Personal Finance, 2nd Edition Solution Manual

Type:

Solution Manual

Resource:

Personal Finance

Edition:

2nd Edition

Author(s):

Vickie L. Bajtelsmit

CHAPTER 1 Instructor Manual and Solutions The Financial Planning Process LEARNING OBJECTIVES LO 1.1 Describe the personal financial planning process, and explain how the elements of a comprehensive financial plan fit together.

LO 1.2 Describe how individual characteristics and economic factors influence personal financial planning.

LO 1.3 Create a prioritized list of short-term and long-term personal financial goals.

LO 1.4 Know when and how to find qualified financial planning professionals.

LO 1.5 Consider opportunity costs and marginal effects in making personal finance decisions.

SUGGESTED COURSE PLAN The first chapter can typically be covered easily in one week out of a typical 15-16 week semester. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

1

Ch 1 The Financial Planning Process Read LO1.1 PFP Process, LO1.2 Factors Affecting PFP Ch 1 Financial Decision-making Strategies Read LO1.3 Setting Goals LO1.4 Financial Professional LO 1.5 Decisionmaking

Register in WileyPLUS

2

Discussion 1.2: Impact of Inflation

WileyPLUS Resources to Use in Class

DP 1.1 Percentage Change Reflection Question 1: Effects of Inflation

Interactive: Decisionmaking Style Reflection Question 2: Decision-making style

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

Money Attitudes (PFP 1.1)

Interactive: Financial Literacy Quiz

Goal Setting (PFP 1.3 and PFP 1.4)

Chapter 1 Homework: R:23,6; P:1-2,11 Adaptive Practice Ch 1

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CHAPTER OUTLINE AND SUMMARY LO 1.1 Describe the personal financial planning process, and explain how the elements of a comprehensive financial plan fit together.

WHAT IS PERSONAL FINANCIAL PLANNING? I.

WHY STUDY PERSONAL FINANCIAL PLANNING? A. What Are the Benefits of Personal Financial Planning?

B. Why Do People Avoid Financial Planning?

C. What Problems Can Be Caused by Poor Financial Planning?

II.

THE PERSONAL FINANCIAL PLANNING PROCESS A. Step 1: Organize Your Financial Information and Set Short-Term and Long-Term Goals B. Step 2: Analyze Your Current Financial Status C. Step 3: Identify and Evaluate Alternative Strategies for Achieving Your Goals D. Step 4: Implement Your Financial Plan E. Step 5: Monitor Your Progress and Revise Your Plan as Needed

III.

ELEMENTS OF A COMPREHENSIVE FINANCIAL PLAN

LO 1.2 Describe how individual characteristics and economic factors influence personal financial planning.

FACTORS THAT INFLUENCE FINANCIAL PLANNING I.

INDIVIDUAL CHARACTERISTICS AND YOUR FINANCIAL PLAN A. Life Cycle Factors B. Demographic Characteristics C. Values and Attitudes

II.

ECONOMIC FACTORS AND YOUR FINANCIAL PLAN A. Inflation B. Interest Rates C. The Economy and the Job Market D. Political Unrest and Global Issues

LO 1.3

Create a prioritized list of short-term and long-term personal financial goals.

SETTING SHORT-TERM AND LONG-TERM FINANCIAL GOALS I. II. LO 1.4

WHY GOALS ARE IMPORTANT THE GOAL-SETTING PROCESS Know when and how to find qualified financial planning professionals.

SELECTING QUALIFIED FINANCIAL PLANNING PROFESSIONALS I. II. III.

LO 1.5

WHEN DO YOU NEED A FINANCIAL PLANNER? FACTORS TO CONSIDER IN CHOOSING A FINANCIAL PLANNER HOW ARE PLANNERS PAID?

Consider opportunity costs and marginal effects in making personal finance decisions.

MAKING EFFECTIVE DECISIONS I. II. III. IV. V.

.

MAKE REASONABLE ASSUMPTIONS APPLY MARGINAL REASONING CONSIDER OPPORTUNITY COSTS USE SENSITIVITY ANALYSIS DECISION-MAKING STYLES

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

TEACHING SUGGESTIONS 1. Ask students to take the Personal Financial Literacy quiz (Interactive Figure 1.1) before the first class or during the first week. Although you will not see their scores or count their actual grades on the quiz, it can be a helpful baseline for students and can also help to preview topics that will be covered in the course. Have a discussion in class about what components of the course they think will be most helpful to them. You may want them to retake that same quiz at the end of the course to compare results.

2. Most personal finance instructors ask students to develop a personal financial plan during the semester. The first class is an appropriate time to explain this assignment and to direct the students to the related resources included in WileyPlus Learning Space.

3. Ask students to complete Excel Worksheet 1.1 Money Attitudes Questionnaire and, if possible, to have family members or roommates complete it as well. Follow-up class discussion can center on how differences in attitudes can make joint financial decisions more difficult.

4. Many students take a personal finance class because they have a financial problem they would like to work on, such as overspending or credit card debt. Ask each student to list three short-term personal finance goals that they would like to achieve in the coming year and three long-term goals they would like to achieve in the next five years. Break the class into small groups and have them compare their lists. As a class, compile a list of the most common short-term goals coming out of the small groups. Discuss which is/are more important and why.

5. Illustrate the impact of inflation by comparing the cost of tuition at your university for the current year to that in previous years. If you do not have this information, you can use the average tuition costs available at trends.collegeboard.org. This example is a good way to illustrate the concept of percentage change and annualized percentage change.

6. Use Interactive Figure 1.4 Socioeconomic Differences in Risk Aversion in class, asking students to vote by show of hands on each of the questions. Use this to open up a discussion about why people have different attitudes and risk aversion and how that might affect their personal finances in the future.

7. Ask students to complete Interactive Figure 1.6 Decision-Making Styles. This could be the springboard for a discussion related to good and bad personal finance habits and the influence that personality traits can have on financial outcomes.

CONCEPT REVIEW QUESTIONS 1. Allen has just graduated from college and is considering the purchase of a new or used car.

Describe how Allen can use the personal financial planning process in making this purchase.

Answer: When making a decision about buying a new or used car, Allen should know his future financial goals and how he will fund them based on his current financial position. If his car payments are too high or he is laid off unexpectedly, he will not be able to meet his basic needs nor achieve his longer-term goals. He needs to make only those financial choices that are consistent with his financial plan and will not place undue stress or burden on him.

Sec 1.1; LO 1.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

2. For each component of a comprehensive financial plan, identify a decision that must be made.

Answer: Establish a firm foundation: What financial goals are most appropriate for you given your personal needs and preferences? Securing basic needs: Should you borrow or pay from savings for acquiring certain assets, such as a car, television, furniture? Wealth building and protection: How should you diversify your investments to minimize the risk of losing your entire investment nest egg?

Sec 1.1; LO 1.1; BT: C; Difficulty: E; TOT: 3 min; AACSB:

3. Why is it important to establish a establish a firm foundation and secure your basic needs before beginning to invest?

Answer: Before you can begin investing, you need to establish the necessary foundations by learning about the personal financial planning process, evaluating your current financial situation, and securing your basic needs such as transportations, housing, an emergency fund and insurance.

Once your basic needs are taken care of, you can determine what you have available to apply to long-term goals.

Sec 1.1; LO 1.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

4. Under what circumstances might the Federal Reserve take action to increase short-term interest rates?

Answer: The Federal Reserve is likely to raise interest rates if the economy is growing at a fast pace, employment is at a high level, and there is an increased risk that inflation will increase. The increased rates will slow business and household spending, which will, in turn, slow economic growth and price inflation.

Sec 1.2; LO 1.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

5. What are the steps in the goal-setting process?

Answer: (1) Make a wish list (2) Prioritize your list (3) Break large goals into subgoals (4) Reevaluate regularly Sec 1.3; LO 1.3; BT: K; Difficulty: E; TOT: 2 min; AACSB:

6. What factors should you consider in selecting a financial planning professional? .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Answer: A financial planner should be selected based on their knowledge, education, professional certifications, experience, client base, fee structure, reputation, and ethical approach to financial planning.

Sec 1.4; LO 1.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

7. What are the advantages of using a fee-only planner compared with a commission-based planner?

Answer: A fee-only planner is more likely to make recommendations that are in the best interest of their clients and not based on the commission they would receive from the sale of a product.

Sec 1.4; LO 1.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

8. Kenny and Ellen were married during their senior year in college. They planned and saved $3,000 for a honeymoon trip to Europe after graduation. They both have offers for jobs that begin in July. Two months before graduation, they discover that Ellen is pregnant. How might this change in life circumstances affect their current financial plan? If you were in their situation, would you change your honeymoon plans? Why or why not?

Answer: Unexpected events require adjusting both short-term and long-term goals, especially when an event such as childbirth is around the corner. Kenny and Ellen will have to plan for prenatal medical expenses and child necessities when the child is born. These can be expensive.

Furthermore, one of the parents may have to stay home to take care of the child. This will affect their family income and ability to spend and save. All of these things will force Kenny and Ellen to think about how their lifestyle will change and how they should spend $3,000 that they have saved. They need to plan how they will modify and adjust their lives and goals to meet the new responsibility. Given that Kenny and Ellen will have new and unplanned expenses and their financial priorities will change, altering their honeymoon plans is a good idea. The couple will need the money, as Ellen may not be able to start her new job due to her pregnancy. The couple might consider a cheaper alternative honeymoon trip closer to home.

Sec 1.2; LO 1.2; BT: C; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

9. Identify three areas of your personal financial plan that you expect will change when you graduate from college. For each area, give a specific example.

Answer: After graduation, your goals will change, and you will place more emphasis on reaching life's milestones in terms of acquiring assets and funding future needs. As an example, retirement planning will become necessary. As a result of new employment, your financial condition will also change, offering new opportunities to spend and acquire things that have been out of reach so far.

This will require that you prioritize your spending—deciding, for instance, how much to spend on taking vacations, buying a car, and paying down student loans. Last, you will need to determine how to implement financial strategies to attain your financial goals. For example, one of your major decisions will require choosing between buying a home versus renting one.

Sec 1.2; LO 1.2; BT: C; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

10. How does your attitude toward risk affect your financial decisions?

Answer: Attitude toward risk depends on age, wealth, income, experience, and natural tendencies.

A person with a low tolerance for risk will seek safer investments and attain returns consistent with that risk. Someone with higher tolerance for risk may make riskier investments, such as in stocks, in the hope of earning higher returns. However, while stocks can provide higher returns in the long run, there is no guarantee that they will do so in the short-run. Thus, investors with low tolerance for risk will have to spend less and save more if they want to achieve a higher standard of living in the future.

Sec 1.2; LO 1.2; BT: C; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

11. Give two examples of how general economic conditions can have a beneficial or adverse impact on your personal finances.

Answer: When the economy is booming, it creates jobs, and employment rises. Furthermore, people's incomes rise, and they can spend as well as save more. When the economy goes through a downturn, layoffs increase, and some people lose their jobs. This requires them to dip into savings to meet expenses and to find new work, which may pay less. They will need to reassess their financial goals and spending habits to conform to their new circumstances.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 3 min; AACSB:

12. For a college student who is single, what are two areas of financial planning that will be particularly important?

Answer: Young singles should first focus on establishing a firm foundation and securing basic needs. They need to develop short-term and long-term financial goals, create a budget, and make well-thought-out cash and credit decisions, which may include student loan obligations.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

13. For a young married couple with two children under the age of 5, what are two areas of financial planning that will be particularly important?

Answer: Young families need to establish a firm foundation, secure basic needs, and establish a plan to build a protect wealth. It is of particular importance that they have a plan in place to take care of the family’s needs in the event of death or disability. It is also a good time to begin a savings plan for their children’s college education and their own retirement.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

14. For a double-income couple with children in college, what are two areas of financial planning that will be particularly important?

Answer: This is the stage where they should be taking steps to build and protect wealth. Now that they are almost done with funding college education expenses, they will need to focus on their own retirement plans and estate planning.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

15. For a recently retired couple, what are two areas of financial planning that will be particularly important?

Answer: During retirement, estate planning and cash management are the most important components of planning. The couple wants to ensure that their wealth will last throughout their retirement, and they need to be prepared for future medical and long-term care costs.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

APPLICATION PROBLEM SOLUTIONS 1. Your school just announced a tuition increase of 20 percent for next year. The annual tuition will increase from $8,000 to $9,600. If you expect that your other college-related expenses will increase with inflation from $10,000 to $10,400, what is the expected percentage increase in your total college costs for next year?

A. 11% B. 20% C. 4% D. 16% Answer: 11.11% Solution: Your total costs last year were $18,000. Next year, your costs will be $9,600 + $10,400 = $20,000. Use Equation 1.1 to calculate the percentage change.

New Value

Percentage Change = Old Value − 1 Percentage Change =

($9,600+10,400) $18,000

− 1 = 0.1111 or 11.11%

Sec 1.2; LO 1.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

2. If your expenses total $20,000 in Year 1 and you expect the inflation rate to be 3 percent, how much more will you have to spend to buy the same goods and services in Year 2, assuming that all your expenses increase at the same rate as inflation?

A. $600 B. $300 C. $1,200 D. $0 Answer: $600.00 Solution: Additional Expense = Inflation Rate ∗ Current Expenses. The additional cost will be 3% x $20,000 = $600, bringing the total cost for Year 2 to $20,600.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. If the Consumer Price Index rose from 250 to 255 in one year, what was the approximate annual inflation rate?

A. 2% B. 3% C. 4% D. 5% Answer: 2% Solution: Use Equation 1.1 to calculate the percentage change.

New Value

Percentage Change = Old Value − 1 To find the inflation rate divide the more recent CPI by the previous CPI, subtract 1 and convert the answer into a percentage.

255

Percentage Change = 250 − 1 = 1.02 − 1 = .02 or 2% Sec 1.2; LO 1.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. Your starting salary in Year 1 is $30,000. If you receive a raise of $5,000 for Year 2, what is the percentage change in your salary?

Answer: 16.7% Solution: Use Equation 1.1 to calculate the percentage change in your salary.

New Value

Percentage Change = Old Value − 1 35,000

Percentage Change = 30,000 − 1 = 0.167 or 16.7% Sec 1.2; LO 1.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

5. Use the inflation calculator in Excel Worksheet 1.2 to find out what a $20,000 annual salary in 1983 would have been worth in 2019 dollars.

Answer: A $20,000 salary in 1983 would be the equivalent of $51,182 in 2019.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

6. Use the inflation calculator in Excel Worksheet 1.2 to find out what a movie ticket that cost 25 cents in 1970 would have cost in 2019 dollars. Have movie ticket prices increased at a faster or slower rate than other prices?

Answer: A ticket that cost $0.25 in 1970 would cost $1.66 in 2019 dollars. Movie tickets in 2019 averaged several times that cost, so they have increased in price at a faster rate than other goods and services.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

7. The original Volkswagen Beetle sold for $2,000 in 1970. Assuming that a new Beetle cost $20,000 in 2012, did the price increase more or less than inflation? Use the inflation calculator in Excel Worksheet 1.2 to see what the inflation-adjusted price would have been in 2012.

Answer: The price increased more than inflation, because $2,000 in 1970 would be the equivalent of $11,982 in 2012.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

8. Janelle has asked her friend Danny to drive her to the airport, which is a 60-mile, two-hour round trip, so that she can save the $20 cost of the shuttle bus. Danny will have to miss his personal finance class in order to take her there. If Janelle is willing to pay Danny for this service, should Danny charge her more or less than the cost of the shuttle bus, taking into account his opportunity cost in addition to the price of gas?

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Answer: Danny should account for the opportunity cost of missing class. While missing class is difficult to quantify, Danny should account for his time and the cost of attendance. Hence, he will need to charge Janelle more than the shuttle bus ticket ($20) that she is hoping to avoid buying.

Sec 1.5; LO 1.5; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

9. Jamal would like to buy a car one year from now. He anticipates making a down payment of $1,200 and borrowing the remaining $10,000. Show how he can break this larger goal into several specific, smaller sub-goals. Be sure to include an estimate of his required monthly allocation of funds to this goal.

Answer: Jamal needs to save up for the down payment. If he saves $100 per month, he will have the $1,200 by the time he buys the car. He needs to research loan choices and decide on a lender.

He also needs to research his choices of the vehicle to buy. If he decides to finance the car, he will need to include the future monthly payments in his budget.

Sec 1.3; LO 1.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

10. You have a friend who just graduated from college with a liberal arts major. He has a new job as a financial planner at a local brokerage firm. You are thinking of hiring a professional to help with your financial planning needs. Would your friend be a good choice? Why or why not?

Answer: Your friend may or may not be a good choice to select for your financial planner. It is important to consider his education, certifications, experience, reputation, and fees. If your friend just graduated, it’s likely that he doesn’t have much experience yet.

Sec 1.4; LO 1.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

11. Your employer has just given you a 4 percent annual raise. You learn the following two pieces of information: (1) the average raise in the United States for your profession was 3 percent this year, and (2) prices of goods and services, as measured by the national inflation rate, increased 5 percent since last year. Explain how your raise relates to these two pieces of information.

Answer: There are two ways to view your raise against the national averages. Compared with your profession, you received a higher raise than the national average. But because inflation averaged 5 percent, this means that in real terms you have taken a 1 percent pay cut, because your money won’t buy as much even with the raise as it would have the year before.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

12. Your friend tells you that her only financial goal is to become a millionaire. In what ways does this goal violate the requirements for SMART Goals (Specific, Measurable, Attainable, Realistic, and Time-specific)?

Answer: This goal is specific and measurable, but may not be attainable, realistic, or time-specific.

If she wants to attain this goal, she needs to develop a plan with a set of sub-goals that can lead her to achieve her bigger goal. For example, if she determines that she needs to invest a certain amount each year between now and a certain future date, and she has a plan for being able to do that, her goal might be both realistic and attainable.

Sec 1.3; LO 1.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

13. Fernando owes $10,000 on a credit card that charges 18 percent interest. Use Table 1.4 to determine the monthly payment Fernando will have to make in order to pay back the debt within 4 years. If Fernando doubled the payment, would he be able to pay off his debt in 2 years? Why or Why not?

Solution: Table 1.4 shows that Fernando would need to pay $294 per month for 48 months in order to pay off $10,000 worth of debt at 18 percent interest. To pay off this balance in two years, his payment would need to be $499, so he would be able to pay it off in less than two years with a monthly payment of $588.

Sec 1.3; LO 1.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CASE APPLICATION SOLUTIONS 1. Miranda is a single mother of two, struggling to make ends meet. Her salary of $40,000, after taxes and child-care expenses, doesn’t go very far. Miranda is a careful budgeter, and she has been setting aside $40 per month for Christmas presents for her kids. By October, she is proud to have $400 in her savings account. And then disaster strikes. Her car breaks down, and the mechanic tells her the cost of fixing it will be $350 . What are Miranda’s options? What are some ways that Miranda might lessen the impact of financial emergencies in the future?

Answer: Miranda will probably have to use her holiday savings account to cover the cost of fixing the car. She will need to cut back on her holiday spending plans, or put some of the expenses on a credit card. If she uses credit, she will have to budget for repayment of the credit over the next several months. Miranda needs an emergency fund of at least three to five months take-home pay. To build a fund, she will need to reexamine her budget to cut expenses and allow more savings.

Sec 1.1; LO 1.1; BT: Ap; Difficulty: E; TOT: 3 min; AACSB:

2. Sanjay is currently employed as an engineer at a major technology firm and earns $50,000 a year. He thinks that an MBA will increase his chances of being promoted to a management position. He is trying to decide whether to enroll in a part-time evening MBA program that will take two years or in a one-year full-time MBA program.

A. Identify the factors that Sanjay should consider in making this decision.

Answer: The part-time program will take longer to complete, but Sanjay will continue to receive salary, because he can continue working throughout the program. The full-time program will take less time to complete, and he may get a promotion earlier. However, the job market for MBAs could change, and Sanjay also has to consider the loss of his salary for one year.

Sec 1.5; LO 1.5; BT: C; Difficulty: M; TOT: 2 min; AACSB:

B. What are the opportunity costs that Sanjay needs to consider?

Answer: Sanjay needs to consider the following opportunity costs: costs of tuition, fees, and books for the program he chooses; the delay in possible promotion if he selects the two-year program; and the foregone salary while he is in school. He also needs to consider the time and effort that will be required to complete the MBA part-time while continuing to work full time. This may take away from his personal and family time.

Sec 1.5; LO 1.5; BT: C; Difficulty: M; TOT: 2 min; AACSB:

C. Does Sanjay need any additional information to make an effective decision? If so, what information?

Answer: To make a more effective decision, Sanjay needs to have reliable information on salaries and career opportunities for people in his field who have MBAs compared with those who do not. He also needs to investigate expected economic conditions over the next two years. If economic conditions deteriorate at the end of one year, he may not be able to find a job quickly, and his opportunity cost will increase. This assumes that tuition, books, and fees are the same under both alternatives.

Sec 1.5; LO 1.5; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. How can marginal reasoning be applied to this analysis?

Answer: Marginal reasoning considers only the change associated with a decision as opposed to the entire cost of the decision. Since Sanjay has decided to get an MBA, the only relevant components are the differences between doing it full time or doing it part time. By saving one year out of a two-year program, Sanjay will be able to earn a higher salary quicker. One year's salary differential will partially offset the loss of two years' salary, which is an opportunity cost.

Sec 1.5; LO 1.5; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. Lucy and Desi are expecting their first child. Although they had previous developed a prioritized list of personal financial goals, they expect that their new family circumstances will necessitate some changes.

A. Identify three goals that they are likely to add to their original list.

Answer: The goals they would likely add to their original list are: reevaluate the current financial plan in light of their growing family, start saving for the necessary costs of raising a child, and set up an education fund for the baby.

Sec 1.2; LO 1.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

B. How might their priorities change after the birth of their child?

Answer: They will need to reallocate their budget to be able to pay the additional child-related costs, which could include childcare, additional health insurance and out-of-pocket medical costs, clothing, and funding of future educational expenses.

Sec 1.1; LO 1.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CHAPTER 2 Instructor Manual and Solutions Financial Planning Tools: Personal Financial Statements and the Time Value of Money LEARNING OBJECTIVES LO 2.1 Develop a system for financial record-keeping, and prepare a personal balance sheet.

LO 2.2 Prepare a personal cash flow statement, and evaluate your financial situation using financial ratios.

LO 2.3 Explain how compound interest benefits investors.

LO 2.4 Calculate present value of funds to be received or paid in the future.

SUGGESTED COURSE PLAN You will probably need to allocate more than one week out of a typical 15–16 week semester for this chapter. For 50-minute classes, you can cover the first two Learning Objectives on financial statements in one class session, and then allot one class session for future value and one class session for present value. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

WileyPLUS Resources to Use in Class

Personal Financial Planner Assignment Cash Flow Statement and Balance Sheet (PFP 2.2 and 2.4)

WileyPLUS Homework Assignment

1

Ch. 2 Pers. Fin. Stmts.

Read LO 2.1 Balance Sheet, LO 2.2 Cash Flow Statement

Reflection Question 1: Change in Balance Sheet Over Lifecycle

CS2.1, CS2.2, Table 2.2 Interactive: It’s Just a Latte

2

Ch. 2 Time Value of Money Read LO 2.3 Future Value

Interactive: Future Value

DP2.2, DP2.3

Chapter 2 Homework A: R: 6-8; P:1,5-7,11,15 Case 2-1

3

Ch. 2 Time Value of Money Read LO 2.4 Present Value

Interactive: Present Value of a College Degree

DP2.4, DP2.5, DP2.6

Chapter 2 Homework B: R: 13; P: 16,20,22,23 Adaptive Practice Ch. 2

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

1

CHAPTER OUTLINE AND SUMMARY LO 2.1

Develop a system for financial record-keeping, and prepare a personal balance sheet.

ORGANIZING YOUR FINANCIAL INFORMATION I.

WHAT FINANCIAL RECORDS DO YOU NEED TO KEEP? A. Will You Need Them in the Future?

B. How Long Should You Keep Them?

C. Where Should You Keep Them?

II.

SUMMARIZING YOUR FINANCIAL CONDITION A. How Much Are You Worth Today?

B. Organizing the Personal Balance Sheet C. Valuing Your Assets and Debts

III.

CASE STUDY 2.1 DANELLE WASHINGTON DEVELOPS A BALANCE SHEET A. Net Worth and Life Changes B. Cash Flow and Balance Sheet Impacts of Divorce

LO2.2 ratios.

Prepare a personal cash flow statement, and evaluate your financial situation using financial

EVALUATING YOUR PERSONAL FINANCIAL SITUATION I.

THE PERSONAL CASH FLOW STATEMENT A. Cash Inflows B. Cash Outflows

II.

NET CASH FLOW

III.

CASE STUDY 2.2 DANELLE WASHINGTON’S PERSONAL CASH FLOW STATEMENT

IV.

USING FINANCIAL RATIOS A. Measuring Liquidity B. Measuring Debt Usage C. Measure Savings Adequacy D. How Do You Compare?

LO 2.3

Explain how compound interest benefits investors.

THE TIME VALUE OF MONEY I.

THE POWER OF COMPOUND INTEREST

II.

TIME VALUE CALCULATION METHODS A. Three Ways to Calculate Time Value B. Using Timelines to Clarify the Timing of Cash Flows

III.

TIME VALUE CALCULATION METHODS A. Future Value of a Lump Sum B. Future Value of an Annuity

LO 2.4

2

Calculate present value of funds to be received or paid in the future.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

PRESENT VALUE: HOW MUCH DO I NEED TODAY TO REACH A FUTURE GOAL? I. II. III.

.

PRESENT VALUE OF A LUMP SUM PRESENT VALUE OF AN ANNUITY LOAN PAYMENTS

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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TEACHING SUGGESTIONS 1.

This chapter introduces important personal financial planning tools that will appear throughout the text, but there are a lot of numbers involved, which can be intimidating to students. Students will be most interested and engaged if they think that these tools can help them personally, so it is best to use examples from their own lives. Depending on the level of your course, you may want to place less emphasis on calculation and more on intuition. Learning Objectives 2.3 and 2.4 focus on time value of money and include the calculation and calculator methods. However, the examples also explain the intuition and practical relevance. If you don’t use financial calculators, the text provides tables with some types of solutions and Excel Worksheet calculators. If you are not asking students to do calculations, remind them that there will be some ORION practice questions that cover that material, so to not worry about getting them wrong.

2.

Require students to track their spending for at least a week using Excel Worksheet 2.3 (Personal Financial Planner: Spending Log). Are there any particular types of expenditures that represent cash leakages? Discuss in class the cost of regular small, but unnecessary, expenditures (such as daily Starbucks lattes). Recommend that students do Interactive: It’s Just a Latte, or use it in class.

3.

The best way to explain the use of financial statements and financial ratios is to walk through a case example. Case Study 2.1 shows the construction of a simple balance sheet for a college senior. Case Study 2.2 develops her personal cash flow statement. The calculations of various financial ratios are illustrated using this set of financials. After going over the example, have students work in small groups to complete the same financial ratio calculations for one of the endof-chapter Case Applications.

4.

Refer students to Table 2.2 (How Do You Compare to Other U.S. Households?). Ask them to reflect on the following questions: a. Are your expenditures similar to the averages for your income level? b. In what ways are the middle-income households different from low-income households and high-income households? c. Do all households spend proportionally the same on different categories of expenditures? d. Which category of expenditures would be the easiest to adjust downward if you wanted to find more money in your budget to put toward increased savings?

5.

Break the class into groups and have them discuss the total cost of going to college. Have each group estimate what they could have earned at age 22 if they did not have a college education and what they expect to earn once they have their degree. Using this information, have them estimate the value of having a college degree, assuming they will work until they are 65 years old and that the income differential will remain the same for that whole time period. How much difference will it make if they also have greater potential for raises over time? What if they have a higher likelihood of having an employer-provided retirement plan? Note that this application of present value is also discussed in Interactive: Present Value of a College Degree, so students who have read the chapter in advance will be better able to discuss this.

6.

Although auto and student loans will be covered in a later chapter, Demonstration Problem 2.6 (Estimating Student Loan Payments) is a good illustration for why it is useful to know how to solve for payments on a loan. You can also show students how to use Excel Worksheet 2.7 (How Much Is the Loan Payment?) to do this calculation without a financial calculator.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CONCEPT REVIEW SOLUTIONS 1. Why is it important to have a system for organizing your financial records?

Answer: It is important to have a system for organizing your financial records so that you can keep track of your progress toward your goals. In the short term, you will be able to pay your bills on time, because you will know where they are and which ones you have paid. By carefully organizing your records, you can maintain accurate monthly and yearly budgets, prepare your tax reports in a timely fashion, and prepare personal balance sheets and income statements. You will know where warranties are for merchandise that fails to perform and to keep your insurance up to date. Lastly, you will know where your essential records are kept.

Sec 2.1; LO 2.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

2. What options do you have for safeguarding your important records and documents?

Explain which types of records each option is appropriate for.

Answer: Your options for safeguarding your important records and documents include a safe deposit box and a lockbox. The safe deposit box is a secure private storage area maintained in a remote location, often at a financial institution’s place of business. The lockbox is a fireproof, keyed safe kept in your home. A lockbox is not as secure as a safe deposit box because it can be taken by thieves. Important personal documents, such as passports, birth and marriage certificates, social security cards, stock certificates, and wills and deeds, should be kept in a safe deposit box.

Personal documents that can be replaced, such as a title to your car and a deed for your property, can be kept in the lockbox.

Sec 2.1; LO 2.1; BT: C; Difficulty: E; TOT: 2 min; AACSB:

3. What are personal financial statements, and why are they important for personal financial planning?

Answer: There are two personal financial statements that individuals use: (1) a personal balance sheet and (2) a personal cash flow statement. They are important for personal financial planning because they allow you to accurately evaluate your current financial condition and to plan how to get where you want to be in the future. They also allow you to improve your situation so that you can be prepared when problems arise.

Sec 2.1; LO 2.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

4. Explain the difference between short-term and long-term liabilities. Give an example of each.

Answer: A short-term liability is one that is due within one year, such as a current bills and credit card debts, or a loan that will be paid off within one year. A long-term liability may take as long as 30 years to repay, such as a home mortgage.

Sec 2.1; LO 2.1; BT: C; Difficulty: M; TOT: 1 min; AACSB:

5. When you are constructing a personal balance sheet, what is the most appropriate measure of the value of your assets? Why? Answer: When you are constructing a personal balance sheet, the most appropriate measure of the value of your assets is the market value, or the price at which something can be sold for today.

The purpose of a personal balance sheet is to have an accurate accounting of everything you own .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

5

and everything you owe. The market value is most appropriate because it provides an accurate assessment of the value of the assets you own.

Sec 2.1; LO 2.1; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

6. Under what circumstances, will net worth be negative?

Answer: Net worth will be negative when total liabilities are greater than the value of total assets.

This can happen early in your life when you have not yet accumulated much in assets but are taking on debt for education or other investments in your future.

Sec 2.1; LO 2.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

7. How is net cash flow calculated? Under what circumstances, is net cash flow negative?

Answer: Net cash flow is calculated by subtracting total cash outflows from total cash inflows. Net cash flow can be negative when you are spending more than you are earning.

Sec 2.2; LO 2.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

8. Differentiate between fixed and variable expenses, and give an example of each.

Answer: A fixed expense is one that is the same dollar amount each period, and examples include rent and car payments. A variable expense is one that is different from period to period, and examples include groceries and gasoline.

Sec 2.2; LO 2.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

9. What are the three aspects of your finances measured by personal financial ratios?

Answer: The three aspects of your finances that are measured by personal financial ratios are (1) liquidity, (2) debt management, and (3) adequacy of savings.

Sec 2.2; LO 2.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

10. Give an example that illustrates the importance of the time value of money.

Answer: The concept of time value of money is important because, whether you are borrowing money or saving money, interest rates magnify the impact that time has on your outcome. Interest rates measure the time value of money. It can either help in achieveing your goal (compound interest), or it can impede your financial progress (costs increase with higher rates). There are many possible examples: If you want to send your child to college and you decide to start saving for that goal when your child is born, you will have 18 years to save. If you assume that four years of college will cost $160,000 and you can earn 8 percent on your savings, you will need to save $332.27 a month. If you wait until your child enters first grade at six years of age, you will only have 12 years to save, and you will need to save $665.26 a month. If you wait until the child is 12 years old, you will need to save $1,738.65 a month.

Sec 2.3; LO 2.3; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

11. How does the interest rate affect the future value of an annuity?

Answer: The greater the interest rate, the larger the future value, all else equal. So if you put money in an investment account on a regular basis and earn 6 percent instead of 4 percent, the value of your investment account will grow faster with the higher interest rate. In addition, when

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

you invest a series of payments and leave the money, including interest, in the account, the future value is greater due to the benefit of compound interest.

Sec 2.3; LO 2.3; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

12. How does the length of the investment period affect the future value of a lump sum invested today?

Answer: The longer you keep your funds invested, the greater the accumulated value, all else equal. This is due to the power of compound interest: when you leave your original investment in the account as well as any interest earned, you will earn interest on the original amount plus the accumulating interest. The longer the time period, the greater the impact of compound interest.

Sec 2.3; LO 2.3; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

13. For each of the following types of financial activities, identify which time value of money principle could be used to help you select your best options.

A. Estimate payments on a car loan Answer: present value of an annuity Solution: To estimate payments on a loan, you can use the present value of an annuity. The present value is the amount of money you are borrowing today and you are solving for the amount of the payment.

Sec 2.3; LO 2.3; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

B. Estimate monthly payments necessary to pay off a credit card Answer: present value of an annuity Solution: To determine how much you need to pay each month to pay off a credit card by a stated date, you can use the present value of an annuity to calculate the payments required to pay off the current balance (the present value).

Sec 2.3; LO 2.3; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

C. Estimate how much to save for retirement Answer: future value of an annuity Solution: If you know how much you are investing for retirement on an annual or monthly basis, you can use the future value of an annuity to calculate how much your contributions will be worth by the time you retire. You can also use the future value of an annuity to determine how much you should be contributing each month or year to reach your retirement wealth goal. Also, if you know how much you have already invested today, you can use future value of a lump sum to find out how much it will be worth when you retire.

Sec 2.4; LO 2.4; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

14. What is the purpose of saving each of the following types of records, and what, if any, is the length of time that you should save each one?

A. Annual magazine subscription receipt Answer: You should save copies of your regular bills for a year so that you can accurately reflect the costs in your budget and personal cash flow statements.

B. Checking account statement .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Answer: The purpose of saving this statement is for verifying deposits and withdrawals and for tracking budget, taxes, and records. You should save this document for one year or more.

C. Student loan statement Answer: The purpose of saving a loan statement is to track your budget and to document any tax deductions or credits you may qualify for based on this expenditure. You should save this document for one year for budgeting purposes and seven years for tax-related documentation, if applicable.

D. Cell phone bill Answer: The purpose of saving a cell phone bill is for paying bills and tracking your budget. You should save this document for one year.

E. Credit card statement showing a zero balance Answer: The purpose of saving a credit card statement is for tracking your budget. You should save this document for one year.

F. Tax return Answer: The purpose of saving a tax return is for your taxes and records. You should save this document for seven years.

G. College tuition, fees, and housing bill Answer: The purpose of saving this bill is for tracking your budget and for taxes and records. You should save tax documents for seven years.

Sec 2.1; LO 2.1; BT: C; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

15. List the primary categories of assets and the primary categories of debts.

Answer: The primary categories of assets are: liquid assets, personal property, investments, and real property. The primary categories of debts are: current bills, credit card balances, short-term debts, and long-term debts.

Sec 2.2; LO 2.2; BT: C; Difficulty: E; TOT: 2 min; AACSB:

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

APPLICATION PROBLEM SOLUTIONS 1. You have estimated your total assets to be $10,000 and your total debts to be $11,000. What is your net worth?

Answer: –$1,000 Solution: To find net worth, subtract total debts from total assets. (Equation 2.1) Net worth = Total assets − Total debts Net worth = $10,000 − $11,000 = −$1,000 2. Sec 2.2; LO 2.2; BT: Ap; Difficulty: E; TOT: 1 min; Identify whether each of the following is an asset, a debt, or neither.

AACSB:

Analytic

A. Credit card balance Answer: Debt B. Weekly employment earnings Answer: Neither C. Car Answer: Asset D. Rent paid to landlord Answer: Neither E. Checking account Answer: Asset

Sec 2.2; LO 2.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: 3. Assess Jason’s personal finances using the following balance sheet information.

Assets Bank accounts Car Personal assets

Debts $3,000 $5,000 $2,000

Current bills Student loan Car loan

$1,500 $10,000 $3,000

A. What is Jason’s net worth?

Answer: –$4,500.00 Solution: To calculate the net worth, subtract total debts from total assets. (Equation 2.1) Net worth = Total assets − Total debts Net worth = ($3,000 bank account + $5,000 car + $2,000 personal assets) − ($1,500 current bills + $10,000 student loan + $3,000 car loan) = −$4,500 B. .

How much does Jason have in liquid assets?

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Answer: $3,000 Solution: Total liquid assets are present in bank accounts ($3,000).

C. Calculate Jason’s debt ratio.

Answer: 1.45, or 145% Solution: To calculate the debt ratio, divide total debts by total assets. (Equation 2.4): Debt ratio =

Total debts Total assets

Debt ratio =

$14,500 = 1.45 ~ 145% $10,000

D. Calculate Jason’s liquidity ratio assuming that his monthly expenses total $1,200.

Answer: 2.5 Solution: To calculate the liquidity ratio, divide liquid assets by monthly expenses. (Equation 2.3): Liquidity ratio =

Liquid assets Monthly expenses

Liquidity ratio =

$3,000 in bank account = 2.5 $1,200

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Analytic 4. Holly is putting together her end-of-the-year financial statements. She isn’t sure how to classify some of her financial data. Identify whether each of the following financial transactions represents an asset, a liability, income, or an expense.

A. She borrowed $1,000 from her parents this year, but will not begin to pay it back until she graduates from college in two years.

Answer: Liability Solution: Even though this is a debt to her parents and she is not due to pay it back yet,

it is a liability for Holly. Because it is not payable this year, she would list it on her balance sheet as a long-term liability.

B. She deposited her tax refund in her checking account.

Answer: Asset Solution: The tax refund is a return of funds to Holly that she had previously paid to the IRS. This increases her checking account balance, which is an asset to Holly.

C. She receives $200 per month from a trust fund.

Answer: Income 10

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Solution: Her regular receipt of funds is treated as income and is likely being used to pay for her regular monthly expenses.

D. She rents an apartment for $800 per month in her name.

Answer: Expense Solution: The rent payment is a regular monthly expense for Holly.

E. Her roommate has not yet paid her half of the December rent.

Answer: Asset Solution: When you are owed an amount of money by someone, the debt is considered an asset to you. Note that it would be a liability to your roommate. Accountants would call this type of debt a “receivable.”

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

5. Lucin earns $30,000 per year. She pays 20 percent of her gross income in taxes. She has fixed expenses of $1,000 per month and variable expenses that average $900 per month.

What is her net cash flow for the year?

A. $1,200 B. $1,500 C. $900 D. $1,700 Answer: $1,200 Solution: To find the net cash flow, subtract total cash outflows from total cash inflows.

(Equation 2.2). Net cash flow = Total cash inflows − Total cash outflows Total Cash Inflow = $30,000 earnings - $6,000 taxes ($30,000 earnings x 20%) = $24,000 Total Cash Outflow = $12,000 fixed expenses ($1,000 monthly fixed exp. x 12 mos.) + $10,800 variable expenses ($900 monthly variable exp. x 12 mos.) = $22,800 total expenses Net cash flow = $24,000 total cash inflows − total $22,800 cash outflows = $1,200 Sec 2.3; LO 2.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

6. Masako would like to buy a new car. She currently has after-tax monthly income of $2,000.

Her monthly expenses are as follows: Car insurance Rent Groceries Entertainment Utilities Credit card payment Other expenses

$100 $900 $300 $200 $200 $100 $100

A. What is Masako’s net cash flow per month?

. Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

11

Answer: $100 Solution: To find the net cash flow, subtract cash outflows from cash inflows. (Equation 2.2): Net cash flow = Total cash inflows − Total cash outflows Total cash out flow = $100 car insurance + $900 rent + $300 groceries + $200 entertainment + $200 utilities + $100 credit card + $100 other expenses) = $1,900

Net cash flow = $2,000 total cash inflow − $1,900 total cash outflows = $100 Sec 2.3; LO 2.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

B. Can Masako afford to buy a car? Why or why not?

Answer: Unless Masako can reduce some of her other expenses, she cannot afford to buy the car, since she only has $100 net cash flow.

Solution: To find the net cash flow, subtract cash outflows from cash inflows Equation 2.2):

Net cash flow = Total cash inflows − Total cash outflows Total cash out flow = $100 car insurance + $900 rent + $300 groceries + $200 entertainment + $200 utilities + $100 credit card + $100 other expenses) = $1,900

Net cash flow = $2,000 total cash inflow − $1,900 total cash outflows = $100 Sec 2.3; LO 2.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

7. The Sandell family reports the following financial information: Checking and savings account: $3,000 Monthly after-tax income: $2,500 Total monthly expenses: $2,000 Monthly savings: $500 Total debts: $10,000 Total assets: $40,000 A. Calculate the Sandells’ liquidity ratio.

Answer: 1.5 Solution: To find the liquidity ratio, divide liquid assets (checking and savings account) by total monthly expenses. (Equation 2.3) Liquid assets Liquidity ratio = Monthly expenses

Liquidity ratio =

$3,000 checking & savings account = 1.5 $2,000

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic B. Calculate the Sandells’ debt ratio.

Answer: 0.25, or 25% 12

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Solution: To find the debt ratio, divide total debts by total assets. (Equation 2.4) Debt ratio =

Total debts Total assets

Debt ratio =

$10,000 = 0.25 ~ 25% $40,000

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

C. Calculate the Sandells’ savings ratio.

Answer: 0.20, or 20% Solution: To find the savings ratio, divide monthly savings by after-tax monthly income.

(Equation 2.7) Monthly savings Savings ratio = After − tax monthly income Savings ratio =

$500 = 0.20 ~ 20% $2,500

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

8.

Use the following balance sheet and cash flow statement information to assess Carmelo’s finances using personal financial ratios.

Liquid assets: $5,000 Total assets: $180,000 Current bills: $1,500 Short-term debt: $4,500 Long-term debt: $160,000 Monthly gross income: $10,000 Monthly after-tax income: $7,000 Monthly mortgage payment (principal, interest, taxes, and insurance): $1,300 Monthly nonmortgage debt payments: $450 Total monthly expenses (not including taxes or current savings): $6,200 Current monthly savings: $700 A. Calculate Carmelo’s liquidity ratio.

Answer: 0.81 Solution: To calculate the liquidity ratio, divide liquid assets by total monthly expenses.

(Equation 2.3) Liquid assets Liquidity ratio = Monthly expenses

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

13

Liquidity ratio =

$5,000 = 0.81 $6,200

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

B. Calculate Carmelo’s debt ratio.

Answer: 0.92, or 92% Solution: To calculate the debt ratio, divide total debt by total assets. (Equation 2.4) Total debts Debt ratio = Total assets Debt ratio =

$1,500 current bills + $4,500 s. t. debt + $160,000 l. t. debt = 0.92 ~ 92% $180,000

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

C. Calculate Carmelo’s mortgage debt service ratio.

Answer: 0.13, or 13% Solution: To calculate the mortgage debt service ratio, divide monthly mortgage payment by gross monthly income. (Equation 2.6) Principal + Interest + Taxes + Insurance Mortgage debt service ratio = Gross monthly income Mortgage debt service ratio =

$1,300 Monthly mortgage payment = 0.13 ~ 13% $10,000

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

D. Calculate Carmelo’s debt payment ratio.

Answer: 0.25, or 25% Solution: To calculate the debt payment ratio, divide total debt payments by after-tax monthly income. (Equation 2.5) Total monthly debt payments Debt payment ratio = After − tax monthly income Debt payment ratio =

$1,300 mortgage pmt + $450 other debt pmts = 0.25 ~ 25% $7,000

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

E. Calculate Carmelo’s savings ratio.

Answer: 0.10, or 10% Solution: To calculate the savings ratio, divide monthly savings by after-tax monthly income.

(Equation 2.7)

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Savings ratio =

Monthly savings After − tax monthly income

Savings ratio =

$700 = 0.10 ~ 10% $7,000

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

F. Calculate Carmelo’s net worth.

Answer: $14,000 Solution: To calculate the net worth, subtract total debts from total assets. (Equation 2.1)

Net worth = Total assets − Total debts Net worth = $180,000 − ($1,500 current bills + $4,500 s. t. debt + $160,000 l. t. debt) = $14,000 Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

G. Calculate Carmelo’s net cash flow.

Answer: $100 Solution: To calculate the net cash flow, subtract cash outflows from cash. (Equation 2.2) Net cash flow = Total cash inflows − Total cash outflows

Net cash flow = $7,000 after tax income − ($6,200 total expenses + $700 savings) = $100 Sec 2.3; LO 2.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

9.

You would like to begin saving for a down payment on a home. If you want to buy the home five years from now, and you will make annual end-of-year payments into savings, how much will you have for your down payment if you save $500 per year and earn 10 percent on your investment, compounded annually? (round to the nearest dollar) Answer: $3,053 Solution: Calculate the future value of $500 annual savings (annuity) over 5 years at 10% APY. Financial Calculator Enter PMT = -500, N = 5, I/Y = 10, PV = 0, and solve for FV = 3,052.55 ~ $3,053 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.1, 5, -500, 0, 0 ) => 3,052.55 ~ $3,053 TVM Equation FVA = PMT x

.

(1 + 𝑖)𝑛 -1 𝑖

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

15

FVA = $500 x

(1 + 0.1)5 -1 = $3,052.55 ~ $3,053 0.1

Sec 2.3; LO 2.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

10. Using one or more of the methods presented in this chapter, calculate the future value of $2,500 invested today at a 3 percent rate and held for six years.

A. $2,985 B. $2,814 C. $2,898 D. $3,075 Answer: $2,985 Solution: Calculate the future value of $2,500 (lump-sum) over 6 years at 3% APY. Financial Calculator Enter PV = -2,500, N = 6, I/Y = 3, and solve for FV = 2,985.13 ~ $2,985 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.03, 6, 0, -2500, 0) => 2,985.13 ~ $2,985 TVM Equation FV = PV x (1+i)n

FV = $2,500 x (1+0.03)6 = $2,985.13 ~ $2,985 Sec 2.3; LO 2.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

11. Using one or more of the methods presented in this chapter, calculate the future value of $2,000 invested at the end of each year for six years at 8 percent interest (round to the nearest dollar).

A. $14,672 B. $13,951 C. $14,307 D. $15,047 Answer: $14,672 Solution: Calculate the future value of a $2,000 annual annuity over 6 years at 8% APY. Financial Calculator Enter PMT = -2,000, N = 6, I/Y = 8, PV = 0 and solve for FV = 14,671.86 ~ $14,672 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.08, 6, -2000, 0,0 ) => 14,671.86 ~ $14,672 TVM Equation FVA = PMT x

16

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(1 + 𝑖)𝑛 -1 𝑖 Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

(1 + 0.08)6 -1 FVA = $2,000 x = $14,671.86 ~ $14,67 0.08 Sec 2.3; LO 2.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

12. Using one or more of the methods presented in this chapter, calculate the present value of $200,000 to be received 30 years from today, discounted at 12 percent.

A. $6,676 B. $15,074 C. $11,462 D. $8,737 Answer: $6,676 Solution: Calculate the present value of $200,000 (lump-sum) 30 years from now at 12% APY. Financial Calculator Enter FV = 200,000, N = 30, I/Y = 12, and solve for PV = -6,675.59 ~ $6,676 Excel Spreadsheet =PV(rate, nper, pmt, fv, type) => =PV(0.12, 30, 0, 200000, 0) => -6,675.58 ~ $6,676 TVM Equation 𝑛 1 ) PV = FV x ( (1 + 𝑖) 30 1 ) = $6,675.59 ~ $6,676 PV = $200,000 x ( (1 + 0.12)

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. Using one or more of the methods presented in this chapter, calculate the present value of $50,000 to be received 10 years from today, discounted at 8 percent.

A. $23,160 B. $27,013 C. $25,012 D. $21,444 Answer: $23,160 Solution: Calculate the present value of $50,000 (lump-sum) 10 years from now at 8% APY. Financial Calculator Enter FV = 50,000, N = 10, I/Y = 8, and solve for PV = -23,159.67 ~ $23,160 Excel Spreadsheet =PV(rate, nper, pmt, fv, type) => =PV(0.08, 10, 0, 50000, 0) => -23,159.67 ~ $23,160 TVM Equation

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

17

𝑛 1 ) PV = FV x ( (1 + 𝑖)

PV = $50,000 x (

10 1 ) = $23,159.67 ~ $23,160 (1 + 0.08)

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

14. Using one or more of the methods presented in this chapter, calculate the present value of $1,000 to be received at the end of each year for 10 years, assuming a 5 percent discount rate.

A. $7,722 B. $7,360 C. $6,710 D. $6,144 Answer: $7,722 Solution: Calculate the present value of a $1,000 annual annuity for 10 years at 5% APY. Financial Calculator Enter PMT = 1,000, N = 10, I/Y = 5, FV = 0 and solve for PV = -7,721.73 ~ $7,722 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV(0.05, 10, 1000, 0, 0) => -7,721.73 ~ $7,722 TVM Equation 1

PVA = PMT x

1 − ((1+𝑖))

𝑛

𝑖 1

PVA = $1,000 x

10

1 − ((1+0.05)) 0.05

= $7,721.73 ~ $7,722

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

15. You’ve just won $10 million in a lottery, and the payout is 1/25 of the jackpot ($400,000) payable at the end of each year for 25 years. Alternatively, you have the option of receiving your payout as a $3 million lump sum.

A. What is the present value of the annuity if your investments earn 8 percent?

A. $4,269,910 B. $5,113,342 C. $4,661,433 D. $3,929,032 Answer: $4,269,910 Solution: Calculate the present value of a $400,000 annual annuity over 25 years at 8% APY.

18

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Financial Calculator Enter PMT = 400,000, N = 25, I/Y = 8, FV = 0 and solve for PV = -4,269,910.48 ~ $4,269,910 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV(0.08, 25, 400000, 0,0) => -4,269,910.48 ~ $4,269,910 TVM Equation 1

PVA = PMT x

1 − ((1+𝑖))

𝑛

𝑖 1

PVA = $400,000 x

1 − ((1+0.08))

25

0.08

= $4,269,910.48 ~ $4,269,910

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. What is the present value of the annuity if your investments earn 10 percent?

Answer: $3,630,816 Solution: Calculate the present value of a $400,000 annual annuity over 25 years at 10% APY. Financial Calculator Enter PMT = 400,000, N = 25, I/Y = 10, FV = 0 and solve for PV = -3,630,816.01 ~ $3,630,816 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV(0.1, 25, 400000, 0,0) => -3,630,816.01 ~ $3,630,816 TVM Equation 1

PVA = PMT x

1 − ((1+𝑖))

𝑛

𝑖 1

PVA = $400,000 x

25

1 − ((1+0.1)) 0.1

= $3,630,816.01 ~ $3,630,816

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. Based on the present value calculations, is it better to take the lump sum or the annuity?

Answer: The answer depends on what you can earn on your investments. At 8% or 10% APY, the present value of the annuity is greater than the lump sum. But if you can earn more than 12.66% APY, the $3 million would be enough to provide you a better annuity income.

Solution: Calculate the break-even interest rate where the present value of the $400,000 annual annuity over 25 years equals the lump-sum value of $3 million to determine which option would be better.

Financial Calculator Enter PMT = 400,000, N = 25, PV = -3,000,000, FV =0 and solve for I/Y = 12.66 Excel Spreadsheet .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

19

=RATE(nper,pmt,pv,fv,type) => =RATE(25,400000,-3000000,0,0) => 12.66 Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking 16. Miguel would like to save money to pay for his daughter’s college expenses. He estimates that he will need to accumulate $40,000 over the next 10 years. How much will he need to invest at the end of each year for 10 years to achieve his savings goal if he can earn 6 percent per year on the investment and he makes end-of-year payments?

