, for a total of $8,500 invested. Using the formula provided in the problem (which assumes beginning of year contributions, the amount in his account after 40 years = 40 x $8,500 x (1.04)40 = $1,632,347. For end of year contributions, the formula is FV = n x CF x (1+i)n-1. In that case, the amount accumulated is $1,569,564. d. If he buys a 25 year annuity with his accumulated $1,632,347, the payment will be $104,490 (PV = 1,632,347; I=4; N=25; Solve for PMT). This would replace less than half his final salary. If he wanted an inflation adjusted annuity, the payment would be $76,069 in the first year. To solve this, you need to use the equation for the inflation adjusted annuity. y PV = PMT x 1 −  1 + i       (r − i )   1 + r   Assuming that inflation will average 3%, you can solve for PMT as follows:

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PMT =

        1 1  = 1,632,347 x(.04 - .03 )x   PV x (r − i ) x    1+ i  y    1.03  25      1-  1-    1+ r     1.04  

= $76,069 per year d. Based on this analysis, Ernie is not better off with the defined contribution plan. His income under the defined benefit plan, which would be adjusted annually for inflation would be substantially higher. However, if Ernie takes a little more risk in his investments and earns more than 4% on average, he might be able to do better with the DC plan. He would still face the risk that his investment portfolio might decline in value due to a market downturn as he nears retirement. He could minimize this risk by investing in riskier securities while he is young but gradually decreasing the risk of his portfolio as he gets closer to retirement.

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CHAPTER 15 SAVING FOR DISTANT GOALS: RETIREMENT AND EDUCTION FUNDING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 511 in Textbook 1. Monthly Savings Required a. FV = $1,000,000; I=8/12; N=30 x 12 = 360 ; Solve for PMT = $670.98 b. FV = $1,000,000; I=10/12; N=30 x 12 = 360 ; Solve for PMT = $442.38 2. Inflation-Adjusted Retirement Income The retirement wealth you need now is the present value of an inflation adjusted annuity that will pay $40,000 the first year and increase with inflation thereafter. Calculate: 30 Retirement Wealth Now =  40,000    1.04   x 1 − .05 − .04    1.05     = $998,204 3. Effect of Employer Match a. Fred must contribute 5% of salary to receive the total matching dollars from his employer. If he puts 5% x $28,000 = $1,400, his employer will contribute and additional 3%, or $840. b. 2% x $28,000 = $560. This will grow to $560 x (1.1)40 = $25,345 c. If Fred puts in 5%, his $1,400 will grow to 1,400 x (1.1)40 = $63,363 His employer’s contribution of $840 will grow to 840 x (1.1)40 = $38,018 for a total of $101,381 in forty years. d. The cost of losing the employer full match in the first year is $38,018. 4. Income Generated by an Investment Account a. Annual cash flow = $250,000 x 0.05 = $12,500 b. Equal annual payments: PV =- $250,000; N=20; I=5; Solve for PMT = $20,061 5. The Effect of Early Investing Tom: after 10 years: PMT = $3,000; N=10; I=10. Solve for FV = $47,812.27. If he leave it there to accumulate interest but makes no more contributions, calculate amount at age 65: PV = $47,812.27; N=33; I=10; FV = $1,110,447. Harry: Amount in his account at age 65: PMT = 3,000; N=33; I=10; Solve for FV = $666,755 Tom has 1,110,447 – 666,755 = 443,692 more than Harry at retirement. 6. Future Cost of Education a. Amount needed is 4 x 15,000 = 60,000 b. Future value in 6 years: 60,000 x (1.05)6 = 80,406 7. College Funding FV = 90,000; N=12 x 12 = 144; I=6/12; Solve for monthly PMT =$428.27 8. Effect of Early Withdrawal from IRA The withdrawal will be subject to 10% penalty and 20% tax, so all that will be available will be 15,000 x (1 - 0.3) = $10,500.

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CHAPTER 15 SAVING FOR DISTANT GOALS: RETIREMENT AND EDUCTION FUNDING THE LEARNING OBJECTIVES 1. Estimate your retirement income needs. 2. Evaluate your future benefits form employer-sponsored retirement plans and Social Security. 3. Determine your retirement wealth goal and monthly savings target. 4. Describe your alternatives for personal retirement saving. 5. Understand your options for retirement income payouts. 6. Develop a plan for funding your children’s education, taking tax rules into account. CHAPTER OUTLINE AND SUMMARY I. Estimating your retirement income needs A. What are your retirement goals? 1. You have to make a tradeoff between current and future consumption. 2. Retiring earlier and/or spending more in retirement will mean that you have to save more now. B. What will your expenses be in retirement? 1. Replacement ratio method assumes that your retirement expenses will be some fixed proportion of your preretirement expenses. 2. Adjusted expense method estimates after-tax retirement income needs in current dollars by adjusting current expenses for changes expected in retirement. C. Adjusting for inflation 1. You need to adjust your retirement expenses for inflation between now and retirement to arrive at total income needs in your first year of retirement. 2. Use time value of money calculation: FV = PV x (1 + i)n 3. Long-run average is between 3 and 4 percent. D. Adjusting for Income Taxes 1. Some or all of your before-tax (BT) income in retirement may be subject to federal and state income taxes. 2. Calculate after-tax (AT) income needs as: AT = BT x (1- tax rate) II. Sources of Retirement Income: The Three Legged Stool A. The three legged stool = 1. Social Security 2. Employer-sponsored retirement plans 3. Private Savings B. Estimating your benefits from employer-sponsored plans 1. Retirement income from defined benefit plans a. Benefit is based on a formula that takes into account the number of years you’ve worked for the employer and how much you earned.

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2. Retirement income from defined contribution plans a. Assume contributions will continue until retirement b. Estimate the return on investment, but this is subject to risk. C. Estimating your Social Security benefits 1. What is Social Security and how is it funded? a. Defined benefit program administered by the Social Security Administration. b. Intended to provide at least subsistence-level retirement income to program participants. c. Funded by FICA (Federal Insurance Contribution Act) payroll tax paid by employer and employee. Currently 5.3% Social Security, 0.9% disability, and 1.45% Medicare, for a total of 7.65% each (15.3% total). d. Social Security and disability taxes wages up to a maximum that increases each year with inflation. No limit on Medicare tax. 2. Who is eligible to receive Social Security benefits? a. To be eligible based on your own earnings, you must be “fully insured”: you paid taxes in at least 40 quarters (10 years) and earned at least a specified minimum dollar amount in each of those quarters. b. You can also receive benefits if your spouse is fully insured. 3. How much will I get from Social Security? a. Average indexed monthly earnings (AIME) is the average of a person’s 35 highest years of monthly earnings, adjusted for inflation, used in computing that individual’s Social Security benefit. b. Primary insurance amount (PIA) is the Social Security benefit payable to a program participant who retires at the normal retirement age. 4. Will Social Security be around when I retire? a. Pay-as-you-go financing for the system; current payroll taxes are used to fund current benefit payments. b. If taxes collected exceed benefits paid, the Social Security Administration invests the extra money in special-issue Treasury bonds. c. Causes of projected Social Security insolvency: 1) People are living longer and the baby boom will be retiring, which will cause tax inflows to lag benefit outflows within the next two decades. 2) Assuming the federal government repays their IOUs and there are no reforms put in place, the trust fund will be depleted in about 40 years. d. Prospects for reform 1) President Bush wants a defined contribution approach. 2) Other possibilities include increasing the retirement age, tweaking the PIA formula; limiting benefits for the wealthy. III. Establishing a monthly savings target A. Retirement income shortfall 1. = Total before-tax income needs – Projected income from employer retirement plans – Projected Social Security benefit 2. This is the amount of income your investments will have to generate in your first year of retirement. It will need to increase with inflation each year to provide equivalent purchasing power.