A. $3,035 B. $2,895 C. $2,761 D. $2,633 Answer: $3,035 Solution: Calculate the annuity payment necessary at the end of each year to achieve $40,000 in 10 years earning 6% APY. Financial Calculator Enter PV = 0, FV = 40,000, N = 10, I/Y = 6, and solve for PMT = -3,034.72 ~ $3,035 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT(0.06, 10, 0, 40000, 0) => -3,034.72 ~ $3,035 TVM Equation FVA = PMT x

(1 + 𝑖)𝑛 -1 𝑖

FVA PMT = (1+𝑖)𝑛 -1 = 𝑖

$40,000 ((1+0.06)10 −1)

(

0.06

= $3,034.72 ~ $3,035

)

Sec 2.3; LO 2.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

17. You are borrowing $50,000 to buy a condo. If mortgage rates are currently at 6 percent, and you take out a 30-year loan with fixed payments, how much will your monthly mortgage payment be, assuming you make fixed payments at the end of each month?

A. $300 B. $333 C. $367 D. $402 Answer: $300 Solution: Calculate the monthly annuity payment necessary to pay off a $50,000 loan over 30 years (360 months) at 6% APR (0.5% monthly periodic rate).

20

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Financial Calculator Enter PV = 50,000, FV = 0, N = 360, I = 0.5, and solve for PMT = -299.78 ~ $300 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT(0.005, 360, 50000, 0, 0) => -299.78 ~ $300 TVM Equation 𝑖

PMT = PVA x

1

1 − ((1+𝑖))

𝑛

0.005

PMT = $50,000 x

1

360 = $299.78 ~ $300

1 − ((1+0.005))

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

18. Jerry wants to buy a new car. He has $2,000 for a down payment, and he estimates that he can afford to make a loan payment of up to $300 per month. The current rate for a 36-month car loan is 6 percent.

A. How much can Jerry borrow for a loan payment of $300 (round to the nearest dollar)?

Answer: $9,861 Solution: Calculate the present value of a $300 monthly payment for 36 months at an APR of 6% (0.5% monthly periodic rate).

Financial Calculator Enter PMT = -300, N = 36, I = 0.5, FV = 0 and solve for PV = 9,861.30 ~ $9,861 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV(0.005, 36, -300, 0, 0) => 9,861.30 ~ $9,861 TVM Equation 1

PVA = PMT x PVA = $300 x

1 − ((1+𝑖))

𝑛

𝑖 1−(

36 1 ) (1+0.005)

0.005

= $9,861.30 ~ $9,861

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. What is the maximum total cost that Jerry can afford, including taxes and dealer charges (round to nearest dollar)?

Answer: $11,861 Solution: First, calculate how much Jerry can borrow; which is the present value of a $300 monthly payment for 36 months at an APR of 6% (0.5% monthly periodic rate). Then add the .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

21

$2,000 he has saved for the down payment. $9,861 is the present value of payments + $2,000 down payment = $11,861.

Financial Calculator Enter PMT = -300, N = 36, I = 0.5, FV = 0 and solve for PV = 9,861.30 ~ $9,861 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV(0.005, 36, -300, 0, 0) => 9,861.30 ~ $9,861 TVM Equation 1

PVA = PMT x PVA = $300 x

1 − ((1+𝑖))

𝑛

𝑖 1−(

36 1 ) (1+0.005)

0.005

= $9,861.30 ~ $9,861

Maximum price of a car Jerry can afford = $9,861 loan + $2,000 down-payment = $11,861 Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. How much difference will it make if the dealer offers Jerry zero percent financing?

Answer: $939 Solution: Zero cost financing would mean the entire $300 monthly payment is for the loan principal; $300 x 36 months = $10,800. Then calculate how much Jerry can finance at 6% APR; which is the present value of a $300 monthly payment for 36 months at an APR of 6% (0.5% monthly periodic rate). The $300 monthly financing at 6% would support a $9,861 loan, where the zero financing at the same payments would support $10,800 loan; $939 difference.

Financial Calculator Enter PMT = -300, N = 36, I = 0.5, FV = 0 and solve for PV = 9,861.30 ~ $9,861 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV(0.005, 36, -300, 0, 0) => 9,861.30 ~ $9,861 TVM Equation 1

PVA = PMT x PVA = $300 x

1 − ((1+𝑖))

𝑛

𝑖 1−(

36 1 ) (1+0.005)

0.005

= $9,861.30 ~ $9,861

Loan principal on 6% APR 36 month loan = $9,861 Loan principal on 0% 36 month loan = $10,800 Difference between loan proceeds = $10,800 (0% deal) - $9,861 (6% APR deal) = $939 Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

22

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CASE APPLICATION SOLUTIONS 1. As their daughter Lisa starts high school, Homer and Marge decide that it’s time to take stock of their family finances to see how they will be able to pay for Lisa’s education. They have constructed the following personal balance sheet and cash flow statements.

Assets

Debts

Bank accounts Car Personal assets Homer’s retirement account Marge’s IRA Market value of home Total Assets

$3,000 5,000 20,000 50,000 9,000 150,000 $237,000

Current bills Credit cards Car loan Mortgage Total Debts

Cash Inflows (Monthly)

$1,200 10,000 8,000 100,000 $119,200

Cash Outflows (Monthly)

Homer’s gross income Interest income

$5,400 500

Income/payroll taxes Groceries Mortgage payment Property taxes Homeowner’s insurance Utilities Car loan payment Car expenses Auto insurance Credit card payments Clothing/gifts Entertainment Vacations Retirement funds Church donations Other expenses

$2,000 600 750 190 60 150 240 125 60 215 170 235 300 400 80 160

Total Cash Inflows

$5,900

Total Cash Outflows

$5,735

A. Describe how Marge and Homer most likely determined the values of their car and home.

Answer: They most likely determined the fair market value of the assets. The market value of the car can be estimated by auto industry sources like Kelly Blue Book or Edmunds.com), local auto dealerships and auto lenders. The market value of their home can be estimated by comparable sales from local realtors, and industry sources like Zillow.com, or from your local municipal taxing authority (towns periodically appraise all real estate for tax assessments).

Sec 2.1; LO 2.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

B. Calculate the family’s net worth and net cash flow.

Answer: $117,800; $165 per month Solution: To find net worth, subtract total debts from total assets. (Equation 2.1) Net worth = Total assets − Total debts .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

23

Net worth = $237,000 − $119,200 = $117,800 To find the net cash flow, subtract total cash outflows from total cash inflows. (Equation 2.2).

Net cash flow = Total cash inflows − Total cash outflows Net monthly cash flow = $5,900 total cash inflows − $5,735 total cash outflows = $165 Sec 2.1and 2.2; LO 2.1 and 2.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

C. After calculating their net cash flow, Marge is surprised to find that they should have a little money left over every month. She has usually found that they are down to their last dollar by the end of the month. “Doh!” says Homer, “I forgot to count my tab at Moe’s.”

If the couple recorded all their other expenses accurately, how much is Homer spending each month on beer at Moe’s, and should they revise their cash flow statement to reflect this expenditure?

Answer: $164; Yes Solution: Homer is spending $164 a month at Moe’s. To find the net cash flow, subtract total cash outflows from total cash inflows. (Equation 2.2).

Net cash flow = Total cash inflows − Total cash outflows Net monthly cash flow = $5,900 total cash inflows − $5,735 total cash outflows = $165 The Simpson’s net monthly cash flow is $165, and if Marge is only seeing $1 left each month, then $164 must have been spent by Homer at Moe’s.

The personal cash flow statement should include all expenditures. They should add the $164 to the Entertainment budget category.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

D. How will Marge and Homer’s net cash flow and net worth change after they adjust their statements to reflect Homer’s extra entertainment expenditures?

Answer: Net cash flow will fall to $1. Net worth will not change, because Moe’s expenses are already reflected in the cash balance of $3,000.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

E. Evaluate Homer and Marge’s financial status with respect to liquidity, debt, and savings using personal financial ratios.

Answer: Liquidity ratio = 0.52 months; Debt ratio = 0.50 or 50%; Debt payment ratio = 0.4279 or 42.79%; Mortgage debt service ratio = 0.1852, or 18.52%; Savings ratio not including Moe’s = 0.0485, or 4.85%; Savings ratio including Moe’s = 0.0, or 0%.

Solution: Liquidity ratio (Equation 2.3) Liquidity ratio =

Liquid assets Monthly expenses

$3,000 bank accounts = 0.52 𝑚𝑜𝑛𝑡ℎ𝑠 $5,375 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 Without current monthly cash inflows (ie., earnings) they only have enough liquid assets to cover about ½ a month’s expenses.

Liquidity ratio =

24

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Debt ratio (Equation 2.4) Total debts Total assets $119,200 total debts Debt ratio = = 0.50 ~ 50% $237,000 total assets Debt ratio =

Debt accounts for 50% of their assets.

Debt payment ratio (Equation 2.5) Debt payment ratio =

=

Total monthly debt payments After − tax monthly income

$750 mortgage+$240 car+$215 credit card+$190 property tax+$60 HO insurance $5,400 earnings−$2,000 payroll taxes

= 0.4279 ~ 42.79%

Debt payments take up 42.79% of the household after-tax income.

Mortgage debt service ratio (Equation 2.6) Mortgage debt service ratio = =

Principal + Interest + Taxes + Insurance Gross monthly income

$750 𝑚𝑜𝑟𝑡𝑔𝑎𝑔𝑒 + $190 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑡𝑎𝑥 + $60 𝐻𝑂 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 = 0.1852 ~ 18.52% $5,400 gross income

Housing costs account for only 18.52% of their gross income.

Savings ratio (Equation 2.7) Savings ratio =

Monthly savings After − tax monthly income

Savings ratio =

$165 net cash flow = 0.0485 ~ 4.85% $5,400 gross income − $2,000 payroll taxes

Savings ratio including Moe′ s =

$1 net cash flow = 0.0003 ~ 0% $5,400 gross income − $2,000 payroll taxes

They save only 4.85% of their monthly earnings, and when Homer’s entertainment expense at Moe’s is accounted for, they save 0 of what they earn.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Analytic

F. Based on your analysis of Homer and Marge’s household finances, do you think they are sufficiently prepared to send Lisa to college in four years? What suggestions do you have for improving their personal finances?

Answer: They are completely unprepared to send Lisa to college in four years. They have no savings or investments to help pay for college. There is no room for savings in their present .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

25

cash flow. Marge could consider getting a job. In addition, Lisa should consider part-time work to help pay college costs (after school, weekends, summers, and/or school holidays). The family should also try to reduce expenses. They might, for example, spend less on groceries, reduce or eliminate visits to Moe’s, use a lower-interest-rate loan for credit cards, tap into home equity, and reduce or eliminate vacations.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

2. Melody and Charles Verona have been married for less than one year and currently live in a one-bedroom apartment. They would like a bigger place, and with two incomes, they think they could afford to pay a mortgage on a small house or condominium. Unfortunately, they don’t have enough for a down payment yet, so they want to begin saving for this purpose.

Over the last few months, Melody has been dismayed to find that they always seems to be a little short on cash at the end of the month. She decides to sit down with Charles to look more carefully at their spending habits and begin making a plan that will enable them to buy a house. The Veronas collect the following financial information in preparation for evaluating their current finances and determining how much to save: Cash Inflows

Melody Charles

Gross Income

After-Tax Income

$32,000 35,000

$25,000 27,000

Cash Outflows

Monthly

Groceries Eating out Rent Credit card payments Telephone Utilities Car loan payments Car expenses and fuel Clothing Entertainment Health club membership Travel and vacations

$500 250 1,250 200 100 116 560 260 150 200 60 200

A. Assuming that the cash flows above are accurate and complete, calculate the Veronas’ net monthly cash flow.

Answer: $487 Solution: To determine monthly cash flow, subtract monthly cash outflows from monthly cash inflows (Equation 2.2).

Monthly cash inflows = $2,083.33 Melody net earnings + $2,250 Charles net earnings = $4,333.33 Monthly cash outflows = $500 groceries + $250 eating out + $1,250 rent + $200 credit card + $100 telephone + $116 utilities + $560 car loan + $260 car expense + $150 clothing + $200 entertainment + $60 health club + $200 vacations = $3,846 26

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Net cash flow = $4,333.33 cash inflows − $3,846 cash outflows = $487.33 ~ $487 Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. If the Veronas could allocate their net cash flow to savings each month and could earn 4 percent after taxes, how much would they have in the account after two years?

Answer: $12,147 Solution: Calculate the future value of $487 monthly savings over 2 years (24 months) at a 4% APY (.33333% monthly periodic rate).

Financial Calculator Enter PMT = -487, N = 24, I/Y = 4/12, PV = 0 and solve for FV = 12,147.19 ~ $12,147 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.0033333, 24, -487, 0,0) => 12,147.18 ~ $12,147 TVM Equation FVA = PMT x

(1 + 𝑖)𝑛 -1 𝑖

(1 + 0.0033333)24 -1 FVA = $487 x = $12,147.18 ~ $12,147 0.0033333 Sec 2.3; LO 2.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic C. What is a possible explanation for why the Veronas are having cash flow problems each month? What would you suggest they do to identify the reasons for this problem?

Answer: A possible explanation for the Veronas’ cash flow problems is that they are missing an expense category and are not keeping track of some expenses. They are spending more money than they think and need to figure out where the extra expense is coming from. They should keep a spending log for a few months to help determine the source of their cash shortfall. They should also try to reconcile their bank statement with their check register and/or spending log.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. Are there any categories of expenditures that the Veronas may have neglected to include on the list?

Answer: Some categories the Veronas may have neglected to include on the list include: insurance, gifts, uninsured medical expenses, education, charitable contributions, and other payments/expenses.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking E. Calculate the couple’s debt payment ratio. What does this say about their ability to manage additional debt?

Answer: Their debt payment ratio is 0.175 or 17.5%. This says that considering other expenses, unless the Veronas reduce their debt payments, it might be difficult for them to manage additional .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

27

debt. For example, if a mortgage payment were as great as their rent payment, their debt payment ratio would be nearly half of their disposable income.

Solution: To calculate the debt payment ratio, divide total debt payments by after-tax monthly income. (Equation 2.5) Total monthly debt payments Debt payment ratio = After − tax monthly income Debt payment ratio =

$200 credit card payment + $560 car payment = 0.175 ~ 17.5% $4,333.33

Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

F. Assuming that Melody and Charles receive 4 percent raises each year for the next two years and that their income tax rate is 20 percent, what will be the total of their after-tax income for the second year? How will the increased income affect their debt payment ratio?

Answer: $57,974; If their debt payments remain the same, the increased income will reduce their debt payment ratio.

Solution: First, calculate the future value of their gross earnings ($67,000) in 2 years at an APY of the 4% raise. (Equation 2.8). Then subtract 20% income taxes.

Financial Calculator Enter PV = -67,000, N = 2, I/Y = 4, and solve for FV = $72,467.20 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.04, 2, 0, -67000, 0) => $72,467.20 Excel Worksheet 5.6 allows you to enter the initial loan information and the number of payments you have already made to solve for the balance owed and total interest paid.

TVM Equation FV = PV x (1+i)n FV = $67,000 x (1+0.04)2 = $72,467.20 Calculate the future after-tax income $72,467.20 FV x 0.2 tax rate = $14,493.44 taxes $72,467.20 FV - $14,493.44 taxes = $57,973.76 ~ $57,974 FV of after-tax income Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. Kristopher Stephens is a 19-year-old college student. His parents pay his college tuition, buy his books, and cover his room and board expenses, but they expect him to earn enough to cover all his incidental expenses while he is in school. He estimates that these total about $60 per week for the 40 weeks that he isn’t home for the summer. He nets $2,600 after taxes from his summer job, and he has a part-time job at the university from which he earns $50 per week after taxes. Kristopher would like to buy a used car that costs $5,000. He estimates that he can obtain a car loan at 6 percent interest for three years. He expects to make a down payment of $500.

28

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

A. What is Kristopher’s annual net cash flow?

Answer: $2,200 Solution: You can calculate Kristopher’s net cash flow by subtracting his cash outflows from his cash inflows (Equation 2.2).

Total cash inflows = $2,600 summer earnings + $2,000 ($50 per week x 40 weeks) = $4,600 Total cash outflows = $60 per week expenses x 40 weeks = $2,400

Net cash flow = Total cash inflows − Total cash outflows Net annual cash flow = $4,600 cash inflows − $2,400 cash outflows = $2,200 Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. What will the monthly payment on his car loan be under these terms? How much will he pay each year (round to the nearest dollar)?

Answer: $137 per month Solution: Calculate the monthly annuity payment necessary to pay off a $4,500 car loan ($5,000 car cost less $500 down payment) over 3 years (36 months) at a 6% APR (0.5% monthly periodic rate).

Financial Calculator Enter PV = 4,500, FV = 0, N = 36, I/Y = 6/12, and solve for PMT = -136.90 ~ $137 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT(0.005, 36, 4500, 0, 0) => -136.90 ~ $137 Excel Worksheet 5.6 allows you to enter the initial loan information and the number of payments you have already made to solve for the balance owed and total interest paid.

TVM Equation 𝑖

PMT = PVA x

1

𝑛

1 − ((1+𝑖)) PMT = $4,500 x

0.005 1

1 − ((1+0.005))

36

= $136.90 ~ $137

Sec 2.4; LO 2.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. Are there any additional car expenses that Kristopher should take into account?

Answer: Yes, he needs to consider car insurance, gas, maintenance, and repairs.

Sec 2.2; LO 2.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

D. Can he afford to buy the car? Why or why not?

Answer: Kristopher’s net annual cash flow ($2,200 – $1,644 = $556) may cover his car loan payments, but not auto insurance, potential repairs and maintenance, and any emergencies .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

29

that may arise. He should also think of the possibilities of school expense increases and earnings potential for the next three years.

Solution: You can calculate Kristopher’s net cash flow by subtracting his cash outflows from his cash inflows (Equation 2.2). He is adding $137 monthly car loan payments to his cash outflows ($1,644 annually).

Total cash inflows = $2,600 summer earnings + $2,000 ($50 per week x 40 weeks) = $4,600 Total cash outflows = ($60 per week expenses x 40 weeks) + ($137 x 12 months) = $4,044

Net cash flow = Total cash inflows − Total cash outflows Net annual cash flow = $4,600 cash inflows − $4,044 cash outflows = $556 Sec 2.2; LO 2.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

30

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CHAPTER 3 Instructor Manual and Solutions Budgeting and Cash Management LEARNING OBJECTIVES LO 3.1 Develop, implement, and monitor a household budget.

LO 3.2 Explain why cash management is an important component of your financial plan.

LO 3.3 Identify and evaluate the types of financial institutions that provide cash management services.

LO 3.4 Evaluate checking and savings account choices based on liquidity, safety, and cost.

LO 3.5 Select appropriate tools for dealing with cash management problems and protect yourself from identity theft.

SUGGESTED COURSE PLAN You will probably need to allocate a full week out of a typical 15–16 week semester on this chapter.

For 50-minute classes, you can focus on developing a budget in the first class period and cover the other topics in a second class period. The types of cash management products and types of financial institutions could be self-study so that more class time can be spent on LO 3.5. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

WileyPLUS Resources to Use in Class

1

Ch. 3 Budgeting Read LO3.1 Budgeting LO3.2 Cash Management Plan

Reflection Question 1 Underestimating Budget Items

CS3.1, CS3.2

2

Read LO3.3 Cash Management Providers LO3.4 Checking and Savings LO 3.5 Cash Management Problems

Reflection Question 3 Emergency Fund

DP 3.1 Rule of 72

Personal Financial Planner Assignment PFP 3.1 Budget

WileyPLUS Homework Assignment Chapter 3 Homework A: R:5,11; P:1,3,4,9 Chapter 3 Homework B: R: 8-13, P: 7,10 ORION Quiz Ch. 3

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY LO 3.1

Develop, implement, and monitor a household budget.

DEVELOPING, IMPLEMENTING, AND MONITORING A HOUSEHOLD BUDGET I.

FACTORS AFFECTING HOUSEHOLD BUDGETS

II.

THE BUDGETING PROCESS A. Forecasting Future Income and Expenditures B. Implementing Your Budget

III.

CASE STUDY 3.1 THE RIVERAS DEVELOP A BUDGET A. Monitoring Your Budget

IV.

CASE STUDY 3.2 THE RIVERAS TRACK THEIR BUDGET VARIANCES A. Revising Your Budget

V.

MONEY ATTITUDES AND HOUSEHOLD BUDGETING A. Ethics in Action: Financial Infidelity

LO3.2

Explain why cash management is an important component of your financial plan.

THE ROLE OF CASH IN YOUR FINANCIAL PLAN I.

COSTS AND BENEFITS OF HOLDING CASH A. Managing Monthly Transactions B. Preparing for Cash Emergencies C. Making a Temporary Investment

II.

HOW MUCH SHOULD YOU HOLD IN CASH?

III.

THE RULES OF EFFECTIVE CASH MANAGEMENT A. Balance Your Transaction Accounts Every Month B. Pay Your Bills on Time C. Pay Yourself First D. Evaluate Alternative Accounts and Providers

LO 3.3

Identify and evaluate the types of financial institutions that provide cash management services.

PROVIDERS OF CASH MANAGEMENT SERVICES

2

I.

DEPOSITORY INSTITUTIONS A. Commercial Banks B. Savings Institutions C. Credit Unions D. Internet-based Financial Institutions

II.

NONDEPOSITORY INSTITUTIONS A. Mutual Fund Companies B. Life Insurance Companies C. Brokerage Firms D. Financial Services Firms E. Online Payment Processors

III.

EVALUATING FINANCIAL INSTITUTIONS A. Products Copyright © John Wiley & Sons, Inc.

Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

B. Price C. People LO 3.4

Evaluate checking and savings account choices based on liquidity, safety, and cost.

EVALUATING CASH MANAGEMENT PRODUCTS AND SERVICES I.

CRITERIA FOR EVALUATING CASH MANAGEMENT ACCOUNTS A. Liquidity B. Safety C. Costs and After-tax Interest

II.

CHECKING ACCOUNTS A. Regular Checking Accounts B. Interest-earning Checking Accounts

III.

SAVINGS ACCOUNTS A. Demand Deposits versus Time Deposits B. Regular Savings Accounts C. Certificates of Deposit D. Money Market Mutual Funds E. Money Market Deposit Accounts F. US Savings Bonds THE RULE OF 72

IV. LO 3.5

Select appropriate tools for dealing with cash management problems and protect yourself from identity theft.

RESOLVING CASH MANAGEMENT PROBLEMS AND AVOIDING IDENTIFY THEFT I.

II.

CASH MANAGEMENT PROBLEMS AND SOLUTIONS A. If You Overdraft Your Account…

B. If You Receive a Bad Check…

C. If You Want to Stop Payment…

D. If You Need Money in a Hurry…

E. If You Are Unbanked…

IDENTITY THEFT

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TEACHING SUGGESTIONS 1. Many students decide to take a personal finance course because they have run into some difficulties related to cash management. The content in this chapter can therefore be used to help them improve their own financial circumstances. You can begin with a class discussion about approaches to money management that students have observed in their family or among their peers. This should generate both good and bad examples.

2. Ask how many students have a budget and follow it. If not, why not? Have them make a list of goals that they have for themselves with respect to budgeting.

3. Ask students to complete Excel Worksheet 3.1 (Personal Financial Planner: Household Budget) for their first year of full-time employment after college (or their current circumstances), using the example in Case Study 3.1 as a guide. If the students completed personal financial statements in the previous chapter, they should have all of the information they need to develop their budget.

Encourage them to estimate future inflation-adjusted expenses. Reflection questions could include the following: a. In what budget categories do you expect to have the largest variances? Why? b. Are there any expenses you could easily trim from your budget? c. If you have any consumer debt or student loan debt, evaluate how much difference it will make to your budget if you could reduce the debt or the interest rate you are paying?

4. Break up the class into small groups and assign one of the common budget mistakes (listed in Table 3.2) to each of the groups. Give them 5 minutes to discuss the problem and possible solutions and then have each group report back to the class.

5. Invite a local banker to come in as a guest speaker to discuss their firm’s cash management products.

6. Have the class brainstorm different ways that they could be at risk for identity theft. Identify strategies they can use to minimize this risk. Several ideas are given in Table 3.6.

7. Illustrate annual percentage yield by comparing rates offered by several local lenders. You can also use Interactive Figure 3.3 (Annual Percentage Yield) in class to see if students understand the concept of more frequent compounding.

8. Use the rates on the different types of savings accounts in Table 3.5 or look up the current rates (bankrate.com) and ask students what features are associated with higher rates, e.g., greater liquidity ➔ lower rates; no FDIC insurance ➔ higher rate; variable rate ➔ higher rate, longer CD term ➔ higher rate.

9. Explain the Rule of 72 and then ask students to brainstorm situations in which this rule of thumb could be a helpful shortcut. Several examples are given in “Interactive: Double Your Money.”

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

CONCEPT REVIEW SOLUTIONS 1. You have estimated your budget for next year. Based on your first pass, your net cash flow is negative. What are your choices for reconciling your budget?

Answer: Net cash flow is your anticipated cash inflows less your cash outflows for expenses. If your forecasted net cash flow is negative, you need to find a way to increase your income or decrease your expenses.

Sec 3.1; LO 3.1; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

2. How does a budget differ from a personal cash flow statement?

Answer: A personal cash flow statement details all of your cash inflows and cash outflows for a period of time in the past, often one year. A budget is forward looking and therefore is a little more uncertain. It reflects both your anticipated cash flows and a plan for implementing financial objectives during a future period of time.

Sec 3.1; LO 3.1; BT:C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. What are the four steps in the budgeting process, and what activities should you undertake in each?

Answer: The four steps in the budgeting process are as follows: (1) forecasting, (2) implementing, (3) monitoring, and (4) reevaluating regularly. In the forecasting stage, you use your past history of cash flows (from your personal cash flow statement) and anticipated changes for the future (e.g., due to inflation or changes in circumstances) to estimate as accurately as possible your future cash flows. In the implementation stage, you make decisions about how to allocate surplus funds to particular financial goals and how to adjust income or expenses to make the budget balance. Your income and spending will need to be monitored carefully to ensure that you are sticking to your budget and that your forecasts were reasonable. You will need to reevaluate and make changes along the way.

Sec 3.1; LO 3.1; BT:C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

4. Why do so many financial advisors recommend that you “pay yourself first”?

Answer: Even when you have forecast that you will have leftover cash at the end of the month to apply to a financial goal, it can be very easy to fritter away that cash on unnecessary expenditures.

The idea of “pay yourself first” is that when you have decided to save some amount of money each month, you should commit the funds to savings at the beginning of the month so that it is never available to be spent on other things. This strategy helps people stick to their financial goals.

Sec 3.1; LO 3.1; BT:C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

5. Pat Johannsen earns $35,000 per year and takes home $2,300 per month after taxes. She has total monthly expenses of $1,800. How much of an emergency fund should she have?

What factors should she consider in deciding how much is necessary?

Answer: Although there is not a hard and fast rule about the size of a household’s emergency fund, conservative advisors suggest between five and eight months of expenses. This would imply that Pat should have at least $9,000 in liquid assets. Even less conservative advisors recommend at least two months, or in this case $3,600. In deciding how much to allocate to the fund, Pat Copyright © John Wiley & Sons, Inc.

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should consider whether she has alternative sources of cash, such as family resources or credit cards, that she could tap into in the event of a short-term financial emergency.

Sec 3.1; LO 3.1; BT:C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

6. What criteria should you use to select a financial institution to meet your cash management needs?

Answer: Financial institutions should be evaluated based on the 4 P’s: product, price, people, and place. Does the institution provide an appropriate selection of the products you need to manage your cash effectively? Are the interest rates competitive? Do you receive the level of service you desire or require? Is the location convenient?

Sec 3.2; LO 3.2; BT:C; Difficulty: E; TOT: 2 min; AACSB:

7. Why might a financial institution customer value “one-stop shopping”? What kinds of products or services would a customer most likely prefer to get from the same institution?

Answer: The idea of “one-stop shopping” is that you will save time and effort by using the same financial institution to meet all of your needs. For example, you might prefer to have your checking and savings accounts at the same bank. That will make it easier to transact business and to transfer funds between accounts. You might also be able to have an investment account at the institution and get your car loan from it.

Sec 3.2; LO 3.2; BT:C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

8. Explain the similarities and differences between regular checking accounts and interestearning checking accounts. Is it always better to have an interest-earning checking account?

Answer: Regular checking accounts do not pay interest and offer minimal services. They may be available at no charge if a minimum balance is kept in the account, but they typically limit the number of checks that can be written each month. Interest-earning checking accounts pay a small interest rate on account balances and often include other services, such as free debit cards, access to online banking, and unlimited check writing. They will usually require keeping a larger minimum balance in the account. The decision between these types of accounts should consider the minimum balance requirement and the number of transactions one needs to make per month, versus the level of interest paid on the account.

Sec 3.2; LO 3.2; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

9. When a bank offers several certificates of deposit (CDs) with different maturities, which will have a higher APY, a five-year CD or a one-year CD? Why? Answer: CDs require that you keep the money in the account for a stated period of time to earn the corresponding rate of interest. When you agree to leave your money in the bank for a longer time, the bank will pay you a higher rate of interest. This is because it can lend the money out for a longer period of time, earning a higher rate of return for the bank, and also because you are giving up the right to use the money for a longer period of time. However, the longer term also exposes you to the risk that rates will change in the meantime, possibly making the rate you are earning less favorable.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

Sec 3.4; LO 3.4; BT:C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

10. Why are financial institutions required to report APY, in addition to the nominal rate, for all of their account offerings?

Answer: The Truth in Savings Act requires that financial institutions report the annual percentage yield (APY) on all interest-earning accounts, in addition to the nominal rate. APY adjusts for different compounding periods to make it possible to compare “apples with apples.” Financial institutions offer products that compound interest at different intervals, which makes it impossible to compare rates based solely on the nominal rate.

Sec 3.4; LO 3.4; BT:C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

11. Explain how using credit cards increases your risk of identity theft. What are some methods you can use to minimize this risk?

Answer: Credit card account numbers are very easy to steal and use. Thieves need only the account number, the expiration date, and the security code, to be able to make purchases on the card. To minimize this risk, you should take steps to safeguard your cards, using them only for purchases from reputable merchants and on websites with state-of-the-art encryption.

Sec 3.5; LO 3.5; BT:C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

12. Sanjay has just completed an annual budget for his family. He has determined that his family has a very small positive net cash flow for the year. Explain to Sanjay why he should also evaluate his budget on a monthly basis and track the budget variances.

Answer: Even though the family has a positive net cash flow for the year, it is possible that there are certain cash flows that occur irregularly that may put financial strains on the monthly budget.

In addition, there may be certain cash expenditures that were overlooked in the creation of the household budget. By tracking the budget monthly for a few months, Sanjay can better identify these cash leakages or adjust the budget as necessary to make it more accurate. Also, very common are spikes in seasonal expenditures, like electricity during summer months and oil/gas during winter months, which can be anticipated and adjusted accordingly on the budget.

Sec 3.1; LO 3.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

13. What are the differences and similarities between U.S. Series EE savings bonds and Series I savings bonds?

Answer: Both are fixed-rate U.S. savings bonds, issued by the federal government, and exempt from state and local income taxes. Both types must be held for at least one year and are subject to an interest penalty if redeemed in less than five years. Series EE bonds pay a low rate of interest, compounded semiannually, and are guaranteed to double in value in at least 20 years.

Series I bonds protect holders from the risk of inflation by adjusting the face value of the bond semiannually based on the inflation rate and applying the fixed rate of interest to the new face value.

Sec 3.4; LO 3.4; BT:C; Difficulty: M; TOT: 2 min; AACSB:

14. Which of the reasons for holding cash would be most important for a freshman college student, and which would be most important for a 40-year-old single parent?

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Answer: College students will be primarily interested in having sufficient cash to meet their transactional needs. A single parent will also need cash for this purpose, but may be more worried about holding cash for emergencies, such as car or home repairs or unexpected medical expenses.

Sec 3.2; LO 3.2; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

15. Discuss the pros and cons of keeping extra cash in a transaction account with an online payment processor such as Venmo.

Answer: The primary advantage of keeping money in a Venmo account is that you will not need to make regular transfers from your checking account to cover future payments you make. The disadvantages are that this account is not FDIC insured and does not pay any interest on account balances.

Sec 3.3; LO 3.3; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

APPLICATION PROBLEM SOLUTIONS 1.

Your bank pays a nominal rate of 3% interest on a savings account. If interest is compounded monthly, what is the Annual Percentage Yield (APY) on this account?

A. 3.04% B. 3.00% C. 3.08% D. 3.40% Answer: 3.04% Solution: Calculate the APY of an account with a stated nominal rate of 3% that compounds monthly. (Equation 3.1) APY = (1 + APY = (1 +

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑚

) − 1, where m = number of compounding periods per year

𝑚 .03 12 12

)

− 1 = .0304 ~ 3.04%

Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

2.

Your bank pays a nominal rate of 3% interest on a savings account. If the interest is compounded daily (365 days), what is the Annual Percentage Yield (APY) on this account?

A. 3.05% B. 3.0% C. 3.2% D. 3.4% Answer: 3.05% Solution: Calculate the APY of an account with a stated nominal rate of 3% that compounds daily. (Equation 3.1) APY = (1 + APY = (1 +

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑚

) − 1, where m = number of compounding periods per year

𝑚 .03 365 365

)

− 1 =.0305 ~ 3.05%

Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3.

Erikka estimates that her take-home pay for the coming year will be $1,420 per month. She expects total monthly expenses to be as follows: housing and utilities, $800; food, $200; auto, gas, and insurance, $220; credit card payment, $60; and other expenses $100. The balance on her credit card is $3,000, and she currently pays 18 percent interest on this balance. Erikka would like to reduce her credit card debt. If she decides to budget Copyright © John Wiley & Sons, Inc.

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all of her net monthly cash flow to this goal, how long will it take (in months) to pay off her credit card?

A. 40 B. 30 C. 75 D. 25 Answer: 40 Solution: First, calculate Erikka’s net monthly cash flow to see what additional amount is available to pay down her credit card balance. Then calculate the number of months (N) that it would take her new monthly payment (existing $60 budgeted + net monthly cash flow) to amortize her $3,000 balance (PV) at the 18% APR. Erikka’s current budget

.

Income

$1,420

Expenses Housing and utilities

$800

Food

$200

Auto, gas, and insurance $220 Credit card payment

$ 60

Other expenses

$100

Total Expenses

$1,380

Net Monthly Cash Flow

$

40

New Monthly Credit Card Payment = $60 (budgeted) + $40 (net cash flow) = $100 Financial Calculator Enter PMT = -100, PV = $3,000, I/Y = 18/12, FV = 0, and solve for N = 40.15 ~ 40 months Excel Spreadsheet =NPER(rate, pmt, pv, fv ,type) => =NPER(.18/12, -100, 3000, 0, 0) => 40.15 ~ 40 months Sec 3.1; LO 3.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

4. First National Bank requires a minimum balance of $1,000 in its interest-earning checking accounts. Account holders are paid 2 percent on the average balance if the balance stays above the minimum all month. If you normally have an average balance of $2,500, what is the annual opportunity cost of keeping the money in a First National checking account instead of a savings account that pays 3.5 percent?

A. $22.50 B. $37.50 C. $52.50 10

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D. $25.00 Answer: $22.50 Solution: The annual opportunity cost is the reduction in interest you earn by keeping more than the minimum balance ($2,500 instead of $1,000) in the checking account instead of the higher yielding savings account. The difference is a 1.5% pick-up in yield (3.5% savings – 2% checking).

The lost interest due to the difference in APY earned on the $1,500 excess required balance is $22.50 ($1,500 x 0.015 yield pick-up).

Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

5. You have estimated that you need $6,000 in liquid assets in an emergency fund. You currently have only $1,000, which is invested in a savings account earning 3 percent nominal interest, compounded monthly. Your current budget leaves $300 per month to apply to this goal. If you plan to add this money to your savings at the end of every month, how much will you have after one year?

Answer: $4,680 Solution: Calculate the future value of $1,000 and $300 monthly additions for 12 months at a 3% APY (0.25% monthly periodic rate).

Financial Calculator Enter PMT = -300, N = 12, I = 3/12, PV = -1,000, and solve for FV = 4,680.33 ~ $4,680 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.03/12, 12, -300, -1000, 0) => 4,680.33 ~ $4,680 TVM Equation (FVA Equation 2.9 + FV Equation 2.8)

[FVA = PMT x [$300 x

(1 + 𝑖)𝑛 -1 ] + [𝐹𝑉 = 𝑃𝑉 𝑥 (1 + 𝑖)𝑛 ] 𝑖

(1+0.0025)12 -1 0.0025

] + [$1,000 𝑥 (1 + 0.0025)12 ] = FV

$3,649.91 + $1,030.42 = $4,680.33 ~ $4,680 Sec 3.2; LO 3.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

6. You live in a college town and notice that a local financial institution is advertising “free checking” for students. After calling the bank, you find that the $10 per month service charge is waived as long as the account balance stays above $200 during the month. In addition, the number of checks is limited to 20 per month. Is this really a “free account”?

Why or why not?

Answer: No, this account is not really “free.” You have to take into account the opportunity cost of holding $200 in the checking account at all times. If you do not hold the minimum, then there is a charge of $10 per month. The account is either costing you the $10 fee or the opportunity cost of holding $200 without earning interest.

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Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

7. You have $10,000 invested in a five-year CD with an APY of 5 percent. It will mature four years from now. If you withdraw money from the CD prior to maturity, the interest rate drops to 3 percent.

A. If you will pay 25 percent in taxes on the interest earnings, what is your after-tax yield on this investment, assuming that you leave the money in the account to maturity?

A. 3.75% B. 3.00% C. 5.00% D. 2.25% Answer: 3.75% Solution: 5% APY on CD x .25 (25% tax rate) = 1.25% tax 5% APY on CD – 1.25% tax = 3.75% after-tax equivalent APY on CD Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. What risks are you exposed to by holding this much cash in a CD? What are your alternatives?

Answer: You are subject to a reduced rate and/or a penalty for early withdrawal, and federal, state, and local income taxes are owed on interest earned. Some alternatives are regular savings, money market mutual funds, money market deposit accounts, U.S. Series EE savings bonds, and U.S Series I savings bonds.

Sec 3.4; LO 3.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

8. As part of his cash management plan, José Ramirez invested money in a five-year CD paying 4 percent interest. Assume that two years after the purchase of the CD, the economy enters a boom period, and the prices of goods and services rise at an annual inflation rate of 5 percent.

A. What rate is José actually earning on this investment if he has to pay 20 percent income tax on the interest.

A. 3.2% B. 0% C. 4% D. 0.32% Answer: 3.2% Solution: 4% APY on CD x .20 (20% tax rate) = 0.80% tax 4% APY on CD – 0.80% tax = 3.2% after-tax equivalent APY on CD Sec 3.4; LO 3.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic 12

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

B. Explain inflation risk to José, and tell him why he is effectively losing money on this investment.

Answer: Inflation risk is the potential to lose purchasing power of your savings when prices of goods and services rise. This means that money to be received in the future will not necessarily buy as much as it would buy today. In this case, José is earning 3.2% (after-tax equivalent) while inflation is 5%, which means that his purchasing power is actually -1.8% (3.2% CD earnings – 5% inflation) in the second year.

Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

9. You currently have $6,000 invested in a savings account with an APY of 7percent. Each year, you have to pay 20 percent tax on your interest earnings. Assuming that you leave the original investment in the account along with all the after-tax interest, use the Rule of 72 to estimate how many years it will take for you to have $12,000?

A. 13 B. 10 C. 5.6 D. 26 Answer: 13 Years Solution: First, calculate the after-tax equivalent APY on CD, then use the Rule of 72 to estimate the number of years it will take the balance to double at that rate.

After-tax Equivalent APY on CD 7% APY on CD x .20 (20% tax rate) = 1.4% tax 7% APY on CD – 1.4% tax = 5.6% after-tax equivalent APY on CD Rule of 72 Estimation Number of years to double =

72 𝐴𝑃𝑌

Number of years to double =

72 = 12.86 ~ 𝟏𝟑 𝐲𝐞𝐚𝐫𝐬 5.6

Sec 3.4; LO 3.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

10. Kenneth Allen has collected the following information in order to develop a budget for his sophomore year of college. He has a football scholarship that covers his meals, tuition, fees, and books. He estimates that his monthly income from all sources will be $1,000. His monthly expenses are as follows: one-fourth of rent and utilities for an apartment shared with three friends, $450; auto expenses and insurance, $300; cell phone, $25; health insurance, $50; and entertainment, $150.

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A. Develop a budget based on his current expenditures, and calculate his net monthly cash flow.

Answer: Income

$1,000

Expenses Housing and utilities Auto expenses and insurance Cell phone Health insurance Entertainment

$450 300 25 50 150 _______ $975

Total Expenses

Sec 3.1; LO 3.1; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Analytic

B. Kenneth has developed his budget, but when he tracks Net Monthly Cash Flow $25 his actual income and expenses, he finds that he is always out of money. Use his budgeted and actual expenses for the months of September and October to calculate his budget variances. What areas of his budget does he need to work on?

Item

Budgeted

Housing Auto Cell phone Health insurance Entertainment

$450 300 25 50

September Actual $450 280 50 50

Budget Variance ? ? ? ?

October Actual $470 320 25 50

Budget Variance ? ? ? ?

150

220

?

175

?

Answer: +$75 in September; +$65 in October He needs to work on controlling his discretionary spending; entertainment in particular.

Solution: Item Housing Auto Cell phone Health insurance Entertainment

Budgeted $450 300 25 50 150

September Actual Variance $450 280 -$20 50 +25 50 220

Net Cash Flow

14

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+70 +$75 over

October Actual Variance $470 +$20 320 +20 25 50 175

+25 +$65 over

Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

He needs to control his discretionary spending. Entertainment in particular was considerably above budget, and his cell phone bill most likely incurred roaming or data charges in excess of his program allowance.

Sec 3.1; LO 3.1; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Analytic

11. Suppose that you have developed a budget for next year, assuming that the costs of your variable expenditures on goods and services will increase by 2.5 percent from the previous year’s levels. Your total variable expenditures were $1,000 per month last year.

How much will your variable expenses be for the coming year, assuming no other changes?

Answer: $1,025 Solution: Calculate the future value of a 2.5% increase in the current $1,000 total variable expenditure in 1 year. (Equation 2.8). FV = PV x (1 + i)n FV = $1,000 x (1 + 0.025)1 = $1,025 Sec 3.1; LO 3.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

A. 12. You created a budget for this year assuming that your variable expenses will be 3% higher than they were last year. If it turns out that inflation is actually 4% for the year, how much budget variance per month will this causeif your monthly variable expenses averaged $1,000 per month last year?

A. -$10 B. +$10 C. -$30 D. +$40 Answer: +$10 Solution: Your budgeted monthly variable expenses were $1,000 X 1.03 = $1,030, but actual monthly variable expenses were $1,000 X 1.04 = $1,040. Since your expenses turned out to be $10 more per month than you estimated ($1,040 - $1,030), you are $10 over budget per month.

Sec 3.1; LO 3.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. Robert and Jamie are newlyweds in their 20s. Both are employed, but Robert’s monthly take-home pay is substantially more than Jamie’s. Robert’s take-home pay is $3,000 per month and Jamie’s is $1,500 per month. When they sit down to pay their bills together for the first time, Robert suggests that they split the regular bills (rent, utilities, phone, and groceries) equally. Although Jamie makes enough to pay her half, she knows she’ll have trouble covering her other monthly out-of-pocket expenses. Is this a fair way to manage their household finances? Why or why not? What are some other alternatives Jamie could suggest?

Answer: Individuals can have different opinions on how best to divide household expenses.

Robert’s suggestion will mean that he has a greater percentage of his income available for Copyright © John Wiley & Sons, Inc.

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discretionary spending or savings and Jamie will run short. An alternative could be to determine a household budget and split it proportionate to their income. Since Robert earns two thirds of the household income and Jaime earns one third, they could split their expenses in that proportion. It is usually better for each person to have some discretionary funds.

Sec 3.1; LO 3.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

14. Clark, age 45, and Lois, age 40, are engaged to be married. Both of them have been married previously, and both have well-paying jobs. Under what circumstances would you advise them to have a prenuptial agreement?

Answer: If Clark, Lois, or both bring significant assets to their marriage, it would be advisable for them to have a prenuptial agreement. If either of them has children from a prior marriage, a prenuptial also might be a good idea.

Sec 3.1; LO 3.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

CASE APPLICATION SOLUTIONS 1. Ron Harrington works for a large technology company as a software engineer and currently earns $120,000 per year. He and his wife, Nancy, live in a five-bedroom suburban home with their three children, ages 10 to 17. Although Nancy has a degree in business marketing, she has not worked outside the home since their last child was born. Ron’s employer recently announced plans to lay off a substantial number of employees over the course of the following year as a cost-cutting measure, and Ron is worried that he might lose his job in the next three to six months. Although the company has not explicitly said anything about severance pay, the rumor is that laid-off workers will receive only one month’s pay after they are fired. Ron will also be eligible for unemployment compensation for several months, but he is concerned that this amount will be insufficient to cover their household expenses, and he knows it will take a long time to find a comparable job. He estimates that he will have to take a lower-level job at a salary significantly lower than what he now earns. Ron and Nancy currently live comfortably on Ron’s income, they have no credit card or student loan debt, and they have about $50,000 in home equity. They recently bought their current home, and it was financed with an $180,000 mortgage.

A. Explain why the Harringtons need to develop a budget.

Answer: Ron and Nancy need to establish a budget to understand their current cash flows. This will provide a baseline for analyzing 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 potentially reduced salary.

Sec 3.1; LO 3.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

B. What financial steps should Ron and Nancy be taking to prepare for the possible layoff?

Answer: Ron and Nancy should (1) evaluate their assets, liabilities, and net worth to get a picture of their current financial situation. By mapping out their current cash flows, they can establish a baseline to examine where they can modify their budget; (2) estimate Ron’s anticipated lower net earnings and budget their expenses to reflect their new situation; (3) increase savings/emergency funds to provide a safety net; and (4) evaluate the possibility of Nancy’s returning to the workforce to supplement household cash flow. In addition, Ron should take steps to evaluate the job skills demanded for software engineers and update his skills. He should also update his resume, establish references, and do practice interviews. He should start looking for a job now by letting friends and acquaintances know he is looking and use job-listing services.

Sec 3.1; LO 3.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

2. Katie Stewart is a legal secretary at a major law firm in New York City, where she has worked for the last two years, since graduating from Brookdale Community College. It’s too expensive to live in the city on her $38,000 salary, so Katie commutes from New Jersey at a cost of $50 per week. Katie is worried about her personal finances. In the two years she has worked in New York, she has spent more than she has earned, primarily to buy clothes for work. A few lunch-hour shopping sprees with coworkers have resulted in impulse purchases on credit cards, and Katie now has $4,500 in credit card debt. Katie is considering a legal

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secretary position with a small firm in New Jersey that will pay $3,000 less than her current job.

A. Explain why Katie’s first step should be to develop a budget.

Answer: Before taking a new job for less money, she needs to understand the cash flow situation under her current circumstances. Once she establishes a baseline budget, she can examine how her cash flows may change if she switches jobs.

Sec 3.1; LO 3.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

B. What are some alternatives Katie has for reducing her credit card debt?

Answer: Establish a budget that limits her spending. Her discretionary spending is counterproductive to any debt reduction strategy she may employ. Set a clothing allowance and stick to it. Go shopping less often. Use the savings to pay down the credit card debt.

Sec 3.1; LO 3.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. If Katie’s credit card interest rate is 14 percent, and she wants to pay off her credit card debt over four years, how much should she pay each month?

Answer: $123 Solution: Calculate the payment necessary (annuity) to amortize a $4,500 loan balance (PV) in 4 years (48 months) at a 14% APR (1.16667% monthly periodic rate).

Financial Calculator Enter PV = 4,500, FV = 0, N = 48, I = 14/12, and solve for PMT = 122.97 ~$123 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT(.14/12, 48, 4500, 0, 0) => 122.97 ~ $123 TVM Equation (Equation 2.12)

𝑖

PMT = PVA 𝑥 1−( PMT = $4,500 𝑥

1

𝑛

(1+𝑖)

0.0116667 1

)

1 − ((1+0.0116667))

48

= $122.97 ~ $123

Sec 3.1; LO 3.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Analytic

D. What factors should Katie consider in deciding whether to change jobs? How would taking the New Jersey job affect her finances?

Answer: Katie needs to consider equally the earnings potential of her current job, as well as the immediate impact the new job will have on her cash flows. The current job may promise greater future earnings based on expectations of a more lucrative career path in the city.

However, the new job in her state of residence will have immediate impact to her cash flows.

She would no longer have to pay non-resident city and state income tax to New York, eliminate 18

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the commute on NJ Transit and remove her from the temptations of working near one of the most expensive shopping centers in the world.

Sec 3.1; LO 3.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. Erica Whitman, a college junior, normally prides herself on keeping control of her finances.

But the fall semester was a disaster. She contracted West Nile virus and was very sick for months. It was an effort just to keep up with her classes, let alone balance her checkbook.

Because she had to quit her part-time job, she knew her checking account balance was getting a little low, but she didn’t quite realize how low until she got a bank notice indicating that she had overdrawn her account. The disallowed transactions are as follows: Payment to: Valley Electric Authority Corner Market Hot Wok Café Johnny’s Pizza

Amount $80.32 $94.28 $12.54 $17.68

Account Balance

–$24.77

Purpose Electric bill Groceries Take-out Chinese Pizza

Bank Action _ Paid Returned check Returned check Returned check

A. Assuming that each retailer (but not the electric company) charges Erica a penalty of $20 and her bank charges $35 for the first overdraft, how much will this cash management mistake cost Erica in total?

Answer: $95 Solution: Each merchant charges $20 fee for each returned check and her bank charges $35 for the initial overdraft.

Payment to: Valley Electric Authority Corner Market Hot Wok Café Johnny’s Pizza Total

Amount $80.32 $94.28 $12.54 $17.68 $60

Fee $20 $20 $20

Purpose Electric bill Groceries Take-out Chinese Pizza

Bank Action Bank Fee Paid Returned check $35 Returned check Returned check _ $35

$60 total merchant fees + $35 bank overdraft fee = $95 total fees incurred.

Sec 3.5; LO 3.5; BT: C; Difficulty: E; TOT: 1 min; AACSB:

B. How much does Erica need to deposit in the account to have enough to pay all the retailers plus her penalties?

A. $209.27 B. $184.50 C. $234.04 D. $119.77 Answer: $209.27 Copyright © John Wiley & Sons, Inc.

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Solution: First, calculate the merchant fees and bank overdraft fee. Then add the returned check amounts and the overdraft balance that have to be paid. The account balance is negative because the $34 overdraft fee has been assessed.

Payment to: Valley Electric Authority Corner Market Hot Wok Café Johnny’s Pizza Total Account Balance

Amount $80.32 $94.28 $12.54 $17.68

Fee $20 $20 $20 $60

Purpose Electric bill Groceries Take-out Chinese Pizza

Bank Action Bank Fee Paid Returned check $35 Returned check Returned check _

–$24.77

Amount required to bring account balance to zero & pay the bounced checks $60 merchant fees + $94.28 Corner Market check + $12.54 Hot Wok check + $17.68 Johnny’s Pizza check + $24.77 overdraft = $209.27 Sec 3.5; LO 3.5; BT: C; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. Erica’s current account balance is not the same as the total of her bounced checks, because Erica had at least some funds in her account when these checks came in.

Assuming that the bank overdraft fee was already subtracted to arrive at the amount shown and she has no other bank charges, how much did she have in her account to start with?

Answer: $90.55 Solution: Reconcile the bank statement.

Payment to: Beginning Balance Valley Electric Authority Corner Market Bank Hot Wok Café Johnny’s Pizza Account Balance

Amount

Purpose

Bank Action

$80.32 $94.28 $35.00 $12.54 $17.68

Electric bill Groceries Overdraft Fee Take-out Chinese Pizza

Paid Returned check Returned check Returned check

Balance $90.55 10.23 10.23 (24.77) (24.77) (24.77) –$24.77

_

Original Balance - $80.32 Valley Electric check - $35 overdraft fee = -$24.77 Balance Original Balance = $90.55 Sec 3.5; LO 3.5; BT: C; Difficulty: M; TOT: 2 min; AACSB: Analytic

D. What advice would you offer to Erica that will help her avoid this problem in the future?

Answer: Erica should reconcile her checkbook register with her online bank records often. This way she knows what her account balance is and what checks have not cleared her account yet.

She should reconcile her balance before she makes payments, and she may want to sign up for overdraft protection.

Sec 3.5; LO 3.5; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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4. Phil and Kendra Gonzalez graduated from college last May and were married in December.

Both work for the same high-tech company as software designers and their combined takehome pay is $5,200 per month. With monthly expenses that average only $3,000, they’ve been able to accumulate $14,000 over the last year in a joint savings account that currently pays 3 percent interest. They also generally keep a little more than the $500 minimum balance in a checking account that pays no interest. If their checking account drops below the $500 minimum in any given month, the bank assesses a monthly fee of $10. This happens to them about once every three months. At present, Phil and Kendra have no investment accounts other than their savings account and their employment-based retirement funds.

Phil is trying to talk Kendra into putting $5,000 of their savings into a higher-interest CD and another $5,000 into a stock mutual fund. He has found an online bank that is offering 6percent interest on five-year CDs, and he has been investigating several stock funds that have had good returns over the last year. Kendra is not sure about what they should do. To investigate their options, she calls their current bank and asks about cash management account alternatives that might provide them with better interest earnings. The bank officer suggests that they consider moving their checking to an interest-earning account that pays 2 percent per year and carries a $1,000 minimum balance. He suggests spreading their investments into several CDs with increasing maturities. The five-year CD at this institution pays 5.75 percent.

A. How much do you think the Gonzalezes should hold in liquid accounts? Explain your reasoning.

Answer: The Gonzalezes should hold between $6,000 and $24,000 in liquid accounts, depending on how conservative they want to be. It is recommended that people hold from 2 to 8 months’ expenses in liquid accounts in case of emergencies.

Sec 3.2; LO 3.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

B. What are the risks of putting money in CDs or in stocks instead of keeping it in a regular savings account?

Answer: Regular savings accounts allow you to withdraw your money at any time without any fees or loss of value. With CDs or stock funds, there may be additional costs for withdrawals.

The main risks for the CDs are liquidity risk and default risk. If the Gonzalezes have CDs and need to withdraw the money early, they will be subject to a reduced rate and/or penalties for early withdrawal. CDs offered by banks are FDIC insured, so they should check to see if the CD offering the higher rate is actually insured. CD rates could rise in the future, in which case the rate they are currently locking in will be less attractive. In the stock market, their investment is much more volatile, and the amount they hold can vary greatly from day-to-day. Stock market investments are generally not good choices for cash management because of the greater risk of short-term fluctuations.

Sec 3.4; LO 3.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

C. Based on your analysis of their needs and options, what course of action would you recommend to the Gonzalezes? What additional information do they need to consider in making their decision?

Answer: Answers will vary, but some issues that should be discussed include the following: Kendra and Phil first need to decide on how much they want to have in a liquid emergency fund Copyright © John Wiley & Sons, Inc.

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account and identify the type of cash management account that will best meet their needs for that purpose. They then need to consider their goals for the remaining funds. If they can afford to leave the money in an investment for a longer period of time, it may be worthwhile to invest in a longer-term CD. If they do decide to consider other alternatives, they should carefully evaluate the financial institutions offering their preferred account options.

Sec 3.2; LO 3.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

5. Felicia Kobayashi has been using the same financial institution since she moved to Springfield in 1995. Since that time, there’s been a lot of consolidation in the banking industry, and her formerly local bank has been bought up by a national conglomerate. After the resulting layoffs in the small branch office where she usually conducts business, Felicia began to notice that it took much longer to make deposits and withdrawals, whether at the drive-through teller or inside the office. As a result, she is considering switching her business to a different financial institution. She currently maintains a regular checking account for paying bills and has a savings account with $15,000 in it. Based on what you’ve learned in this chapter, outline a plan for Felicia to use in choosing a new bank and deciding among alternative account choices.

Answer: Felicia should make a list of products and services that she views as important features in a bank. Then, she should investigate which banks in her area offer these services at convenient locations. PFP Worksheet 3.4 is a good template to start with to compare financial institutions.

Sec 3.3; LO 3.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

22

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

CHAPTER 4 Instructor Manual and Solutions Tax Planning LEARNING OBJECTIVES LO 4.1 Understand the major features of the federal income tax system.

LO 4.2 Determine whether you need to file a federal income tax return and which forms you should use.

LO 4.3 Prepare a basic tax return.

LO 4.4 Establish financial planning strategies to legally minimize the taxes you pay.

SUGGESTED COURSE PLAN You probably will not need to allocate a full week out of a typical 15–16 week semester to this chapter. Although it is helpful for students to better understand the mechanics of income taxation, the most important concepts can usually be covered in a single class period, with a greater emphasis on Learning Objective 4.4. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

WileyPLUS Resources to Use in Class

1

Ch. 4 Tax Planning Read LO1-LO4

IF4.2

DP4.1, DP4.2, CS4.1

Personal Financial Planner Assignment

WileyPLUS Homework Assignment Chapter 4 Homework: R: 18,12; P:1,3,4,6,8 ORION Quiz Ch. 4

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY LO 4.1

Understand the major features of the federal income tax system.

I.

THE FEDERAL INCOME TAX SYSTEM

II.

THE PROGRESSIVE NATURE OF THE U.S. TAX SYSTEM

III.

MARGINAL TAX RATES A. Tax Rate Schedules B. Marginal versus Average Tax Rates C. Inflation Indexing of Tax Brackets D. Consider the Marginal Tax Effect in Making Financial Decisions

LO 4.2

Determine whether you need to file a federal income tax return and which forms you should use.

FILING REQUIREMENTS I. II. III. LO 4.3

FILING STATUS ADJUSTED GROSS INCOME AND TAXABLE INCOME IRS FORMS

Prepare a basic tax return.

FEDERAL INCOME TAX CALCULATION I.

REPORTING INCOME A. Total Income B. Adjusted Gross Income

II.

DEDUCTIONS A. Standard Deduction B. Itemized Deductions

III.

CALCULATION OF TAXES OWED A. Tax Table and Tax Schedules B. Tax Credits C. Does the Alternative Minimum Tax Apply?

D. Additional Taxes Owed By the Self-Employed

IV.

DETERMINING TAXES DUE OR REFUND TO BE RECEIVED

V.

CASE STUDY 4.1 WILL THE RIVERAS RECEIVE A TAX REFUND?

LO 4.4

Establish financial planning strategies to legally minimize the taxes you pay.

TAX PLANNING STRATEGIES I. II. III. IV.

MAXIMIZE PRE-TAX CONTRIBUTIONS TO QUALIFIED BENEFIT PLANS REDUCE APPLICABLE TAX RATE ON CERTAIN INCOME MAKE USE OF AVAILABLE DEDUCTIONS AND CREDITS AVOID AUDITS AND PENALTIES A. Enforcement of Tax Laws B. What Are the Odds of Getting Audited?

C. Tax Reform

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TEACHING SUGGESTIONS 1. A general approach to teaching students about income taxation, which they may initially perceive as a dry or boring topic, is to focus on how they can use the tax system to their benefit, such as, reducing the cost of owning a home, paying for child care, paying for health care, and saving for retirement. To best understand these issues, students need to understand three essential concepts: a) marginal tax rate; b) after-tax cost, and c) the difference between tax deductions and tax credits. These concepts can be explained using a very simple example comparing a lowincome taxpayer with a high-income taxpayer using a flexible spending account for child-care expenses.

2. Before introducing many details about exemptions and deductions, ask students to brainstorm (and write down) all of the things they can think of that people are allowed to deduct on their individual (not business) taxes. Use this to springboard a discussion of the different categories of deductions.

3.

Ask students whether they should take state income tax rates into account when they decide where to live. What is the difference in after-tax income for people living in Florida, Nevada, or Alaska (each of which has 0% state income tax) versus a high-tax state such as New York, New Jersey, or Vermont (which have 7%–9% top brackets)?

4. Have the class discuss why interest on mortgages is tax deductible, whereas interest on car loans, credit cards, and person loans is not.

5. Have students use Excel Worksheet 4.2 (Personal Financial Planner: Federal Income Tax Estimator) to estimate their taxes for this year.

6. As an assignment, ask students to go to the IRS website and download the current year Form 1040 and Schedule A. Compare these forms to the ones that are included in the text and identify the differences between the forms. The differences should include new standard deduction amounts, but may also include new or changed deduction categories, or limits on certain deductions and credits.

7. Have students review the list of Tax Credits in the text to identify any that they think currently apply to them or that they will be eligible for in the future.

8. Most households get refunds each year from the IRS. Use Reflection Question 2 to spark a discussion of the pros and cons of over-withholding in order to receive a refund. Encourage students to think about whether they want to give the IRS an interest-free loan (considering the time value of money). Two behavioral concepts can be applied: a) people like to avoid pain, so would prefer the automatic subtraction of small amounts from income rather than the pain of a large amount being owed in April; b) people may be using the refund as a form of mental accounting, in that they allow themselves to think of the windfall at the end of the year as “fun money” that can be applied to something outside of their budget, such as a vacation or large purchase. .

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9. Discuss the pros and cons of charitable contributions, from a tax perspective. Ask students to consider how the change in standard deduction in 2017 might have impacted charitable donations.

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CONCEPT REVIEW SOLUTIONS 1. In what ways does our current federal income tax system equitably distribute the tax burden among taxpayers?

Answer: The US tax system is progressive in that it imposes higher marginal tax rates on households with higher income. The system also allows deductions from income that result in reduced taxable income for lower- and middle-income households. The net effect is that higherincome households pay a much larger percentage of total taxes. In fact, the top 10 percent of households by income, account for 75 percent of the taxes collected.

Sec 4.1; LO 4.1; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

2. What is the difference between a progressive tax and a regressive tax? Which type of tax is our federal income tax? Which type is the Social Security payroll tax?

Answer: A progressive tax is one that requires higher-income taxpayers to pay proportionately more in taxes than lower-income taxpayers. The federal income tax is progressive because it includes marginal tax rates that increase with income. In contrast, a regressive tax places a bigger burden on lower-income taxpayers, as is the case with Social Security, which has the same payroll tax rate applied to all taxpayers. Social Security is even more regressive in that there is a maximum income to which the tax applies.

Sec 4.1; LO 4.1; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. What is the difference between your marginal tax rate and your average tax rate? In making financial decisions, which is more important to consider?

Answer: The marginal tax rate is the rate that applies to your next dollar of taxable income. The average tax rate is your total taxes paid as a proportion of taxable income. In making financial decisions, the average tax rate is important for budgeting because you need to know how much you have paid or will pay in the future. For financial decisions that have tax implications, such as whether to take advantage of an opportunity for tax-advantaged saving, you should consider the marginal tax effect of your decision.

Sec 4.1; LO 4.1; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

4. What is a tax bracket, and why is it important for tax brackets to be inflation-indexed?

Answer: A tax bracket is the range of taxable income to which a particular tax rate applies. It is important that these are inflation-indexed because if the brackets did not change with inflation, taxpayers could be bumped into higher tax brackets as they receive cost-of-living raises each year, but not actually have more spending power than in past years. This would result in lower net purchasing power.

Sec 4.1; LO 4.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

5. Under what circumstances should you file a tax return even when you’re not required to?

Answer: You should file a tax return if you are entitled to a refund of taxes withheld from your pay during the year.

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Sec 4.2; LO 4.2; BT: K; Difficulty: M; TOT: 1 min; AACSB:

6. Under what circumstances does a person qualify as a dependent for tax purposes?

Answer: A dependent, for tax purposes, is a member of your household who receives at least half of his or her financial support from you.

Sec 4.2; LO 4.2; BT: K; Difficulty: M; TOT: 1 min; AACSB:

7. How are tax credits different from deductions? Assuming that a tax credit and a deduction are the same dollar amount, which is more advantageous to the taxpayer?

Answer: A tax deduction reduces taxable income, whereas a tax credit directly reduces taxes owed. If, for example, you are in the 10 percent tax bracket and you get a tax deduction of $1,000, you will save $100 (10 percent of $1,000). If instead, you get a tax credit of $1,000, it will reduce your taxes owed by the full $1,000.

Sec 4.2; LO 4.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

8. What is the purpose of the alternative minimum tax (AMT) and how does it accomplish that purpose?

Answer: The purpose of the AMT is to ensure that higher-income households end up paying their fair share of taxes. The AMT recalculates your taxes under a different set of rules that removes some of the tax breaks that normally apply. Taxpayers that meet a certain taxable income threshold under that calculation, must pay a higher tax rate on income over that threshold.

Sec 4.3; LO 4.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

9.

What are the major categories of itemized deductions? Are there any limitations on expenses you may deduct in each of these categories?

Answer: The categories for itemized deductions include medical and dental expenses, state and local income taxes you paid, property taxes paid, some types of interest you paid, gifts to charity, and casualty and theft losses. Mortgage interest is deductible for your primary residence and second home up to $375,000 of mortgage debt ($750,000 if married filing jointly). State and local income taxes, and property taxes are limited to a maximum of $10,000. Medical and dental expense deductions are limited to the amount that exceeds 10 percent of adjusted gross income.

Casualty and theft losses arising out of a federal disaster area are limited to the amount of the loss less $100 less 10 percent of your adjusted gross income.

Sec 4.2; LO 4.2; BT: K; Difficulty: M; TOT: 2 min; AACSB:

10. Why is it beneficial to defer income to later tax years?

Answer: It is beneficial to defer income to later tax years because it is always better to pay taxes later rather than earlier. If your tax rate will be lower in a later year, deferring income will reduce your taxes owed.

Sec 4.4; LO 4.4; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

11. What are the tax advantages of saving for retirement by investing in an IRA? Does it matter which type of IRA you have?

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Answer: A traditional IRA allows you to deduct your annual contribution from your gross income on your tax return and defers all taxes until distributed from the account. In contrast, you do not get a deduction for Roth IRA contributions, which must be made with after-tax dollars, however, the account, including all accumulated investment earnings, can grow tax-free, and you can take the money out at retirement without paying any taxes on the investment earnings. If you are in a high tax bracket, the current deduction from the traditional IRA may be more valuable to you. But being able to withdraw money from the Roth without paying any tax on it in retirement, is a great benefit.

Sec 4.4; LO 4.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

12. In what ways is a person’s home considered to be a tax shelter?

Answer: The tax laws offer several advantages to homeowners. Interest on home mortgages and property taxes are both tax deductible. If you lived in your home for at least two of the last five years, you can exclude $250,000 ($500,000 for a married couple) of the capital gain from your realized capital gain. For most people, this means they will never pay capital gains tax on the profit from the sale of their home.

Sec 4.3; LO 4.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

13. Which would you prefer—paying $100 less in taxes per month or receiving a $1,200 tax refund next year? Why do people often prefer getting a tax refund even though it is the equivalent of giving the federal government an interest-free loan?

Answer: When you overpay your taxes during the year and receive a refund the following year, it is like giving a zero interest loan to the government. If you paid less each month, you could invest the difference and earn interest on it during the year. Most people prefer to receive refunds because they like the windfall of receiving a lump sum check at the end of the year instead of simply having a few more dollars each month which might be more easily spent rather than saved.

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

14. How can a flexible spending account help reduce your out-of-pocket medical and childcare expenses?

Answer: A flexible spending account allows you to pay for qualified health-care and child-care expenses with pre-tax dollars. This reduces the after-tax cost of these expenditures by your marginal tax rate. If, for example, you are in the 25% tax bracket and you have $3,000 in childcare expenses in a given year, you would need to have $4,000 in gross income to have $3,000 left after taxes. ($4,000 x (1 – 0.25) = $3,000). If you could pay with pretax dollars through an FSA, you only need $3,000 in income to pay $3,000 in child-care costs, which saves you $1,000.

Sec 4.4; LO 4.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

15. Why do higher-income taxpayers often face a higher risk of audit than lower-income taxpayers?

Answer: Higher-income taxpayers are more likely to be audited because their tax returns are more complex and therefore may be more subject to errors or fraud.

Sec 4.4; LO 4.4; BT: C; Difficulty: E; TOT: 1 min; AACSB:

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APPLICATION PROBLEM SOLUTIONS 1. You were single and had taxable income of $24,000 in 2019. What was your marginal tax rate?

A. 10% B. 12% C. 22% D. 24% Answer: 12% Sec 4.1; LO 4.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

2. You were single and had taxable income of $24,000 in 2019. How much tax did you owe, assuming that you didn’t qualify for any tax credits?

A. $2,686 B. $2,400 C. $2,880 D. $4,116 Answer: $2,686 Solution: According to the income tax rate schedule for single filers, you would owe 10% on your first $9,700 of taxable income, plus 12% on taxable income between $9,700 and $39,475. $9,700 x 0.10 = $970.00 ($24,000-$9,700) x 0.12 = $1,716.00 Total tax = $970.00 + $1,716.00 = $2,686.00 Sec 4.1; LO 4.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. You were single and had adjusted gross income of $37,000 in 2019. You calculated that your taxable income was $24,000 and that you owed $2,686 in federal income taxes. What is the average tax rate that you paid on your adjusted gross income and what was your marginal tax rate?

A. average tax rate 11.2%; marginal tax rate 12% B. average tax rate 7.3%; marginal tax rate 12% C. average tax rate 11.2%; marginal tax rate 22% D. average tax rate 7.3%; marginal tax rate 22% Answer: average tax rate 11.2%; marginal tax rate 12% Solution: Calculate the average tax rate by using Equation 4.1. The marginal tax rate is the tax rate associated with the highest income bracket in the tax rate schedule.

Average tax rate =

Taxes paid Taxable income

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𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐭𝐚𝐱 𝐫𝐚𝐭𝐞 =

$2,686 = .112 ~ 𝟏𝟏. 𝟐% $24,000

Marginal tax rate is the rate applicable on your next dollar of taxable income. $24,000 taxable income falls in the $9,700 - $39,475 bracket, which has a 12% marginal tax rate.

Sec 4.1; LO 4.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. June’s 15-year old nephew has lived in her home for the entire tax year, and his parents are not providing any funds for his support. Can she claim him as a dependent on her taxes?

Answer: She can claim him as a dependent as long as she pays for at least half of his care. If her nephew has other sources of income, she will be able to claim him as a dependent as long as he is not paying more than half of his own expenses.

Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB:

5. Rashid adjusted gross income of $40,000. He incurred the following expenses during the year: medical expenses, $1,200; property taxes, $1,900; mortgage interest, $8,400; and state income taxes, $1,600. If the standard deduction for a single filer is $12,200, should he itemize deductions? Why or why not?

Answer: No; The standard deduction is greater than his itemized deductions.

Solution: Calculate itemized deductions and compare with the standard deduction of $12,200.

Itemized deductions Expense medical expenses $1,200 property taxes $1,900 mortgage interest $8,400 state income taxes $1,600 Total itemized deductions

Allowable expense $1,200 less ($40,000 AGI x 10% = $4,000) = N/A $1,900 $8,400 $1,600 $11,900 is less than $12,200 standard deduction

Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

6. You are in the 24 percent marginal tax bracket and itemize deductions. What impact will an additional $1,000 of itemized deductions have on your federal income taxes owed?

A. It will reduce my taxes owed by $240.

B. It will increase my taxes owed by $240.

C. It will reduce my taxes owed by $1,000 D. It will have no effect on my taxes owed.

Answer: Reduce by $240 Solution: The value of deductions is proportional to your marginal tax rate. Multiply the additional itemized deduction by your marginal tax rate: [$1000 x .24 = $240]. .

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Sec 4.2; LO 4.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

7. You are in the 24 percent marginal tax bracket and itemize deductions. What impact will an additional $1,000 tax credit have on your federal income taxes owed?

A. It will reduce my taxes owed by $1,000 B. It will reduce my taxes owed by $240.

C. It will increase my taxes owed by $240.

D. It will have no effect on my taxes owed. .

Answer: It will reduce income tax owed by $1,000 Solution: Tax credits are worth dollar-for-dollar in income tax owed. If you receive an additional tax credit of $1,000, it will reduce your total income tax owed by $1,000.

Sec 4.2; LO 4.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

8. Jack Spratt has an investment that gives him $1,000 per year in interest income. His friend Peter Pumpkineater has been telling Jack that he should invest in something that provides him with capital gains instead of interest. This year, for example, Peter sold some shares of a mutual fund (which he had held for more than one year) for a $1,000 profit. Assuming that both Jack and Peter are in the 37 percent marginal tax bracket, how much difference did the type of income they received from these two investments make to the taxes owed on the income?

Answer: $170 Solution: Interest income is treated as ordinary income subject to the same tax rates as earnings. Long-term capital gains (assets held > year) are subject to a lower capital gains tax rate. Since Jack is subject to the 37 percent marginal income tax rate, this means that he will be subject to the highest capital gains tax rate, which is 20%.

Tax on interest: $1,000 interest x 0.37 marginal tax rate = $370 tax Tax on Capital Gain: $1,000 long-term capital gain x 0.20 long-term capital gain rate = $200 That’s a $170 tax difference.

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

9. Assume that you are in the 24 percent marginal tax bracket and you normally itemize deductions. If you make an end-of-year contribution to your church in the amount of $1,000, what is the effective cost to you of that gift, rounded to the nearest dollar, taking into consideration the tax savings it will generate?

Answer: $760 Solution: Calculate the after-tax value by using Equation 4.2 After-tax value = Before-tax value × (1 − Tax rate) After-tax value = $1,000 x (1-0.24) = $760 Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

10. Carly Simmons is single and her adjusted gross income in 2019 was $65,000. She had the following expenses: Copyright © 2016 John Wiley & Sons, Inc.

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• Medical expenses • Mortgage interest • Property taxes • State income tax • Charitable gifts

$4,500 $10,400 $2,400 $1,800 $1,500

A. Should Carly take the standard deduction ($12,200 in 2019) or itemize her deductions?

Explain your reasoning.

Answer: Itemize deductions; Carly should itemize her deductions because the standard deduction of $12,200 is less than the $16,100 she can take as itemized deductions. To determine whether to itemize or take the standard deduction, calculate total eligible deductions.

Itemized deductions Expense medical expenses $ 4,500 property taxes $ 2,400 mortgage interest $10,400 state income taxes $ 1,800 Charitable gifts $ 1,500 Total itemized deductions

Allowable expense $ 4,500 less ($65,000 AGI x 10% = $6,500) = N/A $ 2,400 $10,400 $ 1,800 $ 1,500 $16,100 is more than $12,200 standard deduction

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

B.

Calculate Carly’s taxable income

Answer: $48,900 Solution: Tentative taxable income is AGI less itemized deductions.

Taxable Income = $65,000 AGI - $16,100 itemized deductions = $48,900 Calculation for itemized deductions: Itemized deductions Expense medical expenses $ 4,500 property taxes $ 2,400 mortgage interest $10,400 state income taxes $ 1,800 Charitable gifts $ 1,500 Totalitemized deductions

Allowable expense $ 4,500 less ($65,000 AGI x 10% = $6,500) = N/A $ 2,400 $10,400 $ 1,800 $ 1,500 $16,100 is more than $12,200 standard deduction

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

11. Kristoff and Anna Svenson are a married couple who have adjusted gross income of $84,000 in 2019. They have the following expenses: • Medical expenses • Mortgage interest • Property taxes • State income tax • Charitable gifts

.

$3,000 $8,100 $2,000 $3,200 $ 730

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A. Should the Svensons take the standard deduction ($24,400) or itemize their deductions?

Explain your reasoning.

Answer: Standard deduction; The Svensons should take the $24,400 standard deduction because it is greater than their $14,030 in itemized deductions. To determine whether to itemize or take the standard deduction, calculate total eligible deductions.

Itemized deductions Expense medical expenses $ 3,000 property taxes $ 2,000 mortgage interest $ 8,100 state income taxes $ 3,200 Charitable gifts $ 730 Total itemized deductions

Allowable expense $ 3,000 less ($84,000 AGI x 10% = $8,400) = N/A $ 2,000 $ 8,100 $ 3,200 $ 730 $14,030 is less than $24,400 standard deduction

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

B. Calculate the Svensons’ taxable income. What is their marginal tax rate?

Answer: $59,600; 12% marginal tax rate Solution: First, calculate the taxable income, then find your highest tax bracket in the tax rate schedule, and the corresponding tax rate is your marginal tax rate.

Calculation for itemized deductions: Itemized deductions Expense medical expenses $ 3,000 property taxes $ 2,000 mortgage interest $ 8,100 state income taxes $ 3,200 Charitable gifts $ 730 Total itemized deductions

Allowable expense $ 3,000 less ($84,000 AGI x 10% = $8,400) = N/A $ 2,000 $ 8,100 $ 3,200 $ 730 $14,030 is less than $24,400 standard deduction

Tentative taxable income is AGI less itemized deductions.

Tentative taxable Income = $84,000 AGI - $24,400 standard deduction = $59,600 $59,600 falls in the $19,400 - $78,950 bracket; 12% is their marginal tax rate Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. If the Svensons contribute to a deductible IRA, what impact will this have on their taxes?

Answer: The Svensons’ AGI is well below the income limitation set for households that have an employer sponsored retirement plan. Thus, we can calculate the tax benefit of a contribution to a traditional IRA by multiplying the marginal tax rate byo the contribution. They can each contribute the maximum of $6,000 to their traditional IRAs. The tax benefit for $12,000 in contributions would be $1,440 ($12,000 contributions x 0.12 marginal tax rate).

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

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12. What potential strategies for minimizing taxes should a real estate investor in a high tax bracket investigate?

Answer: Real estate offers many tax efficiencies. Investments typically provide 2 sources of taxable income: cash-flow and capital gain. Real estate investments provide rent as a recurring cash-flow and the potential for asset value growth over time.

Rental income is ordinary taxable income. However, you only have to pay tax on the net rental income. You can deduct all expenses related to the income producing operation of the property.

In some cases, if the costs of operation exceed the income, the loss may be used to offset other earnings or you may even be allowed to carry forward the loss to future years to offset future income. Also, the investor can efficiently time the recognition of expenses and income to achieve the best taxable outcomes from year to year.

The long-term capital gain of the asset has special rates that are lower than your marginal tax rate. While this is common to all long-term investments, real estate investments provide opportunities to often favorably adjust the cost-basis of the investment. Any improvements to the real estate property will increase the cost basis of the investment, thereby reducing the capital gains recognized for tax purposes.

Sec 4.4; LO 4.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

13. What potential strategies for minimizing taxes should working parents with preschoolers investigate?

Answer: Child care expenses when parents work may qualify for tax benefits. Working parents can use a flexible spending account (FSA) if offered by an employer (Dependent Care FSA), and can claim a child care tax credit, although not for the same expenses. These tax incentives encourage employment. Eligible expenses are typically services like preschool, summer day camp, before/after school programs and child daycare.

FSA accounts are pre-tax payroll contributions up to $5,000 per year. The 2019 child care tax credit is up to 35% of qualifying expenses up to $3,000 for one child, or up to $6,000 for two or more children, based on income levels. You cannot claim the same expense to both programs. If your household income is low, you should also investigate whether you are eligible for the earned income tax credit and child tax credit.

Sec 4.4; LO 4.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

14. What potential strategies for minimizing taxes should a college student who is independent of his or her parents investigate?

Answer: He or she should investigate claiming educational credits, such as the American Opportunity Tax Credit and the Lifetime Learning Credit, and the student loan interest deduction.

Many of these deductions and credits may not be available based on dependency of higher income parents.

Sec 4.4; LO 4.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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15. Consider your own personal tax situation for the coming year. In answering the following questions, it may be helpful to consult Excel Worksheet 4.2 to estimate your taxes owed.

A. What will your filing status be for this year?

Answer: If you are not married and have no dependents, you will file as a single. If you are married, you will file as either married filing jointly or married filing separately. If you are not married but have a child or other dependent, you will file as head of household.

Sec 4.2; LO 4.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

B. What tax form will you file?

Answer: Everyone must file the Form 1040 but you may also need to file additional schedules if you have any adjustments to income, sources of income other than wages, or if you will claim any itemized deductions or tax credits.

Sec 4.2; LO 4.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

C. Will you itemize deductions or take the standard deduction?

Answer: If your total eligible itemized deductions is greater than the standard deduction ($12,200 in 2019 for singles, $24,400 for married couples), then you should itemize. Otherwise, you will take the standard deduction.

Sec 4.2; LO 4.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

D. Will you be eligible for any tax credits?

Answer: Consult Table 4.5 to see if you might be eligible for any tax credits. Common credits that might apply to you are the Child and Dependent Care Expense Credit, the Earned Income Tax Credit, the American Opportunity Credit, the Lifetime Learning Credit, and the Retirement Savings Contributions Credit. If you think you might be eligible for a credit, you should go to the IRS website (irs.gov) and read the applicable instructions.

Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

E. If you complete the tax estimator worksheet and have determined that you will owe additional taxes for the year, is there anything you can do now to reduce your tax liability?

Answer: If you itemize deductions and it is not yet December 31, of the current tax year, you can reduce the taxes you owe by incurring additional deductible expenses before the end of the year. For example, if you make a contribution to your church or a charity, you will be able to deduct this amount to reduce your taxable income. If you are already in the new year, you can reduce taxable income by making a contribution to a traditional IRA. Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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CASE APPLICATION SOLUTIONS 1. Xiao Yang, a single woman with no children, graduated from college in 2019 with a degree in psychology. She had been working part-time at a local department store while in school and was offered a job as assistant manager starting in June following graduation. It is now February of the following year, and she is getting ready to file her taxes. This is the first year that she has been independent from her parents.

Xiao has collected the following information to use in preparing her 2019 return: • The standard deduction for 2019 is $12,200 • The W-2 form from her employer shows wages of $21,750 for the previous tax year, $1,200 in federal income taxes withheld, $600 in state income tax withheld, and FICA (Social Security) tax of $1,850.

• Rent, $4,200 • Groceries, $2,500 • Dress clothes for work, $1,000 • Out of pocket health insurance premiums, $2,000 • Unreimbursed medical expenses, $500 • Church offerings, $250 • Donation to Salvation Army, $150 • Graduation gifts received, $1,000 • Credit card interest payments, $900 A. Should Xiao itemize deductions for 2019? Why or why not?

Answer: No, Xiao should not itemize her deductions, because her total itemized deductions of $1,325 is less than the standard deduction of $12,200.

Calculation of Xiao’s itemized deductions.

Itemized deductions Expense medical expenses $ 2,500 state income taxes $ 600 Charitable gifts $ 400 Total itemized deductions

Allowable expense $ 2,500 less ($21,750 AGI1 x 10% = $2,175) = $325 $ 600 $ 400 $ 1,325 is less than $12,200 standard deduction

Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

B. What is Xiao’s taxable income?

Answer: $9,550 Explanation: Since Xiao has no adjustments to income, her adjusted gross income is the same as her total income $21,750.

Taxable income = Adjusted Gross Income – Itemized/standard deduction Taxable income = $21,750 income - $12,200 standard deduction = $9,550 Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

C. Is Xiao entitled to any tax credits? If so, which one(s)?

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Answer: No. Explanation: Xiao has no children and was previously dependent on her parents, who will likely take any tax credit for the education expenses they incurred on her behalf. She did not spend any qualified education expenses and she has not made any contribution to a retirement account during the year.

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

D. What is Xiao's marginal tax rate?

Answer: 10% Solution: Calculate Xiao’s taxable income, then find the highest bracket in the tax schedule (Table 4.4) that encompass her taxable income, and that tax rate is her marginal tax rate.

Since Xiao has no adjustments to income, her adjusted gross income is the same as her total income $21,750.

Taxable income = Adjusted Gross Income – Itemized/standard deduction Taxable income = $21,750 income - $12,200 standard deduction = $9,550

Her marginal tax rate is the rate associated with the income bracket her taxable income falls in.

Taxable income of $9,550 falls in the $0 - $9,700 income bracket at 10% marginal rate.

Sec 4.1; LO 4.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:Analytic

E. Would it be beneficial for Xiao to contribute to an IRA at this time? Explain.

Answer: Yes. It is almost always a good idea to put money in an IRA. If she contributes to a traditional IRA, it would reduce her taxable income, which would save her the marginal tax rate for every dollar she puts into an IRA. In addition to the deduction, her low-income this year will allow her to receive the retirement savings contribution tax credit. The amount of the credit is 50%, 20% or 10% of your retirement plan contributions depending on your adjusted gross income (AGI). The maximum contribution amount that may qualify for the credit is $2,000 ($4,000 if married filing jointly), making the maximum credit $1,000 ($2,000 if married filing jointly). Based on her AGI of $21,750, she will receive a credit equal to 10% of her IRA contributions.

Sec 4.4; LO 4.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

F. How much are Xiao’s federal income taxes for 2019?

Answer: $955.

Solution: Calculate Xiao’s taxable income, then calculate her taxes owed based on the income tax table (Table 4.1).

To determine Xiao’s taxable income, first calculate her adjusted gross income (AGI).

Since Xiao has no adjustments to income, her adjusted gross income is the same as her total income $21,750.

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Taxable income = Adjusted Gross Income – Itemized/standard deduction Taxable income = $21,750 income - $12,200 standard deduction = $9,550 Based on the tax table, the entire taxable income of $9,550 is taxed at 10%.

Tentative tax owed = $9,550 taxable income x 0.10 tax rate = $955 Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB:Analytic

G. What refund will Xiao be entitled to receive?

Answer: $245 Solution: Xiao had $1,200 withheld from her paycheck throughout the year, and her tax liability for the year is $955, thus she will receive a refund of $1,200 withheld - $955 total tax owed = $245 refund.

Total Tax Owed Calculation Calculate Xiao’s taxable income, then calculate her taxes owed based on the income tax table (Table 4.1).

To determine Xiao’s taxable income, first calculate her adjusted gross income (AGI).

Since Xiao has no adjustments to income, her adjusted gross income is the same as her total income $21,750.

Taxable income = Adjusted Gross Income – Itemized/standard deduction Taxable income = $21,750 income - $12,200 standard deduction = $9,550 Based on the tax table, the entire taxable income of $9,550 is taxed at 10%.

Tentative tax owed = $9,550 taxable income x 0.10 tax rate = $955 Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

2. Christine Melinsky and her husband Jared have four children, ages 4 to 10. Christine works as a marketing executive for a cosmetics firm, and Jared is a stay-at-home dad who is not employed outside of the home. Christine’s salary is $75,000. They have collected the following information to use in preparing their 2019 federal income tax return: • • • • • • • • •

The standard deduction for 2019 is $12,200 for singles and $24,400 for married filing jointly.

Unreimbursed medical expenses, $2,500 Mortgage interest, $15,300 Property taxes, $3,600 Federal income tax withheld $6,000 State income tax withheld, $2,750 Traditional IRA contribution, $6,000 Gambling winnings, $600 Student loan interest, $420 You should consult Table 4.1 for marginal tax rates.

.

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A. Should they itemize deductions this year?

Answer: No Solution: No, they should not itemize their deductions, because their $21,650 itemized deductions is less than the standard deduction of $24,400.

Calculation of the Melinsky’s itemized deductions.

Itemized deductions Expense medical expenses $ 2,500 mortgage interest $15,300 property taxes $ 3,600 state income taxes $ 2,750 Total itemized deductions

Allowable expense $ 2,500 less ($69,180 AGI1 x 10% = $6,918) = N/A $15,300 $ 3,600 $ 2,750 $ 21,650 is less than $24,400 standard deduction

Note1: AGI Calculation AGI = total income +/- adjustments AGI = $75,000 W-2 wages + $600 gambling winnings – $6,000 IRA contribution - $420 student loan interest = $69,180 Sec 4.2; LO 4.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

B. What is the Melinskys' taxable income for 2019, assuming that their filing status is married filing jointly?

Answer: $44,780 Solution: To determine their taxable income, first calculate their adjusted gross income (AGI), then subtract the higher of their itemized deductions or standard deductions.

Taxable Income = $69,180 (AGI) - $24,400 (standard deduction) = $44,780 AGI Calculation AGI = $75,000 W-2 wages + $600 gambling winnings – $6,000 IRA contribution - $420 student loan interest = $69,180 Calculation of Melinsky’s itemized deductions.

Itemized deductions Expense medical expenses $ 2,500 mortgage interest $15,300 property taxes $ 3,600 state income taxes $ 2,750 Total itemized deductions

Allowable expense $ 2,500 less ($69,180 AGI1 x 10% = $6,918) = N/A $15,300 $ 3,600 $ 2,750 $ 21,650 is less than $24,400 standard deduction

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB:Analytic

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C. Use the tax rate schedule in Table 4.1 to calculate the tentative tax they owe (before any credits), assuming that their status is married filing jointly.

Answer: $4,986 Solution: To determine their tax owed, you need to calculate their taxable income, then use the tax table to calculate the total tax due. To determine the taxable income, calculate their adjusted gross income (AGI), then subtract the higher of their itemized deductions or standard deductions.

Taxable Income = $69,180 (AGI) - $24,400 (standard deduction) = $44,780 AGI Calculation AGI = $75,000 W-2 wages + $600 gambling winnings – $6,000 IRA contribution - $420 student loan interest = $69,180 Calculation of Melinsky’s itemized deductions.

Itemized deductions Expense medical expenses $ 2,500 mortgage interest $15,300 property taxes $ 3,600 state income taxes $ 2,750 Total itemized deductions

Allowable expense $ 2,500 less ($69,180 AGI1 x 10% = $6,918) = N/A $15,300 $ 3,600 $ 2,750 $ 21,650 is less than $24,400 standard deduction

Calculation of the Melinsky’s Tentative Tax (prior to credits) Using Table 4.1 - Schedule Y-1. 2019 Tax Rate Schedule for Married Filing Jointly.

Calculate the tentative tax on $44,780 taxable income.

$19,400 income x 0.10 tax rate = $1,940.00 $25,380 income x 0.12 tax rate = $3,045.60 $44,780 income $4,985.60 total tentative tax Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB:Analytic

D. Are the Melinskys eligible to take any tax credits? Explain.

Answer: Yes. The Melinskys have “four children, ages 4 to 10”.

The Child Tax Credit introduced with the 2017 TCJA provides a tax credit worth up to $2,000 per qualifying dependent child under 16 years old. The Child Tax Credit starts to phase out with $400,000 AGI (married filing jointly) and $200,000 for everybody else. $1,400 of the child tax credit is refundable, which means that the $1,400 can be used to not only reduce a tax liability to zero, but the difference will be paid out to the taxpayer as a refund. The Melinskys qualify for the Child Tax Credit and all 4 of their children are under 16 years old.

The Melinskys will have $8,000 in Child Tax Credits and $5,600 of which is refundable.

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

19

They may be eligible for a Child and Dependent Care Tax Credit if they use any child-care providers, besides Jared. They can get up to 35% tax credit, up to $3,000 for one child and $6,000 for two or more dependent children under 13 years old. This credit is not refundable and the credit phases out with higher income. Since, the Melinskys will have no tax liability due to the Child Tax Credit, they cannot use any nonrefundable tax credits.

Sec 4.3; LO 4.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

Copyright © 2016 John Wiley & Sons, Inc.

Bajtelsmit, Personal Finance, 1e, Instructors Manual

20

CHAPTER 5 Instructor Manual & Solutions Managing Consumer Credit: Credit Cards and Consumer Loans LEARNING OBJECTIVES LO 5.1 Describe the role of consumer credit in your financial plan.

LO 5.2 Maintain your creditworthiness, and understand your consumer credit rights.

LO 5.3 Evaluate credit card choices based on terms and costs.

LO 5.4 Evaluate consumer loan choices based on your financial needs, loan terms, and costs.

SUGGESTED COURSE PLAN You will probably need to allocate more than one week out of a typical 15-16 week semester on this chapter. For 50 minute classes, you can cover one Learning Objective in each session over 4 sessions. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

1

2

LO5.1 What is Consumer Credit LO5.2 Your Consumer Credit Plan LO5.3 Credit Cards

3

LO5.4 Consumer Loans

Suggested WileyPLUS Pre-Class Assignments

Interactive: Debt Danger Interactive Card Statement Reflection 2

WileyPLUS Resources to Use in Class

Figs 5.4,5.5 (FICO Scores) Demo Prob. 5.1 Demo Prob. 5.2

Demo Prob. 5.3 Demo Prob. 5.4 Ethics: Payday Loans

Personal Financial Planner Assignment (and Excel resources) Household Credit Summary (PFP5.1)

WileyPLUS Homework Assignment Chapter 5 Homework A: R:13,17; P: 6,7,8

Credit Card Comparison (PFP5.3) Debt Repayment Plan (PFP5.2)

Chapter 5 Homework B: R:11-12, 20 P:1-3,9,10 Adaptive Practice Ch 5

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CHAPTER OUTLINE AND SUMMARY LO 5.1

Describe the role of consumer credit in your financial plan.

What is Consumer Credit?

I.

TYPES AND SOURCES OF CONSUMER CREDIT A. Closed-End versus Open-End Credit B. Sources of Consumer Credit.

II. THE ADVANTAGES AND DISADVANTAGES OF CONSUMER CREDIT A. Advantages of Consumer Credit B. Disadvantages of Consumer Credit C. Consumer Credit and the Economy III. APPLYING FOR CONSUMER CREDIT

LO 5.2

Maintain your creditworthiness, and understand your consumer rights

YOUR CONSUMER CREDIT PLAN I.

MEASURING YOUR CREDIT CAPACITY A. Using Financial Ratios to Measure Credit Capacity B. The Five C’s of credit C. Understanding Your Credit Score

II. WHEN AND HOW TO USE CONSUMER CREDIT III. STRATEGIES FOR REDUCING DEBT IV. YOUR CONSUMER CREDIT RIGHTS A. Full Information from Prospective Lender B. Clear and Accurate Billing Statements C. Limits on Interest Rate Increases and Fees D. Freedom from Discrimination E. Privacy of Financial Information F. Know Why You Were Denied Credit G. Fair and Respectful Debt Collection H. Accuracy of Reported Credit Information I. Correcting Information on Your Credit Report

2

IV. BANKRUPTCY Options for when you get into financial trouble: A. Contact Your Creditors Directly B. Consult a Professional Credit Counselor C. File for Bankruptcy 1. Chapter 7 Bankruptcy 2. Chapter 13 Bankruptcy LO 5.3

Evaluate credit card choices based on terms and costs.

CREDIT CARDS I. TYPES OF CARDS A. Bank Credit Cards B. Retail Credit Cards C. Travel and Entertainment Cards D. Debit Cards E. Smart Cards and New Technology II. COMMON CREDIT CARD CONTRACT TERMS A. Annual fees B. Annual Percentage Rate (APR) C. Transaction, Billing, and Due Dates D. Minimum Payment E. Penalties and Fees F. Finance Charge LO 5.4

Evaluate consumer loan choices based on your financial needs, loan terms, and costs.

CONSUMER LOANS I.

COMMON TYPES OF CONSUMER LOANS A. Home Equity Loans B. Automobile Loans C. Student Loans

II. COMPARING CONSUMER LOAN ALTERNATIVES A. Secured versus Unsecured Loans B. Interest Rates C. Payment Arrangements D. Finance Charges 1. Simple interest 2. Add-on interest 3. Discount interest E. Repayment of Principal F. Other Loan Repayment Plans

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

TEACHING SUGGESTIONS 1.

Have students construct questions for a survey with no more than five multiple-choice questions that allows them to collect data on college students’ use of credit cards. Once the class selects 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.

2.

Ask each student to list their largest purchase in the last 12 months. Then ask then to explain how they decided on the item they purchased and why they purchased it.

3.

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 their purchase decisions, and how they feel about the purchases now.

4.

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.

5.

Poll the class on their use of various payment methods, including cash, checks, debit cards, credit cards and payment services such as Venmo and Square cash and compare this to the data reported in the chapter. Ask students what changes they expect to see in the next five years and why. 6. Break up the class into small groups and have each group play the role of loan officers at a bank. They will use the Five C’s of Credit to assess whether to accept a customer’s application for a car loan. Each group should make a list of the documentation that they need to get from the applicant in order to make their decision,

7.

Discuss the common practice by insurance companies to base premium costs for car and homeowner’s insurance on an individual’s consumer credit history. Why do insurance companies do this? Is it fair to consumers? Why or why not?

8.

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?

4

CONCEPT REVIEW QUESTION SOLUTIONS 1. Why is the availability of consumer credit good for the economy?

Answer: Consumer credit allows individuals to invest in or purchase a wider range of products and services by spreading the costs over time. When consumers spend more, businesses are more profitable, employment increases, and the economic outlook improves.

Sec 5.1; LO 5.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

2. What is the difference between Give some examples of each.

open-end

and

closed-end

consumer

credit?

Answer: You are using consumer credit when you borrow to pay for consumer goods and services.

Closed-end credit is credit that a lender approves for a specific purpose, such as the purchase of a car. It must be paid back with interest over a specific period of time. Open-end credit is not generally earmarked for a specific purpose, and the payment period is not specified in advance. Instead, the lender preapproves an amount of credit and the borrower can use this credit until they have reached the limit. The borrower makes regular payments that include interest and principal, and can continue to borrow and pay back the credit over time. Examples of open-end credit include credit cards, overdraft protection, and home equity lines of credit.

Sec 5.1; LO 5.1; BT: K; Difficulty: M; TOT: 2 min; AACSB:

3. Penny has just found out from her dentist that she needs to have her wisdom teeth removed.

Because she has been experiencing some jaw complications, she cannot delay this expenditure, but she does not have dental insurance. Explain the advantages and disadvantages of using credit to pay for this expense.

Answer: Credit lines can be an important source of funds to meet emergency needs. By using credit to pay for the dental surgery, Penny can receive the care she needs now rather than having to wait until she raises enough cash to pay for the procedure. However, if the cost of the procedure exceeds Penny’s ability to make the monthly payments, the resulting payments, fees, and penalties could significantly limit her cash flow and damage her credit profile.

Sec 5.1; LO 5.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

4. Your friend tells you that he always makes the minimum payment on his credit cards. Explain to him why he should pay more than the minimum payment each month.

Answer: By making minimum payments, your friend is accruing interest on the outstanding balance.

If he pays more than the minimum payment, the additional payment will be applied to the outstanding balance, thus reducing the amount of the interest being accrued and reducing his overall debt. Ideally, your friend should pay the full balance of the cards each month and avoid interest charges entirely.

Sec 5.2; LO 5.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

5. Describe the relationship between the maturity of a loan and the monthly payment.

Answer: As the maturity of a loan gets longer, the monthly payment gets smaller, assuming the interest rate does not change. Longer-maturity loans typically carry higher rates of interest. The monthly payment is lower because the principal repayment is spread over a longer period, which .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

reduces the principal repayment component of the monthly payment. However, because the borrower is paying back the principal more slowly with a longer-term loan, the amount of interest paid over the life of the loan will be greater.

Sec 5.4; LO 5.4; BT: C; Difficulty: H; TOT: 2 min; AACSB:

6. If a lender assesses your credit capacity and determines that it will approve a loan to you, does that necessarily imply that you can afford the loan? Why or why not?

Answer: No, a lender's approval does not automatically imply that you can afford the loan. A lender may approve you for a loan based on your financial ratios and the ability to make the payments to the lender. The lender does not take into account other factors, such as a potential reduction in the borrower’s standard of living and the inability of the borrower to reach his or her financial goals, such as saving for an emergency or retirement. The real cost to the borrower is not simply the interest rate on the loan, but the impact of payments on the ability to meet his or her financial goals while maintaining a reasonable standard of living.

Sec 5.3; LO 5.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

7. What are the Five Cs of Credit? Give an example of each.

Answer: The Five Cs of Credit are capacity, capital, collateral, character, and conditions.

(1) Capacity is the financial ability of a borrower to pay back the loan as measured by financial ratios, such as the debt payment ratio.

(2) Capital represents a borrower's net worth, or the difference between his or her assets and liabilities. For specific loans, such as a home mortgage, lenders also seek a minimum down payment before approving the loan. Contribution of capital by the borrower reduces the borrower's willingness to default on a loan.

(3) Collateral is what a lender may require in order to reduce its risk exposure in the event of a default. Car loans have the automobile as collateral. In the event of a default by the borrower, the lender can repossess the car and sell it off, applying the resulting proceeds to the principal balance owed by the borrower. The higher the value of the collateral, the more attractive it is to the lender.

(4) Character represents a borrower's past track record of handling debt obligations and making timely payments. It is assessed by factors such as length of credit history, employment, and home ownership.

(5) Conditions refer to general economic conditions, such as recession, unemployment, and job creation, in the wider economy, as well as the individual's personal credit situation. Economic conditions affect cash inflows to the borrower and ultimately impact the lender if insufficient inflows result in a payment default by the borrower.

Sec 5.2; LO 5.2; BT: K; Difficulty: E; TOT: 5 min; AACSB:

8. Assume that one of your high priority financial goals is to pay off your current credit card balance of $5,000. The rate of interest on this debt is 18%, and you have been making minimum payments only. What are some strategies you can employ to pay off this debt as soon as possible?

6

Answer: Any strategy to pay off a debt must involve a disciplined commitment to pay back the principal on the outstanding loan. Like any SMART goal, the commitment must be specific, measurable, attainable, realistic, and time-specific. Your first step should be to carefully assess your budget to see if you can realistically find money to specifically apply to this debt each month. If you want to pay off the debt within 2 years, you will need to make monthly payments of about $250 (See Table 5.3). If you do not have that much money available each month, you may need to set a longer timeframe for repayment, or you may decide to take more extreme measures. You should reconsider your budget to see if you can cut back on some discretionary expenditures to accommodate your payoff goal. Other options include taking a second job and applying all of supplemental income to debt reduction, selling assets, living with other family members or taking on a roommate to reduce your expenses. Committing to a payment plan (amortization schedule) provides the specific, measurable, attainable, and relevant goal towards debt payoff at a specific date.

Sec 5.2; LO 5.2; BT: C; Difficulty: M; TOT: 4 min; AACSB: Reflective Thinking

9. How is annual percentage rate (APR) different from and similar to annual percentage yield (APY), which was defined and explained in Chapter 3?

Answer: APR is the effective annual interest rate that you pay on a loan, whereas APY is the effective annual interest rate that you earn when you invest in an interest-earning account. APR and APY are similar in that they both take into account the total finance charges associated with the account, including interest and fees. They both are expressed as a percentage return for the year, but may have different periodic interest periods within the year (either loan payments or interest payments). The two differ in the way they are calculated. APR is typically used in borrowing where periodic interest is paid, thus there is no compounding of interest. APY is typically used in interestearning accounts, where the periodic interest is left and reinvested to compound the account returns.

Sec 5.3; LO 5.3; BT: C; Difficulty: M; TOT: 3 min; AACSB:

10. You currently have $10,000 in a savings account at your local financial institution earning 2 percent interest. Your outstanding consumer credit totals $3,000 and costs 12 percent interest per year. Your monthly debt payment is $60. Should you take the money from your savings to repay the debt? Why or why not?

Answer: If the rate you earn on your investments is less than the rate you pay on the debt, you are essentially losing money, and it is usually better to pay off the debt with the savings. If you use $3,000 from your savings to repay your consumer credit account, you will save the 12% interest you would have paid on this loan. Your opportunity cost is that you will have $3,000 less on which to earn your 2% interest. Although you could do the full calculation to determine the costs and benefits, it does not require calculation to see that the lost investment returns will be far less than the gains from paying less interest on your credit. In this example, if you pay $60 per month for the credit, it will take you 70 months to repay the loan and you will have paid a total of almost $1,200 in interest over that time period, where you would have earned $371 in the savings account for that time period.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Reflective Thinking

11. Explain why the rates charged on secured loans are usually lower than those for unsecured personal loans. .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Answer: Secured loans (mortgages and auto loans) carry lower rates of interest than unsecured loans (credit card debt) because the loans are backed by collateral, such as a car or a home, which reduces the probability of default. Furthermore, in the event of a default, the lender can repossess the underlying asset and offset the loan balance with the proceeds from the sale of the collateral. A lower risk of default and the availability of cash from the sale of collateral reduce the risk of loss to lenders; thus, they charge lower rates of interest on secured loans.

Sec 5.4; LO 5.4; BT: K; Difficulty: M; TOT: 2 min; AACSB:

12. How can a debt consolidation loan help you to reduce your outstanding credit obligations?

Answer: Debt consolidation is a form of refinancing of existing loans with a new loan that either has a lower cost of financing or more manageable payments. A debt consolidation loan is usually earmarked to pay off high-interest loans, such as credit cards, and carries a lower rate than the original debt. One way to achieve debt consolidation is to take out a home equity loan and pay off the credit card debt immediately. Once a debt consolidation loan is taken, it is unwise to borrow against credit cards again. Otherwise, the new loan payment burden may not be sustainable. By saving on high-interest payments, the new loan can be paid off faster.