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B. Total retirement wealth needed 1. Use time value of money tools to estimate amount needed to generate sufficient income. You need to consider: a. The number of years you’ll live in retirement. b. Inflation during retirement 2. Two approaches a. Use the interest earnings alone, preserving the principal. b. Assume you will buy an inflation-adjusted annuity: series of payments at equal intervals that increase with inflation. C. Monthly savings target 1. Given your retirement savings goal, you can estimate the monthly savings required to achieve that goal. 2. It is important to start early 3. The rate of return on your investments makes a big difference IV. Personal retirement savings options A. Individual retirement accounts (IRAS) 1. Traditional IRAs a. Contributions tax deductible in the year made. b. Taxes owed on withdrawal. c. If you participate in an employer-sponsored plan, the deductibility of contributions depends on you adjusted gross income. d. Maximum contribution $4,000 in 2005 ($4,500 for over 50) subject to income limits. 2. Roth IRAs a. Contributions made with after-tax dollars b. Investments accumulate tax-free with no tax due on withdrawal, as long as the taxpayer ahs reached age 59 ½ or is using the proceeds for qualifying educational, medical, or first-time home purchase expenses. c. Same contribution limits as traditional IRAs but higher income limits. B. Investing in taxable accounts 1. Allows more financial flexibility C. Asset allocation in retirement accounts 1. Consider your time horizon. 2. Don’t forget about taxes. 3. Diversify. V. Preparing for retirement payouts A. Distributions from retirement accounts 1. In general, distributions from employer plans and traditional IRAs will be taxable when they’re received. 2. Distributions from Roth IRAs not subject to tax. 3. Tax rules require that you begin taking payouts form both employer plans and IRAs by April 1 of the year after you reach 70 1/2. 4. It is always better to pay taxes later rather than sooner. 5. When you retire, you may receive a lump sum, an annuity, or a combination of both. a. Annuity for a specified term: Equal payments for a specific period.

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b. Single life annuity: Equal payments until you die. c. Joint and survivor annuity: Equal payments until the death of the second spouse. B. Tapping your home equity: can generate tax-free retirement income. 1) Payments are required, but interest paid is tax deductible. 2) Reverse annuity mortgage can allow you to remain in the home. C. What happens if you don’t have enough money to retire? 1. Reduce expenses. 2. Continue to work. 3. Increase savings. 4. Rely on family. 5. Rely on public assistance. VI. Funding Your Children’s Education A. How much will you need? 1. Average cost of one year of undergraduate education at a public in-state university in 2005 $13,500 and at a private university $34,000. 2. Use present value calculations or estimate using Exhibit 15-7 B. Monthly saving target 1. Use the time value of monthly to estimate the monthly savings amount. C. Tax programs to help you save for education expenses 1. Tax-preferred savings plans a. Coverdell Education Savings Accounts are educational savings arrangement which allows after-tax contributions of $2,000 per year per child and tax-free withdrawals. b. Section 529 Plans are state-sponsored programs that provide tax-benefits for college savings. Can be either a prepaid tuition plan or savings plan. 2. Tax Credits for Education a. Hope Scholarship tax credit is a tax credit of up to $1,500 per year for eligible expenses incurred during the first two years of college. b. Lifetime Learning tax credit is a tax credit of 20% of the first $5,000 of college expenses up to a maximum of $1,000 for every eligible dependent who has incurred these expenses during the year. ADDITIONAL WEBSITE ASSIGNMENTS 1. www.moneycentral.msn.com: Click on “Planning” and then “Retirement” and go to the “Retirement Planner.” Use this tool to estimate how much income you will need in retirement. 2. www.asec.org: Click on “Savings Tools” and then under “ASEC Savings Tools for Youth,” click on the interactive savings calculator to see what it would take to meet your retirement needs. 3. www.wiser.org: Read “Your Future Paycheck,” an informational pamphlet produced by the Women’s Institute for a Secure Retirement in cooperation with the Society of Actuaries. Write a short summary that identifies the most important challenges that women face in planning for retirement.

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4. www.aarp.org: The AARP is one of the most powerful political lobbies in the United States. As the population ages, AARP membership is expected to grow accordingly. Read “Strengthening Social Security: Questions and Answers.” In the current Social Security debate, what is the AARP’s opinion about the need for Social Security reform and, in particular, the viability of reform measures that include private accounts? Explain why this makes sense, given the membership of the AARP. 5. www.ssa.gov: Use the Social Security Administration website to estimate your future benefit, assuming you retire at age 67. How much difference will it make if you retire early? 6. www.irs.gov: Search the Internal Revenue Service website for information on IRAs. What is the maximum you can contribute this year? 7. www.collegeboard.com: The College Board website reports average costs for different types of colleges and universities. Find the most recent data and compare it to the costs provided in Exhibit 15-7 (which were estimates calculated by applying an expected annual increase to the 2003-2004 actual costs). How can you explain the discrepancy? Which type of college or university experienced the largest increase in costs since the 2003-2004 academic year? ADDITIONAL MINI-CASES 1. Case 1 – Is an IRA Enough? Ima Saiver expects to graduate from college at age 25 in May 2008. Since she doesn’t expect to work for an employer that offers a retirement plan as part of her benefit package, she plans to open a Roth IRA account and fund it with the maximum allowed contribution ($5,000 per year). a. Assuming there are no changes in the allowed limits until she retires at age 67, how much will she be able to accumulate by the time she retires if her annual return on investment is 5%? b. Ima thinks she could currently live comfortably on $30,000 per year. Using the replacement ratio method, forecast Ima’s retirement income needs in retirement, assuming 4% inflation. c. If Ima doesn’t think Social Security will be available when she retires and she has no other income sources, how much retirement wealth will she need at the date of retirement in order to fund her income needs. Will it be realistic for Ima to plan to live off the investment earnings on her assets or will she need to use the principal as well? Explain. 2. Case 2 – Saving for an MBA Juana Raze was a French major in college and, as much as she loved studying a foreign language, she is now finding that there aren’t that many well-paying jobs that fit her skills. She is currently working as an office manager for a law firm making $25,000 per year. She would like to save enough money to be able to back to school for a Masters in Business Administration (MBA) in a few years. Tuition and fees for a one-year program at a nearby university are currently $6,000. Books will cost another $1,500. If she goes to school full-time, Juana would likely qualify to receive a graduate teaching assistantship which would cover her tuition and fees and pay her a