Sec 5.2; LO 5.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

13. Under what circumstances would you recommend that someone consult a consumer credit counselor?

Answer: A person who is in serious credit trouble, who has fallen way behind in monthly payments, and who sees no way to avoid further financial difficulty would be prudent to consult with a consumer credit counselor. The counselor will help to develop a plan and a budget to pay down the debt and avoid bankruptcy. Counseling includes understanding of the reasons why someone got into serious financial trouble in the first place and how to avoid it in the future. It may also require reaching out to creditors and negotiating a reduced payment plan so as to pay off the debt over a fixed period of time.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

14. Under what circumstances might it be advisable to declare bankruptcy? If you do so, what impact will the bankruptcy have on your personal finances?

Answer: A Chapter 7 bankruptcy allows a person to be legally relieved of certain debts and obligations. There are some debts that cannot be discharged in bankruptcy, depending on the legal route taken. Due to changes in the bankruptcy laws, most people are required to first file for Chapter 13 bankruptcy under which they are required to make a repayment arrangement with their creditors.

Even though it does not cancel your debts, it often will include negotiated reductions in balances and payments. Bankruptcy should be the choice of last resort, and a person should file for bankruptcy only after a substantial reduction in income or cash flow due to job loss, injury, or medical expenses renders meeting and satisfying debt obligations in full a virtual impossibility. Bankruptcy affects a person's credit negatively and stays on the credit report for 10 years. It makes it harder to obtain a mortgage and other types of loans in the future.

Sec 5.2; LO 5.2; BT: C; Difficulty: M; TOT: 3 min; AACSB:

8

15. Explain why lenders often charge lower rates of interest on loans with shorter maturities.

Answer: Lenders charge lower rates for shorter maturities because they are less risky. The main risks that impact these loans are liquidity risk, inflation risk, and default risk. With a shorter loan, the lender will be repaid sooner, and will have the funds available to reinvest. If market rates rise, a longer-term loan with a fixed rate exposes lenders to the risk of receiving lower interest income than they could on new loans. They are also exposed to the risk that inflation will cause general market rates to rise. Their profits will decline if they are locked into a long-term loan at a low rate. As loan maturities get longer, a lender's exposure to default risk increases. For example, a borrower may have good credit at the time of approval of the loan, but their credit situation may deteriorate. .

Sec 5.4; LO 5.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

16. Distinguish between simple interest, add-on interest, and discount interest loans. Which type generally results in the lowest APR, given the same nominal rate of interest? Why are the APRs different?

Answer: Simple interest is the periodic nominal rate that is applied to the remaining outstanding balance after the prior payment has posted. Under a typical simple interest installment loan, payments are fixed for a set number of payments, where interest is calculated at the end of the interest period based on the remaining principal. Every period, the fixed payment will pay down more of the principal as the interest cost declines with the declining outstanding principal. This is commonly referred to as loan amortization and why this is the least expensive method. Home mortgages and car loans use simple interest amortization.

Add-on interest is a payment method where the nominal interest for the entire loan maturity is added to the principal then divided by the total payments. Hence, principal and interest is equally spread over the repayment period. This level amortization results in an APR higher than the nominal rate, as interest does not decline as principal is paid down as is the case for simple interest. This method is not common today and typically offered by sub-prime lenders for shortterm installment loans.

Discount interest is a single payment loan where the interest cost is subtracted from the loan proceeds up-front. The loan is quoted as the principal and interest due at maturity. These loans are typically short-term, as there are no periodic payments. U.S. Treasury Bills and short-term corporate debt are examples of discounted loans. The discounted rates are higher than interest-equivalent rates because the interest is calculated based on the payment value at maturity and not the cash flow received upfront. Hence the APR is higher because it is based on the total interest cost over the discounted loan proceeds.

Sec 5.4; LO 5.4; BT: C; Difficulty: M; TOT: 4 min; AACSB:

17. If you discover an error on your credit report, what should you do to correct it?

Answer: When you discover an error on your credit report, you must immediately notify the credit reporting agency and ask for the error to be corrected. You may be required to submit documentation and proof for verification. Credit agencies work independently, and it cannot be assumed that information reported by all of them is correct on the basis of only one agency. Credit bureaus are required to certify that any negative information carried in the report is correct. However, the person to whom the report relates has the right to add an explanation providing information about any extenuating circumstances that may have led to a missed payment or past delinquencies. .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Sec 5.2; LO 5.2; BT: K; Difficulty: E; TOT: 2 min; AACSB:

18. If you discover a fraudulent or incorrect charge on a credit card bill, what should you do to correct it?

Answer: Upon discovery of a fraudulent or incorrect charge on a credit card bill, you should immediately contact the card issuer and report the occurrence. The issuer usually requires more information and verification before the charge can be reversed. You may report the charge over the phone or in writing. If you report it by phone, it is also a good idea to follow up with a written report.

Card issuers are bound by regulations in terms of the process and specific timeline to correct the disputed charges. Many card issuers employ sophisticated software to detect fraudulent charges quickly and may place a hold on your credit card or cancel it to prevent further loss.

Sec 5.3; LO 5.3; BT: K; Difficulty: E; TOT: 2 min; AACSB:

19. Perry‘s insurance agent recently notified him that his auto insurance premium is going to increase because his credit report shows so many late payments in the last six months. In addition, the agent noted that Perry had applied for several new credit cards during that time period. Perry complains to his friends that this treatment is totally unfair and argues that there is no possible relationship between his bad credit and his risk of having auto accidents or damaging his vehicle. Do you agree that it is unfair to use credit information in setting insurance premiums? What is the justification for this practice?

Answer: This practice would be unfair if there were no legitimate link between credit and insurance claims costs or if using credit discriminated against certain groups of people, such as by race or ethnicity. However, insurance company claims data shows that people with poor credit also make more claims on their auto and homeowners’ insurance. Credit trouble is not limited to any particular income, race, or ethnic groups.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Ethics

20. You have just received a credit card solicitation in the mail that offers you a 4 percent APR. Your current card, which has an outstanding balance of $5,000, has an APR of 14 percent.

What factors should you consider in making the decision to transfer your balance?

Answer: You need to read the offer carefully to determine all the relevant aspects of the credit terms. Is there a balance transfer fee for the 4% APR deal? Although introductory incentives such as low rate deals and bonus points are attractive, you must consider the long-term aspects of the credit agreement, such as what the rate will be after the introductory teaser rate, grace period, other fees and what the penalty rate will be if you make a late payment. What are the other perks, such as airline miles, cash rebate, and membership points. Also, what is the ratio of money spent to points/miles earned. If you usually pay your bill in full, you should look for a card that includes a good grace period for new purchases.

Sec 5.3; LO 5.3; BT: An; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

21. Your younger sister is 18 years old and just starting college. At present, she has no credit history.

10

A) What are some strategies you can suggest to help her build a credit history?

Answer: Your sister can build up her credit history by managing typical college expenses and always paying on-time. (1) Obtain her own cell phone service (2) obtain a credit card with a low limit, use it for necessities such as groceries, utilities and school expenses, and (3) obtain her own rent and utility account. She must make payments on time or pay off the balance each month. Some vendors may open an individual account, and some may require her parents to cosign.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

B) How can you help her avoid getting into trouble with credit while she is a student?

To help her avoid getting into trouble while she is a student, you should discuss with her the importance of a monthly budget and keeping track of expenses. A monthly budget and cash management go a long way in managing your finances and making sure that you do not spend too much on things that can build up debt. A plan with financial goals imposes discipline and reduces impulsive spending. It also enables a person to detect problems before they get out of control. Managing bank balances accurately avoids overdraft fees and prevents bouncing of checks, both of which can hurt your credit rating.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

APPLICATION PROBLEM SOLUTIONS 1. The total annual finance charges on your credit card account are $200. You also pay an annual fee of $50. If your average outstanding balance during the year is $1,000, what is the annual percentage rate?

A. 25% B. 20% C.15% D. 2.5% Answer: 25% Solution: APR takes into account all the finance charges associated with the account, even when they aren’t technically called “interest.” To determine the annual percentage rate (APR), add the finance charges ($200) and the annual fee ($50), then divide by the average outstanding balance ($1,000): (Equation 5.1) Total annual finance charges + Annual fee Average loan balance over the year $200 + $50 APR = $1,000 APR =

APR = 0.25 ~ 𝟐𝟓% [Notes for programmer: Please make this problem algorithmic. Suggestions for variables, three different outstanding balances ($1000,2000,3000). Annual finance charge should calculated as be 15%, 20%, or 25% of the average outstanding balance. Annual fee: $25, $50, $75. Distractor answers: Finance charge/average balance; (Finance charge-annual fee)/average balance; correct answer/10.]

Sec 5.3; LO 5.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

2. You have just received a credit card solicitation in the mail that offers you a 4 percent APR. Your current card has an APR of 14 percent. How much interest will you save the first month by switching cards? Assume you make no additional charges and both cards calculate interest based on the average daily balance of $5,000.

A. $42 B. $500 C. $50 D. $58 Answer: $42

12

Solution: The finance charge is the dollar amount of interest charged by the lender in a particular billing cycle. It is calculated using Equation 5.2: Nominal rate Finance charge = x Account balance owed Number of billing periods per year 0.14 x $5,000 = $58.33 12 months per year 0.04 Finance charge for new offer = x $5,000 = $16.67 12 months per year You can save $41.66 ($58.33 - $16.67) for the first month interest (finance charge).

Finance charge for current card =

Sec 5.3; LO 5.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. Your home is currently valued at $120,000. You have a first mortgage in the amount of $80,000. If your lender applies a 90 percent loan-to-value ratio for approving home equity lines of credit, what is the maximum amount you can borrow (rounded to the nearest dollar), assuming you meet all other lender requirements?

A. $28,000 B. $36,000 C. $12,000 D. $30,000 Answer: $28,000 Solution: In evaluating home equity loan applications, lenders apply a maximum loan-to-value ratio, commonly from 75 percent to 90 percent. This means that they will not allow total debt on the home, including the first mortgage and the home equity loan, to exceed a set percentage of the current market value of the home. To calculate the maximum amount you can borrow, multiply your current home value ($120,000) by the loan-to-value ratio supplied by the lender (90%, or 0.9). Then, to see how much more than your primary mortgage you can borrow, subtract your first mortgage amount ($80,000). 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑙𝑜𝑎𝑛 = (𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 ℎ𝑜𝑚𝑒) 𝑥 (𝑙𝑜𝑎𝑛 𝑡𝑜 𝑣𝑎𝑙𝑢𝑒 𝑟𝑎𝑡𝑖𝑜) Maximum loan = $120,000 x .90 = $108,000 Maximum home equity line of credit = $108,000 max loan – $80,000 primary mortgage = $28,000 Sec 5.4; LO 5.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. Your credit card lender charges an annual rate of 15 percent on the average daily balance.

Your balance on March 10, the end of the last billing cycle, was $5,000. The following transactions were posted to your account during the billing cycle: 3/15 New credit purchase $500 3/20 Payment received $750 4/1 New credit purchase $1,000 .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

The last day of the monthly billing cycle is April 10. Calculate the finance charge.

A. $65.02 B. $62.50 C. $71.88 D. $81.25 Answer: $65.02 Solution: The finance charge is the dollar amount of interest charged by the lender in a particular billing cycle. It is calculated using Equation 5.2: Nominal rate Finance charge = x Account balance owed Number of billing periods per year The account balance on which the finance charge is assessed each month depends on the calculation method used by each lender. The most common method used is the average daily balance. The average daily balance is calculated by identifying how much you owed on each day of the billing period, adding these amounts together, and dividing by the number of days.

Average Daily Balance (31 days in March billing cycle )

Beginning balance for 5 days @ $5,000 = $25,000 +$500 on 3/15 for 5 days @ $5,500 = $27,500 -$750 on 3/20 for 12 days @ $4,750 = $57,000 +$1,000 on 4/1 for 9 days @ $5,750 = $51,750 $161,250 / 31 days = $5,201.61 Average daily bal. .15

𝐅𝐢𝐧𝐚𝐧𝐜𝐞 𝐜𝐡𝐚𝐫𝐠𝐞 = 12 billing periods per year x $5,201.61 = $65.02 Sec 5.3; LO 5.3; BT: Ap; Difficulty:H; TOT: 4 min; AACSB: Analytic

5. Your credit card lender charges an annual rate of 15 percent on the average daily balance.

Your balance on March 10, the end of the last billing cycle, was $5,000. The following transactions were posted to your account during the billing cycle: 3/20 Payment received $750 The last day of the monthly billing cycle is April 10. Calculate the finance charge.

A. $56.15 B. $62.50 C. $53.13 D. $71.88 Answer: $56.15 Solution: The finance charge is the dollar amount of interest charged by the lender in a particular billing cycle. It is calculated using Equation 5.2: 14

Finance charge =

Nominal rate x Account balance owed Number of billing periods per year

The account balance on which the finance charge is assessed each month depends on the calculation method used by each lender. The most common method used is the average daily balance. The average daily balance is calculated by identifying how much you owed on each day of the billing period, adding these amounts together, and dividing by the number of days.

Average Daily Balance (31 days in March billing cycle ) Beginning balance for 10 days @ $5,000 = $50,000 -$750 on 3/20 for 21 days @ $4,250 = $89,250 $139,250 / 31 days = $4,491.94 Average daily bal. .15

𝐅𝐢𝐧𝐚𝐧𝐜𝐞 𝐜𝐡𝐚𝐫𝐠𝐞 = 12 billing periods per year x $4,491.94 = $56.15 Sec 5.3; LO 5.3; BT: Ap; Difficulty: H; TOT: 4 min; AACSB: Analytic

6. Suppose the average household in the United States pays $1,340 in interest and fees on credit cards each year. If a household could instead contribute this amount of money each year to a retirement savings account earning 6 percent per year compounded annually, how much money would they have in the account when they retired 40 years from now?

A. $207,381 B. $219,824 C. $13,783 D. $53,600 Answer: $207,381 Solution: Calculate the future value of a $1,340 annual payment over 40 years at a 6% APY. Financial Calculator PV = 0, PMT = -1340, I = 6, N = 40, Solve for FV = 207,381.03 ~ $207,381 Excel Spreadsheet =FV(rate, nper, pmt, pv) => =FV(.06, 40, -1340, 0) => 207,381.03 ~$207,381 TVM Equation [(1 + i)n − 1] FVA = PMT X i [(1 + .06)40 − 1] FVA = $1,340 X = $207,381.03 ~ $𝟐𝟎𝟕, 𝟑𝟖𝟏 . 06 Sec 5.2; LO 5.2; BT: An; Difficulty: H; TOT: 4 min; AACSB: Analytic

7. If you owe $1,000 and the APR is 10%, what monthly payment would you need to make to reduce your debt to zero within two years? .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Answer: $46 Solution: Calculate the monthly amortization payment necessary to pay off a $1,000 loan in 2 years at a 10% APR. When using financial calculators and Excel spreadsheet TVM functions, payments are expressed as negative numbers because payments are technically cash out-flows and the PV is a cash in-flow or principal loan.

Financial Calculator PV = 1000, FV = 0, I = 10/12, N = 2*12, Solve for PMT = -46.14 ~ $46 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.0083333, 24, 1000, 0) => -46.15 ~ $46 TVM Equation PMT = PVA X

𝑖 1 𝑛 1 − (1 + 𝑖 )

𝑃𝑀𝑇 = $1,000 𝑋

.008333 1−(

24 1 ) 1.00833

= 46.14 ~ $𝟒𝟔

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

8. Calculate the monthly payment, rounded to the nearest dollar, for a three-year $10,000 simple interest car loan if the loan terms are a rate of 6 percent with monthly payments.

A. $304 B. $312 C. $235 D. $254 Answer: $304 Solution: Calculate the monthly amortization payment necessary to pay off a $10,000 loan in 3 years at a 6% APR. When using financial calculators and Excel spreadsheet TVM functions, payments are expressed as negative numbers because payments are technically cash out-flows and the PV is a cash in-flow or principal loan.

Financial Calculator PV = 10000, FV = 0, I = 6/12, N = 3*12, Solve for PMT = -304.22 ~ $304 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.005, 36, 10000, 0) => -304.22 ~ $304 TVM Equation

16

PMT = PVA X

𝑖 1 𝑛 1−( ) 1+𝑖 .005

PMT = $10,000 X 1−(

36 1 ) 1+.005

= $304.22 ~ $𝟑𝟎𝟒

Sec 5.4; LO 5.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

9. What is the APR for a $1,000, two-year, 10 percent simple interest installment loan with monthly payments?

Answer: 10% Solution: APR takes into account all the finance charges associated with the account, even when they aren’t technically called “interest.” The APR for a simple interest loan with no other charges or fees is the same as the nominal rate.

Sec 5.4; LO 5.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

10. What is the approximate APR for a $1,000, two-year add-on loan with a 10 percent quoted rate?

Answer: 20% Solution: If a lender uses the add-on interest method, 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. Precise calculation of the APR for an add-on interest loan is a little tricky because the changing allocation of your payment dollars to interest and principal makes it more difficult to measure the average loan balance. You can roughly estimate the APR for an add-on interest loan using Equation 5.5: Total annual finance charges APR approximation for add − on interest loan = Original loan amount x 0.5 APR approximation for add − on interest loan =

$1,000 x .10 = 0.20 ~ 𝟐𝟎% $1,000 x 0.5

Sec 5.4; LO 5.4; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

11. What is the approximate APR for a $1,000, two-year discount interest single-payment loan with a quoted rate of 10 percent?

Answer: 12.5% Solution: Discount interest is a single payment loan where the interest is subtracted in advance from the loan proceeds. The loan is quoted as the principal and interest due at maturity. These loans are typically short-term, as there are no periodic payments. The discounted rates are higher than interest-equivalent rates because the interest is calculated based on the payment value at maturity and not the cash flow received upfront. Hence the APR is higher because it is based on the total interest cost over the discounted loan proceeds. .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

APR =

Total annual finance charges Average loan balance of the year

APR =

$1,000 x 0.10 = 0.125 ~ 𝟏𝟐. 𝟓% $800

Sec 5.4; LO 5.4; BT: Ap; Difficulty:H; TOT: 2 min; AACSB: Analytic

12. For a $3,000, three-year loan, calculate the APR if the loan is an 8 percent simple interest single-payment loan.

Answer: 8% Solution: Because this is a simple interest loan, the APR will always be the same as the quoted rate.

Sec 5.4; LO 5.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. For a $3,000, three-year 8 percent loan with monthly payments, how much will you pay in interest over the life of the loan?

A. $384 B. $492 C. $720 D. $3,384 Answer: $384 Solution: First calculate the monthly payment necessary to pay off a $3,000 loan in 3 years at a 8% APR, then subtract the original loan principal from the aggregate payments.

Financial Calculator PV = 3000, FV = 0, I = 8/12, N = 3*12, Solve for PMT = -94.01 ~ $94.01 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.0066667, 36, 3000, 0) => -94.01 ~ $94.01 TVM Equation PMT = PVA X

𝑖 1 𝑛 1 − (1 + 𝑖 ) .0066667

PMT = $3,000 X 1−(

36 1 ) 1+.0066667

= $94.01

18

Aggregate Payments = $94.01 payment x 36 payments = $3,384.36 Total Interest Cost of Loan = $3,384.36 aggregate payments - $3,000 loan = $384.36 ~ $384 Sec 5.4; LO 5.4; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

14. For a $3,000, three-year 6 percent add-on interest installment loan, calculate the approximate APR. A. 12% B. 6% C. 18% D. 13% Answer: 12% Solution: If a lender uses the add-on interest method, 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. Precise calculation of the APR for an add-on interest loan is a little tricky because the changing allocation of your payment dollars to interest and principal makes it more difficult to measure the average loan balance. You can roughly estimate the APR for an add-on interest loan using Equation 5.5: Total annual finance charges APR approximation for add − on interest loan = Original loan amount x 0.5 APR approximation for add − on interest loan =

$3,000 x .06 = 0.12 ~ 𝟏𝟐% $3,000 x 0.5

Sec 5.4; LO 5.4; BT: Ap; Difficulty:H; TOT: 2 min; AACSB: Analytic

15. Danny‘s original car loan amount was $13,000, and the loan is a 6 percent simple interest 48month loan.

A) What is the monthly payment?

A. $305 B $3,752 C. $313 D. $287 Answer: $305

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

Solution: Calculate the monthly amortization payment necessary to pay off a $13,000 loan in 48 months at a 6% APR. Financial Calculator PV = 13000, FV = 0, I = 6/12, N = 48, Solve for PMT = -305.31 ~ $305 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.005, 48, 13000, 0) => -305.31 ~ $305 TVM Equation PMT = PVA X

𝑖 1 𝑛 1−( ) 1+𝑖 .005

PMT = $13,000 X 1−(

48 1 ) 1+.005

= $305.31 ~ $𝟑𝟎𝟓

Sec 5.4; LO 5.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B) What is the APR? A. 6.0% B. 0.5% C. 0.6% D. 6.2% Answer: 6.0% Solution: APR takes into account all the finance charges and fees associated with the account, even when they aren’t technically called “interest.” For simple interest loans with no fees, the nominal rate is also the APR. Sec 5.4; LO 5.4; BT: C; Difficulty: E; TOT: 1 min; AACSB: Analytic

16. Chuan took out a $13,000 car loan at 6 percent simple interest for 48 months. What is the remaining balance on his loan after two years, or 24 months? (Hint: Use the amortization function on your financial calculator or Excel Worksheet 5.5.)

A. $6,889 B. $7,327 C. $7,503 D. $5,673 Answer: $6,889 Solution: First calculate the monthly payment necessary to pay off a $13,000 loan in 48 months at a 6% APR, then compute the remaining balance at the end of 24 months. With the financial calculators, you have to reset “N” prior to solving the amortization after 24 months. With Excel, its best to construct an amortization table.

20

Financial Calculator (HP 12-C) Step 1: PV = 13000, FV = 0, I = 6/12, N = 48, Solve for PMT = -305.31 ~ $305.31 Step 2: N = 0, Solve for 24 AMORT = -1,215.89 total interest Step 3: RCL PV to display the loan balance = 6,888.56 ~ $6,889 Financial Calculator (TI BAII Plus) Step 1: PV = 13000, I/Y = 6/12 = 0.5, N = 48. Solve for PMT = -305.31 Step 2: 2nd followed by AMORT, P1 = 1, Down arrow key and P2 = 24 Step 3: Press the Down arrow again and you will see that Balance = 6,888.56 ~ $6,889 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.005, 48, 13000, 0) => -305.31 ~ $305.31 Excel Worksheet 5.6 allows you to enter the initial loan information and the number of payments you

have already made to solve for the balance owed and total interest paid.

You can also use the Excel function =CUMPRIN(rate,nper,pv,start_period,end_period,type) to calculate the amount of principal that has been repaid by the end period and then subtract that from the original loan value. =>13,000 - CUMPRINC(.05/12,48,13000,1,24,0) = ~ $6,889 Sec 5.4; LO 5.4; BT: Ap; Difficulty:H; TOT: 3 min; AACSB: Analytic

17. Marie graduated from college with $20,000 in student loan debt. The annual rate on her loans is 5 percent simple interest, and she will make monthly payments for 10 years.

A) What is the monthly payment?

A. $212 B. $2,590 C. $215 D. $175 Answer: $212 Solution: Calculate the monthly amortization payment necessary to pay off a $20,000 loan in 10 years at a 5% APR. When using financial calculators and Excel spreadsheet TVM functions, payments are expressed as negative numbers because payments are technically cash out-flows and the PV is a cash in-flow or principal loan.

Financial Calculator PV = 20000, FV = 0, I = 5/12, N = 10*12, Solve for PMT = -212.13 ~ $212 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.0041667, 120, 20000, 0) => -212.13 ~ $212 TVM Equation .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

PMT = PVA X

𝑖 1 𝑛 1−( ) 1+𝑖 .0041667

PMT = $20,000 X 1−(

120 1 ) 1+.0041667

= $212.13 ~ $212

Sec 5.4; LO 5.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B) What is the APR? Answer: 5% Solution: For simple interest loans with no fees, the nominal rate is also the APR. The answer here will always be the nominal rate, so this problem can be numeric entry.]

Sec 5.4; LO 5.4; BT: C; Difficulty: E; TOT: 1 min; AACSB: Analytic

18. Marie graduated from college with $20,000 in student loan debt. The annual rate on her loan is 5 percent simple interest, and she will make monthly payments for 10 years. What is the remaining balance on her loan after five years, or 60 months? (Hint: Use the amortization function on your financial calculator or Excel Worksheet 5.5.)

A. $11,241 B. $10,000 C. $12,728 D. $7,272 Answer: $11,241 Solution: First calculate the monthly amortization payment necessary to pay off a $20,000 loan in 10 years at a 5% APR, then compute the amortization at the end of 60 months. With the financial calculators, you have to reset “N” prior to solving the amortization after 60 months. With Excel, its best to construct an amortization table.

Financial Calculator (HP 12-C) Step 1: PV = 20000, FV = 0, I = 5/12, N = 120, Solve for PMT = -212.13 Step 2: N = 0, Solve for 60 AMORT = -3,968.83 total interest Step 3: RCL PV to display the loan balance = 11,240.97 ~ $11,241 Financial Calculator (TI BAII Plus) Step 1: PV = 20000, I/Y = 5/12 = .417, N = 120. Solve for PMT = 212.13 Step 2: 2nd followed by AMORT, P1 = 1, Down arrow key and P2 = 60 Step 3: Press the Down arrow again, and you will see that the Balance = 11,240.97 ~ $11,241 Excel Spreadsheet =PMT(rate, nper, pv, fv) => =FV(.0041667, 120, 20000, 0) => -212.13. Excel Worksheet 5.6 22

allows you to enter the initial loan information and the number of payments you have already made to solve for the balance owed and total interest paid.

You can also use the Excel function =CUMPRIN(rate,nper,pv,start_period,end_period,type) to calculate the amount of principal that has been repaid by the end period and then subtract that from the original loan value. =>20,000 - CUMPRINC(.05/12,120,20000,1,60,0) = 11,240.97 ~ $11,241 Sec 5.4; LO 5.4; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

19. You have after-tax monthly income of $1,200, and your monthly debt payments total $300.

What is your debt payment ratio?

Answer: 25% Solution: Debt Payment ratio =

Total monthly debt payments After−tax monthly income

Debt Payment ratio =

$300 = 0.25 ~ 𝟐𝟓% $1,200

Sec 5.2; LO 5.2; BT: Ap; Difficulty:E; TOT: 1 min; AACSB: Analytic

20. Ellen‘s gross monthly income is $2,500. Her take-home pay is 80 percent of her gross income. She currently pays $75 per month for credit cards and $310 per month for a car loan.

She is considering the purchase of a $1,500 living room set, and the store has offered financing with payments of $50 per month.

A) What is Ellen’s debt payment ratio before the furniture purchase?

A. 19.25% B. 21.75% C. 15.40% D. 12.40% Answer: 19.25% Solution: Debt Payment ratio =

Total monthly debt payments After−tax monthly income

Debt Payment ratio =

$75 + $310 = 0.1925 ~ 𝟏𝟗. 𝟐𝟓% . 80 ∗ $2,500

Sec 5.2; LO 5.2; BT: Ap; Difficulty:E; TOT: 1 min; AACSB: Analytic

B) If she borrows the money to buy the furniture, what will be her debt payment ratio?

A. 19.25%

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

B. 21.75% C. 15.4% D. 12.4% Answer: 21.75% Solution: Debt Payment ratio =

Total monthly debt payments After−tax monthly income

Debt Payment ratio =

$75 + $310 + $𝟓𝟎 = 0.2175 ~ 𝟐𝟏. 𝟕𝟓% . 80 ∗ $2,500

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

C) Assuming that she has already comparison-shopped for the living room set, what other factors should she consider before making this credit decision?

Answer: APR, the impact on her credit capacity, and the effect on her budget Solution: Taking on the extra debt will raise Ellen’s debt payment ratio from 19.25% to 21.75%. While this ratio may be manageable for Ellen, she will have other fixed payments as well, such as rent. Taking on additional fixed payments may interfere with her ability to maintain her standard of living and reach her financial goals in terms of retirement savings and emergency funds. Furthermore, the monthly payment on the furniture loan may be low, but the APR may be high, which means Ellen will be locked into these payments for a long time, reducing her budget flexibility. Furniture is a depreciating asset, and if she needed money in a hurry, she would be able to sell the used furniture only at a steep discount. Risk of job loss also adversely affects a person's ability to cope with fixed payment obligations.

Total monthly debt payments After − tax monthly income $75 + $310 Debt Payment ratio 𝐛𝐞𝐟𝐨𝐫𝐞 furniture purchase = = 0.1925 ~ 𝟏𝟗. 𝟐𝟓% . 80 ∗ $2,500 $75 + $310 + $𝟓𝟎 Debt Payment ratio 𝐚𝐟𝐭𝐞𝐫 furniture purchase = = 0.2175 ~ 𝟐𝟏. 𝟕𝟓% . 80 ∗ $2,500 Debt Payment ratio =

Sec 5.2; LO 5.2; BT: Ap; Difficulty: E; TOT: 4 min; AACSB: Reflective Thinking

24

CASE APPLICATION SOLUTIONS

1. You are out shopping with your friend Andrea and find some wonderful bargains on last season‘s clothing. You are standing next to Andrea in the checkout line when both her credit cards are declined. She laughs it off and rummages around in her purse for her checkbook, saying that she probably just made a late payment. You are not so sure. You recall other instances in which her card has been turned down, and you know that she is always spending more on clothes than her income would seem to justify. When you ask Andrea about her credit, she confesses that she has gotten in over her head. In fact, she recently applied for a new credit card, figuring that she would be able to make overdue payments on her other cards using cash advances from the new one.

A) Does Andrea exhibit any warning signs (Hint: See Interactive Figure 5.3, Are You in Debt Danger?)

of

credit

trouble?

Answer: Yes, Andrea exhibits several warning signs of credit trouble: credit card purchases denied; lack of concern about being denied, meaning that this must have happened before; spending too much; making a joke out of the concept of late payments; and using a new card to make payments on existing cards.

Sec 5.2; LO 5.2; BT: C; Difficulty: E; TOT: 2 min; AACSB:

B) If Andrea asks for your advice, where would you suggest she go for more information?

Would you suggest that she seek professional help? If so, where would you recommend she go?

Answer: Yes. Andrea has already admitted to being “over her head” with credit and is pursuing a Ponzi scheme to maintain her current payment obligations. She has already exhibited probably the most common strategy in this situation: avoidance. Ignoring credit problems, and applying for even more debt, will result in more serious problems for her. She should seek professional help from a consumer credit counseling organization.

There are many reputable sources of free help, so she should avoid companies that charge for this service. The National Foundation for Consumer Credit (www.nfcc.org), an organization sponsored by large creditor firms, offers free consumer credit counseling through local nonprofit branches called Consumer Credit Counseling Services. In addition to providing educational materials, the certified counselors at these offices help millions of consumers each year to develop realistic budgets, plan for debt reduction, and negotiate with creditors. Large employers may offer financial counseling through their human resources departments, or she may be able to get free counseling through her financial institution, a county extension office, or an employee union.

Sec 5.2; LO 5.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C) What are some strategies that Andrea might employ to dig herself out of this debt trap?

Answer: Andrea needs identify all her liabilities and sources of monetary assets to determine where she stands, create a budget that will allow her to live within her means, and to set up a debt repayment plan. It will be important for her to control her excessive spending and commit to some S.M.A.R.T. goals. Some strategies she can use include: .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

(1) Set up a debt repayment plan.

(2) Take a second job specifically earmarked to pay down the debt.

(3) Develop a zero-based budget. Zero-based budgeting is a strategy often recommended by financial planners. To construct a zero-based budget, Andrea should start with absolute necessities and debt payments and then add expenditures until she runs out of cash. Thus, “fun” money for entertainment, eating out, and clothes shopping would have lower priority than payments to reduce her debt.

(4) Live with family or friends to reduce her expenses.

(5) Sell assets and use the proceeds to pay down debt.

Sec 5.2; LO 5.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

2. Mike and Allison Randall are middle-income baby boomers. Mike works as an engineer for a well-established company, and Allison works part-time so that they can afford to send their two children to a private elementary school. Although they have a combined pre-tax income of $120,000 and after-tax income of $90,000, the Randalls’ budget has been a little tight ever since they decided to buy a larger home two years ago. As a result, they are not currently making contributions to savings other than those required by Mike’s employer for his retirement account. Allison estimates that their debt ratio is about 90 percent and their debt payment ratio is 35 percent. One day, Allison is surprised to come across a bill for a credit card she did not know they had. According to the statement, the card is maxed out to the full credit limit of $10,000, and the minimum monthly payment is $200. When Allison confronts her husband, he confesses to her that he has a small gambling problem and has been too embarrassed to tell her about it. In addition to the amount he owes on the account, she discovered he owes an additional $5,000 on another. Mike tells his wife that he has been looking into the possibility of a debt consolidation loan.

A) What risks do Mike and Allison face as a result of their high level of debt payments? If they have little in savings, what options would they have in the event that Mike lost his job?

Answer: Mike and Allison face a number of risks, including the inability to make monthly debt payments in addition to living expenses and private school fees, the absence of a safety net, very little equity in their home (which they bought only two years ago), and debt ratio and debt payment ratio estimates that are much too high, especially with the additional $15,000 in credit card debt. If Mike lost his job, they would have to immediately contact their creditors and let them know. Consumers are often surprised to find out that, although interest and late fees will still accrue, creditors are often willing to make alternative payment arrangements. Creditors much prefer to get something rather than nothing. If your budget crunch is temporary, as in the case of a short period of unemployment, this type of arrangement may help you get through it without becoming seriously delinquent.

In addition to making arrangements with creditors, they should consider getting professional consumer credit counseling. In addition to providing educational materials, the certified counselors at these offices help millions of consumers each year to develop realistic budgets, plan for debt reduction, and negotiate with creditors. Debt reduction plans will most likely include reducing their monthly expenses, such as eliminating private school, downsizing their home and selling other assets. Mike may have to find a second job and Allison might have to obtain a fulltime employment.

26

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

B) Why is it important that the Randalls confront the cause of their credit problems and not simply deal with the symptoms? Where would you suggest they go for help?

Answer: It is important that the Randalls confront the cause of their credit problems because these problems have put them into severe financial trouble that will impact their family for years.

If their spending habits cannot be controlled, then they will perpetually find themselves in the same situation. Mike must take steps to deal with his gambling, which may include seeking professional help. A debt consolidation loan could reduce their payments and interest costs, but only if they refrain from taking on more debt in the meantime. Credit counseling services are essential and will help the family greatly. No matter which method you choose to use for reducing your debt, you’ll be more successful if you have a plan with specific goals, including a timeline for achieving them.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C) What might be some problems associated with applying for and being approved for the debt consolidation loan?

Answer: The Randalls will likely face several problems in applying for and being approved for a debt consolidation loan. Their credit scores would most likely prohibit them from obtaining new credit, let alone a competitive rate. They are “maxed out.” Their credit cards have hit the highest credit utilization ratio and their mortgage is leveraged to nearly the value of their home. They have little monetary assets and no liquidity. Applying for new credit will also lower their credit scores.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D) What are some strategies that this family should consider for dealing with their debt problems?

Answer: The Randalls needs to identify all their liabilities and sources of monetary assets to determine where they stand, create a budget that will allow them to live within her means and to set up a debt repayment plan. It will be important for them to immediately stop their spending habits and commit to some S.M.A.R.T. goals: (1) Set up a debt repayment plan that will allow them to repay the debt within a specific period of time.

(2) Mike should consider a second job specifically earmarked to pay down the debt. Although working two jobs may not sound like fun, it’s often the fastest way to reduce your outstanding credit card debt. Allison needs to find full-time employment.

(3) Develop a zero-based budget. Zero-based budgeting is a strategy often recommended by financial planners. To construct a zero-based budget, they can start with absolute necessities and debt payments and then add expenditures until they run out of cash. Thus, “fun” money for entertainment, eating out, and clothes shopping would have lower priority than payments to reduce their debt.

(4) Reduce expenses. Downsize their home, or find tenants. Although this arrangement may not be ideal, it can be quite helpful as a means of reducing the debt load.

(5) Sell assets and use the proceeds to pay down debt.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Reflective Thinking

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

3. Lana and Zack Worzala were married a year ago, and they are thinking about buying a home.

They have saved $10,000 to put toward the down payment, but they are wondering if they should pay off some of their consumer debt instead. Their combined gross monthly income is $5,000, and their after-tax monthly income is $4,000. They have the following debts: Balance Owed

APR

Monthly Minimum Payment

$ 2,000

6%

$340

Lana’s Visa

1,300

18

35

Zack’s MasterCard

4,200

21

110

Lana’s student loan

3,370

5

37

114

Zack’s student loan

10,600

6

122

114

Zack’s car loan

Number of Payments Left 6

A) What is the Worzalas’ debt payment ratio, based on their current situation?

Answer: 16.1% Explanation: Debt Payment ratio =

Total monthly debt payments After−tax monthly income

$340 + $35 + $110 + $37 + $122 Debt Payment ratio = = 0.161 ~ 𝟏𝟔. 𝟏% $4,000 Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytical

B) Assume mortgage lenders require that the mortgage debt service ratio for a new home purchase not exceed 28 percent of gross monthly income. Given Zack and Lana’s gross income, what is the maximum mortgage debt service amount that would be allowed by a lender (including mortgage principal and interest, property taxes, and insurance)?

Answer: $1,400 Solution: Mortgage Debt Payment ratio = H . 28 = $5,000

Total housing debt payments Gross monthly income

𝐻 = .28 ∗ $5,000 = $𝟏, 𝟒𝟎𝟎 The maximum debt service that will allow the Worzalas to qualify for a loan based on this ratio is $1,400.

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytical

C) If mortgage lenders require that total debt payments not exceed 36 percent of after-tax disposable income, will Zack and Lana have any trouble meeting this requirement?

Explain.

28

Answer: Although their total debts before housing are only 16.1% of their gross income, they will need to consider how the additional mortgage debt service will impact this ratio. If their mortgage debt service is $1,400 per month, then their debt payment ratio would be: 𝐓𝐨𝐭𝐚𝐥 monthly debt payments 𝐀𝐟𝐭𝐞𝐫 − tax monthly income $𝟑𝟒𝟎 + $𝟑𝟓 + $𝟏𝟏𝟎 + $𝟑𝟕 + $𝟏𝟐𝟐 + $𝟏, 𝟒𝟎𝟎 𝐃𝐞𝐛𝐭 Payment ratio = = 𝟎. 𝟓𝟏𝟏 ~ 𝟓𝟏. 𝟏% $𝟒, 𝟎𝟎𝟎 𝐃𝐞𝐛𝐭 Payment ratio =

Since the debt payment ratio in that case would be 51%,and this is much higher than the maximum 36%, they will not meet this requirement.

D) Zack and Lana estimate that, given the prices of homes in the area and the costs of property taxes and insurance, the minimum mortgage debt service they would have to pay is $1,000 per month (including mortgage principal and interest, property taxes, and insurance). If that is the case, will they be able to get a loan with their current debt obligations, assuming that the lender’s maximum debt payment ratio is 36 percent?

Should they consider applying some of their savings to debt repayment?

Answer: No. Even if their debt service is only $1,000, they will not be able to get a loan because their debt payment ratio will be 41.1% which is higher than the 36% maximum.

If they pay off the car loan with savings, their debt payment ratio would be 32.6%, which would be low enough to qualify for the loan.

Total monthly debt payments Debt Payment ratio = After − tax monthly income Existing monthly payments + mortgage debt payment $1,000 + $340 + $35 + $110 + $37 + $122 Debt Payment ratio = = 0.411 ~ 𝟒𝟏. 𝟏% $4,000 After car loan pay-off 𝐷ebt Payment ratio =

$1,000 + $35 + $110 + $37 + $122 = 0.326 ~ 𝟑𝟐. 𝟔% $4,000

Sec 5.2; LO 5.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

CHAPTER 6 Instructor Manual and Solutions Making Automobile and Housing Decisions LEARNING OBJECTIVES LO 6.1 Evaluate your household automobile needs and budget.

LO 6.2 Decide whether to lease or buy a vehicle, and negotiate the terms for purchase and financing.

LO 6.3 Evaluate your housing needs and budget.

LO 6.4 Evaluate mortgage financing alternatives.

LO 6.5 Identify factors that affect home prices, and explain the other costs of completing a real estate transaction.

SUGGESTED COURSE PLAN This chapter can be covered in two to three class sessions. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

1

Read LO6.1 Making Auto Decisions on a Budget LO6.2 Should You Lease or Buy a Car? Read LO6.3 Making Housing Decisions on a Budget LO6.4 Mortgage Financing LO 6.5 Real Estate Transaction

Interactive: What Car Can You Afford to Buy?

2

Interactive: Interest Rates and Home Affordability

WileyPLUS Resources to Use in Class

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

DP6.5,DP6.7

PFP 6.5 Rent vs Buy a Home

Chapter 6 Homework: R:3,510,13,14,17 P:1-3,12-14 Case 6-1,Case 62 Adaptive Practice Ch. 6

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

1

CHAPTER OUTLINE AND SUMMARY LO 6.1

Evaluate your household automobile needs and budget.

MAKING AUTO DECISIONS ON A BUDGET I.

MAKING SMART PURCHASE DECISIONS A) Keep Your Financial Goals in Mind B) Don’t Ignore the Small Stuff C) Why Auto and Housing Decisions Are Harder?

II.

ASSESSING NEEDS AND AFFORDABILITY A) Do You Need a Car? B) Can You Afford a Car?

III.

CASE STUDY 6.1 THE WALKERS ESTIMATE THE COSTS OF AN ADDITIONAL VEHICLE

IV.

EVALUATING VEHICLE CHOICES A) Price B) New versus Used C) Equipment D) Size and Fuel Economy E) Safety F) Reliability and Warranties

LO6.2

Decide whether to lease or buy a vehicle, and negotiate the terms for purchase and financing.

SHOULD YOU LEASE OR BUY A CAR? I.

LEASING VERSUS BUYING A. What Is a Lease?

B. What Determines the Cost of an Auto Lease?

C. Closed-End versus Open-End Leases D. Lease Contracts

II.

NEGOTIATING THE AUTO PURCHASE PRICE A. Components of Auto Dealer Profit B. Negotiation Strategies

III.

MAKING CONSUMER COMPLAINTS

LO 6.3

Evaluate your housing needs and budget.

MAKING HOUSING DECISIONS ON A BUDGET

.

I.

HOUSING NEEDS OVER THE LIFE CYCLE

II.

THE RENT-VERSUS-BUY DECISION A. Types of Housing B. The Costs of Renting versus Buying C. Legal Issues for Tenants

III.

HOW MUCH HOUSE CAN YOU AFFORD? A. The Non-financing Costs of Home Ownership B. The Down Payment

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

2

C. Expected Closing Costs D. Maximum Loan Amount and House Price LO 6.4

Evaluate mortgage financing alternatives.

MORTGAGE FINANCING I.

WHAT IS A MORTGAGE? A. Common Characteristics of Mortgage Loans B. Resale of Loans in the Secondary Market C. Types of Mortgages

II.

FACTORS THAT AFFECT MORTGAGE PAYMENTS A. Interest Rate B. Term of the Loan C. Points D. Other Factors

III.

WHEN TO REFINANCE A. Why Refinance?

B. Costs of Refinancing

IV.

CASE STUDY 6.2 THE NGUYENS CONSIDER REFINANCING THEIR MORTGAGE

LO 6.5 Identify factors that affect home prices, and explain the other costs of completing a real estate transaction.

COMPLETING THE REAL ESTATE TRANSACTION

.

I.

DETERMINANTS OF REAL ESTATE VALUE

II.

THE HOME BUYING PROCESS A. Choosing a Broker B. How a Broker Is Paid C. Your Legal Relationship with a Broker D. Negotiating the Contract E. Arranging the Mortgage Financing

III.

THE CLOSING

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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TEACHING SUGGESTIONS 1. This chapter covers content that will be immediately relevant to most of your students. It is also a great application of the time value of money and many students may be motivated to understand how payments on car loans and mortgages are determined.

2. Discuss the reasons manufacturers offer warranties on their products. Have students discuss an item they purchased that came with a warranty and if they needed to use the warranty. If so, what happened?

3. 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.

4. 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.

5. 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 her or him agree to less favorable terms. Use this to introduce a discussion of the sources of dealer profit.

6. Lead a short class discussion on the factors you should consider in deciding whether to trade in your old vehicle or sell it on your own.

7. Ask students to come to class prepared with price information on comparable gas, hybrid or electric vehicles. Use their data to determine whether it is “worth it” to buy a more fuel-efficient vehicle (See Demonstration Problem 6.2 for an example. Alternatively, you could assign the class to do this evaluation on their own prior to class).

8. Show the class how Excel Worksheets 6.2 and 6.4 can be used to compare the cost of leasing versus buying.

9. Using a copy of a lease agreement from a local auto dealership or online advertisement, point out the auto lease terms and costs. Provide a list of lease “lingo” (e.g. capitalized cost reduction, finance charge, down payment, etc.) and have them match each term to the corresponding component in the ad.

10. 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.

11. Have the students research the housing market in your area, either online or by looking in newspapers.

Ask them to research the lowest price for a single-family detached home, and how much less it would be to buy a condominium of a similar size.

12. Discuss the pros and cons of a parent buying a condo or house for their son or daughter to reside while in college. Note that this exercise is also relevant to the discussion of investment real estate in Chapter 13.

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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CONCEPT REVIEW SOLUTIONS 1. Look up the manufacturer’s suggested retail price (MSRP) for a vehicle that is available in both gasoline and hybrid models. What is the price differential between the two models?

How should you evaluate whether the difference in cost is worth the potential fuel savings?

Answer: Calculate the difference in annual fuel cost for the two vehicles. Use Equation 6.1 to determine the annual gasoline costs. 𝐴𝑛𝑛𝑢𝑎𝑙 𝑔𝑎𝑠 𝑐𝑜𝑠𝑡𝑠 =

𝐴𝑛𝑛𝑢𝑎𝑙 𝑚𝑖𝑙𝑒𝑠 𝑑𝑟𝑖𝑣𝑒𝑛 𝑥 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑔𝑎𝑙𝑙𝑜𝑛 𝑀𝑃𝐺

Compare this to the difference in cost to determine how long it will take to recoup the cost difference.

Sec 6.1; LO 6.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:Analytic

2. Describe the process for negotiating a new car purchase.

Answer: The best approach to buying a new car is to be prepared with the facts and to not succumb to sales pressure by the dealer. First, you should research the manufacturer’s suggested retail price (MSRP) of the cars you like, along with dealer invoice prices and potential discounts available from the manufacturer. Next, you should drive the cars you like and decide on your preferred make and model. Then, shop around for a car loan, and approach a lender (such as a bank), and get pre-approved for an amount sufficient to cover the balance of the price after your down payment. Choose the best car dealer, make an offer close to the dealer invoice price, adjusted for discounts plus a reasonable markup for dealer profit, say $200 to $300. It is a good idea to start low to give yourself some negotiating room. If the dealer rejects your offer outright or asks for substantially more money, do not be afraid to walk away. That signals to the dealer that you are firm about your offer and the dealer needs to come down in order to win your business.

Sec 6.1; LO 6.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

3. Explain why a dealer might be willing to sell you a new car at only a few dollars above its cost.

Answer: Dealers may be willing to sell a new car at a price only a few dollars above the invoice price because they may be able to earn additional money from the manufacturer in the form of incentives which are not passed on to the consumer, such as rebates, allowances, and discounts.

Furthermore, dealers make a profit on used cars, as their trade-in values are much lower than their sale prices. Dealers have many other sources of profit, such as dealer-financing, sales of extended warranties, and dealer-installed add-ons or services. The objective of dealers is to maximize their overall profit. When they have a large inventory of a particular type of make and model, they are more willing to discount its price. So, it pays to shop around.

Sec 6.1; LO 6.1; BT: C; Difficulty: M; TOT: 2 min; AACSB:Reflective Thinking

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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4. Manuel bought a new car two years ago. The car has had electrical system problems ever since he bought it. He has taken the car back to the dealership for servicing under his warranty several times, but they have been unable to solve the problem. What should he do?

Answer: Manual should write to the state consumer affairs department. If a car turns out to be chronically defective, or is a lemon, then the buyer has rights under their state's lemon laws, which vary from state to state. The dealer may be required to reimburse the buyer for repair expenses incurred elsewhere or refund the price the buyer paid for the vehicle. In complex cases, legal assistance may be needed.

Sec 6.1; LO 6.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

5. If all else is equal, explain how your decision to lease or buy a car will be affected if you tend to drive more than 15,000 miles per year.

Answer: Leases typically limit the number of miles the car may be driven without paying a penalty.

For example, a common limit is 10,000 miles. If the lessee drives the car more than the allowed miles, he or she must pay an additional depreciation charge for the excess miles based on a stipulated per-mile rate. If you tend to drive more miles than the allowed limit, you may find it cheaper to buy a car instead of leasing one, due to the excess mileage surcharge at the end of the lease.

Sec 6.2; LO 6.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:Reflective Thinking

6. If all else is equal, explain how your decision to lease or buy a car will be affected if you want a lower monthly payment.

Answer: When leasing a car, a person only pays for the depreciation of the car over its lease period, as well as, associated finance charges. When buying a car, the person pays for the entire car and the finance charge. Assuming the same initial down payment, the lease payment is almost always lower than a loan payment due to this difference between paying for just the expected depreciation versus the entire car. If the person does not intend to keep the car beyond the lease period under either alternative, lower lease payments will swing the decision in favor of leasing.

Sec 6.2; LO 6.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:Reflective Thinking

7. If all else is equal, explain how your decision to lease or buy a car will be affected if the car you want is one that loses market value quickly.

Answer: When leasing a car, a person only pays for the expected depreciation of the car over its lease period, plus associated finance charges and fees. If the proposed car has a high depreciation rate, then the leasing deal should have this priced accordingly. The high depreciation rate would mean that the car will have a low residual value when the lease ends, thus requiring a large differential to amortize over the lease period. A lease payment deal will still be less than a comparable car loan payment unless the expected value of the car at lease end is worthless. Cars that depreciate less quickly over the initial years of ownership, will have greater residual value and thus a smaller amount to amortize over the lease period. It’s no coincidence that mid-priced luxury vehicles have competitive lease deals, because they typically have high resale value in 3 years. .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Sec 6.2; LO 6.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:Reflective Thinking

8. If all else is equal, explain how your decision to lease or buy a car will be affected if you don’t have much money for a down payment.

Answer: Both leases and purchases commonly require a down payment. If you make a smaller down payment under either lease or purchase, both payments will be higher, but lease payments will still be lower than ownership payments.

Sec 6.2; LO 6.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:Reflective Thinking

9. Explain why lease payments are usually less than loan payments for the same vehicle.

Answer: Lease payments are lower than loan payments because the lessee pays only for the portion of the car that depreciates during the lease period. The expected depreciation in a lease deal is the difference between the purchase price of the car and the expected residual value at the end of the lease term. Under ownership, a person pays for the entire purchase of the car. The lessee pays for the finance charges associated with the difference in purchase price less residual value at lease-end, and the purchaser pays for the finance charges associated with the entire purchase price less down payment.

Sec 6.2; LO 6.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

10. What are the advantages and disadvantages of renting as compared with owning a home?

Answer: The advantages of renting are: (1) rent payments are usually less than mortgage payments; (2) a renter is more mobile than a homeowner; (3) a renter has less responsibility to pay for repairs and landscaping. The disadvantages of renting are: (1) rent payments increase with time; (2) rent is not deductible for personal income tax purposes; (3) a renter does not build up equity in the property; (4) there may be restrictions on use of the property; and (5) there is no guarantee that the rental unit will be available at the end of the lease.

Sec 6.3; LO 6.3; BT: C; Difficulty: M; TOT: 3 min; AACSB:

11. How would you expect your housing needs to change over your life cycle?

Answer: Housing needs are a function of the life stage. Single people tend to rent or live in shared housing, such as apartments or condominiums. Married couples and families with children typically prefer single-family homes that offer relatively more living space and are located in good school districts. Retirees or couples with adult children tend to downsize into smaller homes, often moving to areas that are closer to accommodate their lifestyle.

Sec 6.3; LO 6.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

12. Why might some buyers prefer to purchase a condominium instead of a single-family home even though they will have to pay monthly condominium fees?

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

7

Answer: A condominium is a type of residential property in which the unit owner has control over and use of their unit, but shares the common areas with other unit owners. Maintenance and repairs of the external building and property (e.g., landscaping) are managed by the condominium association, with costs shared by all of the unit owners. Single people and retirees sometimes prefer to live in condominiums because they do not have to take care of repairs and maintenance, and common services are folded into home association dues. Such living arrangements reduce the burdens of ownership while still providing benefits of ownership.

Sec 6.3; LO 6.3; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

13. What are some reasons you might want to spend less on housing costs than the maximum you can afford?

Answer: Cutting down on housing costs, which account for 30 to 35 percent of a typical household's budget, can enable a person to pay off other higher-cost debt obligations, such as student loans and credit card debt. Even retirement savings can be funded with the money saved from lower housing costs. Another factor to consider is whether the higher loan payment, taxes, and maintenance costs would create a financial strain on your household, if you had a temporary reduction in your income. The final decision belongs to the individual, who must first identify his or her financial priorities.

Sec 6.3; LO 6.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

14. Explain how your other credit obligations, such as credit card debt and personal loans, can affect your ability to qualify for a mortgage loan.

Answer: Before lending money, banks compute an applicant’s debt payment ratio. Most lenders have a maximum debt payment ratio that they will accept. If a borrower’s total debt payments are too high in relation to the borrower’s income available to service such payments, the lender may decide that the borrower poses a great risk of defaulting on the mortgage loan. This may result in the applicant being denied the loan or being charged a higher mortgage rate.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

15. Why are lenders required to provide mortgage applicants with a “Loan Estimate” prior to charging them any loan fees?

Answer: The federal “Know Before You Owe” law is intended to ensure that borrowers fully understand the costs associated with their mortgage loan. The law requires that a lender, at the time of loan application, provide the mortgage loan applicant with a Loan Estimate that clearly lays out the APR, monthly payment, estimated closing costs, and cash needed to close. A few days before the closing, lenders must provide a Closing Disclosure that includes the same information for easy comparison to the original estimates.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

16. Mortgage lenders often require you to pay additional funds into an escrow account along with your principal and interest payments. What are these funds for, what does your lender do with the money, and why do lenders have this requirement? .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Answer: Escrow accounts are created to set aside property taxes and premiums for homeowner's insurance. This provides the lender protection against penalties or liens on the property due to lack of timely tax payments and cancelled insurance due to nonpayment of premiums.

Sec 6.4; LO 6.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

17. What factors should you consider when deciding whether to refinance your existing home mortgage?

Answer: Refinancing an existing mortgage at a lower interest rate will result in lower monthly payments but will require payment of closing costs at the time of refinancing. Refinancing may allow borrowing against equity already built up in the home, or change the length of the mortgage loan. Refinancing requires calculating the payback of any closing costs based on monthly savings and comparing the payback period with the time the homeowner plans to live in the house. Other factors to consider when refinancing include higher payments resulting from a shorter maturity (repayment ability), and justifying the purpose for which additional equity is tapped.

Sec 6.4; LO 6.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

18. What are the pros and cons of using a real estate broker to help you sell your home as opposed to selling it yourself?

Answer: The advantages of using a real estate broker are the broker can provide: (1) expert advice regarding market value based on current market conditions, knowledge of the area, and experience; (2) access to marketing resources and a large network of other brokers who will act as cooperating brokers; (3) assistance in the negotiation process; (4) help buyers to get a mortgage; (5) an opportunity to sell a house before it is officially listed if the broker belongs to a larger realtor's office and other brokers in the same office already have buyers looking for houses; (6) anonymity so the buyer does not have to meet the seller and the transaction can be handled privately.

The disadvantages of using a real estate broker are: (1) the seller will have to pay a percentage of the selling price to the broker as a commission for their services; (2) the seller and the broker may have conflicting objectives, with the broker potentially desiring a quick sale as opposed to the highest price; (3) any information the owner provides to the listing broker may find its way to the buyer’s broker and the potential buyer, even if the information does not favor the seller.

Sec 6.5; LO 6.5; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

19. Your college roommate has recently obtained his real estate license. What factors should you consider when deciding whether to use him as your real estate broker?

Answer: Factors to consider when hiring a real estate broker: (1) qualifications and years of experience; (2) association with a reputable realty firm and the size of the firm; (3) knowledge of current market conditions in the area in which the house is located; (4) whether the broker is working full-time or part-time; (5) how many houses the broker has sold in the past and the average price; (6) references from previous clients.

Sec 6.5; LO 6.5; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

20. What are the primary qualitative factors that affect the value of the house or apartment you currently live in? Do you think your home is worth more or less than other nearby homes?

Why?

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Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Answer: The qualitative factors that can affect the value of a home are predominantly of personal preference and collective desirability. Students’ answers may differ based on their own housing, but they may choose to discuss desirability of location in terms of access to their school, church, open space, and transportation. Other qualitative factors they could identify include: (1) condition of the home; (2) type of structure—single or multifamily; (3) age of home; (4) quality of construction; (5) lot size; (6) characteristics of the property (architectural style, number of bedrooms, bathrooms, square footage; (7) curb appeal and landscaping; and (8) interior appeal (height of ceilings, carpet and flooring, décor).

Sec 6.5; LO 6.5; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

21. Describe the process of making a consumer purchase, and explain why it is important to follow this process when making large purchases such as houses and cars.

Answer: When making a purchase, you should (1) determine what you need, (2) assess your budget to see what you can afford, (3) do your research by identifying alternatives and comparing them based on price and attributes, (4) decide how you will finance your purchase, and (5), negotiate the purchase price and terms (when applicable). As compared to small purchases, large purchases such as houses and cars will have a significant impact on your budget. Therefore, you will need to invest more time in this decision-making process to make sure that you are making the best decision for your household budget.

Sec 6.1; LO 6.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

10

APPLICATION PROBLEM SOLUTIONS 1. You are paying $20,000 for a car.

If the loan amount is $12,000, the loan term is 48 months, and the APR is 8 percent, what is your loan payment?

A. $292.96 B. $488.26 C. $302.96 D. $212.96 Answer: $292.96 Solution: Calculate the monthly payment on a $12,000 loan for 48 months at 8% APR. Financial Calculator N = 48, I = 8/12, PV = 12,000, FV = 0, and solve for PMT = -292.96 ~ $292.96 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.08/12), 48, 12000, 0,0) => -292.96 ~ $292.96 TVM Equation (Equation 2.12) 𝑖 PMT = PVA x => PMT = $12,000 x 𝑛 1 1−((1+𝑖))

0.0066667 1

1−((1+0.0066667))

48

= $292.95

Sec 6.2; LO 6.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

2. If you drive 10,000 miles per year, your car gets 22 miles per gallon (MPG), and the average cost of gasoline is $4 per gallon, how much will you spend on gasoline per year? (Rounded to the nearest dollar.)

Answer: $1,818 Solution: Calculate the annual gasoline cost of $10,000 miles driven at 22 miles per gallon (MPG) for $4 per gallon of gasoline. You can use Equation 6.1 Annual gasoline cost = Annual gasoline cost =

Annual miles driven x Price per gallon MPG 10,000 miles 22 MPG

x $4 per gallon = $1,818.18 ~ $1,818

Sec 6.1; LO 6.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. Given the following information about the costs of automobile ownership, what is the total cost of ownership for the first year?

• First-year depreciation: $3,000 • Auto insurance cost: $200 • Registration and license: $250 • Regular oil changes: $120 • Monthly loan payment $293 • Gasoline costs $1,818 .

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11

A. $8,904 B. $8,681 C. $5,388 D. $3,570 Answer: $8,904 Solution: Add up all of the first year costs of ownership as follows: Loan payments ($293 x 12 = $3,516) + Gasoline [$1,818] + First-year depreciation ($3,000) + Auto insurance ($200) + Registration ($250) + Oil changes ($120) = $8,904.

Sec 6.1; LO 6.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. Assume that you own a car that gets 20 miles per gallon (MPG) on average. If you typically drive 16,000 miles per year and the price of gasoline goes from $2.00 per gallon to $3.00 per gallon, what is your additional cost per year (rounded to the nearest dollar)?

Answer: $800 Solution: Calculate the annual gasoline cost of $16,000 miles driven at 20 miles per gallon (MPG) for $2 per gallon of gasoline, and compare it to $3 per gallon of gasoline. You can use Equation 6.1 Annual gasoline cost =

Annual miles driven

Annual gasoline cost @ $2 = Annual gasoline cost @ $3 =

MPG 16,000 miles 20 MPG 16,000 miles 20 MPG

x Price per gallon

x $2 per gallon = $1,600 x $3 per gallon = $2,400

Difference = $2,400 - $1,600 = $800 Sec 6.1; LO 6.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

5. Your three-year auto lease includes a mileage penalty of 25 cents per mile in excess of 12,000 miles per year. At the end of the lease, your mileage is 40,000. How much will you owe to the lessor (rounded to the nearest dollar)?

Answer: $1,000 Solution: Calculate the total miles included with the lease agreement, then subtract that from the actual miles driven. Then multiply the excess miles driven by the $0.25 per mile charge.

Miles included in the lease agreement = 12,000 miles per year x 3 years = 36,000 miles Excess miles driven = 40,000 miles actually driven – 36,000 miles allotment = 4,000 miles Excess miles surcharge = 4,000 excess miles x $0.25 per mile surcharge = $1,000 Sec 6.2; LO 6.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

6. Assume that you are considering the purchase of a used car for $6,000. Your lender is allowing you to finance the entire purchase price. What is the monthly payment, assuming

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

12

that the lender is offering you a 48-month loan at 6 percent APR? (Round to the nearest dollar.)

Answer: $141 Solution: Calculate the monthly amortizing payment for a $6,000 loan for 48 months at 6% APR. Financial Calculator N = 48, I = 6/12, PV = 6,000, FV = 0, and solve for PMT = -140.91 ~ $141 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.06/12), 48, 6000, 0,0) => -140.91 ~ $141 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.005

PMT = $6,000 x

1−((1+

1 0.005

) )

= $140.91 ~ $141

48

Sec 6.2; LO 6.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

7. If you buy a car and finance it with a $6,000, 36-month loan at 5 percent APR, how much total interest will you pay over the life of the loan?

A. $474 B. $6,474 C. $6,000 D. $900 Answer: $474 Solution: First, calculate the monthly amortizing payment for a $6,000 loan for 36 months at 5% APR, then compute the total payments required to payoff the loan, and lastly subtract the total payments by the original $6,000 loan principal.

Financial Calculator N = 36, I = 5/12, PV = 6,000, FV = 0, and solve for PMT = -179.83 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.05/12), 36, 6000, 0,0) => -179.83 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.0041667

PMT = $6,000 x

1−((1+

1 0.0041667

36 = $179.83

) )

* Total payments = $179.83 x 36 payments = $6,473.88 ** Total interest paid = $6,473.88 total payments - $6,000 loan principal = $473.88 ~ $474 Sec 6.2; LO 6.2; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

8. What factors should you consider when deciding between a 48-month loan at 6 percent APR and a 36-month loan at 5 percent APR? Answer: With a shorter-term loan, the monthly payments will be higher but the overall interest paid over the course of the loan will be lower. A longer-term loan offers a lower monthly payment .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

13

but more interest over the course of the loan. Also with a longer-term loan, you need to consider other uses for those funds saved as a result of lower monthly payments.

Sec 6.2; LO 6.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

9. You bought a car three years ago for $20,000 and financed $16,000 at 6 percent APR for 60 months. You are now thinking about trading in that vehicle for a new one and would like to know how much you still owe on the loan. Assuming that you have already made 36 payments, what is the balance remaining on your loan?

A. $6,979 B. $4,864 C. $11,136 D. $7,325 Answer: $6,979 Solution: First calculate the monthly amortizing payment for a $16,000 loan for 60 months at 6% APR, then calculate the present value (principal remaining) of the annuity (monthly payment) for the remaining 24 months (60 month loan – 36 months paid) at a 6% APR. STEP 1: Calculate Monthly Payment Financial Calculator N = 60, I = 6/12, PV = 16,000, FV = 0, and solve for PMT = -309.32 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.06/12), 60, 16000, 0,0) => -309.32 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.005

PMT = $16,000 x

1−((1+

1 0.005

) )

60 = $309.32

Step 2: Calculate PV of remaining principal Financial Calculator PMT = -309.32, N = 24, I = 6/12, FV = 0 and solve for PV = 6,979.15 ~ $6,979 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV((0.06/12), 24, -309.32, 0,0) => 6,979.15 ~ $6,979 TVM Equation PVA = PMT x

1−(

𝑛 1 ) (1+𝑖)

𝑖

=>

PVA = $309.32 x

1−(

24 1 ) (1+0.005)

0.005

= $6,979.15 ~ $6,979

Sec 6.2; LO 6.2; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

10. Maria is comparing two housing alternatives: renting an apartment or buying a condo. She can rent an apartment for $800 per month. The security deposit is $1,200 (one and a half months’ rent), and renter’s insurance is $140 per year. She earns 1 percent on her savings .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

14

account after tax, and her marginal tax rate is 25 percent. What is Maria’s total first-year cost of renting? You may find it helpful to use Excel Worksheet 6.5 to answer this question.

A. $9,752 B. $952 C. $10,940 D. $7,314 Answer: $9,749 Solution: Add all of Maria’s rental costs for the year, as well as the opportunity cost of her security deposit: Rent ($800/month x 12) $9,600 Renter’s Insurance $ 140 Lost interest income ($1,200 x 0.01 interest) $ 12 Total first year cost of renting

$9,752

Sec 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

11. Greta has decided to buy a condominium instead of renting. She estimates the following costs: purchase price, $103,000; down payment, $3,000; mortgage payment, $599.55 per month ($7,195 per year, of which $5,967 is interest in the first year); property tax, $1,300; homeowner’s insurance, $500; repairs and maintenance, $500; closing costs, $2,000. The annual increase in the condo’s value is estimated at 4 percent. She earns 1 percent on her savings account after tax, her marginal tax rate is 25 percent, and she does not itemize deductions. What is Greta’s total first-year cost of buying? You may find it helpful to use Excel Worksheet 6.5 to answer this question.

A. $9,917

B. $14,545 C. $5,348 D. $8,100 Answer: $9,917 Solution: Add all of Greta’s housing costs for the year, as well as the opportunity cost of her down payment and closing costs: Down payment Closing costs Mortgage payments Property tax Homeowners insurance Repairs & Maintenance Total direct costs

$3,000 $2,000 $7,195 $1,300 $ 500 $ 500 $14,495

Opportunity cost of upfront costs ($3,000 down-payment + $2,000 closing cost) x 1% foregone after tax interest TOTAL COSTS OF OWNERSHIP

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

50 $14,545

15

Benefits of Home Ownership: Savings from repaying principal1 Increase in home value2 Tax savings from 1st year home ownership3 TOTAL BENEFITS OF OWNERSHIP

$ 1,228 $ 4,120 $ 0 $ 5,348

NET TOTAL FIRST-YEAR COST OF BUYING

$ 9,917

Note1: Calculating savings from home ownership: The total payments made for the year are 7195 (=599.55 x 12). You know that the interest paid on the loan during the year was $5,967.

Principal repaid = Total payments – Interest = $7,195 - $5,967 = $1,228 Note that you could also calculate the principal repaid using a financial calculator or excel spreadsheet amortization function but you do not need to do so in this problem because the total interest paid is given to you in the fact statement.

Note2: Calculate the increase in home value (equity) $103,000 purchase price of house x (1 + 0.04 growth rate) = $107,120 MV after 1 year $107,120 MV - $103,000 cost = $4,120 increase in equity Note3: Since Greta does not itemize deductions, she does not get the benefit of deducting mortgage interest and property taxes.

Sec 6.3; LO 6.3; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

12. Suppose you need to finance $100,000 for the purchase of a home, and you’re deciding between a conventional 30-year mortgage at 6 percent and an ARM at an initial rate of 4 percent, an annual interest rate cap of 1 percentage point, and a lifetime cap of 5 percentage points. If you take the ARM, how much less will your monthly mortgage payment be in the first year?

A. $122.13 B. $477.42 C. $599.55 D. $369.61 Answer: $122.13 Solution: Calculate the monthly payment for a $100,000 conventional 30-year 6% APR fixedrate loan, and a comparable 30-year ARM with an initial 4% APR, and find the difference in the payments.

Calculation of Conventional Mortgage Financial Calculator N = 360, I = 6/12, PV = 100,000, FV = 0, and solve for PMT = -599.55 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((.06/12), 360, 100000, 0,0) => -599.55

.

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TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.005

PMT = $100,000 x

1−((1+

1

0.005)

360 = $599.55

)

Calculation of Adjustable-Rate Mortgage (ARM) Financial Calculator N = 360, I = 4/12, PV = 100,000, FV = 0, and solve for PMT = -477.42 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((.04/12), 360, 100000, 0,0) => -477.42 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

PMT = $100,000 x

0.0033333 1

1−((1+

0.0033333

360 = $477.42

) )

Calculation of Difference

Difference = $599.55 Conventional Mortgage - $477.42 ARM = $122.13 monthly savings using ARM Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. If you have an adjustable-rate mortgage with an initial rate of 4 percent, an annual interest rate cap of 1 percentage point, and a lifetime cap of 5 percentage points, what is the maximum annual interest rate you could end up paying on the loan?

Answer: 9% Solution: The maximum interest on the ARM is 9 percent, the initial rate of 4 percent plus the lifetime cap of 5 percent.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

14. Calculate the monthly mortgage payment for a 30-year conventional mortgage at 6 percent, assuming a loan amount of $150,000. (Round to the nearest dollar.)

Answer: $899.33 Solution: Calculate the monthly amortization payment for a $150,000 loan for 30 years at 6% APR. Financial Calculator N = 360, I = 6/12, PV = 150,000, FV = 0, and solve for PMT = -899.33 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.06/12), 360, 150000, 0,0) => -899.33 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

PMT = $150,000 x

0.005

1−((1+

1

0.005)

360 = $899.33

)

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic .

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17

15. Calculate the monthly mortgage payments for a 15-year conventional mortgage at 5 percent, assuming a loan amount of $150,000. (Round to the nearest dollar.)

Answer: $1,186 Solution: Calculate the monthly amortization payment for a $150,000 loan for 15 years at 5% APR. Financial Calculator N = 180, I = 5/12, PV = 150,000, FV = 0, and solve for PMT = -1,186.19 ~ $1,186 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.05/12), 180, 150000, 0,0) => -1,186.19 ~ $1,186 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

PMT = $150,000 x

0.0041667

1−((1+

1

0.0041667)

1,186.19 ~ $1,186

180 = $

)

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

16. Your current mortgage interest rate is 7 percent, and your monthly mortgage payment (principal and interest) is $800. Rates have declined, and you estimate that you could reduce your payment to $750 by refinancing at a lower rate. You estimate that your total closing costs will be $3,500. Is it worth it to refinance? What factors will you consider in making this decision?

Answer: The answer depends on the terms of your new loan and how long you expect to stay in the home. You will break even on the closing costs based on your monthly savings of $50 after about 70 months, or about six years ($3,500 refinance cost / $50 savings). If you refinance for a longer period of time than the remaining years on your old loan, you could end up paying more interest in total than you would have by keeping your current mortgage.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

17. Jane’s gross monthly income is $3,300. She is applying for a mortgage loan that will have an $800 monthly mortgage payment (principal and interest). In addition, property taxes will be $100 per month, and homeowner’s insurance will be $50 per month. Jane’s other debt payments are $250 (car loan) and $200 (minimum payments on credit cards). Will she qualify for the mortgage loan if her lender requires the mortgage debt service ratio to be no more than 30 percent and the debt payment ratio to be no more than 40 percent?

A. No, because her debt payment ratio exceeds the lender’s limit.

B. No, because her mortgage debt service ratio and her debt payment ratio both exceed the lender’s limits.

C. Yes, because both her mortgage debt service ratio and her debt payment ratio meet the lender’s requirements.

D. Yes, because her mortgage debt service ratio is lower than the lender’s limits.

Answer: A. No, because her debt payment ratio exceeds the lender’s limit. .

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Solution: Calculate Jane’s mortgage debt service ratio to see if it is less than the lender’s 30% requirement, and calculate the debt payment ratio to see if it is less than the lender’s 40% requirement. Remember to use gross monthly income in the denominator of both equations to be consistent with the way lenders calculate these ratios. .

Calculation of mortgage debt service ratio (Equation 2.6) Mortgage debt service ratio =

Principal + Interest + Taxes + Insurance Gross monthly income

$800 mortgage payment + $100 property tax + $50 home owners insurance = 0.288 ~ 28.8% $3,300 gross income * This is less than 30%, and so will meet the lender’s requirements.

Calculation of debt payment ratio (Equation 2.5) Debt payment ratio =

Total monthly debt payments After − tax monthly income

$800 mortgage + $100 tax + $50 insurance + $250 car + $200 credit card = 0.424 ~ 42.4% $3,300 gross income * This is greater than the lender’s 40% requirement, so she will not be approved for the loan.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

18. Suppose you are shopping for a mortgage and would like to finance $200,000. A lender offers you a conventional 30-year mortgage at 6 percent with no points (monthly payment = $1,199) or a 5.5 percent rate with one point (monthly payment = $1,136). How would you decide whether it makes sense to buy down your rate by paying the point?

Answer: The decision is based on how long you will stay in the home. Calculate the monthly payment savings from the buy down, and divide that into the cost of the buy down. This will calculate the break-even point where you start benefiting from the upfront payment.

Monthly payment savings from buy down = $1,199 (zero-points) - $1,136 (1 point) = $63 Cost of the buy down = $200,000 loan x 0.01 (1 point) = $2,000 Break-even point =

$𝟐,𝟎𝟎𝟎 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒃𝒖𝒚 𝒅𝒐𝒘𝒏 $𝟔𝟑 𝒎𝒐𝒏𝒕𝒉𝒍𝒚 𝒔𝒂𝒗𝒊𝒏𝒈𝒔

= 𝟑𝟏. 𝟕𝟓 𝐦𝐨𝐧𝐭𝐡𝐬

It will take 32 months to recoup the cost of paying the point. If you expect to own the home for at least three years and you have sufficient cash to pay the up-front point, it may be worthwhile to pay the point. Note that if you keep the loan for the full 30 years, you will save $63 x 360 = $22,680.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

.

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19

19. You want to buy a home, and you have $15,000 available to cover the down payment and closing costs. Based on your household budget, you estimate that you can afford to allocate $1,200 per month to housing costs. Your real estate agent has given you the following estimates for the monthly non-financing costs of home ownership: property taxes, $200; homeowner’s insurance, $75; repairs and maintenance, $50. Your lender has provided an estimate of $3,000 for closing costs. What is the maximum you can afford to pay for a home, assuming current mortgage rates are 6 percent? You may want to use Excel Worksheet 6.6 in solving this problem.

A. $157,943 B. $145,943 C. $160,943 D. $163,943 Answer: $157,943 Solution: Calculate the amount you can allocate towards mortgage payments based on your monthly budget. Then calculate the loan (present value) that can be obtained based on your budgeted mortgage payment for 30 years at 6% APR. The maximum purchase price of a home that you can afford is the loan value, plus the down payment, and less the closing costs.

Calculation the budgeted mortgage payment Monthly allocation to housing costs Less: Property tax ($200) Homeowner’s insurance ($ 75) Repairs & maintenance ($ 50) Housing cost budget available for mortgage

$1,200

($ 325) $ 875

Calculation the Loan Amount (present value of amortization payment) Financial Calculator PMT = -875, N = 360, I = 6/12, FV = 0 and solve for PV = 145,942.66 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV((0.06/12), 360, -875, 0,0) => 145,942.66 TVM Equation PVA = PMT x

1−(

𝑛 1 ) (1+𝑖)

𝑖

=>

PVA = $875 x

1−(

360 1 ) (1+0.005)

0.005

= $145,942.66

Calculation of Maximum House Purchase Maximum Purchase Price = $145,943 loan + $15,000 down payment - $3,000 closing cost Maximum Purchase Price = $157,943 Sec 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

.

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20

CASE APPLICATION SOLUTIONS 1. Annette Thoreson is a single mother of two. Her children are getting older, and she wants to replace her old car with a new minivan. In addition to extra room for camping gear and car pools, Annette wants safety features, such as dual front airbags and antilock brakes. She has decided that the best choice is a Honda Odyssey, for which she has negotiated a purchase price of $25,000. She has $4,000 to put toward the purchase and has pre-arranged for a car loan with her bank at 7 percent APR for 48 months. At the last minute, the car dealership’s financing department pressures her to consider leasing the van for four years at $199 per month. The lease terms are as follows: • • • • • • • •

Capitalized cost reduction: $3,000 Security deposit: two lease payments Mileage limit: 12,000 miles per year Over-mileage penalty: $0.25 per mile Purchase option: $14,000 After-tax APY on savings account: 2 percent Estimated value of the car at the end of 4 years: $13,000 Number of miles per year Annette typically drives: 13,000

A. What would Annette’s monthly loan payment be if she decides to buy the car and finance it with the 7 percent 48-month bank loan?

Answer: $502.87

Solution: Calculate the monthly payment for a $21,000 loan for 48 months at a 7% APR. Financial Calculator N = 48, I = 7/12, PV = 21,000, FV = 0, and solve for PMT = -502.87 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.07/12), 48, 21000, 0,0) => -502.87 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

PMT = $21,000 x

0.0058333 1−((1+

1 0.0058333)

)

48 = $502.87

Sec 6.1; LO 6.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. What is the total cost of leasing the minivan for four years? You may want to use Excel Worksheet 6.4 to solve this problem.

Answer: $13,832

Solution: Add all of Annette’s lease cost for the 4 years, as well as her opportunity cost of her upfront payments: Lease payments ($199/month x 48) $9,552 Capitalized cost reduction $3,000 Security deposit ($199 x 2 months) $ 398 .

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21

Mileage surcharge1 Opportunity cost of upfront payments2 Return of security deposit Total cost of lease

$1,000 $ 280 ($ 398) $13,832

Note1: Calculation of mileage surcharge

Miles expected to drive = 13,000 annual expected miles x 4 = 52,000 expected miles Miles included in lease = 12,000 annual miles x 4 years = 48,000 miles included in deal Excess expected miles = 52,000 expected miles – 48,000 included miles = 4,000 miles Expected Surcharge = 4,000 excess expected miles x $0.25 per mile = $1,000 Note2: Calculation of Opportunity cost of upfront payments

Upfront payments = $3,000 capitalized cost reduction + $398 security deposit = $3,398 * Savings account pays 2% APY. Calculator: N = 4, I = 2, PV = -3,398, Solve for FV = $3,678.10 Excel: =FV(rate,nper,pmt,pv,type) => =FV((0.02), 4, 0, -3398, 0) => 3,678 Equation 2.8: FV = PV x (1+i)n = $3,398 x (1.02)4 = $3,678 * $3,678 value of account in 4 yrs - $3,398 beginning balance = $280 interest Sec 6.2; LO 6.2; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

C. What is the total cost of buying the car by financing it with the bank loan? You may want to use Excel Worksheet 6.4 to solve this problem.

Answer: $15,911

Solution: Add all of Annette’s auto financing costs for the 4 years, as well as her opportunity cost of her upfront payments: Loan payments1 ($502.87/month x 48) $24,137.76 Down payment $ 4,000 Opportunity cost of down payment2 $ 330 Opportunity cost of payment3 difference $ 443 Value of car in 4 years ($13,000) Total cost of financing purchase $15,910.76 Note1: Calculation of loan payment Financial Calculator N = 48, I = 7/12, PV = 21,000, FV = 0, and solve for PMT = -502.87 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.07/12), 48, 21000, 0,0) => -502.87 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

PMT = $21,000 x

0.02 1

1−((1+

0.02

) )

4 = $502.87

Note2: Calculation of Opportunity cost of down payment

Savings account pays 2% APY Calculator: N = 4, I = 2, PV = -4,000, Solve for FV = $4,329.73 Excel: =FV(rate,nper,pmt,pv,type) => =FV((0.02, 4, 0, -4000, 0) => 4,329,73 .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

22

Equation 2.8: FV = PV x (1+i)n = $4,000 x (1.02)4 = $4,329.73 * $4,329.73 value of account in 4 yrs - $4,000 beginning balance = $329.73 interest Note3: Calculation of Opportunity cost of lease payment difference

Monthly difference in payment = $502.87 loan - $199 lease = $303.87 monthly savings Total annual savings without interest = $303.87 savings x 12 months = $3,646.44 Savings account pays 2% APY Calculator: N = 4, I = 2, PMT = -3648, PV = 0; Solve for FV = $15,029 Excel: =FV(rate,nper,pmt,pv,type) => =FV(0.02, 4, -3648, 0, 0) => 15,029 Equation 2.9: (1+𝑖)𝑛 -1 (1+0.02)4 -1 FVA = PMT x = $3,648 x = $15,029 𝑖 0.02 * $15,029 FV - $14,585.76 total savings = $443 interest earned on monthly savings Sec 6.2; LO 6.2; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

D. What does the auto dealership have to gain by encouraging Annette to lease instead of buy the minivan?

Answer: The dealership may get incentives from the manufacturer. Dealership representatives might have thought Annette 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 will be higher than the residual value in determining the lease, or that the purchase option was higher than the actual market value.

Sec 6.2; LO 6.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

2. Rami and Sara Sayed are young married professionals. They have been renting a twobedroom apartment in a major metropolitan area for the last two years. Their landlord has recently informed them that he will be increasing their rent to $1,500 per month for the coming year. Although they consider this amount an affordable housing expense, Rami and Sara are seriously thinking about buying a home instead of continuing to rent. They have collected the following information to use in making their decision: Combined gross income: After-tax income: Car loan payments: Credit card payments: Student loan payments: Available down payment: Expected closing costs: 30-year fixed mortgage rate: Estimated property tax: Estimated homeowner’s insurance: Estimated maintenance costs: Additional utilities:

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

$6,000 per month $5,000 per month $550 per month $150 per month $230 per month $20,000 $3,000 6 percent, 0 points $1,800 per year $600 per year $150 per month $60 per month

23

A. Assuming that the Sayeds do not want to spend more than $1,500 per month on total housing expenses, calculate the maximum price that they can afford to pay for a home.

You may want to use Excel Worksheet 6.6 to solve this problem.

Answer: $198,803

Solution: Calculate the amount you can allocate towards mortgage payments based on your monthly budget. Then calculate the loan (present value) that can be obtained based on your budgeted mortgage payment for 30 years at 6% APR. The maximum purchase price of a home that you can afford is the loan value, plus the down payment, and less the closing costs.

Calculation the budgeted mortgage payment Monthly allocation to housing costs Less: Property tax Homeowner’s insurance Maintenance Utilities Housing cost budget available for mortgage

$1,500 ($150) ($ 50) ($150) ($ 60)

($ 410) $1,090

Calculation the Loan Amount (present value of amortization payment) Financial Calculator PMT = -1,090, N = 360, I = 6/12, FV = 0 and solve for PV = 181,802.86 ~ $181,803 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV((0.06/12), 360, -1090, 0,0) => 181,802.86 ~ $181,803 TVM Equation PVA = PMT x

1−(

𝑛 1 ) (1+𝑖)

𝑖

=>

PVA = $1,090 x

1−(

360 1 ) (1+0.005)

0.005

= $181,802.86 ~ $181,803

Calculation of Maximum House Purchase Maximum Purchase Price = $181,803 loan + $20,000 down payment - $3,000 closing cost Maximum Purchase Price = $198,803 Sec 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

B. The Sayeds have applied for a home mortgage from a lender. If they are approved, their monthly payment will be $1,100 per month for principal and interest. Use the Sayeds’ financial information to calculate their mortgage debt service ratio and debt payment ratio (both as a percentage of gross income). If the Sayeds’ mortgage lender requires that total debt payments be no more than 41 percent of gross income and that mortgage debt service be no more than 28 percent of gross income, will the Sayeds qualify for the mortgage? Explain your reasoning.

Answer: No, because their total debt payments are 44.6% of gross income, and this exceeds the lender’s limit of 41%.

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

24

Solution: Calculate the Sayed’s mortgage debt service ratio to see if it is less than the lender’s 28% requirement, and calculate the debt payment ratio to see if it is less than the lender’s 41% requirement. Be sure to use gross income in the denominator of both equations to be consistent with the way that these ratios are calculated by lenders.

Calculation of mortgage debt service ratio (Equation 2.6) Mortgage debt service ratio =

Principal + Interest + Taxes + Insurance Gross monthly income

$1,100 mortgage + $150 tax + $50 insurance = 0.217 ~ 21.7% $6,000 gross income * This is less than 28%, and so will meet the lender’s requirements.

Calculation of debt payment ratio (Equation 2.5) Debt payment ratio =

Total monthly debt payments After − tax monthly income

$1,100 mort. +$150 tax + $50 ins. +$550 car + $150 c. card + $230 s. loan = 0.446 ~ 44.6% $5,000 after − tax income * This is greater than the lender’s 41% requirement, so they will not be approved for the loan.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

C. Assume that the Sayeds buy a home in January and borrow $200,000 to finance it. The mortgage interest and principal payment is $1,199.10 per month. In the first year, they pay $11,933 in interest, $2,456 in principal, $1,800 in property taxes, and $8,000 in state income taxes. Their marginal tax rate is 25-percent. Assuming that they do not have any other itemizable deductions, will they be able to save money by deducting mortgage interest and property taxes on their federal income tax return? If so, how much will this save them in taxes.

Answer: No, it will not make sense for them to itemize deductions because the standard deduction for married couples ($24,400) is greater than their total interest and property taxes.

Solution: Calculate the potential itemized deductions available for the Sayeds and compare with the standard deduction for married filing jointly of $24,400 (2019).

Mortgage interest $11,933 Property tax $ 1,800 Potential available deduction for State & local income taxes* $ 8,000 Total itemized deductions potential $21,733 (* Maximum limit for state and local tax (SALT) deduction is $10,000) Sec 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

25

D. Based on your analysis, would you advise the Sayeds to buy a home? What other factors should they consider?

Answer: The Sayeds can marginally afford to buy the house, but their current liquidity and future cash flow situations could be tight. Although they are within the mortgage debt service ratio, they pass the debt payment ratio only if considering gross income and not after-tax income. This implies that they should reduce their non-housing related expenses. They should create 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. For example, they would need to think about what would happen if Sara needed to take off time from work and how this would affect their ability to make the mortgage payments and other expenses. They may also want to consider the housing market conditions in their area. If homes are appreciating a lot in value each year, the growth in the value of their home could be an advantage to buying rather than renting.

Sec 6.3; LO 6.3; BT: An; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

A. Jonas was reading the paper and saw an advertisement for a 30-year mortgage at 4 percent APR. The advertisement promised very quick processing and minimal closing costs. Jonas currently owns his home, which he financed a few years ago with a 30-year conventional mortgage at 5% APR. His monthly mortgage payment is $429.46. Assume that the current lowest quoted rate on 30-year conventional mortgages is 5.5 percent.

Why is it likely that the advertised rate is for an ARM? Answer: The mortgage markets are competitive, so it is unlikely that a lender will charge 4 percent for a fixed-rate mortgage when others are charging 5.5 percent.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

B. How can lenders afford to offer rates as low as 4 percent? Would you expect that the interest rate caps and annual caps will also be low? Why or why not?

Answer: Adjustable-rate mortgage lenders make up for relatively low rates by charging fees and points, and they have the right to raise the rates if market rates increase. ARM lenders often offer attractive “teaser rates” but then may have unfavorable increases over the term of the loan. ARM rates are typically lower than longer-term fixed rates because the time-value-ofmoney. ARM rates typically reset over a short periodic interval, such as 1 month, 3 months, 6 months or 1 year, corresponding to its benchmark interest rate (i.e., LIBOR or US Treasury Bill).

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. Assume that Jonas calls the lender and finds that 4 percent is a teaser rate for the first year. The lender also charges 1.5 points. After the first year, the loan rate will be calculated by adding 2 percentage points to a particular index (which is currently at 3.8 percent). The annual interest rate increase cap after the first adjustment is 1 percent per year, and the lifetime interest rate increase cap is 5 percentage points over the original rate. If the index goes up to 4 percent next year, what is the maximum rate that this loan could carry in the future?

Answer: The new rate will be 6%, and the maximum rate over the life of the loan is 9%

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

26

Solution: The ARM rate is the Index + 2%. If the Index increases to 4% next year, then the ARM rate would be 4% index + 2% spread = 6%. The maximum rate is the 4% original rate + 5% interest rate increase cap = 9%.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

D. Assuming that Jonas’s current loan balance is $77,579 and the lender charges 1.5 points, what would his first-year monthly payments be if he takes the 4 percent ARM, and how much will he save per month?

Answer: $59.09 Solution: First, calculate the monthly payment for the proposed $77,579 loan for 30 years at 4% APR, then compare it with the existing $429.46 mortgage payment.

Calculation of proposed loan payment Financial Calculator N = 360, I = 4/12, PV = 77,579, FV = 0, and solve for PMT = -370.37 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.04/12), 360, 77579, 0,0) => -370.37 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.0033333

PMT = $77,579 x

1−((1+

1 0.0033333)

)

360 = $370.37

Calculation of potential monthly savings $429.46 current payment - $370.37 proposed payment = $59.09 monthly savings Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

E. Assuming that Jonas’s current loan balance is $77,579, and that the lender charges 1.5 points, how many months would it take Jonas to recoup his mortgage financing costs if he took out the new loan and rates remained the same?

Answer: 20 months Solution: First, calculate the monthly payment for the proposed $77,579 loan for 30 years at 4% APR, then subtract the existing $429.46 mortgage payment to get the monthly savings, and then divide the total cost of the refinance by the monthly savings to calculate the breakeven point.

Calculation of proposed loan payment Financial Calculator N = 360, I = 4/12, PV = 77,579, FV = 0, and solve for PMT = -370.37 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.04/12), 360, 77579, 0,0) => -370.37 TVM Equation (Equation 2.12)

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

27

PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.0033333

PMT = $77,579 x

1−((1+

1 0.0033333

) )

360 = $370.37

Calculation of potential monthly savings $429.46 current payment - $370.37 proposed payment = $59.09 monthly savings Calculation of Break-even point of refinance Total cost of new loan = $77,579 loan x 0.015 buy-down rate = $1,163.69 Break-even point = $1,163.69 buy-down cost / $59.09 monthly savings = 19.7 months * By the 20th month, you will be ahead from the proposed refinance.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

F. Discuss the factors that Jonas should consider in deciding whether to take advantage of the 4 percent ARM. Answer: Jonas must consider how long he plans to stay in the house. The rate is only guaranteed for one year, and the refinance assumes that rates will stay the same or decline.

After the first rate reset, his mortgage rate could rise 1 percent every year until 9% is reached.

In the event that rates rise, his refinance options may be limited, as the current mortgage rates will also move up with index rates. Refinancing a 5% fixed-rate for a 4% teaser with a 9% maximum rate cap seem strongly based on a belief that short-term rates will hold steady or decline for a long time.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

4. Carrie and Brad Crenshaw are refinancing their home to take advantage of falling mortgage rates. Their current rate is 7.5 percent on a 30-year conventional mortgage, originated four years ago in the amount of $130,000. They have two options for refinancing: First, for a $250 fee, their current lender (Bank A) is willing to reduce their rate to 6 percent on a new 30-year conventional mortgage with no points as long as they don’t increase the amount of their loan. Their only closing costs will be an updated appraisal and title insurance certificate, for a total of $500. The Crenshaws’ second option is to take out a conventional loan with Bank B, which is offering 5 percent with 1 point. This lender’s application fee is $250, and appraisal and credit report fees total $300. Bank B will allow them to finance the remaining balance on their loan plus an additional $15,000. Some of this can be used to pay their closing costs so that they will have no up-front costs.

A. What is the Crenshaws’ current mortgage payment?

Answer: $908.98

Solution: Calculate the monthly amortization payment for the existing $130,000 loan for 30 years at 7.5% APR. Calculation of current loan payment Financial Calculator N = 360, I = 7.5/12, PV = 130,000, FV = 0, and solve for PMT = -908.98 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.075/12), 360, 130000, 0,0) => -908.98 .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

28

TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.00625

PMT = $130,000 x

1−((1+

1

0.00625)

360 = $908.98

)

Sec 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Calculate the balance owed on the Crenshaws’ current mortgage.

Answer: $124,619

Solution: First calculate the monthly amortizing payment for a $130,000 loan for 30 years at 7.5% APR, then calculate the present value (principal remaining) of the annuity (monthly payment) for the remaining 312 months (360 month loan – 48 months paid) at a 7.5% APR. STEP 1: Calculate Monthly Payment Financial Calculator N = 360, I = 7.5/12, PV = 130,000, FV = 0, and solve for PMT = -908.98 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.075/12), 360, 130000, 0,0) => -908.98 TVM Equation (Equation 2.12) PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

0.00625

PMT = $130,000 x

1−((1+

1

0.00625)

360 = $908.98

)

Step 2: Calculate PV of remaining principal Financial Calculator PMT = -908.98, N = 312, I = 7.5/12, FV = 0 and solve for PV = 124,618.96 ~ $124,619 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV((0.075/12), 312, -908.98, 0,0) => 124,618.96 ~ $124,619 TVM Equation PVA = PMT x

1−(

𝑛 1 ) (1+𝑖)

𝑖

=>

PVA = $908.98 x

1−(

312 1 ) (1+0.00625)

0.00625

= $124,618.96 ~ $124,619

Sec 6.4; LO 6.4; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

C. If the Crenshaws refinance $130,000 with a new 6 percent loan from Bank A, what is their new monthly payment?

Answer: $779.42 Solution: Calculate the monthly amortization payment for the proposed $130,000 loan for 30 years at 6% APR. Calculation of current loan payment Financial Calculator N = 360, I = 6/12, PV = 130,000, FV = 0, and solve for PMT = -779.42 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.06/12), 360, 130000, 0,0) => -779.42 TVM Equation (Equation 2.12) .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

29

PMT = PVA x

𝑖 𝑛 1 1−((1+𝑖))

=>

PMT = $130,000 x

0.005 1

1−((1+0.005))

360

= $779.42

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

D. If the difference between their previous mortgage payment and the new payment on Bank A’s refinance loan is $100, how many months will it take to recoup the financing costs?

Answer: 7.5 months

Solution: Calculate the break-even point of the refinance.

Total cost of refinance = $250 fee + $500 closing costs = $750 Break-even point = $750 total cost of refinance/$100 monthly savings = 7.5 months * By the 8th month, you will be ahead from the proposed refinance Sec 6.4; LO 6.4; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

E. Calculate the monthly payment for the new Bank B loan (5 percent, one point, $250 application fee, $300 appraisal, and credit report fee), assuming the Crenshaws borrow a total of $140,000.

Answer: $751.55 Solution: Calculate the monthly payment for the proposed $140,000 loan for 30 years at 5% APR. Calculation of current loan payment Financial Calculator N = 360, I = 5/12, PV = 140,000, FV = 0, and solve for PMT = -751.55 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.05/12), 360, 140000, 0,0) => -751.55 TVM Equation (Equation 2.12) 𝑖 PMT = PVA x => PMT = $140,000 x 𝑛 1 1−((1+𝑖))

0.0041667 1

1−((1+0.0041667))

360

= $751.55

Sec 6.3; LO 6.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

F. Discuss the pros and cons of each of the Crenshaws’ loan options.

Answer: 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 savings. With the loan from Bank B, the Crenshaws will face much higher closing costs (total $1,950 compared to $750 for the Bank A loan) because they have to pay a discount point and they will be borrowing an additional $10,000 as well. However, their payment on that loan will be 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 affect their household financial ratios.

BANK A .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

BANK B 30

Loan: Payment:

$130,000 6% APR 30 yrs $779.42

$140,000 5% 30 yrs +1 point buy-down $751.55

Monthly savings Refinance cost Break-even

$129.56 ($908.98-$779.42) $157.43 ($908.98-$751.55) $750 ($250 fee + $500 closing) $1,950 ($250 fee + $300 fee + $1,400) 5.8 months 12.4 months

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

G. Explain to the Crenshaws why they might want to consider a shorter-term mortgage rather than refinancing for another 30 years.

Answer: By extending their loan for four years, they will be paying more interest, and they will be committing themselves to make the payments 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 by comparing the monthly payment amounts.

Sec 6.4; LO 6.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

31

CHAPTER 7 Instructor Manual and Solutions Insuring Cars and Homes LEARNING OBJECTIVES LO 7.1 Apply the risk management process to identify risks and decide how to manage them.

LO 7.2 Explain how risk pooling works, and define common insurance policy terminology.

LO 7.3 Describe the loss coverage provided by homeowner’s and renter’s insurance and the factors that affect premiums.

LO 7.4 Understand your choices for auto insurance coverage and the factors that are likely to increase your premiums.

LO 7.5 Compare insurers based on quality, service, and price, before buying a policy.

SUGGESTED COURSE PLAN This chapter can be covered in one week out of a typical 16 week semester. For 50-minute classes (3 sessions per week), you may be able to cover the chapter in two sessions. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

WileyPLUS Resources to Use in Class

1

Ch 7 How Insurance Works Read LO7.1 Risk Management Process, LO7.2 Risk Pooling Ch 7 Auto and Homeowners Read: LO7.3 HO & Renter’s Insurance, LO7.4 Auto Insurance, LO7.5 Comparing Insurers

Interactive RM Process Interactive Insurance Contract Terms

Reflection Question 1: Personal Risks

2

Reflection Question 2: Auto Rating Factors

CS7.2 Auto Policy Coverage

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

PFP 7.2 Property Risk Checklist

PFP 7.3 Comparison Shopping for Auto Insurance

Chapter 7 Homework: R:1,2,4-9; P: 1,2,7-10,12,15; Case 7.1 Adaptive Practice Ch 7

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

.

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

1

CHAPTER OUTLINE AND SUMMARY LO 7.1

Apply the risk management process to identify risks and decide how to manage them.

MANAGING PERSONAL RISKS

LO7.2

I.

THE RISK MANAGEMENT PROCESS

II.

IDENTIFY AND EVALUATE PROPERTY AND LIABILITY RISKS

III.

RISK MANAGEMENT METHODS A. Avoid the Risk B. Reduce the Risk C. Transfer the Risk D. Retain the Risk

Explain how risk pooling works, and define common insurance policy terminology.

HOW INSURANCE WORKS I.

RISK POOLING AND INSURANCE

II.

INSURANCE PREMIUMS

III.

INSURANCE POLICY TERMINOLOGY

LO 7.3 Describe the loss coverage provided by homeowner's and renter's insurance and the factors that impact premiums.

MANAGING HOMEOWNER’S AND RENTER’S RISKS I.

WHAT RISKS DO HOMEOWNERS AND RENTERS FACE? A. Property Risk B. Liability Risk C. Defenses to Liability Claims

II.

ETHICS IN ACTION: DOG OWNER’S DILEMMA

III.

INSURING YOUR HOME A. Property Coverage B. Additional Losses Covered C. Liability Coverage

IV.

PRICING OF HOMEOWNERS INSURANCE A. Location and Property Characteristics B. Coverage Purchased C. Deductibles and Discounts D. Your Risk Profile

V.

CASE STUDY 7.1 HOW DOES A BAD CREDIT HISTORY AFFECT INSURANCE PREMIUMS?

VI.

UMBRELLA LIABILITY INSURANCE

LO 7.4 Explain your choices for auto insurance coverage and what factors are likely to increase your premiums.

AUTO INSURANCE I. .

STATE AUTO INSURANCE LAWS

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

2

II.

POLICY COVERAGE A. The Personal Automobile Policy (PAP)

III.

CASE STUDY 7.2 WHICH AUTO POLICY WILL COVER THE LOSS? A. No-Fault Auto Insurance

IV.

AUTO INSURANCE PRICING A. How Much You Drive B. How Well You Drive C. Your Risk Characteristics D. Where You Drive E. Where You Park Your Car Overnight F. What Type of Vehicle You Drive G. Who Your Insurer Is

LO 7.5

Compare insurers based on quality, service, and price before buying a policy.

BUYING INSURANCE AND MAKING CLAIMS

.

I.

STEPS TO BUYING PROPERTY AND LIABILITY INSURANCE

II.

THE ROLE OF AGENTS AND BROKERS

III.

COMPARING INSURANCE POLICIES

IV.

USING ONLINE RESOURCES TO EVALUATE YOUR OPTIONS

V.

MAKING A CLAIM ON YOUR INSURANCE A. What to Do If You Have an Auto Accident B. Steps in Filing a Claim

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

3

TEACHING SUGGESTIONS 1. 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 helmet); 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). You can also use Interactive Figure 7.2 for this exercise.

2. 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? Ask students to use this information to complete Personal Financial Planner Worksheet 7.2 Property Risk Checklist. Discuss any property or liability insurance that they have to protect these assets. Does their insurance cover the entire value of their assets? Why or why not?

3. Discuss how differences in risk aversion, income, and wealth might influence a person’s decision to buy insurance, invest in risk-reduction, and/or take a higher deductible. Ask under what circumstances a person might be willing to buy homeowners’ insurance with a $10,000 deductible?

4. Most students will have some experience with the risks of driving a car and the cost of auto insurance, so they may find the section on auto insurance useful. You could begin by asking for a show of hands as to how many have auto insurance (probably most) and how many have homeowners or renters (probably only a few).

For those with auto insurance, ask how many made the selection of insurer on their own and encourage a discussion of how they made that decision. Younger students may still be on their parents’ plans and even those who have purchased on their own, may have bought through the same insurer as their parents.

5. There are many auto insurers, but because consumers generally don’t shop around much, insurers often can increase prices without losing customers. Ask your class, by a show of hands, to indicate how many insurers they called before buying their current auto insurance (start with 5 or more and work down). For most, it will be two or three. 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 (very few do). 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 wide variation in auto insurance prices.

6. Ask students to survey their friends about the types of insurance they carry, their limits of coverage, and any additional insurance they are considering.

7. Divide the class in half and separate them into small groups. Have each group spend 5 -10 minutes brainstorming various methods to reduce insurance premiums, with half the groups covering auto insurance and half covering homeowners insurance. Come back as a group and summarize your results.

8. Ask students to get price quotes from at least three insurance agents in their community, to determine the cost of renter’s insurance on an apartment. What factors determine the cost of the insurance? Discuss the reasons that students should have renter’s insurance, if they are not covered under their parents’ homeowners insurance 9. Determine if their communities have a list of “known dangerous animals”. If so, what animals are included?

Have students read their homeowners or renters policy to see if it excludes coverage for injuries caused by certain breeds of dogs?

10. Although the chapter does not cover rental car insurance, this is an interesting topic to discuss with your class. When you rent a car, do you need the extra coverage? What are your alternatives?

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CONCEPT REVIEW SOLUTIONS 1. Describe the steps in the risk management process, and compare them with the steps in the financial planning process.

Answer: The five steps in the risk management process are as follows: (1) Identify your risks; (2) Evaluate potential losses based on frequency and severity; (3) Choose the most appropriate risk management method (avoid, retain, reduce, transfer); (4) Implement the risk management plan; and (5) Re-evaluate plan regularly. These steps are similar to the five steps of the financial planning process. The latter requires that you collect information and create short and long-term goals, identify your current financial situation, analyze different strategies or alternatives for meeting your goals, implement the chosen strategy, and monitor and review periodically. Both processes have five steps and require that you compare alternatives and choose one, implement the best plan; and follow up periodically. The first two steps in both processes require you to identify your personal situation.

Sec 7.1; LO 7.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

2. Explain why it is sometimes better to retain certain risks rather than purchase an insurance policy that would cover them.

Answer: Risks that have low probability of occurrence and have low severity of loss may be retained if they are small, predictable, and can be budgeted. Some risks may have to be retained or avoided if the cost of insurance is too expensive.

Sec 7.1; LO 7.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

3. Zelda is considering the purchase of a BB gun for her son. Apply the steps in the risk management process to this decision.