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stipend of $1,600 per semester. The part-time evening program is two years and parttime students are not eligible for the assistantship a. What steps would you recommend that Juana take in planning to achieve this goal? b. How much financial difference is there between the full-time and the part-time MBA alternatives. c. What tax incentive programs can Juana take advantage of in the next few years while she is saving to go back to school? d. What tax incentive programs can Juana take advantage of once she is actually spending money to fund her education? e. What additional information will you need in order to be able to estimate how much Juana needs to save to achieve this goal? 3. Case 3 – Planning for the Retirement of Only One Spouse When Karrin and Peter Michener married twenty years ago, their seventeen year age difference didn’t seem to make much difference. But now Peter is 62 and is eligible to retire under both Social Security and his company retirement plan. Karrin is only 50 and will have to work another 12 years. Their youngest child Dwight is a senior in high school and their daughter Rochelle has one more year to graduation from college. a. What unique problems are faced by couples with large age differences? b. If Peter decides to retire, should the Micheners make any changes in their investment allocations? Why or why not? c. If they both currently have equal incomes and carry equal amounts of life insurance, will Peter’s retirement make a difference in this aspect of their financial plan? d. If the Micheners had previously been paying for their daughter’s college expenses out-of-pocket, using Peter’s salary to pay for those expenses and living on Karrin’s salary, will Peter’s retirement necessitate a change in strategy? e. What categories of household expenses and allocation of effort do you expect to change when one spouse retires? TEACHING SUGGESTIONS 1. Begin the discussion of retirement planning by citing the results of the “Retirement Confidence Survey.” This annual survey asks Americans questions about whether they are planning for retirement, how prepared they feel, and what specific steps they are taking. Over the period the survey has been in place, it is clear that a lot of people are not very confident that they will have enough to retire comfortably. Women are generally less confident than men. Ask students to identify some of the reasons for these results. 2. Have students talk to one or more people who are retired to find out what they wish they had done differently in preparing for retirement. 3. Have students write down a list of the things they would like to be able to do in retirement. At what age would they like to retire? 4. The evidence suggests that the poorest elderly are single, divorced, or widowed. Discuss how being married can improve your standard of living. Ask students to consider how much a woman’s expenses will go down when her husband dies.

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5. Take a poll of the class to determine how many think that Social Security will be around when they retire. Use this to moti 6. Have students calculate how much income they can receive from a $1 million nest egg, assuming that it earns 6 percent per year after taxes. If inflation erodes the purchasing power of this annual income by 4% per year and you have to dip into your principal, how much will remain after five years? Do this calculation on the board and use it to illustrate the importance of planning for inflation. 7. Have the students break into groups to discuss Social Security reform. Ask the groups to identify one possible reform and to make a list of arguments both for and against that reform. Alternatively, you can assign particular reform ideas to each group depending on the current political climate (e.g. increase the retirement age, increase the payroll tax rate, increase the maximum wages that are subject to tax, allow some of the payroll taxes to be diverted to individual accounts, reduce benefit promises). Once the groups have discussed this on their own, have them each present their conclusions to the class. 8. Have the class consider the pros and cons of retirees returning to work after retirement. Why would any retiree want to go back to work? With the proportion of retirees increasing, will there be a shortage of younger workers in the future, particularly in the service sector? What will employers have to do to attract and retain these workers? 9. Consider the following method of saving for higher education: each generation pays for the second generation to follow. So your grandparents pay for you, your parents pay for your children, and so on. Discuss the pros and cons of this strategy.

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CHAPTER 16 LIFE INSURANCE AND LONG-TERM CARE PLANNING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 549-550 in Textbook Case 16-1 Vanna and Patrick O’Hara Evaluate Their Life Insurance Needs a. If Vanna and Patrick do nothing more, their children will have $105,000 in life insurance, $35,000 in savings. After paying the family’s debts and costs at death, there will be only $115,000. If the house must be sold, some of the home equity will be lost to real estate commission and closing costs, so the full $50,000 won’t be available to fund the chilren’s income needs. In addition, the children will be eligible for $2,000 per year in Social Security survivor benefits. Whether this will be enough depends on who will take care of the children after the O’Haras die. b. The income multiple method suggests that the minimum you should have is 5 times your income. Pat should have $50,000 x 5 = $250,000. Vanna should have $150,000. c. Financial needs: Pat Vanna Costs at death $ 15,000 $ 15,000 Pay off mortgage Pay off credit cards Education fund Household expenses ($60,000/12) x 3 Lump sum needs

150,000 10,000 130,000

150,000 10,000 65,000

15,000 $305,000

15,000 $190,000

Decreased annual income 50,000 Lost services 5,000 Reduction in expenses 6,000 Social Sec. survivor benefits -24,000 Household Maint. Needs/yr 25,000 Times 11 years = 275,000

30,000 10,000 6,000 0 34,000 374,000

Total Funds Needed

$579,000

$595,000

d. Since their needs are great relative to their income, term life insurance is likely to be the most cost effective choice. They should each carry about $600,000 and they can gradually decrease the amount of coverage as their home equity increases and their college savings accounts grow. e. The risk of term life insurance is that they might not be insurable at some point in the future. For this reason, they should purchase ten-year renewable term insurance. They can then renew regardless of their health situation for at least ten years.

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Case 16-2 Kurt Nelson Considers Buying Long-Term Care Insurance a. Earnings from assets (4% x $500,000) $20,000 Pension 32,000 Social Security 18,000 Total after-tax income 70,000 Expenses Net after-tax cash flow

40,000 30,000

In effect, Kurt does not need to use his earnings on assets to fund his retirement and he is increasing his nest egg at a rate of $10,000 per year. b. Long-term care costs for the next three years would total $180,000 so Kurt has enough wealth to cover it. His net after-tax cash flow not including the long-term care costs would be $70,000 – 20,000 = $50,000, so the LTC expenses would not require that he use up much of his wealth ($10,000 net outflow per year). c. Long-term care in 25 years will cost 60,000 x (1.08)25 = $410,940 per year. With his net cash flow of $10,000 per year reinvested and earning 4% after tax, Kurt’s current $500,000 will grow to 500,000 x (1.04)25 = 1,332,918. If he invests the extra 10,000 cash flow each year, it will grow to $416,459, for a total net worth at age 88 of 1,332,918 + 416,459 = 1,749,377. This will be enough to cover about four years of long-term care. d. No. Life insurance at his age is very expensive, if available. He doesn’t need any unless he wants to give more than $500,000 to his heirs.

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CHAPTER 16 LIFE INSURANCE AND LONG-TERM CARE PLANNING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Page 548 in text 1. Life Expectancy a. Using Exhibit 16-1, at 60 years old, there will be .8787 x 100 = 87 men alive and .9063 x 100 = 90 women alive for the reunion. b. At 70 years old, .7335 x 100 = 74 men and .7974 x 100 = 80 women alive. c. At 80 years old, there will be .4571 x 100 = 45 men alive and .5860 x 100 – 58 women alive for a total of 45 + 58 = 103. Since there are currently 87 + 90 alive at age sixty, this implies that That means that 177 – 103 = 74 will die over the next twenty years. 2. Life Expectancy a. If Cathy has an average life expectancy, she will live to be 50 + 32.7 = 82.7 years old. b. If Mary has an average life expectancy, she will live to be 80 + 9.9 = 89.9 years old. c. Mary will live to the oldest age based on life expectancy, even though her daughter is younger. This may be a surprise, but it is because Mary has already proven herself to have greater tendency to longevity by living to be 80. The longer you live, the greater your probability of living longer than average. 3. Life Insurance Needs Analysis Based on this rule of thumb, you should have $200,000 in life insurance and your wife should have $140,000. 4. Life Insurance Needs Analysis a. The income multiple approach would imply that Kate should carry a face amount of life insurance equal to 5 to 10 times her salary, or $200,000 to $400,000. The low end of this estimate would not be enough money, given her needs. The children’s upkeep at $15,000 per year would be $120,000. Their college costs will be at least $20,000 per year per child, for a total of $160,000. In present value, that amount is about $126,000 (discounting at 3%). b. Assuming that the only upkeep costs for the children are the $15,000 per year, she will need a minimum of $120,000 + $126,000 + $10,000 = $256,000. c. In that case, the upkeep cost would be only $5,000 per year, so that would reduce her insurance needs by $80,000. 5. Life Insurance Policy Terms a. Decreasing term will not change the initial premium. b. Guaranteed renewability will increase the initial premium. c. Increasing term will not change the initial premium. d. Convertibility will probably increase the initial premium.

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6. Life Insurance Policy Terms a. Limited payment will required a larger payment than a traditional whole life policy. b. A variable life insurance policy will require a lower payment since the higher investment returns on the policy help to reduce the present value. c. A policy with an increasing premium over time usually requires a lower payment in the early years. d. A policy with decreasing face value over time will require a lower payment as compared to a traditional face value policy.

7. Comparing Life Insurance a. If you pay the $120 term premium instead of the $1,120 permanent premium, you can have the same level of coverage and an extra $1,000 per year to invest. Every year after the first, however, your term premium will probably increase (since term is age related), so you will have less to invest each year. b. If you invest the $1,000 difference each year, at the end of five years, you would have $5,637 in your investment account (N=5; I=6; PMT=$1,000; solve for FV = $5,637). c. To do this calculation accurately, you would need to have a schedule of expected term premiums for the period over which you expect to need coverage. As your investment account increases in value, you can gradually decrease the amount of term coverage. For example, after 5 years, you may only need $95,000 in coverage since the investment account would bring the total to the required $100,000. The permanent coverage is likely to be a level premium, so that amount can be expected to remain constant for the policy period. You would also want to know whether the term insurance is guaranteed renewable. In the event that you became uninsurable, your insurer could otherwise choose to not renew your policy. 8. Nursing Home Costs a. Most people are surprised by the range of costs from state to state. The differences are likely driven by the costs of medical care (hospitals, caregivers, drugs) and the supply and demand for long-term care (number of facilities close by, percentage of the population over age 75, affluence of the population). b. The cost in Georgia is currently $43,200. If costs rise at 6 percent per year, in five years it will cost $43,200 x (1.06)5 = $57,808 c. The cost in Colorado is currently $52,500. If costs rise at 6 percent per year, in three years it will cost $52,500 x (1.06)3 = $62,528. 9. Nursing Home Costs a. Annual difference in facility cost +$5,000 Cost of visiting Arizona - 3,000 Total annual differene $ 2,000 b. Five years at $2,000 is $10,000 annual cost savings

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Less one-time cost of move $7,000 Net savings = $10,000 - $7,000 = $2,000 so Arizona is better. If she only stays in the home for three years, it would be cheaper to leave her in Illinois. $2,000 x 3 = $6,000 savings is less than the $7,000 cost of the move.

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10. Costs of Household Maintenance a. Assuming 20% decline in expenses: Decreased after-tax income $50,000 Less: Reduction in family expenses 60,000 x 20% 12,000 Annual social security benefit From Exhibit 16.3 28,956 Net Income Shortfall $9,044 b. Assuming 25% decline in expenses: Decreased after-tax income $50,000 Less: Reduction in family expenses 60,000 x 25% 15,000 Annual social security benefit From Exhibit 16.3 28,956 Net Income Shortfall $6,044

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CHAPTER 16 LIFE INSURANCE AND LONG-TERM CARE PLANNING THE LEARNING OBJECTIVES 1. 2. 3. 4. 5.

Assess your life insurance needs. Evaluate insurers and policy types to determine which will best meet your needs. Understand the terms and conditions in life insurance policies. Recognize the costs associated with long-term care. Identify and evaluate long-term care insurance alternatives.

CHAPTER OUTLINE AND SUMMARY I. Life insurance and your financial plan A. How does life insurance work? 1. The insurer pays out the face value if you die during the policy period—only one event is the trigger as compared to other types of insurance which have many possible triggers. 2. Type of pure risk for which the pooling mechanism is well suited. 3. Pay a small premium (relative to potential loss). If you die, your beneficiaries are paid a pre-specified sum of money. 4. Designed to replace the income you would have earned if you hadn’t died prematurely. 5. Your health and family history is required by an insurer to underwrite the policy. B. How is life insurance different? 1. Unlike other insurance, the question is when not if the event will occur. 2. Policies tend to be longer term 3. Determinants of Premiums a. Your risk of dying during the policy period (which increases predictably with age). b. Premium includes additional amounts to cover the insurer’s expenses and its profit to shareholders. c. Also add risk charge, which is to account for the chance that the insurer’s estimate of your mortality risk is inaccurate. 4. Life insurers are able to invest in long-term securities because of long-term nature of life insurance. 5. Benefits of Life Insurance a. Large amounts of coverage for a relatively small annual cost. b. Life insurance policies are not subject to the claims of your creditors. c. Proceeds of life insurance are not subject to income tax. C. Assessing the financial consequences of dying 1. You must carefully evaluate the needs of your beneficiaries. 2. A person’s risk of dying is estimated by the use of standardized mortality tables, which are based on years of statistical data on millions of lives. 3. Why buy life insurance?