Answer: The following five steps summarize the risk management process as applied to the purchase of a BB gun: (1) Identify your risks. In this case, the greatest risk is liability for causing injury or loss to someone; (2) Evaluate your potential losses based on frequency and severity. For example, the gun may destroy someone's property (say, by shattering a window) or cause physical harm requiring medical attention with possible longer-lasting effects; (3) Choose the most appropriate risk management method. Zelda can avoid the risk by not buying the gun. She can transfer the risk by purchasing liability insurance. She can take steps to reduce risk through training, education (exercising good judgment), and perhaps including close supervision; (4) Implement the risk management plan; (5) Reevaluate the plan regularly. Zelda should periodically review the risk management plan based on her son’s use of the item, and re-evaluate as incidents happen and losses are experienced.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 3 min; AACSB:

4. Why is it better to have large numbers of people in a risk pool?

Answer: The presence of a large number of people in an insurance pool enables the insurer to spread the risk over a larger population group, which has the potential to reduce the severity of loss, especially if members of the pool are not affected by common or systemic factors, that is, if their risks are uncorrelated. Diversification of uncorrelated assets will reduce the volatility and impact of a few large losses. This not only reduces premiums but also encourages insurers to accept risks that otherwise may not qualify as being prudent from a cost–benefit trade-off perspective. .

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Sec 7.2; LO 7.2; BT: C; Difficulty: E; TOT: 2 min; AACSB:

5. Explain why risk pooling doesn’t work well for correlated risks such as earthquakes.

Answer: In order to spread risk most effectively, it is necessary that a large number of people pay into a pool, but only a small number of people actually experience the loss. That way, each person can pay a small amount to have protection in the event that the adverse event happens to them. If a risk is highly correlated across an insured population, it will affect a large number of people in the insured pool simultaneously, resulting in excessively high losses and insurance payouts. If, for example, the insurance pool was for homes in an earthquake region and a large number of homes in the pool experienced an earthquake loss at the same time, there wouldn’t be sufficient money in the pool to pay everyone unless the insurer charged a very high premium. Diversification is key, whether by geography, topography, socioeconomic status, commercial and industrial prevalence, or demographics.

Sec 7.2; LO 7.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

6. What effect does a higher deductible have on your insurance premium, if all else is equal?

Answer: A higher deductible has two effects: (1) it reduces the extent of potential loss to the insurer and (2) it motivates the insured to mitigate risk by his/her own actions. For example, a motorist will likely drive carefully and homeowners will likely keep their sidewalks clean during snow season to prevent injury claims. Both of these result in lower premiums.

Sec 7.2; LO 7.2; BT: C; Difficulty: E; TOT: 2 min; AACSB:

7. Explain what it means to identify a state’s minimum auto liability coverage requirement as 50/100/25.

Answer: Auto coverage with liability limits of 50/100/25 means that in an auto accident the insurer will pay up to $50,000 per person for injury, up to $100,000 for all persons injured in the accident, and a maximum of $25,000 for damage to property of others.

Sec 7.4; LO 7.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

8. Describe three ways a consumer can reduce his or her auto insurance premiums.

Answer: Auto insurance premiums can be reduced by installing antitheft devices, insuring multiple cars with the same insurer, and choosing higher deductibles. In addition, having a better driving record, driving a safer car with devices such as airbags, and buying cars that have lower repair costs after a collision, will also reduce premiums.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

9. Describe three ways a consumer can reduce his or her homeowner’s insurance premiums.

Answer: In addition to living in an area/location that is less prone to earthquakes, wildfires, and hurricanes, a homeowner can reduce his or her insurance premiums by: (1) retaining the loss for small jewelry/personal items, which can be absorbed by the homeowner without hardship; (2) increasing the deductible on claims; and (3) taking steps to mitigate risks due to fire, such as installing smoke detectors, sprinklers, and fire alarms; and (4) not owning pets that are considered dangerous or high risk.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

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10. Based on your driving record, personal characteristics, and type of vehicle, what auto insurance discounts might you be eligible for? Explain your reasoning.

Answer: Answers to this question will differ by student. Students might mention the following: People with better driving records are charged a lower premium; good students may be eligible for discounts; being older and being married can also reduce your rates; people who are careful in other areas of life are also careful when it comes to risk on the road, so an insurer might give you a better price if you have a good credit rating; Insurers may give you a better rate if your car has an anti-theft device or a GPS tracker to monitor your mileage and driving characteristics.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

11. What is the difference between collision coverage and comprehensive physical damage coverage?

Answer: Collision coverage pays for damages to the vehicle resulting from an accident involving another vehicle or object, regardless of fault. Comprehensive coverage pays for other perils, such as theft, or damage due to hail, wind, and lightning, without regard to fault.

Sec 7.4; LO 7.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

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APPLICATION PROBLEM SOLUTIONS 1. For each of the following risks, suggest a method for reducing the frequency of loss.

A. Injury to a person who slips on your sidewalk after a snowstorm Answer: Immediately shovel your sidewalk after it snows, drop sidewalk salt to melt the ice, and put up a caution sign near your sidewalk.

B. Damage to your vehicle from hitting a deer while driving at dusk Answer: Drive with your lights on, drive slowly around blind corners, and drive within the speed limit.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

2.

For each of the following risks, suggest a method for reducing the severity of loss.

A. Bodily injury in an automobile collision Answer: Wear a seatbelt, drive within the speed limit, and drive a car with airbags.

B. Fire damage to your home Answer: Clear brush away from your house, make sure the house is made from fire-resistant materials, and install a larger sprinkler system or pool so that water will be easy to access in the event of a fire.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

3. Imagine that you have a $600 smartphone and that there is a 25 percent chance that it will be lost or stolen this year.

A. What is the expected loss?

Answer: $150 [Programmers: Please make this problem algorithmic. Change the value of the phone (600, 800, 1000) and the probability (15%, 20%, 25%, 30%). Set the sensitivity to allow answers that are within $1 of the correct answer.]

Solution: Using Equation 7.1: Expected loss = Expected frequency x Expected severity.

0.25 expected frequency x $600 expected severity = $150 expected loss.

[Programmers: Please make this problem algorithmic by changing the value of the phone ($600 - $1000) and the percentage chance (20-30).]

Sec 7.1; LO 7.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

B. Is it worth it to pay for replacement insurance on the phone? Explain.

Answer: The answer depends on the cost of the replacement coverage. If it is less than your expected loss, then it probably makes sense to buy it. You could budget for the expected loss by saving monthly instead of purchasing the insurance. However, if you experience the loss within the first year, you will not have sufficient funds saved to pay for a new phone. Even if the cost of the insurance is a little more than the expected loss, you may still want to buy the insurance for the peace of mind. .

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Sec 7.1; LO 7.1; BT: An; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

4. For each of the following risks of loss, identify whether it is high or low in frequency and high or low in severity. Then suggest one or more methods for managing the risk.

A. Getting a dent in your car door Answer: This risk is high frequency and low severity. You should retain the risk and try to reduce the risk—for example, by parking far away from other cars or staying out of crowded and busy parking lots. High frequency risk is typically expensive to insure. In this example, to insure your car for dents, lowering your comprehensive to accommodate dent repairs will be expensive.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking B. Complete destruction of your home in a fire

Answer: This risk is low frequency and high severity. The usual method of managing this type of risk is to purchase insurance. You can also try to reduce the risk by having updated smoke detectors, living near a fire station, and buying a home made with fire-resistant materials. Low frequency risk that has high severity is typically what insurance is best for.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

C. Theft of your laptop from your dorm room Answer: This risk is high frequency and high severity (depending on how expensive your laptop is). You can avoid the risk by not leaving your laptop unattended in your dorm room. You can also reduce the risk by keeping your door locked or using a laptop lock. High frequency of risk and high severity is generally not insurable, so the situation would essentially require that you have a plan for how to manage the loss if it were to occur.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

5. One of your classmates suggests that you can save money on renter’s insurance by forming a risk pool. All 100 students in the class agree to contribute money to the pool and agree that anyone who experiences loss or damage to personal property in his or her place of residence can make a claim on the pool’s funds over the course of the year.

A. How would you decide how much money to charge each person in the class?

Answer: Estimate the total expected losses and charge each student at least 1/100 of that total.

Sec 7.2; LO 7.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Is it fair to charge everyone the same amount? Explain your reasoning.

Answer: Not necessarily. Some of the students might be higher risk than others. For example, some may live in more dangerous neighborhoods; have more property that is at risk; or others may not practice very safe risk management (for example, they might not lock their doors when they are away). However, if you try to assess individual risk of loss in order to charge different premiums, people may not tell the truth about their risk of loss.

Sec 7.2; LO 7.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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C. If, at the end of the year, it turns out that the total losses to the group are larger than the amount of money in the pool, what can you do?

Answer: You would need to assess each member of the pool, the additional pro-rata portion of the losses, and increase premiums.

Sec 7.2; LO 7.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. What are some potential problems with this pooling arrangement?

Answer: It might be difficult to agree on an estimate of the losses for the pool up-front, and the amount of the losses that will be paid, as well as who will manage the money during the year.

Some students might not take steps to reduce risk. Other students might have a much higher risk of loss, so it might not be fair to charge everyone an equal share of the losses. There might be fraudulent claims made on the pool. If the claims exceed the amount that has been collected in premiums, everyone will have to pay an additional amount at the end, but it is likely that some of the participants will not want to put in the extra money. In that case, the pool will be unable to pay all the people who experienced losses.

Sec 7.2; LO 7.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

6. Mindy Stern currently insures her home for 100 percent of its replacement cost with a HO3 All-Risk policy, providing her with $200,000 in dwelling coverage.

A. What is Mindy’s maximum coverage for personal property in the home?

Answer: $100,000 Solution: HO-3 covers both home and personal property, but personal property is limited to 50% of the insurance on the house. So personal property coverage = 0.50 limit on personal property x $200,000 coverage on home = $100,000.

[Programmers: Please make this problem algorithmic by changing the dollar amount of coverage.]

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

B. What is Mindy’s maximum coverage for the cost of staying in a motel while her home is being repaired following a loss?

Answer: $40,000 Solution: Homeowners policies typically cover reasonable living expenses during repairs, up to a limit of 20% of the amount of insurance on the home.

Maximum living expenses coverage = 0.20 limitation x $200,000 home coverage = $40,000.

[Programmers: Please make this problem algorithmic by changing the dollar amount of the coverage as in 6a. The solution will always be 20% of the amount of home coverage.]

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB:

7. Imagine that you spend $20,000 to refinish your home’s basement. How would this affect your homeowner’s insurance premium at your policy renewal date, and why?

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Answer: It would increase your homeowner’s insurance premium, because your premium is based on the value of your home. You should notify your insurer that your home value has increased immediately following the construction, so that you will have full coverage.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

8. Imagine that your credit rating has improved because you’ve been doing a much better job of paying your mortgage and credit card bills on time. How might this affect your homeowner’s insurance premium at your policy renewal date, and why?

Answer: It could reduce your homeowner’s insurance premium, because most insurers include credit rating in their pricing formulas.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

9. Imagine that you make a large claim on your homeowner’s insurance. How might this affect your homeowner’s insurance premium at your policy renewal date, and why?

Answer: It could increase your homeowner’s insurance premium, because most insurers consider previous claims in determining homeowner’s insurance rates. If you were receiving a typical “noclaims” discount, then you may lose that benefit.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

10. Imagine that you decide to buy your auto insurance from the same company that provides you with homeowner’s insurance. How might this affect your homeowner’s insurance premium at your policy renewal date, and why?

Answer: It could decrease your homeowner’s insurance premium, because many insurers offer discounts for clients who buy more than one policy from them.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

11. When Ernie Franklin originally bought his home for $150,000, he followed the advice of his agent and purchased homeowner’s insurance in the amount of $120,000 to cover the value of the dwelling, not including the land. His home value has now increased to $210,000, of which $168,000 is the value of the dwelling, not including the land, but he has not increased the amount of coverage. If Ernie’s insurer requires that its policyholders have at least 80% of the value insured, and his home is completely destroyed in a fire, will his loss be completely covered? Explain your reasoning.

Answer: No, Ernie’s loss will not be completely covered. Ernie should have coverage equal to at least 80% of the value of the home, or else the insurer will only pay a proportional amount of any claim. The face value required = 0.80 coverage x $168,000 current value = $134,400. His insurance policy is only 71.43% of the value ($120,000 current coverage / $168,000 current value). Therefore, the amount he can recover for the loss is reduced proportionately. He is carrying $120,000 of coverage when he should have had $134,400 of coverage. He only has 89.29% ($120,000/$134,400) of the coverage required by his mortgage. If his home is completely destroyed, resulting in a loss of $168,000 (current value), his recovery will be limited to 89.29% x $120,000 existing coverage = $107,148.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: H; TOT: 1 min; AACSB: Analytic

12. Bonita Baca has a personal auto policy with coverage limits of 20/40/15. Bonita has collision coverage with a $250 deductible. She runs a red light and causes an auto accident .

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in which three people are injured. Each of them sues her for $20,000 in personal injury and $5,000 for vehicle damage (there is no injury to Bonita or her car). How much will Bonita have to pay out of pocket, and how much will her insurer pay? Explain.

A. Bonita pays $20,000 and insurer pays $55,000 B. Bonita pays $5,000 and insurer pays $60,000 C. Bonita pays $0 and insurer pays $65,000 D. Bonita pays $20,250 and insurer pays 54,750 Answer: A Solution: Bonita will have to pay $20,000 out of pocket. The insurer will pay $40,000 in personal injury and $15,000 in vehicle damages. Her 20/40/15 PAP liability limits are: $20,000 bodily injury liability per person / $40,000 bodily injury liability per accident / $15,000 property damage liability per accident. Although Bonita’s insurance will pay up to $20,000 per person injured, the total personal injury claims are 3 x $20,000 = $60,000, and she has a limit of only $40,000 for all people injured in an accident. Therefore, she will be responsible for the other $20,000. The insurer will pay $40,000 for the personal injuries and $15,000 for the vehicle damage. The deductible applies only if Bonita’s own car was damaged.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. Harrison Hartel has a personal auto policy with coverage limits of 25/50/10. Harrison has collision coverage with a $500 deductible. He backs into his neighbor’s garage door, causing $1,000 damage to the garage and $2,000 damage to his car. How much will Harrison have to pay out of pocket, and how much will his insurer pay?

A. Harrison pays $500, and insurer pays $2,500 B. Harrison pays $1,000 and insurer pays $2,000 C. Harrison pays $0 and insurer pays $3,000 D. Harrison pays $500 and insurer pays 2,750 Answer: A Solution: Harrison will pay $500 out of pocket for his collision deductible, while the insurer will pay $2,500 (the balance of $1,500 for his car and the full $1,000 damage to the property). The garage damage is paid from his liability coverage of $10,000 in property damage per accident.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

14. Patrick O’Hara owns a 10-year-old car in great running condition. It is currently worth $4,000. Patrick has just taken a part-time job delivering pizza, and he is concerned about his increased risk of having an accident. He estimates that he has a 50 percent probability of having an accident within the next year. If he does have an accident, he estimates that there is a 25 percent chance it will cause significant damage to his vehicle ($3,000) and a 75 percent chance it will cause only minor damage ($500).

A. What is Patrick’s expected frequency of loss?

Answer: 50% Solution: Frequency is the likelihood or probability of having an accident within the year, in this case given as 50 percent. .

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Sec 7.1; LO 7.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

B. What is Patrick’s expected severity of loss?

Answer: $1,125 Solution: When there is more than one possible loss outcome, expected severity is the weighted average of the possible losses. In this case, the expected severity of loss is calculated as follows: (0.25 probability x $3,000 loss) + (0.75 probability x $500 loss) = $1,125 expected severity of a loss.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. What is Patrick’s expected total loss?

Answer: $562.50 Solution: Use Equation 7.1: Expected loss = Expected frequency x Expected severity.

The expected severity of loss is the weighted average of the possible losses: Expected severity = (0.25 probability x $3,000 loss) + (0.75 probability x $500 loss) = $1,125.

Expected losses = 0.5 expected frequency x $1,125 expected loss = $562.50.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

D. If Patrick asks your advice about whether to purchase collision coverage for an extra $100 per year with a $500 deductible, what would you suggest, and why?

Answer: Patrick should probably buy the collision coverage. Although the policy deductible is almost the same as his expected loss ($562.50), he still has a fairly high risk (25%) of a large ($3,000) loss. The insurance will allow him to better budget for the possible outcomes.

Sec 7.1; LO 7.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

15. The tenants in the apartment above Blake’s apartment left the water running in their bathtub and it leaked through the ceiling onto his bed. If Blake does not have renter’s insurance, who will pay for his damages, and why?

Answer: The landlord’s homeowner’s policy will repair the ceiling but will not cover any loss or damage to Blake’s personal property. If the upstairs tenants have renter’s insurance, their policy may cover his losses if the losses are due to the upstairs tenants’ negligence.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

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CASE APPLICATION SOLUTIONS 1. Ken and Erika Zumwalt are buying a new home in southern California. The property is in a lovely wooded community outside of San Diego, not far from an area that experienced a serious wildfire the previous year. The home is valued at $400,000, not including the land, and the Zumwalts estimate that they have about $100,000 in personal property, including $10,000 in jewelry. Their net worth, including their home equity, is about $250,000.

A. What type of homeowner’s insurance is best for the Zumwalts?

Answer: HO-3 All-Risk form is the most appropriate for the Zumwalts. It is the most common. It provides open-perils for home coverage and a named-perils coverage for personal property.

They should consider a jewelry rider for $10,000 of jewelry coverage.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB:

B. What is the minimum amount of homeowner’s insurance the Zumwalts should purchase?

Answer: They should have a minimum of $400,000 in dwelling coverage. They should also be sure that they purchase replacement cost coverage.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

C. If the Zumwalts’ homeowner’s policy requires the face amount to be 90 percent of the actual value and the Zumwalts insure for less than that amount, what financial risk do they face?

Answer: If the Zumwalts carry less than the required face value, the insurer will proportionally reduce how much it reimburses for a covered loss. The face value should be 90 percent of the current value of the home ($400,000), which in their case, $360,000. For example, if they keep the coverage of $360,000 and then the home increases in value by 10%, the insurer will reduce any claim thereafter by 10%. By not keeping their coverage updated to the value of the home, they risk being underinsured for potential losses.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

D. Should the Zumwalts consider additional coverage for their personal property? Why or why not?

Answer: The common HO-3 policy will provide them with coverage for their personal property.

It provides an open-perils home coverage, up to the face value and named-perils personal property coverage, up to 50% of the face value. It will not be sufficient to cover jewelry because policies typically limit jewelry coverage to a small dollar amount, typically $1,000.

They may want to buy additional coverage for scheduled jewelry.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

E. Should the Zumwalts consider purchasing an umbrella policy? Why or why not?

Answer: An umbrella policy supplements liability coverage for other insurance policies. The Zumwalts’ net worth is $250,000. They may want to have umbrella liability coverage of $250,000 if they anticipate potential liability that is greater than their homeowner’s and auto liability limits.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking .

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F. What other risk management tools should the Zumwalts employ to reduce their risk of losses due to wildfire?

Answer: Because the home they are buying is in a high wildfire-risk area, the Zumwalts 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 instead (avoid the risk). Alternatively, 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, and install a larger sprinkler system or pool so that water will be easy to access in the event of a fire.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

2. Over the holidays, David and Mary Costanza’s Christmas tree caught fire, and they sustained significant damage to their home and personal property. They had to clean and repaint their living room and replace the living room carpet and furniture, at a cost of $7,000.

While the work was being done, the family stayed in a motel for three days at a total cost of $300. The Costanzas had an actual cash value homeowner’s insurance policy with a deductible of $250. The insurance company’s claims adjuster came to the Costanzas’ home and looked at the damage. He estimated actual cash values of $750 for the furniture and $350 for the carpet, which had needed replacing for some time.

A. How much do you estimate that the insurer will pay the Costanzas?

Answer: $1,150 Solution: The insurer will pay for the hotel stay and the actual cash value of the damage to the furniture and carpet, less the deductible. Total payment = $750 furniture + $350 carpet + $300 motel stay – $250 deductible = $1,150.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. If the Costanzas had purchased replacement cost insurance, how much would they have received from their insurer after the loss?

Answer: $7,050 Solution: If they had replacement cost insurance, the insurer would have paid for the hotel stay and the complete repair and replacement cost of the claim, less the deductible: ($7,000 repair & replacement costs + $300 motel stay – $250 deductible = $7,050.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. If the Costanzas were concerned about the effect of replacement cost insurance on their homeowner’s insurance premium, what other suggestions could you offer that would help reduce their premium?

Answer: 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 had opted for an increased deductible or if they qualified for any discounts for safety equipment or building materials. They might also be eligible for discounts if they had other types of insurance coverage, such as auto or umbrella, with the same insurer.

Sec 7.3; LO 7.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking .

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3. Carrie Richmond is 30 years old and single. She is achieving success as a professional photographer and now earns $50,000 before taxes. Carrie has been fairly diligent about establishing a financial plan and working toward achieving her financial goals. Two years ago, she bought a condominium, and it has appreciated in value to the point that she has $40,000 in home equity. She also has accumulated $25,000 in savings and paid off her student loan. Recently, Carrie paid off the remaining balance on the car loan for her fouryear-old vehicle. After looking at Carrie’s financial situation, her insurance agent suggested that she consider increasing her automobile coverage. Her current coverage is $25,000 bodily injury liability per person, $50,000 bodily injury liability per accident, and $15,000 property damage liability. She also has medical expense coverage of $10,000 per person and uninsured motorist protection of $25,000 per person and $50,000 per accident. Because she previously had a bank loan on the car, she has been carrying comprehensive property damage insurance on the car.

A. Given the value of Carrie’s household assets, what auto insurance liability limits would you recommend? Explain your reasoning.

Answer: 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 judgment that was not paid by the insurance. Her current liability limits of 25/50/15, 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.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

B. Under what circumstances, would Carrie need uninsured motorist protection? Is she adequately insured for this risk? If not, what limits would you recommend?

Answer: Uninsured motorist coverage would pay for any injuries she incurred in an accident with an uninsured or underinsured driver or a hit and run. Because she probably has health insurance coverage and also carries comprehensive on her vehicle, she may not need additional uninsured motorist coverage. However, it might be required coverage in her state.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. Assuming that her car is in fairly good condition and is worth $10,000, should she continue to carry comprehensive physical damage insurance and, if so, in what types and amounts?

Answer: Because 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 even though she has sufficient savings to pay for the actual losses as they occur. And if she does buy this coverage, she should also take a fairly large deductible.

Sec 7.4; LO 7.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

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CHAPTER 8 Instructor Manual & Solutions Life Insurance and Long-Term Care Planning LEARNING OBJECTIVES LO 8.1 Determine how much life insurance you need.

LO 8.2 Select the type of life insurance that best meets your needs.

LO 8.3 Define key terms used in life insurance policies.

LO 8.4 Explain the choices for funding long-term care needs.

SUGGESTED COURSE PLAN You will need to allocate two to three class sessions for this chapter. For 50-minute classes, you can cover two Learning Objectives in each session. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

WileyPLUS Resources to Use in Class

1

Read LO 8.1 Life Insurance Needs LO8.2 Types of Life Insurance Read LO8.3 Life Insurance Policy Terms LO 8.4 Long-Term Care

IF8.1 Reflection Question 1 Survivors’ Financial Needs

Case Study 8.1

2

Reflection Question 3 Talking with Family about LTC

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

PFP 8.1 Life Insurance Needs Analysis

Chapter 8 Homework: R:1,3,7,11-16, 18 P:2,5,6,7,11 Case 8.2 Adaptive Practice Ch 8

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY Chapter 8 Life Insurance and Long-Term Care Planning LO 8.1

Determine how much life insurance you need.

LIFE INSURANCE AND YOUR FINANCIAL PLAN I.

LIFE INSURANCE COMPARED WITH AUTO AND HOMEOWNER’S INSURANCE A. Factors That Affect Premiums B. The Role of Insurance Company Investments C. CASE STUDY 8.1 WHEN WILL CARSON DIE? D. Intended Use of Policy Proceeds

II.

LIFE INSURANCE NEEDS ANALYSIS A. Income-Multiple Method B. Financial Needs Method

III.

CASE STUDY 8.2 HOW MUCH LIFE INSURANCE DO ARJUN AND TANYA CHOPRA NEED?

IV.

FACTORS AFFECTING YOUR LIFE INSURANCE NEEDS

Select the type of life insurance that best meets your needs.

LO8.2

BUYING LIFE INSURANCE I.

CHOOSING THE TYPE OF POLICY A. Term Life Insurance B. Permanent Life Insurance i. Whole Life Insurance ii. Universal Life Insurance iii. Variable Life Insurance C. Buy Term and Invest the Difference?

II.

CHOOSING AN INSURER A. Financial Strength B. Stock versus Mutual Companies

III.

CHOOSING AN AGENT

LO 8.3

Define key terms used in life insurance policies.

READING YOUR POLICY I.

POLICY DECLARATIONS

II.

KEY PROVISIONS IN A LIFE INSURANCE POLICY

III.

ETHICS IN ACTION: THE ETHICS OF VIATICAL SETTLEMENTS

IV.

SETTLEMENT OPTIONS

LO 8.4

Explain the choices for funding long-term care needs.

PLANNING FOR LONG-TERM CARE COSTS I. .

LONG-TERM CARE NEEDS ANALYSIS

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II.

SOURCES OF FUNDS FOR LONG-TERM CARE A. Family Caregivers B. Household Resources C. Community Resources D. Medicare E. Medicaid F. Life Insurance Policies G. Other Insurance Options

III.

LONG-TERM CARE INSURANCE A. When Is the Best Time to Buy Long-Term Care Insurance?

B. Tax Considerations C. Features to Look for in Long-Term Care Insurance D. Talking with Older Family Members about Long-Term Care Insurance

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TEACHING SUGGESTIONS 1. Begin this section by asking how many students currently have life insurance. Unless you have a fairly nontraditional student body, this number is likely to be relatively low. To traditional-age college students, life insurance does not seem very relevant because they usually have no dependents and limited wealth. If you have older students, the topics in this chapter will be of greater interest. In either case, the main objective is for students to begin thinking about the longer-term goal of protecting their loved ones. You can use the variation in answers 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; receiving a large inheritance from a relative.

3. Ask a local life insurance company agent to provide you with an illustration for $100,000 in term life insurance versus $100,000 in permanent life insurance purchased by a 25 year old customer. Use the illustration to motivate discussion of the differences in premiums over time, expected versus guaranteed dividends, rate of return, and cash value. (This topic can also make a good guest lecture if you have time to allocate to it.)

4. 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 7. Why do most policies allow claims after a one to two year waiting period?

5. Have the class break into small groups to discuss the pros and cons of the buy-term-and-invest-thedifference strategy.

6. 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.

7. Have students investigate the impact of smoking cigarettes on the cost of life insurance.

8. 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.

9. The median pre-retiree household in the U.S. has very little savings (a little more than $100,000 without including home equity) and will be relying primarily on Social Security to fund their retirement. Given the average cost of nursing home care that is discussed in the chapter, how long will their savings last?

Discuss the problems that can result for the surviving spouse.

10. 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 the government helps pay these costs, who will actually bear that burden? What other solutions are possible?

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CONCEPT REVIEW SOLUTIONS 1. How does life insurance differ from property insurance with regard to each of the following factors?

A. Predictability of loss Answer: Life insurance is different from property insurance in that there is only one event— death—that triggers a claim on a policy, and the claim is for exactly the contracted death benefit value. Although the probability of death over one’s lifetime is 100 percent, the risk of dying in any given year is quite low. Because people die with a certain degree of regularity and deaths are usually independent of one another, the number of deaths in a given risk pool is fairly predictable, provided that the pool is large enough. In comparison, property risk has variability in claim payouts because of different outcomes of severity, and can be influenced by people and natural phenomena, so it is less predictable.

B. Term of contract Answer: Most property insurance policies are for either six months or one year. Life insurance contracts can be as short a time as one year, but many are long term, providing protection for the entire life of the policyholder.

C. Factors that will result in an increase in premium Answer: The main factors that impact life insurance premiums are: (1) insurance company expenses, such as commissions to agents, underwriting, investigation, and payment of claims; (2) profit to the insurance company owners; and (3) the risk classification of the applicant. All of these are factors in property insurance as well, but some may be less important. The insurer’s investment return also plays more of a role in life insurance, because the insurers will invest the premiums for a longer term. Risk factors for life insurance relate to issues that make the applicant more likely than average to die—for example, health issues, smoking, engaging in risky activities.

For property insurance, the insurer will be more interested in factors related to the value of the property insured or increased likelihood of damage due to location. Another factor in property insurance that is not a factor in life insurance is the applicant’s credit score.

Sec 8.1; LO 8.1; BT: C; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

2. Explain why life insurance is an important component of financial planning.

Answer: Insurance is an indispensable risk management tool that protects long-term financial plans from gravely derailing after unexpected circumstances that can significantly change income and expenses. Life insurance protects against the unexpected loss of the biggest contributor of income, the household earner. It also protects against expenses that arise from the loss of an individual (i.e, funeral expenses, estate taxes and additional household help for families, and replacement costs of key employees and buy-out resources for partners in businesses). If your financial plan includes goals related to providing financially for your family or charitable giving after your death, life insurance is a way to accomplish those goals.

Sec 8.1; LO 8.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. Does everyone need life insurance coverage? Why or why not?

Answer: No, not everyone needs life insurance. People will be more likely to need life insurance if they have dependents, if they do not have a lot of wealth, if they have a lot of financial obligations, .

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and/or if they have a higher risk of premature death. A single college student with no pets and no debts would be unlikely to need life insurance, whereas a middle-aged primary earner with two children will probably want to have some life insurance.

Sec 8.1; LO 8.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

4. What categories of financial costs might be incurred by a family with dependent children upon the death of the primary earner?

Answer: The death of the primary earner could impose any of the following costs: (1) lost current and future earnings; (2) uninsured medical expenses; (3) funeral costs; (4) legal costs for settling the estate; (5) counseling costs for the grieving family; (6) cost of additional services, such as housekeeping and child care, that might be needed if the other parent must return to work.

Sec 8.1; LO 8.1; BT: C; Difficulty: M; TOT: 2 min; AACSB:

5. What are the two approaches used to estimate the amount of life insurance needed, and is one preferable to the other? Explain your reasoning.

Answer: The two approaches used to estimate the amount of life insurance needed are: (1) the income-multiple method and (2) the financial needs method. The financial needs method is generally preferable because it can more accurately reflect the family’s needs, whereas the income-multiple method is a one-size-fits-all approach. Although the income-multiple method is simpler, it makes more sense to take into account the unique circumstances of the family, as well as their other sources of funds to meet their financial needs.

Sec 8.1; LO 8.1; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

6. How do life insurers assess your probability of dying within the policy period? Explain why this estimate is likely to be very accurate on average for a large pool of policyholders.

Answer: Life insurers assess your probability of dying by consulting standardized mortality tables that provide yearly probabilities of dying and surviving based on current age. The tables can also be customized for known risk factors, such as smoking versus nonsmoking. Because these tables are based on many years of statistical data on millions of lives, the insurers can predict with reasonable accuracy the number of deaths in a pool.

Sec 8.1; LO 8.1; BT: C; Difficulty: M; TOT: 1 min; AACSB:

7. Explain how each of the following factors might affect the amount of life insurance you need.

A. The number of children you have Answer: People who have children are usually interested in providing for their children’s financial needs at least through to adulthood, and they may also be interested in providing an education fund for each child. Therefore, the more children you have, the more life insurance you would need to cover these expenses.

B. The age of your children Answer: People who have children are usually interested in providing for their children’s financial needs at least through to adulthood, and they may also be interested in providing an education fund for each child. If a child is younger, there are more years until he or she reaches adulthood

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and there are fewer years for an education fund to earn investment returns. Therefore, the younger the child is, the larger the amount of funds that may be required.

C. Your age Answer: You will need less insurance when you are very young, but will need more during your child-rearing years. At older ages, you may have fewer dependents, fewer debts, and you may already have accumulated enough wealth to cover their needs without insurance.

D. Your spouse’s earning capacity Answer: If your spouse does not rely on your income, then you don’t require insurance for income replacement. However, you may still want to have it for other reasons, such as funding education or retirement accounts, paying off debts, or charitable giving.

E. Your financial wealth Answer: If you have sufficient wealth, your dependents will have their financial needs met, so you won’t need to have life insurance for that purpose. However, if your wealth exceeds the federal and state estate tax exemptions, you may want to have some form of permanent life insurance to pay the estate tax.

F. Your outstanding debt Answer: If your spouse requires your income to contribute towards debt payments, then you will require life insurance to pay off the liabilities.

G. Your health Answer: If you have dependents and are in poor health, you may need more life insurance to cover their financial needs and to pay for your end-of-life health costs. If you die prematurely, your dependents would suffer from the loss of your income and also the loss of future savings currently targeted for education or other long-term goals.

(For all of these) Sec 8.1; LO 8.1; BT: Ap; Difficulty: E; TOT:3 min; AACSB:

8. How can life insurance be used to help your survivors reach household financial goals in the event of your death? For what types of goals would the purchase of life insurance be an appropriate risk management strategy?

Answer: If your beneficiaries receive a lump-sum benefit upon your death, they can invest this money until it is needed for its stated purpose—for example, education funding, retirement funding, or charitable giving. The money could also be applied to cash flows needed when, for example, the goal is to have one parent stay home with the children until they go to school full time. Life insurance could be used to replace the income of the stay-at-home parent.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

9. If you are a stay-at-home parent and don’t contribute any earnings to the household budget, why might you still need to have some amount of life insurance?

Answer: If the stay-at-home parent were to die, the survivor would need to replace his or her lost services (such as housekeeping and child care).

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

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10. Compared with a standard term life insurance policy, will a policy with a decreasing term result in a premium that is higher, lower, or the same? Explain your reasoning.

Answer: For the same initial face value, decreasing term will have a lower fixed premium than standard term. The death benefit will gradually decrease over the life of the policy, so it will cost less to provide the protection.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

11. Compared with a standard term life insurance policy, will a policy with guaranteed renewability result in a premium that is higher, lower, or the same? Explain your reasoning.

Answer: For the same face value, guaranteed renewability will increase the premium. This is because the insurer will have to renew the policy even if the health of the insured person changes, so it must take this risk into account.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

12. Compared with a standard term life insurance policy, will a term life insurance policy that is convertible to permanent insurance result in a premium that is higher, lower, or the same? Explain your reasoning.

Answer: Adding this extra feature will probably increase the premium. The insurer will have to allow the conversion regardless of the insured’s health status at that time, which increases the insurer’s risk.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

13. Compared with an ordinary life insurance policy, will a limited-payment policy result in a premium that is higher, lower, or the same? Explain your reasoning.

Answer: The ordinary life insurance policy requires that you pay premiums for your entire life, whereas with the limited-payment policy you pay only over a stated number of years. The limitedpayment policy will have a higher premium, because you are paying for the same coverage over a shorter period of time. The limited-payments would typically equal the present value of the future payments (annuity) that are being eliminated.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

14. Compared with a level-premium life insurance policy, will a policy with a premium that increases over time result in an initial premium that is higher, lower, or the same? Explain your reasoning.

Answer: Assuming the same face value, the increasing premium policy should have a lower initial premium. This is because you are paying for the same coverage, but will end up paying more in later years, so you will pay less in the earlier years.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

15. Compared with a standard term life insurance policy, will a policy with a face value that decreases over time result in a premium that is higher, lower, or the same? Explain your reasoning.

Answer: For the same initial face value, insurance with a decreasing face value will have a lower fixed premium, because the total cost of providing the coverage over the life of the policy will be

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lower if the face value is lower in later years. Also, you are lowering the face value during the term period where the insurer is more at risk (due to age).

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

16. Why are premiums for permanent insurance so much more expensive per dollar of coverage than premiums for term life insurance?

Answer: Term insurance provides protection for only the term of the policy and is often bought at younger ages when mortality risk is quite low. Permanent life insurance provides protection for your entire life, so the premiums have to be sufficient over your lifetime, to cover the present value of the expected payout. The premiums are fixed, so you’ll have to pay more when you’re younger to cover the higher cost of the protection when you’re older. The insurer invests the premiums so that there will be sufficient funds to cover the claim at the later date.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

17. Compare the purchase of permanent life insurance with the strategy “buy term and invest the difference” with regard to risk, tax consequences, and flexibility.

Answer: “Buy term and invest the difference” is a strategy in which you buy the amount of term insurance you need when it is relatively cheap, and you take the extra amount it would have cost for you to buy permanent insurance and invest it. By the time the term insurance gets very expensive when you are older, your investment fund should have grown sufficiently that you can use it to fund the insurance premiums at older ages or to replace insurance altogether. This is a riskier strategy because you are subject to investment risk and the risk that you might not stick with your investment plan. Life insurance is purchased with after-tax income, but your beneficiaries receive the benefit tax-free. If the investments are in a taxable account, your investment rate of return will be eroded by taxes, and the portfolio will be part of your taxable estate when you die.

However, you will have access to the funds for emergencies, which gives you more financial flexibility.

Sec 8.2; LO 8.2; BT: C; Difficulty: M; TOT: 3 min; AACSB:

18. In what ways is the cash value of permanent life insurance similar to a savings account?

In what ways is it different?

Answer: When you pay into permanent life insurance, you pay in after-tax dollars, and you accumulate cash value in the plan. The cash value is tax deferred, and your beneficiaries get the death benefit tax-free. The rate of return is usually quite low. A savings account is also usually funded with after-tax dollars, but the interest earned is subject to tax. You have complete access to the savings account, which makes it more flexible, but you also can access some of the cash value of life insurance through withdrawals or policy loans.

Sec 8.2; LO 8.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

19. What are the common criticisms of whole life insurance, and how does universal life insurance address these issues?

Answer: Whole life insurance has been criticized for relatively low rates of return and contracts that do not provide much flexibility on premium payments. This can be a problem if the policyholder runs into some temporary financial difficulties. Universal life is a type of permanent insurance that attempts to address these shortcomings by crediting their policyholders with some of the benefits of better-than-expected investment performance, usually through a reduction in the following .

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year’s premium. Universal life also includes a flexible-premium option—a policyholder with sufficient cash reserves can choose not to pay the premiums, using accumulated cash value to meet mortality costs for the period, or to take some of the funds out of the policy entirely.

Sec 8.2; LO 8.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

20. Why did variable life insurance become so popular in the 1990s?

Answer: Variable life insurance allows policyholders to invest the cash value of their policy in investments that are similar to mutual funds. If the funds are invested in assets that have higher rates of return, this results in lower premiums and quicker buildup of cash value. The mid-1980s was a period when the stock market posted very large rates of return and income tax rates declined making the traditional life insurance products less desirable in the 1990s. Also, the 1990s was a period of low interest rates, which made the rates of return on ordinary life insurance very unattractive.

Sec 8.2; LO 8.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

21. Identify the criteria you should use in choosing a life insurance agent.

Answer: The factors you should consider in choosing a life insurance agent are: education, experience, reputation, responsiveness, and ethics.

Sec 8.2; LO 8.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

22. Identify the criteria you should use in choosing which life insurance company to buy insurance from.

Answer: Life insurance is a product that you buy now but do not realize any benefits for many years in the future. Thus, the most important factor is whether the insurance company is in good financial condition so that it will be able to pay your beneficiaries when you die. Evaluating the insurance company’s long-term debt rating is important when you are essentially depending on their ability to pay your beneficiaries potentially 10-20 years from now. S&P, Moody’s, Duff & Phelps, Fitch and AM Best provide ratings. You should also consider the company specialization in certain products, and the quality and level of service.

Sec 8.2; LO 8.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

23. Why do so many people fail to plan adequately for long-term care costs?

Answer: It is very difficult to talk about potentially unpleasant future outcomes, such as death and incapacity. Rather than face it, people tend to avoid discussing it. As a result, this part of the financial plan sometimes does not get as much attention as it should.

Sec 8.4; LO 8.4; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

24. Why is it probably not cost-effective to buy long-term care insurance at an early age?

Answer: Long-term care insurance requires that you pay premiums until you enter care. Since that will probably not happen until you are in your 70s or 80s, if you start paying too early, the total you will pay in premiums will be quite large. Of course, the premium payments will be lower if you start paying earlier, but probably not low enough to justify making these payments in your younger years.

Sec 8.4; LO 8.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

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APPLICATION PROBLEM SOLUTIONS 1. Your current income is $50,000. If your financial planner recommends an income multiplier of 5, how much life insurance should you have?

Answer: $250,000 Solution: Based on this rule of thumb, you should have a multiple of 5 times your income in life insurance. $50,000 current income x 5 multiplier = $250,000 insurance required.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

2. Keisha is a single parent who earns $40,000 per year. Her household expenses are $28,000 per year. If she were to die, she estimates that death costs would total $10,000. She has not participated in Social Security long enough to be fully insured. She wants to provide $50,000 for an education fund for each of her twin children, who are currently 10 years old. She also needs to provide for their care, which she estimates will cost $15,000 per year until they are 18.

A. Would the income-multiple approach result in Keisha’s purchase of sufficient life insurance? Why or why not?

Answer: The income-multiple method would suggest that Keisha should carry a face amount of life insurance equal to 5 to 10 times her salary, or $200,000 to $400,000. Although this method provides a wide range of possible values, it does not take into account Keisha’s family’s unique financial needs.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

B. Using the financial needs approach, how much life insurance would you recommend that Keisha buy? Explain.

Answer: Using the financial needs method, she would need a face value that would cover her immediate costs and then an income replacement cost for a period of time.

Immediate cost = $10,000 funeral cost + $100,000 educational account ($50,000 each child) = $110,000 Income replacement = $28,000 household expenses + $15,000 childcare = $43,000 per year Insurance need = $100,000 immediate cost + ($43,000/yr x 8 years of replacement income) = $444,000 She should round $444,000 or more to take into account the increases in expenses that will occur due to inflation.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. If Keisha was fully insured under Social Security and her children were eligible for annual benefits of $15,000 each, how much difference would this make in her life insurance needs?

Answer: Social Security benefits are payable to the surviving children until they reach age 18. If they could each get $15,000 each, this would reduce her insurance needs by $240,000.

Social Security dependent benefits = $15,000 dependent benefit x 2 dependents x 8 years = $240,000 Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

3. Elaine has just graduated from college, is single, and has no dependents except for her chocolate lab, Rufus. She’s accepted a job with a starting salary of $50,000, and she has $10,000 in student loan debt. Her employer doesn’t provide any group life insurance. Does Elaine need any life insurance? Why or why not?

Answer: Elaine’s only dependent is her dog, so she doesn’t have a great need for life insurance. She might want to have a small policy that would pay her funeral expenses and pre-fund her dog’s care. No one else will be obligated to pay back her student loan.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: .

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4. Carrie and Brad are a young couple with no children or pets. Both are attorneys who earn more than $100,000 per year. Because they’re relatively frugal, they have only a small mortgage on their jointly owned condo, and they have no outstanding debt. With their high net cash flow and some wise investment decisions, they’ve accumulated sizable net worth, and both have good retirement plans with their employers. Does either of them need life insurance? Why or why not?

Answer: They might want a small insurance policy to cover funeral costs, but they most likely could each cover the costs of the other’s death and the remaining mortgage without insurance. There is no need for life insurance for a surviving spouse. There is no estate tax between spouses. However, should either pass away before the other, the surviving spouse may want life insurance to enhance a benefit to other people or a charity.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic 5.

You have been quoted a premium of $120 per year for $100,000 in term life insurance, with the premium fixed for five years, and a premium of $1,120 per year for a permanent life insurance policy with an equivalent face value. Explain what you should do if you want to implement a “buy term and invest the difference” strategy. What else would you need to know about the term life insurance policy?

Answer: With the “buy term and invest the difference” strategy, you would need to buy the term insurance and then take the difference between the term and permanent premiums and invest it. Even if your term premium is fixed for a period of time, it will eventually increase, so you will have less to invest each year. Alternatively, you could buy decreasing term insurance, in which the premium would stay the same each year, but the face value of the life insurance would decrease over time. This should correspond with the increase in your investment portfolio as you continue to fund it with an additional $1,000 each year. You would need 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.

In this case, the annual premium difference is $1,000 ($1,120 premium for permanent policy – $120 premium for term policy). The premium difference of $1,000 over 5 years is $5,000. After 5 years, you saved $5,000 and whatever earnings that provided and can be used towards a new policy. However, you are then presented with the risk of underwriting another policy, unless you initially purchased a guaranteed renewable policy. This exercise would continue and the ultimate result would depend on the results of your investments. This is not much different than what the insurers do. The “buy term and invest the difference” strategy is essentially better if you can do a better job of investing the premiums than the insurer, and the “luck” of your health, as term insurance will win if you die early (paid less cumulative premiums).

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

6.

Suppose that you implemented the “buy term insurance and invest the difference” strategy, investing $1,000 per year at the beginning of every year for the next five years, and earning 6 percent per year after taxes. How much would you accumulate after five years?

Answer: $5,975 Solution: Calculate the future value of an annual $1,000 annuity-due over 5 years at 6% APY. Financial Calculator Set to BGN, Enter PMT = -1,000, N = 5, I/Y = 6, PV= 0 and solve for FV = 5,975.32 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.06, 5, -1000, 0, 1) => 5,975.32 Note that if you invested the difference at the end of the year, the FV would be $5,637.09.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

.

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7. For each of the following characteristics, identify the type of life insurance to which it applies (term, ordinary, universal, variable).

A. flexible premium B. premium increases with age C. investment choices for policyholder D. death protection for entire life E. no cash value Answer: A. universal; B. term; C. variable; D. ordinary; E. term Sec 8.3; LO 8.3; BT: C; Difficulty: M; TOT: 3 min; AACSB: 8. What are some explanations for why the cost of nursing home care is so much more in some states than in others?

Answer: 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), real estate costs, and the supply and demand for long-term care (number of facilities close to family, percentage of the population over age 75, affluence of the population).

Sec 8.4; LO 8.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking 9. Your grandmother needs to go into a nursing home. She currently lives in Illinois and you live in North Carolina. You’re deciding whether it will be cost-effective to move her to North Carolina. A facility in Illinois will cost $60,000 per year, and one in North Carolina will cost $70,000 per year.

You estimate that it would cost you $5,000 to move your grandmother to North Carolina or $3,000 per year to travel back and forth to visit in Illinois.

A. What is the difference in cost between these two strategies for the first year?

Answer: $12,000 Solution: Calculate the initial cost of care in each state.

1st Year cost comparison Illinois North Carolina

Difference

Facility Cost Moving Cost Cost to visit Total Cost Year 1

$12,000

$60,000/yr 3,000 $63,000

$70,000/yr 5,000 $75,000

Sec 8.4; LO 8.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic B. If you estimate that your grandmother will stay in the nursing facility for five years and the cost difference between the two facilities will stay constant over time, which is the better choice?

What if she stays in the facility for only three years?

Answer: Illinois is the better choice; 5 years savings of $40,000; 3 years savings of $26,000 Solution: Calculate the cost of care in each state.

.

5 Year cost comparison

Illinois

North Carolina

Facility Cost1 Moving Cost Cost to visit2

$300,000

$350,000 5,000

Difference

15,000

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Total Cost for 5 years $315,000 $355,000 $40,000 * Note1: Facility cost is for 5 years @ $60,000 in Illinois and 5 years @ $70,000 in North Carolina * Note2: Cost to visit is for 5 years @ $3,000.

3 Year cost comparison

Illinois

North Carolina

Difference

1

Facility Cost $180,000 $210,000 Moving Cost 5,000 Cost to visit2 9,000 Total Cost for 3 years $189,000 $215,000 $26,000 * Note1: Facility cost is for 3 years @ $60,000 in Illinois and 3 years @ $70,000 in North Carolina * Note2: Cost to visit is for 3 years @ $3,000.

Sec 8.4; LO 8.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic 10. Your after-tax income is $40,000. Your spouse’s after-tax income is $20,000 and you have one child under the age of 18. Your family’s annual expenses are $60,000. Your average indexed earnings for Social Security benefit calculations are $40,000. You are 30 years old. If you died today, your family expenses would drop by 20 percent.

A. If you died, how much extra income would your family need to meet their expenses (not taking Social Security survivor benefits into consideration)?

Answer: $28,000 Solution: Household expenses after your death is reduced by $12,000 ($60,000 expenses x 20% reduction). Your net earnings less reduction in household expenses needs to be replaced. $40,000 net earnings - $12,000 reduction in expenses = $28,000 income replacement required.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Will your family be eligible for Social Security survivor benefits and if so, will the benefits be enough to make up for your lost income? (Hint: Consult Table 8.2 in the text.)

Answer: If you are a fully insured worker under Social Security (10 quarters of participation), your surviving spouse and your child will be eligible for Social Security survivor benefits. Based on Table 8.2, the survivor of someone who had $40,000 income and was 30 years old at death will receive $13,524 X 2 (for child and spouse) for a total benefit of $27,048 per year. This is almost enough to cover the household shortfall.

Sec 8.1; LO 8.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. If Social Security benefits are sufficient to cover the family’s income shortfall, will you need to have any life insurance?

Answer: Although Social Security will provide almost enough income to make up the difference in expenses, you may still want to have life insurance to achieve other goals for your family, such as funding your child’s education or your spouse’s retirement account, or paying off the mortgage and other debts.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking 11. Under what circumstances might it be advisable to buy long-term care insurance for your parents, paying the cost out of your own pocket?

Answer: If you are planning to care for your parents outside of a public nursing home, long-term care insurance should be considered when budgeting for home health care or private assisted living.

Medicare Part A will cover the initial 100 days of home health care or assisted living if it is associated with .

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another covered medical procedure, but the rest will be up to their savings. When their savings deplete to their respective state’s maximum allowable assets threshold, Medicaid will cover basic nursing home care.

Sec 8.4; LO 8.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking 12. May-Yun, age 45, estimates that she needs to buy $300,000 in life insurance to protect her dependent children from suffering adverse financial consequences in the event of her death. As a single parent, she is on a pretty tight budget. Will term or permanent life insurance be more appropriate to meet her needs right now? Explain your reasoning.

Answer: Term insurance will be more appropriate for May-Yun. With this type of insurance, she can buy a larger face value for a given level of premium. As her children grow up, she can reduce the amount of coverage or drop it if she no longer has dependents.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: 13. Richard, age 35, is married and childless. He and his wife are both employed full-time. He would like to have $100,000 in life insurance coverage and is interested in a policy that will also give him some low-risk investment earnings. Should he consider term insurance? Why or why not?

Answer: He should not consider term insurance if he is seeking investment value. Term life is not an investment product, and there is no buildup of cash value. He should consider any of the types of permanent insurance that do not involve investment in stocks. However, when he makes this decision, he should also consider whether it would be more beneficial to buy term insurance and invest the difference in premium cost in a low risk mutual fund to achieve his investment objective.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: 14. Cathy, age 50, is working on her financial plan. Mary, her mother, is 80 years old.

A. Based on average life expectancy for her age, about how old will Cathy be when she dies?

(Rounded up to the nearest year.) (Hint: Consult Table 8.1 in the text.)

Answer: 83 Solution: Look up Cathy’s current age on the mortality table. The life expectancy of a 50-year-old woman is given as 32.7. Therefore, based on average life expectancy, she will live another 32.7 years to age 82.7.

B. Based on average life expectancy for her age, about how old will Mary, Cathy’s mother, be when she dies? (Rounded up to the nearest year.) (Hint: Consult Table 8.1 in the text.)

Answer: 90 Solution: Look up Mary’s current age on the mortality table. The life expectancy of an 80-year-old woman is given as 9.9. Therefore, on average, she will live another 9.9 years to age 89.9.

C. Why isn’t their life expectancy the same?

Answer: Based on the mortality table, Cathy’s life expectancy is 83, but her mother’s is 90. This is because, once you have already lived to a later age, your odds of living even longer get better.

If Cathy makes it to age 80, she will also be expected to live to age 90, based on average life expectancy.

(All of these) Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

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CASE APPLICATION SOLUTIONS 1. Vanna and Patrick O’Hara, ages 30 and 40, respectively, are considering the purchase of additional life insurance. They’re both employed full-time, and they have two children who are 7-year-old twins.

Vanna’s after-tax income is $30,000 and Pat’s is $50,000. Currently, Vanna has a $30,000 term life insurance policy paid for by her employer, and Pat has a $75,000 individual term life insurance policy.