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a. To replace you income and services to the household. b. To preserve household wealth. c. To provide for future family needs. d. To cover business losses. 4. Factors affecting your life insurance needs a. Number and age of your dependents. b. Your age and life-cycle stage. c. Your spouse’s earning capacity. d. Financial wealth and obligation. e. Your health. f. Your dependents’ health. 5. Approaches to Life Insurance Needs Analysis a. Income-Multiple Method is the simplest method to estimate life insurance needs, based on a multiplying your income by a factor of 510. 1) Disadvantages: “one size fits all” is not necessarily right, no good reason to choose factor, and the use of a straight multiple ignores other factors, such as inflation 2) Advantage: simplicity b. Financial Needs Approach is a more accurate method for estimating life insurance needs, based on expected capital and income replacement needs 1) Categories of financial needs: costs of death, lump sum needs, and household maintenance costs 6. Life insurance needs will change over your life cycle. II. Selecting a life insurer and type of policy A. Term life insurance provides protection for a specific period of time and has no investment component. 1. If you die during the contract period, your beneficiary will receive the face value of the policy, which is the dollar value of protection payable to beneficiaries under the terms of a life insurance policy. 2. Term allows you to buy a fairly large amount of protection for a relatively modest premium. 3. Problems a. Premiums rise sharply as you get older b. Future availability of coverage isn’t guaranteed unless you have specific provisions in your insurance contract.Guaranteed renewability is the right to renew the contract without additional proof of insurability. 4. Convertible term policies give you the right to convert to permanent life insurance without additional proof of insurability. 5. Decreasing term life insurance is a type of term life insurance featuring a level premium and decreasing protection. B. Permanent life insurance provides an investment component along with the protection component. 1. Cash value is the value of the investment component of permanent life insurance policy.

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2. Whole life insurance provides death protection for a person’s entire life. a. Ordinary life insurance is whole life insurance with premiums payable to the time of death. b. Limited payment life insurance is whole life insurance that is paid up after a specified period. c. Single-premium whole life insurance is whole life insurance that is paid up with a one-time payment. d. Whole life policies have been criticized for relatively noncompetitive rates of return credited to policyholders. They are also relatively inflexible regarding premium payments. 3. Universal life insurance is a type of permanent insurance that allows policyholders to benefit from the investment experience of the insurer and provides a flexible premium option. 4. Current assumption whole life insurance is a type of permanent life insurance with premiums that depend on the insurer’s actual mortality, expense. 5. Variable life insurance is permanent life insurance that has a fixed premium and allows policyholders to choose from different investment alternatives. 6. Variable-universal life insurance is permanent life insurance that involves a flexible premium feature and allows policyholders to choose from different investment alternatives. D. Buy term and invest the difference? 1. Premiums for permanent insurance are many times those for term insurance. 2. As the face value of the term insurance declines over time, the value of your investment portfolio will increase, so you have relatively constant protection. 3. What will determine the success of this strategy? a. Will you stick with your investment plan? b. Can you earn more on your investments than the insurer can? c. Is it cheaper to buy term and invest the difference? E. Choosing an insurer 1. Financial strength of the insurer because life insurance is often a long-term arrangement and it involves large sums of money. 2. Stock versus mutual a. A stock company is owned by shareholders, who expect to make a profit on their equity investments. b. A mutual insurance company is owned by its policyholders. 1) Participating policies are life insurance policies issued by mutual insurers that pay dividends to policyholders. F. Factors to apply in choosing a life insurance agent: 1. Education, professional credentials, and certifications 2. Experience 3. Reputation 4. Responsiveness a. Provides you with the information necessary to make appropriate decisions. 5. Ethical behavior

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III. Reading your policy A. Policy Declarations 1. The name of the insurance company 2. The name of the insured and policyholder 3. The face amount of the policy 4. The policy issue date 5. The type of insurance and key features 6. The period of time that the policyholder has to back out of the contract 7. The insurer’s promise to pay B. Key provisions in a life insurance policy 1. Grace Period a. Insurance premiums are due on a particular date, and if you don’t pay a premium on time, your policy lapses. 2. Policy Loans a. You can borrow from your accumulated funds without terminating the policy. 3. Incontestable Clause states that the insurer cannot contest a claim for misrepresentation after a policy has been in force for a specified period of time. 4. Policyholder dividends a. Dividends from mutual companies are not taxable to the policyholder. b. Amount paid depends on insurer’s financial performance. 5. Entire contract clause explicitly states that the written contract is the entire agreement between the insurer and the insured. 6. Nonforfeiture laws require that, if your contract lapses before maturity but after some minimum amount of time, the insurer must refund a fair amount of the cash reserve. 7. Reinstatement may entitle the insured to reinstate a policy that has lapsed under certain circumstances. 8. You are required to designate a primary beneficiary and you should also name a contingent beneficiary. 9. Suicide clause allows the insurer to deny coverage if the insured commits suicide and the policy has been in force less than a specified period of time. 10. A waiver of premium is an insurance option that allows the insured to waive premium payments under certain conditions, such as permanent disability. 11. Accelerated benefits offer an option under which terminally ill policyholders can receive a portion of their life insurance proceeds before their death. 12. Accidental death benefit is a life insurance contract provision by which the benefit is doubled for an accidental death. 13. Guaranteed purchase options give you the right to purchase additional amounts of insurance in the future without proof of insurability and without “restarting the clock” on the suicide and incontestable clauses. 14. Settlement options a. Lump sum b. Periodic interest only c. Income for a period of time

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d. Income of a specified amount e. Income for life IV. Planning for long-term care costs A. How much will long-term care cost? 1. Long-term care (LTC) is medical and personal care for persons with an extended illness or disability that is not provided in a hospital. 2. Average cost is $50,000 to $60,000 per year. Nursing home costs by state are given in Exhibit 16-8 B. Criteria for selecting a nursing home facility 1. Physician’s recommendations 2. Availability 3. Services provided 4. Location 5. Quality C. Sources of funds for long-term care 1. Household resources 2. Community resources 3. Medicare, if over the age of 65, covers nursing home care for a maximum of 100 days following a period of hospitalization. Also covers cost of home visits by nurses and related medical expenses. 4. Medicaid pays nursing home care for the poor. 5. Your life insurance policy may include some coverage for long-term care. 6. Long-term care insurance. V. Long-term care insurance A. When is the best time to buy long-term care insurance? 1. You may want to delay the purchase of LTC as long as possible, but you run the risk of becoming incapacitated in the meantime. 2. American Health Care Association recommends you buy the insurance between ages 50 and 55 to obtain the optimal price. 3. Uncertainty about future claims costs and a low level of competition have resulted in mispricing. B. Features to look for in long-term care insurance 1. Benefit Amount a. LTC insurance generally will pay you a set amount of money per day of qualified care. 2. Inflation Protection 3. Benefit Period: may be lifetime or a maximum number of years. 4. Waiting Period before the insurance begins to pay for care. Longer waiting periods are cheaper. 5. Services covered C. It’s important to talk with older relatives about their plans for funding long-term care.

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ADDITIONAL WEBSITE ASSIGNMENTS 1. Go to the life insurance section at www.insure.com. Use the life insurance needs calculator there to find out how much life insurance you should have, given your current income, wealth, and family circumstances. 2. Search the web for the latest proposals for reforming Medicaid to limit its coverage of long-term care. Why is there a perceived need for this type of reform? Consider how this will impact the elderly in the future. 3. Go to Learning Center tab at www.insweb.com, click on life insurance, and read the article “Top Ten Money Saving Tips.” Write up a short report on what you find. Will you be able to implement any of these cost-saving measures? 4. Select any life insurance company and go to their home website. Search the site for information on their variable annuity products. What types of information do they report on their site. Can you determine whether the investment performance of these products is comparable to what you could get by investing in mutual funds directly? 5. Search the web for the VARDs report, which compares variable annuity performance. Which companies’ products are ranked the highest in the most recent report? ADDITIONAL MINI-CASES 1. Case 1 – Does It Make Sense to Buy Life Insurance on the Kids? Sylvia and Jay Andrews both have $200,000 face value guaranteed renewable term life insurance policies which they purchased through a reputable life insurer. Their agent has suggested that they should buy a small whole life policy on their newborn son James. The premium is only $20 per month and the policy has a face value of $10,000. If James lives to his 25st birthday, the Andrews can receive the full cash value of the policy, which they can give to James or use for their own purposes. The agent says this is a good financial planning tool because it will pay for funeral expenses if their son were to die prematurely, but it also doubles as a savings account for him and will force them to make regular contributions. a. Use the time value of money to estimate the rate of return the Andrews will earn on this investment, assuming they make 25 annual payments of $240 and that they receive the face value of $10,000 when James reaches the age of 25. b. If the current cost of funeral expenses is $10,000 and inflation averages 3% per year, how much do you expect a funeral to cost in 20 years? c. What are the pros and cons of this method of saving? d. Are their other alternatives for achieving the same objectives? Explain. 2. Case 2 – Medicaid Coverage for Long-Term Care John and Lyn Terrance think that it will soon be necessary to move John’s father, who has Alzheimers’, to an assisted living facility. He has been living with them for about two years, but since John and Lyn both work full-time, they are concerned about their father’s safety during the workday. John’s father qualifies for Medicare and he has about $176,000 in CDs from the sale of his home.

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a. Will Medicare cover any of the costs of John’s father’s long-term care? b. Their accountant has suggested that John’s father gift away all of his money (to the Terrances and other close relatives) so that he can qualify for Medicaid coverage of his long-term care costs. Since John has three married children and ten grandchildren, he should be able to gift $11,000 x 16 = $176,000 in 2005. Is this legal? Is it ethical? Why or why not? Would you feel differently about this if the Andrews and their other relatives have sufficient wealth to cover their father’s long-term care needs? TEACHING SUGGESTIONS 1. Begin this section by asking how many students currently have life insurance. Unless you have a fairly non-traditional student body, this number is likely to be relatively low. You can use this to motivate a discussion on why people buy life insurance. It might be helpful to separate these factors on the board into three categories: personal, social, financial. 2. Test your students’ grasp of these factors by asking them to identify whether each of the following factors will increase or decrease the amount of life insurance they should carry: married to non-working spouse; birth of a child; promotion at work; spouse diagnosed with serious illness; youngest child graduates from college; approaching retirement age; receive a large inheritance from a relative. 3. Ask your class to discuss the pros and cons of allowing the beneficiaries of a person who commits suicide to collect on the life insurance policy. Use this opportunity to remind the students about adverse selection and moral hazard concepts discussed in Chapter 9. Why do most policies allow claims after a one to two year waiting period? 4. Have the class break into small groups to discuss the pros and cons of the buy-termand-invest-the-difference strategy. 5. Ask the students to call two or more life insurance companies/agents for quotes on term life insurance and for their recommendations on how much insurance they should carry. 6. Have students investigate the impact of smoking cigarettes on the cost of life insurance. 7. Have your students read a life insurance policy completely (their own, their parents’ or another person’s). Ask them to write up a summary of the key characteristics and clauses contained in the policy. 8. Invite a manager of a local long-term-care facility to speak to your class. Have this person discuss the types of care available, the cost range, the methods of payment used by their residents, the average length of stay, their opinions on long-term care insurance policies and costs, and the competitive environment for such facilities in your town. 9. Discuss the future prospects for elder care in the United States. Given the aging of the population, the rapidly rising costs of medical care, and the shortage of qualified nurses, what can we expect regarding long-term care costs? Should the government help pay for these costs, either through Medicare or Medicaid? If they do, who will actually bear that burden? What other solutions are possible?

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CHAPTER 17 ESTATE PLANNING SOLUTIONS TO END OF CHAPTER CASE APPLICATIONS Pages 574-575 in Textbook Case 17-1 Mina Bhatti Needs a Will 1. Yes. She needs a will. If she dies before a new will is written, her ex-husband could inherit. Note that in some states, the divorce would nullify the previous will, but Mina’s estate would be treated as if she had died intestate. In either case, the guardianship of her daughter is uncertain. 2. Naming Janna as Naitra’s guardian and a contingent guardian; Naming Sanjay as the executor for the will and specifying the payment he will receive; Designating Naitra as beneficiary of the will, perhaps putting the assets in trust for her care until she reaches the age of 18 (or older). 3. Since her estate is less than the unified exemption, a trust isn’t needed at this time. However, if her assets continue to grow, she should reconsider this decision at a later date. She could name Naitra as the beneficiary of the trust and she can also hold some of her assets jointly with her daughter. 4. This is the reason that Mina needs to name a contingent guardian. If Janna has since died, the guardianship will be decided by the courts. 5. The executor will: document and value all of Mina’s assets and liabilities, pay off all debts that have verified claims, file income and estate tax forms and pay all taxes owed, manage any assets in Mina’s estate until they are completely distributed. This could take up to 8 years (until Naitra is 18). If all assets are placed in a trust, then the trustee would manage the assets. Case 17-2 A Plan to Minimize Estate Taxes 1. Yes. Their existing wills will not: -provide Ricky with support -leave $100,000 to each grandchild -give any funds to the National Endowment for the Arts -minimize taxes 2. They are leaving their estate to each other. No estate taxes will be due when the first one dies. There will be estate taxes due when the second one dies, assuming that the survivor hasn’t spent most of the money. 3. Because the size of the estate is so large, this would not be a good strategy. Bequests to spouses and to charity are tax free, but bequests to grandchildren are not. They would be better off making tax-free gifts to their grandchildren each year. 4. They should set up and fund the following trusts: -a revocable trust to finance Ricky’s music career, to be revoked if he quits. -irrevocable trust to finance the $100,000 to each of the ten grandchildren at age 30. This trust would cease to exist when the last grandchild reaches age 30. - charitable remainder trusts with the National Endowment for the Arts as beneficiary.

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5. They feel that the children would not be ready to manage a sizable inheritance at younger ages. 6. Yes. This is a lot of money and it is possible that the four adult children have been assuming they will be the recipients of some of it. There may be hard feelings about their parents decision to single out Ricky for support. By being clear with everyone up-front, there will be less family strife later.