Each of the O’Haras would like to have enough life insurance so that, in the event of either’s death, it would cover the lost cash flow to the household, help pay off some household debts, and fund their children’s college costs. They have estimated these costs as follows:

College fund for children Pay off existing mortgage on home Pay off credit cards Costs of death

$130,000 150,000 10,000 15,000

In addition, they estimate that their household expenses of $60,000 will be about 10 percent less if either one of them dies. If Vanna were to die, the cost of replacing her services to the household would be $10,000 per year for the next 11 years (until the children go to college). If Patrick were to die, this annual cost would be $5,000. They don’t anticipate that either of them would qualify for Social Security survivor benefits, but the children would be eligible for combined benefits of $2,000 a month until they reach the age of 18. The O’Haras currently have $50,000 in home equity and $35,000 in savings.

A. What would be the financial consequences for the O’Haras’ children, in the event of a tragic car accident in which both parents were killed?

Answer: If Vanna and Patrick do nothing more, their children will have $105,000 in life insurance and $35,000 in savings, for a total of $140,000. After paying the family’s debts ($10,000) and costs at death ($30,000 for two funerals), there will be only $100,000. 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 children’s income needs. In addition, the children will be eligible for $2,000 per month in Social Security survivor benefits. This would end when they turn 18, so there would be no funds for college.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Using the income-multiple method, what is the minimum amount of life insurance that Patrick should have? What is the minimum amount that Vanna should have?

Answer: $250,000 for Patrick and $150,000 for Vanna.

Solution: The income-multiple method suggests that the minimum a person should have is five times his or her income. Thus, Patrick should have $250,000 ($50,000 x 5) and Vanna should have $150,000 ($30,000 x 5).

Sec 8.1; LO 8.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

C. Apply the financial needs method to determine how much life insurance Vanna and Patrick each should have.

Answer: Patrick needs $593,500 and Vanna needs $428,500.

Solution: You can use Excel Worksheet 8.1 to solve this problem.

.

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Vanna

Patrick

A. Costs of Death Funeral expenses TOTAL COST OF DEATH

$ $

15,000 $ 15,000 $

15,000 15,000

B. Lump Sums Mortgage Credit Cards Education fund Household emergency fund (3 mos. Expenses)1 TOTAL LUMP SUMS

$ $ $ $ $

150,000 10,000 130,000 13,500 303,500

$ $ $ $ $

150,000 10,000 130,000 13,500 303,500

C. Cost of Household Maintenance Deceased annual net income Annual cost of lost support Reduction in annual expense2 Annual Social Security survivor benefits NET INCOME SHORTFALL

$ $ $ $ $

30,000 $ 10,000 $ (6,000) $ (24,000) $ 10,000 $

50,000 5,000 (6,000) (24,000) 25,000

TOTAL HOUSEHOLD MAINTENANCE FUND NEEDED Number of years you want to replace income shortfall TOTAL HOUSEHOLD MAINTENANCE FUND NEEDED

$

11 110,000 $

11 275,000

TOTAL FUNDS NEEDED

$

428,500 $

593,500

* Note1: * Note2:

Emergency Fund = ($60,000 annual expenses x 0.90) / 12 months = $4,500 monthly expenses Reduction in annual expense = $60,000 annual expense x 0.10 reduction = $6,000

Sec 8.1; LO 8.1; BT: Ap; Difficulty: H; TOT: 4 min; AACSB: Analytic

D. What type of insurance policy would you recommend for each? Explain your reasoning.

Answer: Because their needs are great relative to their income, term life insurance is likely to be the most cost-effective choice. They can gradually decrease the amount of coverage as their home equity increases and their college savings accounts grow.

Sec 8.2; LO 8.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

E. If the O’Haras choose to buy term life insurance, what risks do they face, and are there any contract terms that could reduce this risk?

Answer: 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 10-year renewable term insurance. They can then renew regardless of their health situation for at least 10 years.

Sec 8.3; LO 8.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

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2. Kurt Nelson is 63 years old and has been retired for several years. Two years ago, his wife of 40 years passed away after two years of battling cancer. During her entire illness, Kurt provided the in-home care she required. Shortly thereafter, his mother became incapacitated and moved in with him. He hired a nurse to come in for a couple of hours each day to cook dinner and help with his mother’s personal needs, but otherwise he took care of her himself. His mother died six months ago. Kurt has five surviving adult children and ten grandchildren, all of whom are financially secure. He would like to leave the bulk of his estate to his family but is worried that, should he require long-term care, the costs would rapidly deplete his hard-earned capital. He also wants to ensure that his beloved dog, Lucky, will be well cared for in the event that he cannot take care of Lucky himself. Lucky isn’t particularly good with children and is accustomed to a lot of personal attention. Kurt knows that none of his children would be willing to take the dog, so he wants to set up a fund for this purpose. He estimates that he could hire someone to perform this service for $5,000 per year. Kurt is considering the purchase of additional life insurance as well as long-term care insurance. At his age, he finds that both will be relatively expensive despite the fact that he’s in good health. He estimates that his investments are worth $500,000 and that his they earn an average of 4 percent per year. He has a defined benefit pension that provides $32,000 in after-tax annual income. He started receiving Social Security benefits at age 62, and his current benefit is $18,000 per year. His annual expenses, excluding those related to Lucky, are $40,000.

A. If Kurt required long-term care for three years beginning this year, would his current income and assets be enough to pay for it, assuming the annual cost is $60,000 per year? If he goes into longterm care, he estimates that his other annual expenses would drop to $20,000, including the expenses for Lucky.

Answer: Kurt’s current retirement income is $50,000 ($32,000 pension and $18,000 Social Security). He also earns $20,000 per year on his investments (4% annual return x $500,000 savings), although this could be taxable. If he enters long-term care, his expenses will be $80,000 per year ($60,000 long-term care + $20,000 other expenses), so he will be short by $30,000 per year and will have to dip into his investments to cover this cost.

Sec 8.4; LO 8.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. What would his situation be if he didn’t need long-term care until he reached the age of 88 (25 years from now)? Assume that long-term care costs grow at 4 percent per year.

Answer: Long-term care in 25 years will cost an estimated $159,950 per year. Over that period, Kurt’s current $500,000 savings will grow to $1,332,918. Kurt currently takes in $10,000 more than his expenses and if he invests the $10,000 net cash flow (annual savings) each year and earns 4 percent after tax, it will be worth $416,459 in 25 years. This all adds up to a total savings at age 88 of $1,749,377. When Kurt is 88 years old, he will have $119,975 in annual earnings from his retirement income of $50,000 and $69,975 earnings from his savings of $1,749,377. Kurt will still be short $39,975 annually for long-term care, however, his $1,749,377 in savings can more than make up the difference.

Solution: Calculation of Long-term care in 25 years ($159,950) Financial calculator: Enter PV = -60,000, N = 25, I/Y = 4 and solve for FV = 159,950.18 Excel Spreadsheet: = FV(rate,nper,pmt,pv,type) => =FV(0.04,25,0,-60000,0) => 159,950.18 Calculation of Kurt’s Savings in 25 years ($1,332,918) Financial calculator: Enter PV = -500,000, N = 25, I/Y = 4 and solve for FV = 1,332,918.17 Excel Spreadsheet: = FV(rate,nper,pmt,pv,type) => =FV(0.04,25,0,-500000,0) => 1,332,918.17 Calculation of Future Value of Annual Net Savings ($416,459) Kurt’s current retirement income is $50,000 ($32,000 pension and $18,000 Social Security) and .

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his expenses are $40,000, thus his annual savings are $10,000.

Financial calculator: Enter PMT=-10,000, N=25, I/Y=4, PV=0, and solve for FV = 416,459.08 Excel Spreadsheet: = PMT(rate,nper,pmt,pv,type) => =PMT(0.04,25,-10000,0,0) => 416,459.08 Kurt’s situation 25 years from now Growth of $500,000 savings = $1,332,918 Growth of $10,000 annual savings = $416,459 TOTAL RESOURCES AVAILABLE $1,749,377 in Savings $ 119,975 annual income ($69,975 savings @ 4% + $50,000 retirement) Long-Term care Cost = $159,950 annually Kurt will still be short $39,975 annually for long-term care, however, his $1,749,377 in savings can more than make up the difference.

Sec 8.4; LO 8.4; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

C. Does Kurt need life insurance? Explain your reasoning.

Answer: No. He doesn’t need any unless he wants to give more than $500,000 to his heirs. At his age, life insurance will be prohibitively expensive.

Sec 8.1; LO 8.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. Assume that long-term care insurance premiums are $12,000 per year. If Kurt expects to enter a long-term care facility at age 73 (10 years from now) for one year, would he be better off investing the money or buying the long-term care insurance? What impact does the number of years of required long-term care have on his decision?

Answer: If he invests $12,000 at the end of each year, he will accumulate $144,073 by the end of 10 years. Long-term care cost will be $88,815 per year. Hence, if he only requires 1 year of long-term care, then he was better off self-insuring by saving $55,258. However, if he requires any additional years of long-term care, then he would have been better of with the insurance.

Calculation of $12,000 per year premiums saved for 10 years Financial calculator: Enter PMT=-12,000, N=10, I/Y=4, PV=0, and solve for FV = 144,073.29 Excel Spreadsheet: = FV(rate,nper,pmt,pv,type) => =FV(0.04,10,-12000,0,0) => 144,073.29 Calculation of Long-term Care cost in 10 years Financial calculator: Enter PV=-60,000, N=10, I/Y=4, PV=0, and solve for FV = 88,814.66 Excel Spreadsheet: = FV(rate,nper,pmt,pv,type) => =FV(0.04,10,0,-60000,0) => 88,814.66 Sec 8.4; LO 8.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

E. Should Kurt consider buying a life insurance policy with a long-term care accelerated benefits option instead? Explain your reasoning.

Answer: Life insurance with a long-term care acceleration rider allows you to use the accumulated cash value to pay for long-term care costs in the future. This might have been a .

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good option if he had bought the insurance at a younger age. At his current age, this type of policy will probably be too expensive.

Sec 8.3; LO 8.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

.

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CHAPTER 9 Instructor Manual Employee Benefits: Health, Disability, and Retirement Plans LEARNING OBJECTIVES LO 9.1 Explain the value of employee benefits as a component of compensation.

LO 9.2 Evaluate your health-related costs,and select appropriate health insurance to meet your needs.

LO 9.3 Analyze your disability income needs,and identify sources of disability income.

LO 9.4 Explain the benefits of participating in employer-sponsored retirement plans.

SUGGESTED COURSE PLAN This chapter will require one week out of a typical 15– to 16-week semester. For three 50-minute classes, you could use one class period each for the introduction to employee benefits (LO 9.1), health and disability (LO 9.2 and 9.3), and retirement plans (LO 9.4). Because Chapter 10 covers retirement planning, some instructors might want to combine LO 9.4 with Chapter 10 content. Here is a suggested course plan for a class that meets twice per week: Class Period

1

2

Topic and Reading Assignment (by Learning Objective) Read: LO8.1 Value of Employee Benefits; LO8.2 Health Insurance Read: LO8.3 Disability; LO8.4 Retirement Plans

Suggested WileyPLUS PreClass Assignments

WileyPLUS Resources to Use in Class DP9.1 Tax Savings from Pretax Benefits CS9.1,CS9.2,CS9.3

Reflection Question 3 Disability income funding

CS 9.4 Disability Income Needs

Personal Financial Planner Assignment Job Comparison (PFP 9.2)

WileyPLUS Homework Assignment

Disability Income Needs (PFP 9.4)

Chapter 9 Homework B: R: 11-14; P6 Adaptive Practice Ch 9

Chapter 9 Homework A: R:2-4,7; P:1-4,7

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY Chapter 9 Employee Benefits: Health, Disability, and Retirement Plans LO 9.1

Explain the value of employee benefits as a component of compensation.

THE VALUE OF EMPLOYEE BENEFITS I.

TYPES OF BENEFITS OFFERED BY EMPLOYERS

II.

WHY BENEFITS ARE PREFERABLE TO CASH COMPENSATION A. Lower Underwriting Costs B. Lower Administrative Costs C. Lower Taxes

III.

CASE STUDY 9.1 LORI EVALUATES TAX SAVINGS FROM EMPLOYER-PROVIDED HEALTH INSURANCE

IV.

COMPARING JOB OFFERS BASED ON SALARY AND BENEFITS A. Comparing Salaries Based on Cost of Living

V.

CASE STUDY 9.2 LORI COMPARES SALARY OFFERS BASED ON COST OF LIVING A. Comparing Employee Benefit Packages

VI.

CASE STUDY 9.3 LORI COMPARES JOB OFFERS BASED ON SALARY AND BENEFITS

LO9.2

Evaluate your health-related costs and select appropriate health insurance to meet your needs.

HEALTH INSURANCE AND YOUR FINANCIAL PLAN I.

HEALTH INSURANCE NEEDS ANALYSIS A. Expected Health-Care Costs B. National Trends in Health-Care Costs

II.

WHAT HAPPENED TO HEALTH-CARE REFORM?

III.

TYPES OF HEALTH INSURANCE PLANS A. Fee-for-Service Plans B. Deductibles and Coinsurance C. Managed-Care Plans D. Dental and Vision Insurance Plans E. Trends in Plan Type

IV.

GOVERNMENT-SPONSORED HEALTH INSURANCE A. The Medicare Program: Health Insurance for Seniors B. Medicaid: Health Insurance for the Poor C. COBRA Continuation Coverage

LO 9.3

Analyze your disability income needs and identify sources of disability income.

PLANNING FOR DISABILITY INCOME

.

I.

DISABILITY NEEDS ANALYSIS

II.

SOURCES OF DISABILITY INCOME A. Employer-Sponsored Disability Income Protection B. Individual Disability Insurance C. Workers’ Compensation

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D. Social Security Disability III.

LO 9.4

CASE STUDY 9.4 MATEO RIVERA ESTIMATES HIS DISABILITY INCOME NEEDS

Explain the benefits of participating in employer-sponsored retirement plans.

EMPLOYER-SPONSORED RETIREMENT PLANS

.

I.

TAX ADVANTAGES OF QUALIFIED PLANS

II.

DEFINED-BENEFIT VERSUS DEFINED CONTRIBUTION PLANS

III.

FEATURES OF DEFINED BENEFIT PLANS A. Benefit Formula B. Vesting Rules C. Portability D. Government-Guaranteed Benefits E. Disability, Survivors, and Retiree Health Insurance

IV.

FEATURES OF DEFINED CONTRIBUTION PLANS A. What Is Your Employer’s Contribution Promise?

B. Can You Contribute to the Plan?

C. Who Makes the Investment Decisions?

D. Retirement Plans for Small Businesses E. Limits on Contributions

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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. Because this chapter immediately follows the property and liability insurance chapter, it is helpful 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, retirement, and disability risk management 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? Would the Affordable Care Act influence their decisions regarding full versus part-time employees, number of employees, or choice of benefits to offer? How will these benefit decisions affect company profitability? Why would you 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. If you have not already introduced the Affordable Care Act, this can be a good way to explain the choices that were made by the people who wrote that law.

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 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 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 before retirement). A DB plan might provide 50% of final average salary, or $75,632. If that same person’s employer contributed 3% of salary for his entire working career (the average employer contribution), and assuming salary growth of 3% per year, the account would be worth $1,307,734 million at retirement, if the account averaged a fairly optimistic 10% return on investment. That would buy a 20-year annuity of $104,936 (assuming a 5% rate of return). If you wanted your benefit to increase with inflation, the initial annuity payment would be much lower. What if investments earned less than 10%? What if the employee was able to contribute additional amounts on their own? (Note that this chapter introduces the types of plans, but the retirement planning components and Social Security are covered in a later chapter.)

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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CONCEPT REVIEW SOLUTIONS 1. Explain why it’s important to consider all of the components of compensation, not just salary, when evaluating a job offer.

Answer: Many employers offer additional benefits, such as health coverage, retirement contribution, life insurance, disability insurance, paid sick leave, and vacation and personal days.

These may be completely or partially paid for by the employer, resulting in lower expenses for the employee. In addition, many benefits are paid for on a pre-tax basis, which may reduce taxes for the employee. Salary is only one part of the total compensation package, and benefits can amount to an additional 30 to 35 percent of salary, even without considering the effect of taxes. In addition, an employee may also consider qualitative factors, such as people, work environment, potential for advancement, attitude of management, location, and so forth. While these benefits are not technically a part of a compensation package, they play an important role.

Sec 9.1; LO 9.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

2. What is the difference between a contributory employee benefit plan and a noncontributory plan? Which would you prefer, and why?

Answer: Under a contributory benefit plan, the employee is required to pay all or part of the total cost of the benefit to the employer. Under a noncontributory plan, the employee does not pay anything. This makes a noncontributory plan preferable over a contributory plan. However, some caution must be exercised when comparing compensation packages across different employers.

Noncontributory plans may be associated with a lower salary, and employee contributions under a contributory plan would be tax-deductible, reducing their net cost to the employee.

Sec 9.2; LO 9.2; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. Explain why it’s often better to receive group insurance through your employer than to receive equivalent cash compensation out of which you must purchase the insurance on your own.

Answer: Group insurance is usually cheaper than individual insurance, and the employee does not have to qualify based on his or her health condition. Premiums are based on the risk of the entire employee group, not a single employee, and administrative costs per employee are lower, which also reduces premiums. Another major advantage is tax savings. If an employee receives cash compensation, he or she has to pay taxes first and then buy insurance. Employer-sponsored insurance payments are tax deductible if the plan is contributory. Thus, in order to equalize the cost of insurance, cash compensation would have to be higher to offset the tax effect.

Sec 9.1; LO 9.1; BT: C; Difficulty: M; TOT: 2 min; AACSB:

4. What are the national trends in health-care costs and insurance coverage, and what are some explanations for these trends?

Answer: Health-care costs in the United States have been rising faster than wages and faster than the costs of other goods and services. Insurance companies, in order to control their costs, are requiring insured persons to pay higher deductibles and copays with higher out-of-pocket limits. Employers are also requiring greater employee payments in terms of premiums, copays, and deductibles in order to reduce their health insurance costs. The extent of the benefits offered is also under cost pressure due to a greater emphasis on managed care plans as opposed to feefor-service plans. Higher medical costs reflect the aging of the American population. .

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Sec 9.2; LO 9.2; BT: C; Difficulty: E; TOT: 2 min; AACSB:

5. What were the key features of the Affordable Care Act (“ObamaCare”) and which components have been repealed? What was the purpose of this law?

Answer: The key features of ObamaCare included: (1) requiring all individuals to have health insurance or pay a penalty, (2) requiring larger employers to provide health coverage to employees or pay a penalty, (3) expanding Medicaid to cover more lower-income people, (4) offering tax subsidies based on income, (5) creating health-care exchanges, (6) requiring health-care plans to include certain minimum coverage and prohibiting insurers from denying coverage due to preexisting conditions, (7) allowing children to remain on their parents’ plans until they reach age 26, and (8) imposing certain restrictions on setting and increasing premiums. The components of the law that have been repealed are mandating employers to provide coverage and requiring individuals to have health insurance or pay a penalty.

The goals were to reduce the number of people who were uninsured, control health-care costs, and improve the health-care delivery system.

Sec 9.2; LO 9.2; BT: C; Difficulty: M; TOT: 3 min; AACSB:

6. Identify several ways you can reduce your expected future out-of-pocket costs for health insurance.

Answer: Expected future out-of-pocket health-care costs can be reduced by participating in an HMO or using "in-network" or preferred providers under an insurance plan. People in good health can reduce premiums by opting for higher deductibles, higher copays, and greater out-of-pocket limits. Additional savings can be generated by setting up tax advantaged flexible spending accounts and health savings accounts.

Sec 9.2; LO 9.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

7. Which type of health insurance plan would you prefer, fee-for-service or managed care?

Why? Answer: Fee-for-service plans reimburse for the actual costs incurred. They are generally composed of a basic health plan and a major medical plan. In the past, such plans have resulted in higher claim costs, and many insurers have replaced them with managed-care plans with higher copays and deductibles. Managed-care plans may place some limits on the types of doctors and specialists you can choose, and you will need referrals by your primary care doctor to see specialists. Nevertheless, these plans have resulted in better control of health-care costs and lower premiums. The type of plan an individual would prefer depends on the relative importance placed on various characteristics of the types of plans.

Sec 9.2; LO 9.2; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

8. What are the different ways to cover disability income needs?

Answer: Shortfalls in income due to disability can be covered by several means. For one thing, of course, you can cut back on discretionary spending. Sources of additional funds include: (1) the family emergency fund, (2) income earned by another household member, (3) paid sick, personal, and vacation days provided by your employer, (4) income from investments, (5) disability insurance, and (6) government benefits, such as workers’ compensation or Social Security disability benefits.

Sec 9.3; LO 9.3; BT: C; Difficulty: M; TOT: 2 min; AACSB: .

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9. What are the key features of disability income insurance? Explain each. Why is it important to consider the definition of disability in the policy?

Answer: Key features of disability income insurance include waiting period, benefit duration, income replacement, renewability, and treatment of other disability benefits. The waiting period is how long you must be disabled before you can receive benefits. Typically, short-term disability policies have a short waiting period, whereas long-term disability benefits might require that you are disabled for up to a year before being eligible. Benefit duration is how long you will receive benefits, which also depends on whether the insurance is short term or long term. Long-term policies typically pay benefits to age 65. Income replacement is how much the benefit will be.

Insurance usually pays a stated percentage of pretax employment income, such as 60 or 70 percent. Renewability relates to whether or not the insurer can cancel your policy if your health deteriorates. A policy with guaranteed renewability is generally preferable.

Insurance companies define disability in many ways. The most advantageous definition for the insured is the inability to work at his or her "own occupation," which means so long as the insured cannot perform in his or her current job, he or she is considered disabled, even though he or she could do other, lower-paying jobs, such as walking dogs. The most restrictive definition is when disability is defined as the inability to perform "any job."

Sec 9.3; LO 9.3; BT: C; Difficulty: M; TOT: 3 min; AACSB:

10. Under what circumstances does Social Security provide disability income replacement?

Answer: Social Security grants disability payments if someone has been disabled for at least five months, expects to remain disabled for at least a year, and cannot work at "any job." Eligibility for Social Security disability benefits and the amount to be received also depends on past participation in Social Security and the employee’s income over their working career.

Sec 9.3; LO 9.3; BT: C; Difficulty: E; TOT: 1 min; AACSB:

11. What is the difference between a defined-benefit plan and a defined-contribution plan?

Answer: Under a defined-benefit retirement plan, the employer promises to pay a retirement benefit according to a predetermined formula, which is usually based on salary history and the number of years worked. The employer carries the burden of ensuring that any money set aside will be sufficient to pay the promised benefits. If the return on the money set aside is low and funds are inadequate to support the retirement obligations, the employer is still liable and must make up the shortfall, imposing financial risk on the employer.

Under a defined-contribution plan, the employer promises to make payments into a retirement account on behalf of the employee. The contributions are commonly based on a formula, such as a percent of salary, but other alternatives are possible, such as a set dollar amount or a number of shares of employer stock. Some plans allow the employee to make contributions to the plan on a pretax basis. If the retirement fund underperforms, the employee suffers the consequences of lower retirement withdrawals. This arrangement shifts the financial risk to the employee. Most employers are now shifting toward defined contribution plans.

Sec 9.4; LO 9.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

12. Which type of retirement plan places more risk on the employee? What kind of risk?

.

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Answer: Defined-contribution plans place more financial risk on the employee because the employee is exposed to the risk that the retirement fund will underperform. Of the different types of defined-contribution plans, an employee stock ownership plan is the most risky, because the plan is invested primarily in employer stock. The employee is exposed to investment risk, as well as the risk of losing both a job and a retirement nest egg at the same time, if the company fails.

13. What are the tax advantages of a qualified retirement plan?

Answer: The tax advantages of such plans are threefold: (1) the employer's contributions to the plan are tax deductible to the employer in the year in which the contributions are made; (2) employee contributions are tax deductible in the year they are made, reducing federal, state and local, taxes paid; and (3) taxes on contributions, investment earnings in the plan, and benefit accruals are tax deferred until they are withdrawn.

Sec 9.4; LO 9.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

14. If your employer offers to match your 401(k) contributions up to 3 percent of your salary, why is it important to contribute enough to get the maximum match amount?

Answer: By maximizing your contributions to get the full employer match, you effectively earn a 100 percent return on your contribution instantaneously. If you fail to do this, the investment amount in the fund is reduced, and its future wealth-building potential is also reduced.

Furthermore, the employer's contributions effectively increase your compensation by the amount of the contribution. For example, if you earn $100,000 per year, and put 3 percent in the plan, a 3-percent employer match translates into a $3,000 annual contribution to the tax-deferred retirement plan. The $3,000 employee contribution results in a $6,000 account balance, and the employee's effective salary is $103,000.

Sec 9.4; LO 9.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

15. Why is it important to pay disability insurance premiums on an after-tax basis instead of a pretax basis?

Answer: If disability insurance premiums are paid from after-tax dollars, then disability income is not taxed upon receipt. It is fully taxable if premiums are paid from pretax dollars. Given that disability benefits are typically 60 to 65 percent of pretax income, your income would be higher if the benefits were tax-free.

Sec 9.3; LO 9.3; BT: C; Difficulty: M; TOT: 1 min; AACSB:

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APPLICATION PROBLEM SOLUTIONS 1. Job A pays a salary of $40,000, and Job B pays a salary of $35,000. The cost of living in the Job A area is 102 percent of the national average, and the cost of living in the Job B area is 88 percent of the national average. If all other factors are equal, which of the two salary offers is better? Explain your reasoning.

Drop Down Choices: Job A, Job B Answer: Job B

Solution: To find out which salary offer is better, use Equation 9.2 to determine if the salary in location A would provide the equivalent purchasing power to the salary in location B. Equivalent salary for Job A =

COLIA x Salary for Job B COLIB

Equivalent salary for Job A =

102 x $35,000 = $40,568.18 88

This means that Job A would have to pay $40,568 to provide a standard of living equivalent to that provided by a salary of $35,000 in location B. Since Job A only pays $40,000, Job B is financially the better choice.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

2. Job A pays a salary of $40,000, and the firm will contribute 5 percent of your salary to a retirement plan. Job B pays a salary of $42,000, and the firm doesn’t offer a retirement plan. They are both located in the same area. If all other factors are equal, which job opportunity is better? Explain your reasoning.

Answer: The $2,000 (5% contribution x $40,000 salary) retirement contribution for Job A puts the gross pay of both jobs at parity. However, the $2,000 retirement contribution is pretax. While you can invest the extra $2,000 you make from Job B in a traditional IRA and get a tax deduction, you will still have to pay FICA payroll tax (7.65%) on those funds, so you will have less than $2,000 after tax available to invest. Therefore, Job A’s compensation is preferable.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. Job A pays a salary of $50,000 but does not provide health insurance. You can buy health insurance on your own for $5,000 per year. Job B pays a salary of $44,000 with fully paid health insurance. Your marginal tax rate is 20 percent. If all other factors are equal, which compensation package is better?

Explain your reasoning.

Answer: If you buy the health insurance on your own, you must pay tax on the income first and then pay your premium out of after-tax dollars. Therefore, it will take $6,250 in pretax income to have $5,000 available to pay for the insurance ($5,000/0.8 = $6,250). This implies that Job B is a better choice, because if you have to purchase health insurance with $6,250 in gross income for Job A, then it leaves only $43,750 compared

to $44,000 salary for Job B. Health insurance premiums are tax deductible, but only to the extent that medical expenses are greater than 10 percent of AGI and if your total itemized deductions are larger than the standard deduction.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. Your health insurance requires payment of an annual deductible of $500 per person or $1,000 per family. After meeting the deductible, you must pay 20 percent of covered charges until you reach $5,000 out of pocket, after which the insurer will pay 100 percent of the costs. Assume that your .

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family has had no other claims during the year and that your child requires emergency surgery. If the total covered charges for the surgery are $20,000, all incurred in the same plan year, how much will you end up paying out of pocket?

A. $4,400 B. $3,900 C. $4,000 D. $5,000 Answer: $4,400 Solution: Because all of the costs are for one family member, the deductible that applies is the individual deductible of $500. To find the total out-of-pocket cost: (1) any amount under the deductible is out-ofpocket; (2) if the covered charges are greater than the deductible, then multiply the remainder by the coinsurance percentage to compute additional out-of-pocket cost; and (3) the total of the deductible and coinsurance is capped at the maximum out-of-pocket limit.

Individual deductible: $ 500 1 Coinsurance : $3,900 Total out-of-pocket: $4,400 Note1: Coinsurance = 20% of $19,500 ($20,000 hospital bill less $500 deductible) Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

5. Your employer offers two health plan choices and requires that employees pay part of the premium cost. The fee-for-service option will cost you $100 per month for single coverage, does not cover preventive care, and imposes a $300 per person annual deductible and 20 percent coinsurance to a limit of $2,000. The fee-for-service plan also covers prescription drugs after a copay of $30 per prescription. The managed care option (an HMO) will cost you $200 per month, covers all medical services (including preventive care and prescription drugs), and requires a $10 copay for each office visit or prescription.

A. Over the course of a year, if you have an annual physical ($200), visit the doctor twice for illness ($50 per visit), and incur prescription drug costs of $500 (10 prescriptions at $50 each), how much would your out-of-pocket expenses be under both the fee-for-service plan and the managed-care option?

Answer: $1,800 for fee-for-service and $2,530 for managed care.

Solution: Compare the premium and co-insurance costs.

Cost

Fee-for-service

1-year premiums ($100/month) $200 physical (applied to deductible) 2 visits @ $50 (applied to deductible) 10 prescr. ($50 ea.) ($30 co-pay each) Total out-of-pocket cost

HMO $1,200 $ 200 $ 100 $ 300 $1,800

($200/month) ($10 co-pay) ($10 co-pay each) ($10 co-pay each)

$2,400 $ 10 $ 20 $ 100 $2,530

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Over the course of a year, if you have an annual physical ($200), surgery for a skiing injury ($3,000 covered charges), and prescription drug costs of $200 (four prescriptions at $50 each), how much would your out-of-pocket expenses be under both the fee-for-service plan and the managed care option? .

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Answer: $2,200 for fee-for-service and $2,460 for managed care.

Solution: Compare the premium and co-insurance costs.

Cost 1-year premiums $200 physical $3,000 surgery1

Fee-for-service HMO ($100/month) $1,200 ($200/month) $2,400 (applied to deductible) $ 200 ($10 co-pay) $ 10 (applied to deductible) $ 100 ($10 co-pay) $ 10 (applied to 20% coinsure.) $ 580 4 prescr.($50 ea,) ($30 co-pay each) $ 120 ($10 co-pay each) $ 40 Total out-of-pocket cost $2,200 $2,460 Note1: Coinsurance = 20% of $2,900 ($3,000 surgery bill less $100 remaining deductible) Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. What factors would you consider in choosing between the fee-for-service plan and the HMO plan?

Answer: The fee-for-service plan has much lower premiums but offers less coverage, so if you are young and healthy, you will likely have lower out-of-pocket costs with that plan. If, on the other hand, you typically see the doctor frequently, expect to have major surgery during the year, and/or have a lot of prescription drug costs, it may be more worthwhile to have the HMO. Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

6. Your employer offers a defined-benefit plan with the following formula: 1 percent of final salary for each of the first 15 years of service, 1.5 percent of final salary for each of the next 15 years of service, and 2 percent of salary for each of the next 20 years of service.

A. If you work for the firm for your entire 45-year career and your final salary is $100,000, how much will you receive annually as a benefit?

Answer: $67,500 per year

Solution: To calculate this benefit, apply the respective benefit multiple to the final salary for every respective year employed and then total the results.

Years of service 15 15 15 45

x

Multiplier 0.01 x $100,000 0.015 x $100,000 0.02 x $100,000

=

Benefit $15,000 $22,500 $30,000 $67,500

Sec 9.4; LO 9.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. If you work for the firm for only five years, but are fully vested, how much benefit will you be entitled to receive at retirement, assuming that your final salary at the company is $40,000?

Answer: $2,000 Solution: If you have worked for only five years, multiply your length of service (5) by 0.01 multiple and by your final salary ($40,000). 5 years x 0.01 x $40,000 = $2,000 per year.

Sec 9.4; LO 9.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic .

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C. If you work for the firm for only five years, but the firm has three- to seven-year graded vesting, how much benefit will you be entitled to receive at retirement, assuming that your final salary at the company is $40,000?

Answer: $1,200 Solution: If you have worked for only five years, multiply your length of service (5) by 0.01 multiple and by your final salary ($40,000). 5 years x 0.01 x $40,000 = $2,000 per year. Then you must apply the vesting schedule to your benefit to see what you actually are entitled to receive.

Three- to seven-year graded vesting Under this rule, you’ll accrue rights to 20 percent of the accrued benefit for each year of service from three to seven years. In this example, you left the employer after 5 years of service, thus at retirement, you’ll be entitled to 60 percent of the accrued benefit (20% after 3 years, 40% after 4 years, and 60% after the 5th year). $2,000 full benefit x 0.60 = $1,200 vested benefit.

Sec 9.4; LO 9.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

7. You’ve been laid off by your employer, where you had been participating in a contributory healthcare plan. Your share of the premiums, $200 per month, was 50 percent of the actual cost to the employer.

A. Under what circumstances, should you consider getting COBRA continuation coverage through your employer’s plan, and how soon do you need to decide?

Answer: Your employer’s total cost of providing health coverage is $400 per month ($200 employee contribution and $200 employer contribution), or $4,800 per year. COBRA coverage will allow you to continue under your employer’s plan but could be fairly expensive. You might be able to find cheaper coverage through a state or federal exchange, but the coverage may not be equivalent. You will also want to consider how long you expect to need the coverage. If you decide to get COBRA coverage, you must notify the employer within 60 days of being laid off.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

B. If you opt for COBRA continuation coverage and your employer adds a 2 percent administrative charge, how much will you have to pay per month for the coverage?

Answer: $408 Solution: Multiply the actual cost of the health premiums by the administrative charge and add to the premium cost: ($400 x 0.02) + $400 = $408 per month.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. What alternative sources of health-care coverage do you have, and are they likely to be more or less expensive?

Answer: An individual health insurance policy might be less expensive than the employer’s group coverage if you are young and live in a relatively low-cost area. You might also have the option of being added to your spouse’s employer coverage, but there is likely to be a waiting period, so you might need to use the COBRA coverage until then.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

8. You are offered a job in Urban City that will pay $50,000 per year. You currently have a comparable job with comparable benefits in Rural Town, but it pays only $40,000. If the cost of living for Urban City is 105 percent of the national average and the cost of living in Rural Town is 85 percent of the national average, which job will give you more purchasing power?

[Text drop-downs: Urban City, Rural Town] .

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Answer: Urban City Solution: Urban City will provide more purchasing power. Use Equation 9.2 to compare the salaries: COLI1 Equivalent salary in City 1 = x Salary in City 2 COLI2 Equivalent salary in Urban City is

105 𝑥 $40,000 = $49,411.76 85

The equivalent salary in Urban City is $49,412. This implies that the Urban City salary provides $588 ($50,000 – $49,412) more purchasing power than the Rural Town salary.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

9. Allison currently earns $3,000 per month and takes home $2,300. Her monthly expenses total $2,000.

Her employer provides five sick days per year and a short-term disability policy that will pay benefits after 30 days of disability. The policy will pay 60 percent of her gross income for up to 12 months.

The disability income payments aren’t taxable because she used after-tax dollars to pay the premiums.

A. If Allison wants to have sufficient liquid assets to cover the short-term disability needs that aren’t met by her employer’s plan, how much should she set aside for this purpose, assuming she might be disabled for a period of one year?

A. $3,867 B. $1,667 C. $2,000 D. $2,400 Answer: $3,867 Solution: She needs enough to cover the 25 days of potential disability before the employer’s short-term disability insurance begins to pay benefits (the 30-day waiting period for short term disability coverage less her 5 sick days). Since her expenses total $2,000 per month, she will need to have at least $1,667 (25 days/30 days x $2,000) set aside to be able to cover her costs for that period of time. In addition, in each month of her disability, she will need to receive $200 (60 percent of her $3,000 salary, or $1,800, less her $2,000 monthly expenses). To cover a full year of disability, she will need $1,667 for the 25 days prior to short-term disability benefits + (11 months x $200 monthly shortfall) = $3,867 to cover her costs.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

B. If Allison is considering purchasing long-term disability insurance to cover a disability that lasts for more than 12 months, and assuming that she wouldn’t qualify for Social Security disability, what would the monthly benefit need to be, assuming that she will pay the premiums with aftertax dollars?

A. $2,000 B. $3,000 C. $1,667 D. $3,867 Answer: $2,000 per month .

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Solution: She needs to cover $2,000 per month in expenses. This is $2,000/$3,000 = 67 percent of her pretax income.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

.

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CASE APPLICATION SOLUTIONS 1. Anna Trebuca, age 40, has just accepted a job as a legal secretary in a large law office. The law firm has a cafeteria plan and gives each employee $4,000 in pre-tax dollars to spend on a menu of benefit options. Any dollars that are not spent can be received as cash compensation. Anna has the following options to choose from:

Benefits Monthly Premiums Health plan A: Fee-for-service (FFS) plan Employee only: $150 per month including basic and major medical; $250 annual Employee + 1: $200 per month deductible and 20 percent coinsurance; $5,000 maximum out-of-pocket; no lifetime limit.

Health plan B: Preferred provider organization (PPO) covering most services from in-network providers at 100 percent after a $100 deductible; out-of-network providers require a 25 percent copay.

Dental insurance: Pays 100 percent of checkups and cleaning; 50 percent of additional services up to a maximum annual benefit of $1,000.

Long-term disability insurance: Pays 60 percent of pre-disability income for up to two years if unable to perform the duties of current job; 12month waiting period.

Employee only: $200 per month Employee + 1: $300 per month

Employee only: $40 per month Employee + 1: $60 per month

$15 per month

A. If Anna is single and childless and has no other group health insurance available, explain why she should participate in one of the health plans, even if she could find individual insurance for a slightly lower premium.

Answer: Individual health insurance can be less expensive than group coverage for younger people.

Depending on her salary, Anna might be eligible for a tax subsidy to help pay for part of her insurance.

There is still some uncertainty about premiums for policies offered on the exchanges. If Anna stays with her employer, she will be eligible for the regular group rate, and her employer will negotiate the details of the coverage. She also benefits from being able to pay for the insurance premiums with pre-tax dollars.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

B. What factors should Anna consider in deciding between the fee-for-service and the PPO plans?

Answer: The PPO limits choice of physicians but has the advantage of a low deductible and no copay for in-network providers. The FFS plan is less expensive based on premiums by $600 per year but has a higher deductible by $100.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

.

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C. Which health plan would result in a lower total out-of-pocket expense for the year if Anna incurred $10,000 in medical expenses for a surgical procedure, assuming that she used a participating provider? Explain.

Answer: The FFS cost would be $4,000: $1,800 in premiums (12 months x $150 premium) + $250 deductible + $1,950 coinsurance (0.20 x $9,750 expenses less deductible). The PPO cost would be $2,500: $2,400 in premiums (12 months x $200 premium) + $100 deductible. In this circumstance, the PPO provides the least out-of-pocket expense.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic D. If Anna is married and her husband’s employer provides a health insurance plan at a lower out-ofpocket premium cost, what should Anna consider when allocating her benefit dollars?

Answer: A married couple should consider the combined costs of both employers’ benefit options. If Anna can keep any unused benefit dollars as cash compensation, it makes sense to buy the health insurance from her husband’s employer if it offers the best coverage and price. She might be allowed to buy the dental insurance and the disability insurance from her employer and take the remainder as cash compensation.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking E. Is the dental insurance a good deal if Anna normally incurs very low dental costs each year ($150 for checkup and cleaning)? How much would her dental costs have to total for her to break even on the cost of the dental insurance?

Answer: Her premium costs would be $480 per year ($40 per month), but she would typically receive a benefit of only the $150 checkup and cleaning. She therefore would be paying $330 more in premiums than she is getting in benefits. For this insurance to be a good deal for Anna, she would need to have expected dental costs of at least $660 (50% x $660 = $330) in addition to her cleaning. In that case, her insurance would pay the $150 cleaning plus 50 percent of the $660, or $330, and she would just break even.

Sec 9.2; LO 9.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

2. Juan Morales is a single father and is worried about what would happen to his family finances if he were to become disabled. His total household expenses are $3,000 per month, although he estimates that, in a pinch, they could be cut to $2,200 per month. Juan currently earns $4,000 per month before taxes at his job as a retail store manager. His employer provides 5 sick days per year, 10 days of paid annual leave, and a short-term disability policy (purchased with after-tax dollars) that, after 30 days of continuous disability, will pay 55 percent of pre-disability gross income for 12 months. He is wondering whether he should also buy long-term disability income insurance through his employer’s group plan (after 12 months of continuous disability, the plan pays 60 percent of pre-disability gross income for up to 5 years of continued disability).

A. What are Juan’s short-term disability income needs?

Answer: 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 adjustable to $2,200 per month.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

B. Suppose Juan can’t work due to an injury at home. If he hasn’t yet used any of the current year’s paid leave or sick days when he became injured, how long will he continue to receive income, and how much will he get? If Juan is disabled for 12 months, does he have sufficient disability income protection? Explain why or why not.

Answer: Juan will require at least $550 in savings to cover his short-term disability policy waiting period, but he should have the minimal household expenses covered for a year. .

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His sick and paid leave will provide him with his usual take-home pay for the first three weeks (5 sick days and 10 personal days = 15 work days). But the short-term disability doesn’t begin to pay benefits 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 (0.55 x $4,000 = $2,200), for 12 months, which totals his monthly expected expenses “in a pinch”. Thus, he will need to cover 1 week of expenses of $550 (based on $2,200 expenses “in a pinch” divided by 4 weeks) or $750 (based on normal monthly expenses of $3,000 divided by 4 weeks). If not Juan cannot keep his expenses down to $2,200 a month, then he will need to have an additional $800 x 12 months = $9,600.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

C. Explain why Juan should look carefully at the definition of disability in both the short-term and long-term insurance policies.

Answer: 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, such as “any occupation”.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

D. If Juan permanently injures his back and is no longer able to perform the duties of his current job, will he be eligible for Social Security disability income? Why or why not?

Answer: Juan would probably not be eligible for Social Security. 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. Social Security disability also requires that the recipient has been disabled for at least five months and expects to remain disabled for at least a year.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB:

E. Suppose Juan estimates that he would be eligible for a Social Security disability benefit of $500 per month. How should he incorporate this in his long-term disability planning?

Answer: If Juan’s future disability qualifies him to receive Social Security benefits, his other disability benefits could be offset by this amount depending on the terms of his insurance. In that case, it shouldn’t make a difference in his planning. But because it is relatively unlikely that he would qualify for Social Security disability, Juan should do his planning based on the assumption that he would not receive Social Security benefits.

Sec 9.3; LO 9.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. Clare Deluna is in her last semester at a major public university, where she is completing a double major in finance and construction management. Her hard work has paid off, and she has been offered two jobs at different civil engineering firms. Matheson, Inc., a Denver-based firm, has offered her a $40,000 starting salary with an expected annual bonus of $5,000. Brandis Construction, a Seattlebased firm, will pay a starting salary of $48,000 but doesn’t give annual bonuses. The firms have also provided Clare with some information about their company benefits packages, which include 401(k) defined-contribution retirement plans and health insurance. The major differences between the two benefit packages are as follows:

•

.

Matheson pays the full cost of employee-only or family health insurance, whereas Brandis pays $200 per month toward the total cost of employee-only health insurance (currently $240 per month for single coverage, $420 for employee plus one, and $600 for a family).

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•

Matheson matches employee contributions to the 401(k) in cash, up to 3 percent of salary, while Brandis matches employee contributions to the 401(k) in company stock, up to 3 percent of salary.

A. Compare the two salary offers, assuming that the Denver cost of living is 105 percent of the national average and the Seattle cost of living is 110 percent of the national average. How should Clare take the bonus offered by Matheson into account?

Answer: First, compare the two jobs in terms of cost of living. The Seattle equivalent to the Denver $40,000 salary is $41,905, which is $6,095 less than the Seattle offer. The expected bonus in Seattle dollars is worth $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, because the firm could decide in the future to give more or less of a bonus or none at all.

Use Equation 9.2 to compare the salaries: Equivalent salary in City 1 =

COLI1 x Salary in City 2 COLI2

Denver’s Seattle equivalent salary =

110 𝑥 $40,000 = $41,904.76 105

Denver’s Seattle equivalent bonus =

110 𝑥 $5,000 = $5,238.09 105

The Seattle equivalent salary in Denver is $41,905. Even if you consider the non-guaranteed $5,000 bonus, this implies that the Seattle salary provides $857 ($48,000 Seattle salary – $41,905 Denver adjusted-salary - $5,238 adjusted-bonus) more purchasing power than the Denver salary.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic B. Are the retirement plan benefits at the two employers comparable? Why or why not?

Answer: Although both firms provide 3 percent matching, the Brandis salary is higher, so the potential contribution amount will be 0.03 x $48,000 = $1,440 compared with Matheson’s 0.03 x $40,000 = $1,200 or .03 X 45,000 (with bonus) = $1,350. 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 and whether there are time limits on doing so. Clare will also be undiversified if she has all her retirement money invested in a single company.

Sec 9.4; LO 9.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic C. Complete a comparison table or worksheet to help Clare decide between these two offers and explain your observations.

Answer: Compare monetary value of compensation and benefits and adjust for standard of living costs between locations. Remember to only consider the marginal differences between the two jobs.

.

Compensation / Benefit

Matheson with bonus (Denver)

Brandis (Seattle)

Difference Difference (no bonus) (with bonus)

Salary Bonus (not guaranteed) Adjusted for COLI1

$40,000 0 $41,905

$48,000 0 $48,000

+$6,095

$40,000 $ 5,000 $47,143

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

+$857

18

Out of pocket health insurance premium2 401K match

0

0

$ 1,200

$ 1,350

$ 480

- $480

-$480

$ 1,440

+$240

+$90

+$5,855

+$467

Total Marginal Benefit of Brandis (Seattle) Job

The Brandis offer is much better than the Matheson offer (+$5,855) if you don’t include the nonguaranteed bonus in the calculation. With the bonus included, Brandis is still better, but not significantly (+$467).

Note1: Calculation of Total adjustment for Cost-of-Living Use Equation 9.2 to compare the salaries: Equivalent salary in City 1 = Equivalent deal in Seattle is

COLI1 x Salary in City 2 COLI2

110 𝑥 $0,000 = $41,905 105

Equivalent deal with bonus in Seattle is

110 𝑥 $45,000 = $47,143 105

Note2 Calculation of the marginal difference in health insurance costs.

When making marginal comparisons, you should consider only the marginal benefit, not the total cost.

Since Matheson is paying the full cost of health insurance premiums, whereas Brandis pays $200 of the $240 per month cost, the difference in out-of-pocket will be the total premium that Clare must pay on her own. This will be ($240 - $200) x 12 months = $480 per year. This premium will be deducted from her paycheck on a pre-tax basis.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic D. How would Clare’s decision change if she needed family health insurance coverage—for example, if she were a single parent?

Answer: If Clare needed family health insurance coverage, the Matheson offer would be better than the Brandis offer by $2,160.

Solution: Compare monetary value of health insurance premiums for the employee-only ($240/month) and employee+1 ($420/month). $2,880 (annual premiums for EE-only) - $5,040 (annual premiums for EE+1) = -$2,160 difference Insurance premiums will cost $2,160 more for the additional insured. Thus, the Matheson deal will be $2,160 better.

Sec 9.1; LO 9.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

.

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CHAPTER 10 Instructor Manual & Solutions Saving for Distant Goals: Retirement and Education Funding LEARNING OBJECTIVES LO 10.1 Estimate your retirement income needs, and develop savings goals.

LO 10.2 Explain how employer-sponsored retirement plans and Social Security can help you meet your retirement goals.

LO 10.3 Explain why individual retirement accounts (IRAs) offer advantages over taxable savings accounts and annuities.

LO 10.4 Develop a plan for funding current or future education costs.

SUGGESTED COURSE PLAN You will probably need to allocate more than one week out of a typical 15–16 week semester on this chapter. For 50-minute classes, you can cover one Learning Objective in each session over 4 sessions. A suggested course plan for a class that meets twice per week: Class Period

1

2

3

Topic and Reading Assignment (by Learning Objective) LO 10.1 Retirement Needs

Suggested WileyPLUS PreClass Assignments

WileyPLUS Resources to Use in Class DP10.1 Retirement Needs

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

LO 10.2 Employer Plans & Soc. Sec., LO 10.3 IRAs & Annuities

Reflection Question 1: Soc. Sec. Reform

Interactive: Effect of Contribution Rate

Ret. Planning (PFP 10.1)

Chapter 10 Homework A: R:3-4,7-11; P:1,3-7,9,10; Case 10.2, Case10.3

LO 10.4 Education Funding

Reflection Question 3: How Well Did You Plan for Your Education Costs?

CS10.2

Education Funding (PFP 10.3)

Interactive Retirement Confidence

Adaptive Practice Ch 9 Chapter 10 Homework B: R:12-15; P:11-13, Case10.4 Adaptive Practice Ch 10

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

CHAPTER OUTLINE AND SUMMARY .

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Chapter 10 Saving for Distant Goals: Retirement and Education Funding LO 10.1 Estimate your retirement income needs, and develop savings goals.

DEVELOPING A RETIREMENT PLAN I.

WHAT ARE YOUR RETIREMENT GOALS?

II.

HOW MUCH WILL YOU NEED TO SAVE FOR RETIREMENT? A. Step 1: Estimating Retirement Expenses B. Steps 2, 3, and 4: Estimating Expected Income and Income Shortfall C. Step 5: Estimating Retirement Wealth Needed D. Steps 6 and 7: Estimating Monthly Savings Target CASE STUDY 10.1 CAMILLA HARDIN DEVELOPS A PLAN FOR RETIREMENT SAVING

III.

WHY DO SO MANY PEOPLE AVOID RETIREMENT PLANNING? A. Myopia B. Ignoring Inflation C. Focusing on Averages D. It Won’t Happen to Me

LO10.2 Explain how employer-sponsored retirement plans and Social Security can help you meet your retirement goals.

RETIREMENT INCOME FROM EMPLOYER PLANS AND SOCIAL SECURITY I.

INCOME FROM EMPLOYER-SPONSORED PLANS A. Income from DB Plans B. Income from DC Plans

II.

INCOME FROM SOCIAL SECURITY A. What Is Social Security, and How Is It Funded?

B. Who Is Eligible and When Can You Receive Benefits?

C. How Much Will Social Security Pay Me? D. Will Social Security Be Around When You Retire?

E. Causes of Projected Insolvency F. Prospects for Reform

III.

ETHICS IN ACTION: COST OF LIVING INCREASES FOR SOCIAL SECURITY BENEFICIARIES

LO 10.3 Explain why individual retirement accounts (IRAs) offer advantages over taxable

savings accounts and annuities.

INDIVIDUAL RETIREMENT SAVINGS ALTERNATIVES

.

I.

INDIVIDUAL RETIREMENT ACCOUNTS A. Traditional IRAs B. Roth IRAs C. Taxes on Benefits Received

II.

TAXABLE ACCOUNTS A. The Importance of Starting Early B. Earnings on Investment Make a Big Difference

III.

ANNUITIES

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A. Key Features of Annuities B. Taxes and Expenses C. Health and Life Expectancy D. Home Equity Loans and Reverse Annuity Mortgages IV.

NOT ON TRACK TO RETIRE?

LO 10.4 Develop a plan for funding current or future education costs.

PLANNING FOR EDUCATION COSTS I.

HOW MUCH WILL FUTURE EDUCATION COST?

II.

HOW MUCH WILL YOU NEED TO SAVE? CASE STUDY 10.2 FUNDING JAKE JOHNSON’S COLLEGE EDUCATION

III.

FINANCING HIGHER EDUCATION WITH STUDENT LOANS A. Federal Student Loans B. Private Student Loans

IV.

.

GOVERNMENT PROGRAMS TO HELP FUND EDUCATION EXPENSES A. Tax-Preferred Education Savings Plans B. Tax Credits for Education Expenses C. Other Education-Related Tax Breaks

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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. Since the survey has been in place, it has been clear that many 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 if anything, 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 decrease when her husband dies.

5. Have students calculate the amount of 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 he/she has to dip into the 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.

6. Take a poll of the class to determine how many think Social Security will be around when they retire. Usually much less than half of the class will think it will be, if your class primarily traditional-aged students. Use this to motivate a discussion of the fiscal imbalance driven by changing demographics and the difficulties Congress faces in reforming a program on which so many people rely. Although the retirement program might be easier to reform, it is difficult to find private market solutions to replace the disability and survivors benefits programs.