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CHAPTER 17 ESTATE PLANNING SOLUTIONS TO END OF CHAPTER APPLICATION PROBLEMS Pages 573-574 in Textbook 1. Estate Planning over the Life Cycle a. No estate planning goals at this life cycle stage. The student is just trying to finish college without too much debt. b. Provide for children’s guardianship and support until age 18 (or older); Plan for college funding; Provide for spouse’s well-being for a few years after death, at least until youngest child goes to school and spouse can work full-time; Possibly fund education for spouse; Replace home services provided by non-working spouse; Have valid wills in place. c. Provide for spouse’s support until death; Specify beneficiaries for couple’s assets after both die; Avoid paying unnecessary taxes at death (maximize bequests); Have valid will in place. d. Provide for children’s support until independent; Minimize estate taxes owed, perhaps through the use of trusts; Have valid will and living will in place. 2. Estate-Planning Tools a. Give your daughter the china now and tell your sister or specify the china bequest in your will or in a letter of last instruction. b. Create a living will with your specific requests for treatment. c. Set up a trust and put enough assets in the trust to fund their college costs. Buy life insurance in an amount sufficient to cover their college costs in addition to other life insurance needs. Own some of your assets jointly with your children so that they will pass directly to the children upon your death. Fully fund a Section 529 prepaid tuition or college savings plan. d. Reduce your taxable estate by moving assets to a trust, gifting to your children each year during your lifetime, owning assets with them jointly. 3. Type of Trust a. QTIP trust b. Life insurance trust c. Qualified personal residence trust d. Charitable income trust 4. Calculating Taxable Estate a. Gross Estate Funeral Expenses Executor Legal/accounting

$2,000,000 10,000 5,000 3,000

Adjusted Gross Estate Humane Society Univ of Missouri

$1,982,000 50,000 100,000

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Boy Scouts

150,000

Taxable Estate

$1,682,000

b. Unified Exemption

$1,500,000

c. Amount Subject to Tax

$ 182,000

Maximum Tax Rate

47%

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CHAPTER 17 ESTATE PLANNING THE LEARNING OBJECTIVES 1. Understand the process of estate planning. 2. Identify the key elements of an estate plan. 3. Understand why your heirs will benefit if you have a valid will and well-organized legal and financial records. 4. Estimate the size of your estate and the taxes that would be owed upon your death. 5. Know how to use trusts, gifts, and charitable contributions to minimize estate taxes. CHAPTER OUTLINE AND SUMMARY I. What is Estate Planning? A. The Estate-Planning Process 1. Estate planning is the process of developing a plan for what will happen to your wealth and your dependents when you die. 2. An estate is a person’s net worth at death. 3. Estate planning involves both financial and legal considerations 4. You must first evaluate your financial situation B. Who Needs an Estate Plan? 1. Everyone should have an estate plan. 2. People’s needs differ causing estate plans to range from simple to complex 3. Probate is the legal process of settling your estate; paying your debts and distributing your assets according to your wishes. 4. Supervised by a local court. C. The Consequences of Failure to Plan 1. More than half of the people in the U.S. don’t have adequate estate plan. 2. If you die without an estate plan or a will, the value of your estate may be eroded. 3. Your heirs may experience other personal costs. D. Estate Planning over the Life Cycle 1. Your estate plan must change as your life situation changes. 2. You need to revisit your estate plan whenever you have a major change in circumstances. 3. Optimally, you should reconsider your estate plan regularly. E. Tax Planning 1. Estate taxes can take a large bite out of your wealth. 2. Tax planning can significantly reduce the amount of taxes owed. II. Key Components of an Estate Plan A. Will 1. A will is a legal document that specifies how you want your property to be distributed upon your death.

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2. An heir is a person or entity designated to receive something from your estate after your death. 3. Intestate is when you die without a valid will; there are rules in every state as to how your property will be distributed. 4. Escheat is the legal process by which the state government acquires the estate of a person who dies without a will and has no living relatives. B. Living Will of Durable Power of Attorney 1. A living will is a legal document that specifies a person’s preferences as to medical care in the event that he or she becomes unable to make decisions because of illness or disability. 2. A durable power of attorney is a legal document in which a person designates another to make decisions on his or her behalf in the event of incapacity. C. Letter of Last Instruction 1. A letter of last instruction is a nonbinding document that provides helpful information to survivors after the writer’s death. 2. Helps your survivors through the process of your death. D. Trusts 1. A trust is a legal entity that holds and manages assets on behalf of someone else. III. Wills and Other Important Documents A. Preparing a Valid Will 1. A testator is the writer of the will. 2. Beneficiaries are the individuals or entities receiving a distribution under the terms of the will. 3. Capacity is the mental competence to make a will, including understanding the nature and content of the document and not acting under threat or coercion from anyone. 4. Common elements of a will: a. Introduction b. Payment of Debt and Taxes c. Distribution of Assets d. Appointment of Executor or Executrix: Person designated to carry out the provisions of a will. e. Appointment of Guardian f. Execution 5. You are well advised to get professional help in drafting your will. 6. You can change or revoke your will at any time, as long as you still have mental capacity. B. Passing Property Outside of a Will 1. Any wealth transferred by will is part of your estate and must go through probate. 2. You can keep property out of probate by using a different mode of ownership. 3. Joint tenancy with right of survivorship is a form of property ownership in which, after the death of one owner, the property passes to the surviving owner without going through probate.

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a. Most common for of joint ownership, particularly for married couples. b. Advantages: Survivor gets immediate ownership of the property without going through probate. c. Disadvantages: 1) You lose some control over the property during your lifetime. 2) You lose complete control over what happens to the property after you die. 3) The transfer may result in greater tax liability. 4) You lose the ability to have the property pass to a trust. 4. Tenancy in common is a type of ownership in which each person owns his or her share independently and retains the right to transfer that share by sale or will. a. Each tenant retains the right to transfer his or her ownership interest independently. 5. Community property is a property law in some states by which any property acquired during a marriage is considered to be jointly owned by both spouses. a. State specific b. One spouse’s share of the property can be willed to someone other than the surviving spouse. 6. Retirement assets pass to the person you’ve named as the beneficiary. C. Organizing Financial and Legal Documents. 1. It is helpful for financial and legal documents to be organized, accessible, and easy to understand. 2. The right people – spouse, trustee, trusted family member, lawyer, or estate planner- need to be easily found. 3. Have one copy of each important document with your estate attorney/planner and one copy at home in a fireproof file. IV. Estate and Gift Taxes A. Federal Gift Taxes 1. Currently (2005), you and your spouse can each give up $11,000 per person per year tax-free to as many people as you like (increasing with inflation in increments of $1,000). 2. Excess amounts will be applied to reduce the amount of your estate that is exempt from estate tax. 3. The lifetime limit on tax-free gifts is currently $1,000,000. 4. Exceptions: a. No limit on how much you can give your spouse. b. No limit on gifts for the payment of medical expenses or certain educational costs, provided that you make the payments directly to the service provider. 5. Estate and gift taxes have increasing marginal tax rates. B. Federal Estate Taxes 1. The amount of your estate that exceeds the allowed exclusions is subject to estate taxes. The maximum tax rate is 47% in 2205, 46% in 2006. 2. Surviving spouse can inherit the entire estate without paying any tax, regardless of the size of the estate.

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3. Primary purpose of estate tax planning is to minimize the taxes payable by your surviving spouse’s estate. 4. Calculation of Taxable Estate a. Calculate gross estate b. Calculate adjusted gross estate c. Calculate taxable estate C. Can You Count on the Death Tax to Stay Dead? 1. Federal estate tax is scheduled to be completely repealed by 2010 under provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 2. It will be reinstated in 2011 unless Congress acts to make the repeal permanent. Significant budgetary cost makes this uncertain. D. State Death Taxes 1. Federal estate law currently gives you a credit against taxes owed for the amount of state death taxes you pay. 2. States calculate their taxes in different ways. V. Reducing Taxes through Trusts and Gifts A. When are trusts useful? 1. A grantor is the person or entity who legally passes ownership to another person or entity. 2. A trustee is a person or entity who manages assets on behalf of another. 3. Trusts are created to a. Bypass probate b. Remove property from the taxable estate c. Ensure that the estate achieves certain purposes after the grantor’s death. 4. Sophisticated legal arrangements; you should seek the advice of an experienced estate-planning lawyer. B. Types of Trusts 1. An irrevocable trust is a trust that the grantor cannot revoke; it is not subject to probate or estate taxes. 2. A revocable trust is a trust whose terms the grantor can change during his or her lifetime; it bypasses probate but is still subject to estate taxes. 3. A living trust is a trust established by the terms of a will. a. Common Types of Living Trusts 1) A pourover will is a will that leaves a person’s remaining assets to a trust. 2) A life insurance trust is a type of living trust designed to remove the proceeds of a life insurance policy from your estate. 3) A qualified personal residence trust is a type of living trust designed to remove a personal residence from your estate for probate purposes. 4. A testamentary trust is a trust established by the terms of a will. a. Common Types of Testamentary Trusts 1) A standard family trust is a trust for married couples designed to avoid estate taxes on the estate of the surviving spouse.

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2) A qualified terminable interest property (Q-Tip) trust is a trust for married couples in which the grantor retains control over the ultimate beneficiaries of the estate. 5. A charitable remainder trust is a trust that enables the grantor to give an asset to a charity but retain the cash flow generated by that asset during his or her lifetime. 6. A charitable lead (or income) trust is a trust that enables the grantor to give income to a charity during his or her lifetime or for a period of years but transfer the asset upon his or her death to a chosen beneficiary. C. Gifting Alternatives 1. Important to consider the tax consequences. 2. Charitable gifts will never be subject to estate taxation, and while alive, are deductible from your current income in calculating your federal income tax liability. 3. You can also reduce the estate taxes by giving away some of your assets while you are alive. ADDITIONAL WEBSITE ASSIGNMENTS 1. Ask your parents or another older relative to give you an estimate of the size of their estate, including life insurance policies, retirement plan assets, and debts. Use the “Estate Tax Calculator” at www.willsandprobate.com to enter their information and provide them with an estimate of the estate taxes that would be owed if they died during the current year. 2. Search the Internal Revenue website www.irs.gov for current information on the repeal of the estate tax. IRS Publication 550 provides an introduction to estate and gift taxation. Find out if any bills have been introduced in Congress to make the estate tax repeal permanent. 3. moneycentral.msn.com: Follow the links to the estate planning worksheet and look at it carefully. Is this worksheet designed for people at your lifecycle stage? Why or why not? What kinds of information would be most helpful for you to know. 4. Use a search engine such as www.google.com for information related to estate planning for small family-owned businesses. Find out what estate planning tools are commonly used to avoid the necessity of selling the business to pay taxes. Write up a short report that summarizes what you learn. ADDITIONAL MINI-CASES Case 1 – Who Should We Appoint as Guardian? Janelle and Harry Caruso have two children: Mary, age 5 and Harry Jr., age 15. They are in the process of writing their will and need to decide on who should to appoint as guardian for their children in the event that both of them were to die. Janelle thinks that they should have her parents be the guardians. Harry would prefer to have his sister and brother-in-law because they currently have two children who are close in age to their own. a. What factors should Janelle and Harry consider in making this important decision?

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b. Why is it important for them to talk with the prospective guardians? c. Since Harry Jr. is 15, in a few years, he will be old enough to care for his younger sister. Would you recommend that the Carusos change their will at that time to allow Harry Jr. to be the guardian? Why or why not? Would your answer change if the Carusos have a very large estate? Case 2 – Who Should You Trust? Buddy and Carol have recently married. It is Buddy’s second time to the altar and Carol’s third. Both Buddy and Carol are high wealth individuals and they are understandably cautious about commingling their assets since previous divorces have been costly. To further complicate things, they each have two adult children from previous marriages. Carol’s estate is currently worth $1.5 million and Buddy’s is worth $2 million. In the event of the death of either of them, the surviving spouse would be able to support himself or herself since both Buddy and Carol are working professionals. a. Do Buddy and Carol need to do any estate planning? b. Assuming that they each want to leave their wealth to their own children, but not to their spouse’s children, suggest alternative ways this might be accomplished. c. If Carol were to die today (without have done any estate planning), how much would she owe in estate taxes? TEACHING SUGGESTIONS 1. Begin the class by asking students to describe what they already know about estate planning. Have any of them been involved in the process of settling an estate? What are their impressions about this process? 2. Ask students to talk to family members about their previous experience with estate planning. Have their parents done any planning yet? Do they have wills in place? Where do they keep their important documents and information? If they have minor children, who have they designated as guardians? 3. Use the example provided in the News You Can Use box on p. 558 to motivate a discussion on living wills. What are the advantages and disadvantages? How specific would you want the instructions to be? Who would you want to make the decisions for you? 4. Have the students investigate the cost of getting a simple will drawn up by a local attorney. Compare that to a “do it yourself” form from a local business supply store. Discuss the advantages and disadvantages of these two approaches at this point in their lives. 5. By a show of hands, find out how many students in the class currently have a will. This number is likely to be fairly small. Have the students who don’t have wills complete the “Learning About Yourself” exercise on p. 578 to identify the reasons why. Discuss whether the most common reasons for the class are likely to also be explanations for the large number of adults in the U.S. who don’t have valid wills. 6. After explaining the gradual estate tax repeal that is scheduled from now until 2010, discuss the political factors that necessitated the reinstatement of the law after 2011.

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Ask the class to identify the economic impact of an estate tax and to make arguments for and against its repeal. 7. Ask the students to estimate the point in their life cycle where estate planning is likely to become important to them. What are some of the risks of waiting until then to include estate planning in their financial plan?

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