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 need to do to attract and retain these workers?

9. Ask the class to identify the ways in which planning for a child’s education costs is similar to planning for retirement and the ways in which they are different. Similarities include: relatively long period of time to save, costs increase over time, investment risk exposure. Differences include: retirement income needs are more uncertain (e.g. could have health issues or long-term care needs); length of the retirement period is more uncertain versus 4-5 years for college; much longer period to save for retirement (if you start early) versus 18 years for each child.

10. Discuss the pros and cons of the following strategy for higher education funding: each generation pays for the second generation to follow-- your grandparents pay for you, your parents pay for your children, and so on.

.

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CONCEPT REVIEW SOLUTIONS 1. In what ways should you take inflation into account in your retirement planning?

Answer: After estimating your retirement needs or expenses in current (or today's) dollars, you should apply the expected inflation rate to calculate the inflation-adjusted amount needed in the future. You can adjust each year's needs for inflation by calculating the future value at the appropriate inflation rate. If you do not plan for the loss of future purchasing power, you will not save enough to maintain your current standard of living.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking 2. In what ways should you take income taxes into account in your retirement planning?

Answer: Your forecasts should always be done on an after-tax basis, since you are interested in ensuring that you have enough cash flow to cover your expenses. If you know how much you need to cover expenses, you can divide the needed income by (1 – Tax rate) to find the required retirement income. You should also consider tax rules in deciding how to invest for retirement. Tax-deferred and tax-free accounts will result in a larger wealth accumulation than taxable accounts. Some of your income in retirement may be taxable if withdrawn from tax-deferred accounts. Some of it may be tax-free, for example, if you withdraw from a Roth IRA. Sec 10.1; LO 10.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. What is meant by the “three-legged stool of retirement income”?

Answer: This phrase refers to the combination of three potential sources of retirement income: (1) employer-sponsored plans, (2) Social Security, and (3) personal savings. Personal savings may include savings accounts, stock and bond investments, real property, and business assets/income. The analogy of a three-legged stool is intended to emphasize that a person’s retirement will be more stable if the person has somewhat equivalent amounts of income from each source.

Sec 10.1; LO 10.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

4. Do most retirees receive income from all three sources of the “three-legged stool of retirement income”? Why or why not? Are there any other sources of income in retirement?

Answer: Many retirees do not receive income from all three sources. While Social Security contributes about one-third of retirement income in the aggregate, on an individual basis, over one-third of retirees receive 90 percent of their income from Social Security. People who have not saved enough, do not receive pension income or have not contributed sufficient amounts to employer-sponsored retirement plans, need to supplement their retirement income in other ways.

Many retirees choose to work, either full-time or part-time, to make up the shortfall, and this source represents about 33 percent of retirement income overall. Public assistance makes up a miniscule part (4 percent) of retirement income. Income from assets represents about 11 percent.

Sec 10.1; LO 10.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

5. How can you estimate the income you’ll receive from an employer-sponsored definedbenefit plan?

Answer: A defined-benefit plan usually prescribes a formula for calculating retirement benefits up to a maximum amount. In the simplest case, it may be based on a percentage of the employee’s salary at the time of retirement (or average of highest three years' salary) multiplied by the number of years of employment. This estimation requires projecting future salary based on growth and .

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promotion assumptions. For example, if the plan provides for 1.25 percent of salary for every year of employment, a retiree earning $60,000 at the time of retirement with 30 years of service would be entitled to an annual benefit of $22,500 (=0.0125 x 30 x $60,000).

Sec 10.1; LO 10.1; BT: C; Difficulty: M; TOT: 2 min; AACSB:

6. How can you estimate how much income you’ll receive from an employer-sponsored defined-contribution plan?

Answer: Projecting income from a defined-contribution plan is difficult because a person needs to project future contributions during working years, the rate of return earned during those years, and finally the return that will be earned during retirement years. A person may withdraw variable amounts during retirement or opt for a fixed or inflation-adjusted annuity. Rates prevailing at the time of retirement will determine the amount of annuity you can purchase with the account balance. If you know the value of the portfolio at the retirement date, you can estimate the income you can receive based on one of three strategies: (1) assume you will only spend the interest and dividends earned on the account balance, in which case you can simply multiply your average rate of return times the account balance to determine the income; (2) estimate the fixed amount you can withdraw, assuming you will also spend the principal during retirement, using the PMT function on your calculator; or (3) estimate an inflation-adjusted annuity amount that you can withdraw, assuming your withdrawals will increase with inflation each year and you will deplete the account balance over time. For the latter calculation, you will also use the PMT function on the calculator but will use an inflation-adjusted rate of return as the interest rate. If you assume that the inflation rate and your investment return will be approximately equal, you can simply divide the account balance by the number of years you expect to be in retirement to arrive at the amount you can withdraw each year.

Sec 10.2; LO 10.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

7. What financial problems are projected for the Social Security system, and what are the causes of these problems?

Answer: The Social Security system was designed as a pay-as-you-go system in which the benefits paid to retirees were paid out of taxes currently collected from participating workers.

Although taxes collected have exceeded benefits paid for many years, accumulating in the Social Security Trust Fund, demographic changes will cause future problems. With the retirement of the baby boomers, Social Security will soon be in the position of taking in less than it is paying out.

Long-term actuarial calculations show that the system is in imbalance, such that expected benefits to be paid out exceed the expected taxes that will be collected. The accumulated funds in the Trust Fund will cover some of the deficit, but unfortunately, these assets represent IOUs of the U.S. government. The government will need to come up with the funds to pay back to the Social Security Trust Fund, most likely by raising taxes. Furthermore, retirees are living longer and putting an additional burden on the system. Congress, in order to appease its voting constituency, has increased benefits instead of decreasing them and has been unwilling to increase taxes or raise the retirement age substantially.

Sec 10.2; LO 10.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

8. Explain the similarities and differences between a traditional deductible IRA and a Roth IRA.

.

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Answer: Similarities: (1) both were created to provide incentives to save in order to accumulate funds for retirement and supplement other sources of income; (2) both provide tax advantages; (3) both impose penalties for early withdrawals; (4) both impose limits on the amount of contribution. Differences: (1) traditional IRA contributions are tax deductible when made, but withdrawals are fully taxable in the future; (2) Roth IRA contributions are made from after-tax dollars, and all future withdrawals are not taxed; (3) traditional IRA contribution is affected by employer-sponsored qualified retirement plans; (4) income limits are higher under Roth.

Sec 10.3; LO 10.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

9. What is the penalty for withdrawing your money from a tax-deferred retirement account prior to retirement age? Are there any exceptions to this rule?

Answer: The penalty for early withdrawals (before age 59½) is 10 percent of the amount withdrawn in addition to payment of applicable income taxes. The penalty is, however, waived if funds are used for qualified educational, medical, or first-time home purchase expenses.

Sec 10.3; LO 10.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

10. Use an example to illustrate how investing in a tax-deferred account can give you a better outcome than investing in a taxable account.

Answer: Examples will differ but should show that the tax-deferred account results in higher accumulation. Suppose you invest in a fund that offers 8 percent annual return and the investment horizon is 20 years. Assume that you start with $1,000 in pretax income, and your marginal tax rate is 30 percent. You can invest the full $1,000 in the tax-deferred account but will only be able to invest $700 per year in the taxable account ($1,000 X (1-.30) = $700). Similarly, your rate of return for tax-deferred account will be the full 8 percent whereas the annual return on the taxable account will be 5.6% after taxes (=8% X (1 - .30)). After 20 years, the taxable account will grow to $24,669.64 despite paying 30% taxes on income earned and income received from interest. The tax-deferred account will grow to $32,033.38, after paying the 30% tax at the end of 20 years to compare after-tax balances.

Calculation of the future value of $1,000 pre-tax earnings invested annually over 20 years at a 8% pre-tax APY. Financial Calculator: Taxable account: Input PMT=-700, I/Y=5.6, N=20, and solve for FV = $24,669.64 Tax-deferred account: Input PMT=-1000, I/Y=8, N=20, and solve for FV = $45,761.96 Net from tax-deferred account after taxes paid: 45,761.96 x (1 - .3) = $32,033.38 Excel Spreadsheet: TVM Function is =FV(rate,nper,pmt,pv,type) Taxable account: =FV(0.056, 20, -700, 0) => $24,669.64 Tax-deferred account: =FV(0.08, 20, -1000, 0) => $45,761.96 TVM Equation: FVA = PMT 𝑥

(1+𝑖)𝑛 -1

Taxable account: FVA = 700 𝑥

𝑖 (1.056)20 -1 .056

Tax-deferred account: FVA = 1000 𝑥

= $24,669.64

(1.08)20 -1 .08

= $45,761.96

Sec 10.3; LO 10.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

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11. Comment on the validity of the following statement: “Once I retire, I won’t have to worry about my investments anymore.”

Answer: This statement is incorrect. Most people will be retired for twenty to thirty years. They will need to continue to manage their money during that period to ensure that their income keeps up with their increasing expenses. A small number of people may have only annuity income from pensions and Social Security, in which case they may not have much wealth to manage.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

12. Describe the planning process for funding your children’s education. How is this similar to the retirement planning process?

Answer: Funding for your child's education is very similar to retirement planning, except that you generally have less time to save (18 years or less). The process involves projecting college costs at a realistic rate of inflation and calculating the future value of required savings (after adjusting for other sources of education funds). This future target account value is then used to estimate the amount of annual or monthly savings required to meet the funding goal. After implementing the savings plan, it must be monitored, and adjusted over time to reach target values.

Sec 10.4; LO 10.4; BT: C; Difficulty: E; TOT: 2 min; AACSB:

13. Explain the similarities and differences between Roth IRAs and Coverdell Education Savings Accounts.

Answer: Coverdell plans are similar to Roth IRAs in that contributions are made from after-tax dollars, and withdrawals for qualified purposes, such as K-12 and college tuition, board, and books, are not taxed. Withdrawals for nonqualified purposes are subject to a 10 percent penalty, and there are income limits that apply. Contributions are limited to $2,000 per year per child, whereas Roth IRA contributions in 2016 were limited to $5,500 ($6,000 for those aged 50 or over).

Sec 10.4; LO 10.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

14. What types of tax incentives are offered for funding higher education?

Answer: Three types of tax incentives for funding higher education are: (1) American Opportunity Tax credit, which allows a taxpayer to claim up to $2,500 for a dependent's education expenses in the first four years of college if the student is enrolled at least half-time; (2) Lifetime Learning tax credit, which allows a taxpayer to claim 20 percent of the first $10,000 of tuition and fees, including graduate school, with a maximum of $2,000 per year per person; and (3) a tax deduction whereby people who have taken out student loans may be eligible to deduct the interest from their taxable income, lowering the overall cost of their education. This is not a tax credit, which directly reduces taxes by the amount of the tax credit. All three benefits are phased out after specified income thresholds.

Sec 10.4; LO 10.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

15. When is the best time to begin planning for your children’s education? Explain.

Answer: As the adage goes, it is never too early to save. The earlier you start, the lower the payments will be. Education planning should start as soon as the child is born, and couples can even start saving earlier if their finances allow them to do so. If savings have a longer period to accumulate, any unforeseen events, such as a market crash or an employment disruption, can be handled more easily, with enough time available to recover from the financial setback. Tax-

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advantaged plans such as Coverdell and 529 plans can be started only after the child is born, however.

Sec 10.4; LO 10.4; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

16. Al and Janet Fernandez have two alternatives for financing their son Joel‘s college costs— an unsubsidized federal student loan with a variable rate of 5.05 percent or a fixed-rate home equity loan at 6 percent. Assume that both loans will have 10-year terms for repayment. What factors should they consider in deciding between these two alternatives?

Answer: The answer to this question depends on expectations of interest rates over the 10-year period. Although the 6% home equity loan rate is higher than the 5.05% student loan, future loans for the same student may be at higher rates, so locking in the home equity rate at 6 may end up being better. Some student loan interest is tax deductible, but these rules are subject to change by Congress, so are not guaranteed to apply throughout the loan period.

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

17. What are the differences and similarities between subsidized and unsubsidized federal direct student loans?

Answer: Both types of loans are disbursements from the federal government and the rates are set annually. Subsidized student loans, which are based on financial need, do not accrue interest until after graduation, whereas the unsubsidized loans begin to accrue interest upon disbursement.

Sec 10.4; LO 10.4; BT: C; Difficulty: E; TOT: 1 min; AACSB:

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APPLICATION PROBLEM SOLUTIONS 1. Alonzo plans to retire at age 67. His current expenses are $40,000, and he expects 3 percent inflation from now until retirement. Use the replacement ratio method to estimate Alonzo’s pretax retirement income needs in the first year of retirement, assuming that he is now 22 years old and will need to replace 80 percent of his final salary. Round to the nearest dollar.

Answer: $121,011 Solution: Alonzo will retire in 45 years (67 – 22). His pre-retirement annual expenses will be $151,264.

His annual expenses in his first year of retirement will need to be $121,011 (80% of pre-retirement expenses).

Calculation of the FV of $40,000 pre-tax annual expenses over 45 years @ 3% inflation.

Financial Calculator: Input PV=-40,000, I/Y=3, N=45, and solve for FV = $151,263.83 Excel Spreadsheet: TVM Function is =FV(rate,nper,pmt,pv,type) =FV(0.03, 45, 0, -40000, 0) => $151,263.83 TVM Equation: FV = PV x (1+i )n FV = $40,000 x (1.03)45 = $151,263.83 * Expenses for 1st year of retirement = $151,263.83 pre-retirement x 0.80 adjustment = $121,011.06 Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

2. Sophia plans to retire at age 67 and she expects 3 percent inflation from now until retirement. Her current expenses are $40,000. Use the adjusted expense method to estimate Sophia’s pretax retirement income needs in the first year of retirement (in future dollars), assuming she is currently 22 years old. Assume that the reduction in expenses for employment costs and mortgage payments will save her $15,000 per year in current dollars and that her additional costs for insurance and vacations will be $10,000.

Answer: $132,356 Solution: To find Sophia’s expenses in retirement, adjust her current annual expenses ($40,000) by reducing it for the lower employment costs and mortgage payments (-$15,000) and adding her additional costs for insurance and vacations (+$10,000). Expected expenses in retirement are: $40,000 current expenses - $15,000 employment expenses + $10,000 insurance and vacations = $35,000. Then calculate the FV of her expected expenses in retirement for 45 years at 3% inflation.

Calculation of the FV of $35,000 over 45 years @ 3% inflation.

Financial Calculator: Input PV=-35,000, I/Y=3, N=45, and solve for FV = $132,355.85 Excel Spreadsheet: TVM Function is =FV(rate,nper,pmt,pv,type) .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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=FV(0.03, 45, 0, -35000, 0) => $132,355.85 TVM Equation: FV = PV x (1+i )n FV = $35,000 x (1.03)45 = $132,355.85 Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

3. Mark is a 30-year-old professional who earns $50,000 per year and will retire at the normal Social Security retirement age for his birth date (67). Use Table 10.4 to estimate Mark’s first-year Social Security benefit in future dollars.

Answer: $84,648 Solution: Use Table 10.4 (Annual Social Security Benefit Estimates, 2019). The table estimates Social Security retirement benefits beginning at 67 years old (NRA). Look at the intersection of $50,000 (2019 income) and 30 (age in 2019): $84,648. This can also be estimated using the Social Security Quick Calculator, although exact answers may differ slightly from the table: https://www.ssa.gov/OACT/quickcalc/index.html.

Sec 10.2; LO 10.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

4. Larissa worked as a homemaker until she was 50. Since then, she has worked parttime as a retail clerk, and she is now ready to retire at age 65. Based on their earnings records, her husband’s Social Security PIA is $2,000, and hers is $500. What will Larissa’s Social Security benefit be?

A. $1,000 B. $1,250 C. $500 D. $0 Answer: $1,000 Explanation: Larissa’s benefit will be the greater of her own qualified benefit ($500) or 50 percent of her husband’s benefit ($1,000). Larissa is eligible for only a very small benefit based on her own earnings history, but will receive a much larger benefit based on her husband’s earnings.

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Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

5. Janelle’s estimated retirement income shortfall is $18,000, and she expects to live 40 years in retirement. If she can earn 6 percent per year on her investments during retirement and wants her retirement income to increase by 4 percent per year during retirement to offset inflation, how much does she need to have saved by the time she retires? You can use Equation 10.4 to solve this problem, or refer to Table 10.1.

A. $479,911 B. $437,934 C. $572,464 D. $512,302 Answer: $479,911 Solution: Calculate the PV of an inflation-adjusted annuity for 40 years in retirement beginning with a payment of $18,000 at 6% APY and 4% inflation rate. You can by either Equation 10.4, or you can reference Table 10.1 to find the retirement wealth factor (26.66171) and multiply it $18,000 to compute the present value of an inflation-adjusted annuity that can last for her retirement (479,910.84).

Calculation of retirement wealth factor for 40 years at 6% APY and 4% inflation rate. 𝑃𝑀𝑇

1+𝑖 𝑛

Equation 10.4 (PV of an inflation-adjusted $1 annuity): 𝑟− 𝑖 x [1 − (1+𝑟) ] $18000

1.04 40

Retirement wealth factor = .06− .04 x [1 − (1.06) ] = $479,911 Table 10.1 (Retirement Wealth Factors for Estimating Retirement Savings Goal, Assuming 4 Percent Inflation)

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* $18,000 (expected annual shortfall) x 26.66 (factor from table) = $479,880. This is slightly lower than the exact calculation using the formula due to rounding of the retirement wealth factor.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

6. What annual contribution will you need to make to your retirement fund, assuming your retirement wealth goal is $500,000 and you’ll earn 6 percent on your investments for the next 40 years? Round to the nearest dollar.

Answer: $3,231 Solution: Calculate the annuity contribution required to achieve $500,000 in 40 years at 6% APY. Financial Calculator Enter PV = 0, FV = 500,000, N = 40, I/Y = 6, and solve for PMT = -3,230.77 ~ $3,231 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT(0.06, 40, 0, 500000,0) => -3,230.77 ~ $3,231 Equation 2.9 FVA = PMT 𝑥

(1 + 𝑖)𝑛 -1 𝑖

$500,000 = PMT 𝑥

(1+0.06)40 -1 0.06

= $3,230.77 = ~ $3,231

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

7. Fred has just started a new job. His employer requires that he contribute 2 percent of his salary to a qualified retirement plan and will fully match any additional contributions up to 3 percent. Fred’s salary isn’t very high ($32,000), so he’s thinking about contributing just the 2 percent minimum. What percentage of his salary does Fred need to contribute to get the maximum contribution from his employer?

Answer: 5% Solution: The employer will not match the first 2% of contribution. After that the employer will match dollar for dollar (100%) up to a maximum of 3% of salary. Therefore, Fred needs to contribute 2% + 3% = 5% of salary to get the employer's 3% match. This amounts to $1,600 (0.05 contribution x $32,000 salary).

Sec 10.2; LO 10.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

8. Tom is contributing 2% of his $32,000 salary to his employer retirement plan. Calculate the future value of his first-year contribution, assuming that his account will earn 10 percent per year until retirement in 40 years. Round to the nearest dollar.

Answer: $28,966

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Solution: Calculate the future value of Tom’s $640 contribution ($32,000 salary x 0.02) over 40 years at 10% APY. Financial Calculator Enter PV = -640, N = 40, I/Y = 10, and solve for FV = 28,965.92 ~ $28,966 Excel Spreadsheet Function =FV(rate,nper,pmt,pv,type) =FV(0.10, 40, 0, -640, 0) => 28,965.92 ~ $28,966 Equation 2.8 Future value of lump-sum. FV = PV x (1+i)n FV = $640 x (1+0.10)40 = $28,965.92 ~ $28,966 Sec 10.2; LO 10.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

9. Miguel has just opened a Section 529 plan to save for his daughter’s college education. If he contributes $1,600 per year and earns a 6% annual rate of return, how much will he have accumulated by the time she starts college in 13 years (rounded to the nearests dollar)?

Answer: $30,211 Solution: Calculate the future value of Miguel’s $1,600 contributions over 13 years at 6% APY. Financial Calculator Enter PMT = -1,600, N = 13, I/Y = 6, and solve for FV = 30,211.42 Excel Spreadsheet Function =FV(rate,nper,pmt,pv,type) =FV(0.06, 13, -1600, 0,0) => 30,211.42 Equation 2.8 Future value of lump-sum. FVA = PMT 𝑥 FVA = 1600 𝑥

(1.06)13 -1 .06

(1+𝑖)𝑛 -1 𝑖

= $30,211.42

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

10. You are currently 37 years old, and you plan to retire in 30 years. You estimate that you need to accumulate an additional $1 million by the time you retire in order to fund your retirement income shortfall.

A. If your invested funds will earn 6 percent per year, how much do you need to save each month?

Answer: $995.51 Solution: Calculate the monthly annuity contribution required to reach $1,000,000 in 30 years at 6% APY. Financial Calculator Enter PV = 0, FV = 1,000,000, N = (30x12), I = (6/12), and solve for PMT = -995.51 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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=PMT((0.06/12), (30*12), 0, 1000000, 0) => -995.51 TVM Equation 2.9 FV of an annuity: FVA = PMT x $1,000,000 = PMT 𝑥

(1+𝑖)𝑛 -1 𝑖

(1 + 0.005)360 -1 Solve for PMT = $995.51 0.005

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic B. If your invested funds will earn 8 percent per year, how much do you need to save each month?

Answer: $670.98 Solution: Calculate the monthly annuity contribution required to reach $1,000,000 in 30 years at 8% APY. Financial Calculator Enter PV = 0, FV = 1,000,000, N = (30x12), I = (8/12), and solve for PMT = -670.98 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT((0.08/12), (30*12), 0, 1000000, 0) => -670.98 TVM Equation 2.9 FV of an annuity: FVA = PMT x $1,000,000 = PMT 𝑥

(1+𝑖)𝑛 -1 𝑖

(1 + 0.00667)360 -1 Solve for PMT = $670.98 0.00667

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 11. Based on your estimates, you’ll need $40,000 per year to cover your expenses after you retire this month. You expect your expenses to increase with inflation at 4 percent per year, and you hope to live 30 years after retiring. How much retirement wealth do you need to have now if you’ll invest your funds to earn 5 percent per year?

A. $998,204 B. $870,583 C. $1,138,450 D. $973,186 Answer: $998,204 Solution: Calculate the PV of an inflation-adjusted for 30 years in retirement with an initial

payment of $40,000 at 5% APY and 4% inflation rate. You can use Equation 10.4 to get the exact answer or reference Table 10.1 for an approximation, multiplying the retirement wealth factor (24.96) by the expected annual shortfall in the first year of retirement ($40,000) to compute the present value of an inflation-adjusted annuity that can last for her retirement ($998,400). .

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Calculation of retirement wealth for 40 years at 5% APY and 4% inflation rate.

Equation 10.4 (PV of an inflation-adjusted annuity): $40,000

1.04 30

$𝑃𝑀𝑇 𝑟− 𝑖

1+𝑖 𝑛

x [1 − (1+𝑟) ]

Retirement wealth factor = .05− .04 x [1 − (1.05) ] = 998,204 Table 10.1 (Retirement Wealth Factors for Estimating Retirement Savings Goal, Assuming 4 Percent Inflation)

* $40,000 (expected annual shortfall) x 24.96 (factor) = $998,400 Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

12. Loveta has saved $250,000 and is ready to retire. She expects to earn 5 percent per year on her investments.

A. How much annual cash flow will this investment generate, assuming that Loveta doesn’t want to touch the principal?

Answer: $12,500 Solution: Loveta can spend her annual earnings and not touch the principal of her savings.

Multiply her savings ($250,000) by the percentage (0.05) she expects to earn from it: $250,000 savings x 0.05 earnings rate = $12,500 earnings.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

B. How much annual cash flow will this investment generate, assuming that Loveta wants to withdraw equal annual payments over the next 20 years and have zero left at the end?

Answer: $20,061 .

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Solution: Calculate the annual annuity payments that she can receive from her $250,000 present value based on 20 years at 5% APY. Financial Calculator Enter PV = 250,000, FV = 0, N = 20, I/Y = 5, and solve for PMT = -20,060.65 ~ 20,061 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT(0.05, 20, 250000, 0, 0) => -20,060.65 ~ 20,061 TVM Equation 2.12 Annuity Payment: PMT = PVA x

0.05

PMT = $250,000 𝑥

1

1 − ((1+0.05))

20

𝑖 1−(

𝑛 1 (1+𝑖))

= $20,060.65

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. Tom decides to get an early start on retirement saving. Beginning at age 22, he invests $3,000 per year in a Roth IRA for 10 years in a row. At that point, he stops contributing to the account but leaves the money invested until age 65 (a period of 33 years). Harry doesn’t start investing until he’s 32 but from then on, invests $3,000 in a Roth IRA each year for 33 years until retirement at age 65. If both men earn 10 percent per year on their investments, compounded annually, which one has more in the account when he reaches age 65?

Drop Down Choices: Tom, Harry, Same Answer: Tom Solution: Calculate the future value of Tom and Harry’s Roth IRA accounts. Tom will have $1,110,447 after 10 years of contributions ($30,000), but 43 years invested. Harry will have $666,755 after 33 years of contributions ($99,000) and in the market for 33 years. This suggests that the number of years invested at 10% APY is more valuable than the amount of total contributions.

Tom’s Roth IRA Account Financial Calculator Initial 10 years: Enter PMT = -3,000, N = 10, I/Y = 10, PV = and solve for FV = 47,812.27 Last 33 years: Enter PV = -47,812.27, N = 33, I/Y = 10, and solve for FV = 1,110,447.35 Excel Spreadsheet Function: =FV(rate,nper,pmt,pv,type) Initial 10 years: =FV(0.10, 10, -3000, 0, 0) => 47,812.27 Last 33 years: =FV(0.10, 33, 0, -47812.27, 0) => 1,110,447.35 TVM Equation

(1+𝑖)𝑛 -1

Equation 2.9: Future Value of an Annuity: FVA = PMT x (1 + 0.10)10 -1 Initial 10 years: FVA = $3,000 𝑥 = $47,812.27 0.10

𝑖

Equation 2.8: Future Value of a Lump Sum: FV = PV x (1+i)n .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Last 33 years: FV = $47,812.27 x (1+0.10)33 = $𝟏, 𝟏𝟏𝟎, 𝟒𝟒𝟕. 𝟑𝟓 𝐇𝐚𝐫𝐫𝐲’𝐬 𝐑𝐨𝐭𝐡 𝐈𝐑𝐀 𝐀𝐜𝐜𝐨𝐮𝐧𝐭 Financial Calculator Enter PMT = -3,000, N = 33, I/Y = 10, PV = and solve for FV = 666,754.63 Excel Spreadsheet Function: =FV(rate,nper,pmt,pv,type) =FV(0.10, 33, -3000, 0, 0) => 666,754.63 TVM Equation Equation 2.9: Future Value of an Annuity: FVA = PMT x (1 + 0.10)33 -1 FVA = $3,000 𝑥 = $𝟔𝟔𝟔, 𝟕𝟓𝟒. 𝟔𝟑 0.10

(1+𝑖)𝑛 -1 𝑖

Sec 10.3; LO 10.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

14. Your child is 8 years old. You anticipate that he’ll go to an in-state public university in 10 years. The current cost of one year of school is $25,000, and you estimate that costs will increase by 6 percent per year for the next 10 years. Estimate the cost of education when your child starts his first year of college? Round to the nearest dollar.

Answer: $44,771 Solution: Calculate the future value of $25,000 in 10 years at an inflation rate of 6%.

Financial Calculator Enter PV = -25,000, N = 10, I/Y = 6, and solve for FV = 44,771.19 Excel Spreadsheet Function =FV(rate,nper,pmt,pv,type) =FV(0.06, 10, 0, -25,000, 0) => 44,771.19 Equation 2.8 Future value of lump-sum. FV = PV x (1+i)n FV = $25,000 x (1+0.06)10 = $44,771.19 Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

15. Your college-funding target is to accumulate four times the expected cost of college when your child starts school. You estimate that the first year of school will cost $43,000.

Calculate the amount you would need to save each year for 10 years to fully fund this future cost, assuming that you will earn 8 percent on a tax-deferred investment.

A. $11,873 B. $17,200 C. $15,040 D. $2,968 Answer: $11,873 .

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Solution: Calculate the annual annuity payments required to achieve $172,000 ($43,000 expected annual cost of college x 4) in 10 years at a 8% APY. Financial Calculator Enter PV = 0, FV = 172,000, N = 10, I/Y = 8, and solve for PMT = -11,873.07 ~ 11,873 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT(0.08, 10, 0, 172000, 0) => -11,873.07 ~ 11,873 TVM Equation 2.12 Annuity Payment: FVA = PMT x

$172,000 = PMT 𝑥

(1 + 0.08)10 -1 = $11,873.07 0.08

(1+𝑖)𝑛 -1 𝑖

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

16. Assume that the first-year cost of attending college is currently $15,000 and that this cost is increasing at a rate of 5 percent per year. What amount is needed now to fund four years of college, assuming that your invested funds earn 5 percent per year after taxes and you plan to begin school this year. Round to the nearest dollar.

Answer: $60,000 Solution: If the annual cost is increasing at the same rate as your investment return, you can simply multiply the annual cost by 4 to arrive at the total.

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

17. You estimate that you will need $80,000 by the time you start college in six years. How much do you need to save each year to meet this goal, assuming that your savings will earn 5 percent per year? Round to the nearest dollar.

Answer: $11,761 Solution: Calculate the annual annuity payments required to achieve $80,000 in 6 years at a 5% APY. Financial Calculator Enter PV = 0, FV = 80,000, N = 6, I/Y = 5, and solve for PMT = -11,761.40 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT(0.05, 6, 0, 80000, 0) => -11,761.40 TVM Equation 2.12 Annuity Payment: FVA = PMT x

(1 + 0.05)6 -1 $80,000 = PMT 𝑥 = $11,761.40 0.05

(1+𝑖)𝑛 -1 𝑖

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

18. You estimate that you’ll need to have saved $90,000 to fund your child’s future college education in 12 years. How much do you need to save each month to reach this goal, if you expect your savings to earn 6 percent per year? .

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

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Answer: $428.27 Solution: Calculate the monthly annuity payments required to achieve $90,000 in 12 years (144 payments) at a 6% APY (0.50% monthly periodic rate).

Financial Calculator Enter PV = 0, FV = 90,000, N = 144, I/Y = 0.50, and solve for PMT = -428.27 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT(0.005, 144, 0, 90000, 0) => -428.27 TVM Equation 2.12 Annuity Payment: FVA = PMT x

(1+𝑖)𝑛 -1

(1 + 0.005)144 -1 $90,000 = PMT 𝑥 = $428.27 0.005

𝑖

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

19. Assume that you are ready to retire at the normal retirement age in 2019. Your average indexed monthly earnings (AIME) is $6,000. What is your primary insurance amount (PIA) using the 2019 Social Security benefit formula, and what percentage of your preretirement income will be replaced by Social Security, assuming that you earned $6,000 per month in your last year of work?

A. PIA is $2,386 and replacement rate is 40% B. PIA is $2,324 and replacement rate is 39% C. PIA is $1,974 and replacement rate is 33% D. PIA is $1,490 and replacement rate is 25% Answer: A. PIA $2,386 and replacement rate 40% Solution: Calculate the PIA based on the 2019 Social Security benefit formula, then divide it into the last monthly income.

(Equation 10.5) PIA = [0.9 × (First $926 of AIME)] + [0.32 × (AIME up to $5,583 − $926)] + [0.15 × (AIME − $5,583)] PIA = (0.9 ×$926) + (0.32 ×$4,657) + (0.15 ×$417) = $2,386.19 ~ $2,386 𝑃𝐼𝐴 $2,386.19 = = 0.3977 ~ 39.77% ~ 𝟒𝟎% 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐼𝑛𝑐𝑜𝑚𝑒 $6,000 Sec 10.2; LO 10.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

20. Rich was laid off three months ago and has exhausted his emergency funds. His new job doesn’t pay enough to cover his expenses, so he’s had to withdraw $15,000 from his IRA.

.

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If his marginal tax rate is 20 percent, how much of this money will he actually have available to use after penalties and taxes?

Answer: $10,500 Solution: A withdrawal prior to age 59 ½ from a traditional IRA will be subject to a 10% penalty and ordinary income tax. Rich’s $15,000 premature withdrawal is subject to 20% marginal tax rate and a 10% penalty.

Ordinary income tax (20%) = $15,000 × 0.20 = $3,000 Pre-mature withdrawal penalty (10%) = $15,000 × 10% = $1,500 Total taxes assessed on $15,000 withdrawal = $3,000 + $1,500 = $4,500 Remaining funds after taxes = $15,000 - $4,500 taxes = $10,500 Sec 10.3; LO 10.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

21. Luciana has just graduated from college and she will have to begin making student loan payments soon. If her total debt is $20,000 and the loan rate is 6% for 10 years, how much will her monthly payment be?

Answer: $222.04 Solution: Calculate the monthly loan payments required to pay off a $20,000 loan in 10 years (120 payments) at a 6% APR (0.50% monthly periodic rate).

Financial Calculator Enter PV = 20,000, FV = 0, N = 120, I/Y = 0.50, and solve for PMT = -222.04 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT(0.005, 120, 0, 20000, 0) => -222.04 TVM Equation 2.12 Annuity Payment: PMT = PVA x

0.005

PMT = $20,000 𝑥 1−(

1

𝑖 1−(

𝑛 1 (1+𝑖))

120 = $222.04

) (1+0.005)

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

.

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CASE APPLICATION SOLUTIONS 1. Ernie Chu, currently age 27, has just taken a job as an instructor at a large public university.

His starting salary is $50,000, and he has been told that salary increases have averaged 4 percent per year. After looking at the benefits package, he learns that the state recently changed its retirement plan from a defined-benefit plan, which paid retirees up to 70 percent of final salary with cost-of-living adjustments, to a defined-contribution plan. Participants contribute 8 percent of their salary to the plan, and the state contributes another 9 percent, all of which can be invested in a variety of mutual funds. Assume that Ernie and his employer contribute a combined 17 percent of his salary each year until he retires. He also finds that his employer is exempt from Social Security, so he won’t have to pay the retirement portion of the payroll tax. Assume that Ernie works for a total of 40 years.

A. How much is his salary at years 10, 20, 30, and 40, respectively, if salaries at the university continue to grow at 4 percent per year?

Answer: $74,012 in 10 years; $109,556 in 20 years; $162,170 in 30 years; $240,051 in 40 years Solution: Calculate the future value of his $50,000 current salary based on 4% annual raise.

Financial Calculator 10 years: Enter PV = -50,000, N = 10, I/Y = 4, and solve for FV = 74,012.21 20 years: Enter PV = -50,000, N = 20, I/Y = 4, and solve for FV = 109,556.16 30 years: Enter PV = -50,000, N = 30, I/Y = 4, and solve for FV = 162,169.88 40 years: Enter PV = -50,000, N = 40, I/Y = 4, and solve for FV = 240,051.03 Excel Spreadsheet: Function: =FV(rate,nper,pmt,pv,type) 10 years: =FV(0.04, 10, 0, -50000, 0) => 74,012.21 20 years: =FV(0.04, 20, 0, -50000, 0) => 109,556.16 30 years: =FV(0.04, 30, 0, -50000, 0) => 162,169.88 40 years: =FV(0.04, 40, 0, -50000, 0) => 240,051.03 TVM Equation: FV of lump-sum: FV = PV x (1+i)n 10 years: FV = $50,000 x (1+0.04)10 = $74,012.21 20 years: FV = $50,000 x (1+0.04)20 = $109,556.16 30 years: FV = $50,000 x (1+0.04)30 = $162,169.88 40 years: FV = $50,000 x (1+0.04)40 = $240,051.03 Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

B. If Ernie had been able to participate in the defined-benefit plan and was eligible to receive the maximum benefit, how much would it be?

Answer: $168,036 Solution: Ernie’s maximum benefit under the defined-benefit plan would have been 70% of his final salary at 40 years. $240,051 final salary x 0.70 = $168,036.

Calculation of final salary ($50,000 current salary; 4% annual raise; 40 years of service) Financial Calculator Enter PV = -50,000, N = 40, I/Y = 4, and solve for FV = 240,051.03 .

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Excel Spreadsheet: Function: =FV(rate,nper,pmt,pv,type) =FV(0.04, 40, 0, -50000, 0) => 240,051.03 TVM Equation: FV of lump-sum: FV = PV x (1+i)n FV = $50,000 x (1+0.04)40 = $240,051.03 Sec 10.2; LO 10.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic C. Assuming that he started work on January 1, what is Ernie’s first-year contribution to his retirement plan, including funding from both himself and his employer?

Answer: $8,500 Solution: His first-year contribution is 8% x $50,000 = $4,000, and his employer’s contribution is 9% x $50,000 = $4,500, for a total of $8,500 combined contribution.

Sec 10.2; LO 10.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

D. Estimate the amount Ernie will have in his retirement account in 40 years, assuming that his investments earn an average rate of 4 percent per year (the same as the rate of increase in his contributions to the account) and he makes beginning-of-year contributions. To do this, you can use the following shortcut: if a contribution increases each year at the same rate as the annual investment return on the account, the future value of the account can be calculated as: FV = n × Initial PMT × (1 + i)n (for beginning-ofyear contributions) and FV = n x initial PMT x (1+i)n–1 (for end-of-year contributions).

Answer: $1,632,347 Solution: Using the formula provided in the problem, FV = n × Initial PMT × (1 + i)n (for beginning-of-year contributions). His first-year contribution is 8% x $50,000 = $4,000, and his employer’s contribution is 9% x $50,000 = $4,500, for a total of $8,500 combined contribution.

FV = 40 x $8,500 x (1.04)40 = $1,632,347.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

E. Assuming that Ernie will live for 25 years in retirement and will continue to earn 4 percent on his investments, what constant level of income could he generate if he had retirement wealth of $1.6 million and wants to spend down both interest and principal? What difference would it make if he wants to be able to increase his withdrawals by 3 percent each year for inflation?

Answer: $102,419; he must withdraw smaller amounts in the early years in order to have enough left for higher expenses in later years of retirement.

Solution: Calculate the fixed annuity amount that he can produce with his $1.6 million present value, over 25 years in retirement, earning 4% APY. Financial Calculator Enter PV = -1,600,000, FV = 0, N = 25, I/Y = 4, and solve for PMT = 102,419.14 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) .

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23

=PMT(0.04, 25, -1600000, 0, 0) => 102,419.14 TVM Equation 2.12 Annuity Payment: PMT = PVA x

0.04

PMT = $1,600,000 𝑥 1−(

1

𝑖 1−(

𝑛 1 (1+𝑖))

25 = $102,419.14

) (1+0.04)

If Ernie wants to increase withdrawals each year with inflation, he will have to start off with a lower level of withdrawl. To estimate how much he can withdraw in the first year and have enough to increase his withdrawals each year with inflation, he can use Equation 10.4 and solve for first-year income.

Equation 10.4: PV of an Inflation-adjusted Annuity = $1,600,000 =

First−year income .04− .03

𝑥 [1 − (

First−year income 𝑡−𝑖

𝑥 [1 − (

1+𝑖 𝑛 1+𝑟

) ]

1.03 25

) ] = $74,561

1.04

You can also approximate this solution with a financial calculator and replacing the I/Y with the investment return minus the inflation rate (r – i = 1%).

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

F. Based on this analysis, is Ernie better off with the defined-contribution plan? Why or why not? What risk does he face now that he wouldn’t have faced with the defined-benefit plan?

Answer: 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 percent on average, he might be able to do better with the defined-contribution 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 decrease the risk of his portfolio as he gets closer to retirement.

Solution: The defined benefit plan would pay $168,036 per year until death. The defined contribution plan would pay $104,489.74 for 25 years.

Defined Benefit Plan Ernie’s maximum benefit under the defined-benefit plan would have been 70% of his final salary at 40 years. $240,051 final salary x 0.70 = $168,036.

Calculation of final salary ($50,000 current salary; 4% annual raise; 40 years of service) Financial Calculator Enter PV = -50,000, N = 40, I/Y = 4, and solve for FV = 240,051.03 Excel Spreadsheet: Function: =FV(rate,nper,pmt,pv,type) =FV(0.04, 40, 0, -50000, 0) => 240,051.03 TVM Equation: FV of lump-sum: FV = PV x (1+i)n FV = $50,000 x (1+0.04)40 = $240,051.03

.

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Defined Contribution Plan Using the formula provided in the previous problem, FV = n × Initial PMT × (1 + i)n (for beginning-of-year contributions). His first-year contribution is 8% x $50,000 = $4,000, and his employer’s contribution is 9% x $50,000 = $4,500, for a total of $8,500 combined contribution.

FV = 40 x $8,500 x (1.04)40 = $1,632,347.

Calculate the annuity amount that he can produce with his $1,632,347 present value, over 25 years in retirement earning 4% APY. Financial Calculator Enter PV = -1,632,347, FV = 0, N = 25, I/Y = 4, and solve for PMT = 104,489.74 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) =PMT(0.04, 25, -1632347, 0, 0) => 104,489.74 TVM Equation 2.12 Annuity Payment: PMT = PVA x

PMT = $1,632,347 𝑥

0.04 1

1 − ((1+0.04))

𝑖 1−(

𝑛 1 (1+𝑖))

25 = $𝟏𝟎𝟒, 𝟒𝟖𝟗. 𝟕𝟒

Sec 10.1; LO 10.1; BT: An; Difficulty: M; TOT: 2 min; AACSB: Analytic

2. Henry decided to take early retirement at age 55 to care for his wife, Ada, who was in poor health. Because he was certain he’d outlive Ada, he convinced her that they should take the pension payout as a single life annuity for his lifetime instead of a joint and survivor annuity.

The difference in the monthly payment was substantial—he’d get $2,500 per month instead of only $1,700 with the joint and survivor annuity. To save money, Henry also reduced the amount of his life insurance policy. When he was 57, Henry had a heart attack during his daily five-mile run and died.

A. What benefit will Ada be eligible for under Henry’s pension?

Answer: Ada will receive nothing. Because he took the single life annuity, the payments will end when he dies. She would have been eligible to continue receiving the annuity payments only if it had been a joint and survivor annuity.

Sec 10.3; LO 10.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

B. Were the assumptions on which Henry based his pension annuity decision reasonable?

Answer: Henry’s decision would have resulted in a higher lifetime payout from the annuity if Henry had outlived his wife. He was making a bet that, due to Ada’s poor health, this would be the more likely outcome. The decision was probably motivated by the desire to have higher current income, without adequate consideration of the potentially devastating financial impact on his wife if he died first.

Sec 10.3; LO 10.3; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. If Ada is also 57 years old, can she qualify for Social Security benefits?

Answer: Ada 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. If she has participated .

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25

sufficiently in Social Security herself, she might be eligible for disability benefits under that program, depending on the nature of her health issues.

Sec 10.2; LO 10.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

D. If Ada can’t qualify for Social Security and has no other sources of income, what are her options?

Answer: If Ada was the beneficiary of Henry’s life insurance policy, she will receive a settlement.

If the family home has significant value, she can sell it and live some place cheaper. If she can’t work due to poor health, she might have to rely on relatives for support or apply for public assistance.

Sec 10.2; LO 10.2; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. Margaret Bradford is 66 years old and has been widowed for 12 years. She was married to her second husband, Charles, for 15 years. Because they hadn’t expected him to die so young, the couple hadn’t gotten around to doing much retirement planning before his death.

She did receive a life insurance settlement of $100,000, which she used to pay the uninsured medical expenses from Charles’s illness and to repay the remaining balance on her home mortgage. Charles’s pension plan gave her a lump sum benefit of $250,000, which she rolled into an IRA. This has been invested in government bonds for the last 12 years. Her average annual return has been 4 percent, and the bond fund is now worth $400,000. After Charles’s death, Margaret took a job as an office manager in a law firm, where she earns $30,000 per year, and she’s been contributing to a 401(k) plan in which she has accumulated $115,000.

Margaret would like to retire when she turns 67 next year. She knows she’ll qualify for Social Security benefits based on her deceased husband’s earnings history, and her home is worth $200,000.

A. If Margaret had invested a little less conservatively and earned 6 percent instead of 4 percent per year for the last 12 years, how much would her account be worth today?

Answer: $503,049 Solution: The original value of the account was $250,000. If Margaret had earned 6% per year for 12 years, the account would now be worth $503,049, which is $103,049 more than it is worth now. Calculate the future value of $250,000 over 12 years at 6% APY.

Financial Calculator Enter PV = -250,000, N = 12, I/Y = 6, and solve for FV = 503,049.12 Excel Spreadsheet: Function: =FV(rate,nper,pmt,pv,type) =FV(0.06, 12, 0, -250000, 0) => 503,049.12 TVM Equation: FV of lump-sum: FV = PV x (1+i)n FV = $250,000 x (1+0.06)12 = $503,049.12 Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

B. Margaret’s annual expenses are currently $18,000 per year. Use the replacement ratio method to estimate her post retirement expenses beginning one year from now,

.

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assuming that inflation is 4 percent and she will need to replace 80 percent of her preretirement income.

Answer: $14,976 Solution: If post retirement expenses are 80% of her $18,000 preretirement expenses, her post retirement expenses should be $14,400 today ($18,000 x 0.80). A year from now, she will need $14,976. (Equation 2.8) FV = PV x (1+i)n FV = $14,400 x 1.04 = $14,976.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:Analytic

C. Estimate the monthly Social Security benefit Margaret will receive, assuming that Charles was fully insured, that he had average indexed monthly earnings (AIME) equal to $2,917 per month in today’s dollars, and that she will make her claim based on his earnings history. (Round to the nearest dollar.)

Answer: $1,470.52 per month Solution: Use Equation 10.5 to estimate Charles PIA. Margaret will be eligible to receive 100% of her deceased husband’s benefit. Margaret will receive $1,470.52 per month.

PIA = [0.9 × (First $926 of AIME)] + [0.32 × (AIME up to $5,583 − $926)] + [0.15 × (AIME − $5,583)] PIA = (0.9 × $926) + (0.32 × $1,991) = $1,470.52 Sec 10.3; LO 10.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

D. If Margaret continues to earn 4 percent on her invested assets throughout retirement, can she afford to retire? Does she face any risk of outliving her assets? Explain.

Answer: She will have enough in the early years at least. Her Social Security benefit ($1,470.52 x 12 = $17,646.24) will be enough to cover her income needs as calculated above. Because these benefits are inflation-indexed, they should increase over time. If her expenses rise due to medical costs or other reasons, she can use her investments or sell her home to fund those costs.

Sec 10.1; LO 10.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. Rosanne and Benjamin Carter married young and had two children by the time they were 25.

They had trouble making ends meet until Rosanne returned to work when Kaitlyn, their younger child, was in school full-time. Rosanne currently earns $25,000 per year after taxes, and the couple estimates that they can allocate a substantial portion of her income to their children’s college fund. The Carters are now 31 years old, and their children are 10 and 7.

They want to begin a savings program to help them pay for their children’s college education at an in-state public university, which currently costs $24,000 per year. Assume that the education costs will increase at a rate of 4 percent per year.

A. What will annual costs be when each of the two children starts college at age 18?

Answer: $32,846; $36,947 Solution: Calculate the future value of $24,000 annual cost of college for each child. The costs for the first year of college for their oldest (10 years old) will be $32,846, and the cost for the younger child (7 years old) will be $36,947.

Calculate the FV of $24,000 at 4% inflation .

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Financial Calculator Oldest child: Enter PV = -24,000, N = (18-10), I/Y = 4, and solve for FV = 32,845.66 Youngest child: Enter PV = -24,000, N = (18-7), I/Y = 4, and solve for FV = 36,946.90 Excel Spreadsheet: Function: =FV(rate,nper,pmt,pv,type) Oldest child: =FV(0.04, (18-10), 0, -24000, 0) => 32,845.66 Youngest child: =FV(0.04, (18-7), 0, -24000, 0) => 36,946.90 TVM Equation: FV of lump-sum: FV = PV x (1+i)n Oldest child: FV = $24,000 x (1+0.04)8 = $32,845.66 Youngest child: FV = $24,000 x (1+0.04)11 = $36,946.90 Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

B. If the Carters’ children can contribute one-fourth of the costs and they qualify for student loans and financial aid to cover another one-fourth of the costs, how much will the family need to save for each of the children? Estimate each separately.

Answer: They will need to have saved $65,691 by year 8 and an additional $73,894 by year 11.

Solution: To fund half the cost of 4 years of college, they would need $65,691 in 8 years for the oldest child and $73,894 in 11 years for the youngest child. Calculate the future value of the $24,000 cost of college today at 4% inflation for each child, then multiply by 4 years, and then take 50% of the total that needs to be funded.

Calculation of the future value of college Financial Calculator Oldest child: Enter PV = -24,000, N = (18-10), I/Y = 4, and solve for FV = 32,845.66 Youngest child: Enter PV = -24,000, N = (18-7), I/Y = 4, and solve for FV = 36,946.90 Excel Spreadsheet: Function: =FV(rate,nper,pmt,pv,type) Oldest child: =FV(0.04, (18-10), 0, -24000, 0) => 32,845.66 Youngest child: =FV(0.04, (18-7), 0, -24000, 0) => 36,946.90 TVM Equation: FV of lump-sum: FV = PV x (1+i)n Oldest child: FV = $24,000 x (1+0.04)8 = $32,845.66 Youngest child: FV = $24,000 x (1+0.04)11 = $36,946.90 Calculation of funding required Oldest child:

$32,845.66 x 4 years = $131,382.64 total cost of 4 years $131,382.64 x 50% = $65,691 funding required in 8 years

Youngest child:

$36,946.90 x 4 years = $147,787.60 total cost of 4 years $147,787.60 x 50% = $73,894 funding required in 11 years

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

C. If the Carters estimate that they will need to have saved $65,000 in 8 years for their older child and $75,000 in 11 years for their younger child, is it realistic for them to think they’ll be able to afford to send their children to college if they can earn 6 percent on their investments after taxes? .

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Answer: The Carters should be able to meet their college funding goals if they save most of Rosanne’s income and earn the expected rate.

Solution: Calculate how much the Carters need to save every year to meet the estimated goals at 6% APY. Then compare the savings required with Roseanne’s income, and evaluate the feasibility.

Calculation of required yearly savings Financial Calculator Oldest child: Enter PV = 0, FV = 65,000, N = 8, I/Y = 6, and solve for PMT = -6,567.34 Youngest child: Enter PV = 0, FV = 75,000, N = 11, I/Y = 6, and solve for PMT = -5,009.47 Excel Spreadsheet Function =PMT(rate,nper,pv,fv,type) Oldest child: =PMT(0.06, 8, 65000, 0, 0) => 6,567.34 Youngest child: =PMT(0.06, 11, 75000, 0, 0) => 5,009.47 TVM Equation 2.9 Future Value of an Annuity: FVA = PMT x

Oldest child: $65,000 = PMT x

(1+0.06)8 -1

Youngest child: $75,000 = PMT x

0.06

𝑖 Commented [MOU1]:

= $6,567.34

(1+0.06)11 -1 0.06

(1+𝑖)𝑛 -1

= $5,009.47

Evaluation of required savings Total savings required = $6,567.34 (oldest child) + $5,009.47 (youngest child) = $11,576.81 With Rosanne’s $25,000 after-tax annual income, they should be able to meet this goal of saving $11,576.81 every year for college. They might want to set aside more than this in the event that one or both of the children want to attend an out-of-state school or a private school.

It is also possible that the children will not realistically be able to pay for 25% of their college costs.

Sec 10.4; LO 10.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:Analytic

D. Should the Carters consider setting up a Section 529 plan for each of the college funds?

What are the pros and cons of doing this?

Answer: Section 529 investment plans are a good idea because of the tax advantages.

However, the large amount of funds the Carters are saving will reduce the children’s ability to qualify for financial aid.

Sec 10.4; LO 10.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

E. Assuming that current tax laws remain in place, what effect will the Carter’s education expenses have on their taxes?

Answer: Unless the family income grows substantially, the Carters should be able to use the tax credits to reduce taxes paid while the children are in college. If they use a 529 plan, they will be able to reduce their annual tax payments. If they take out loans to pay for college, they may be able to take deductions for student loan interest.

Sec 10.4; LO 10.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

.

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F. If the Carters haven’t yet thought about retirement planning, what effect will education funding have on their ability to adequately fund their retirement? Will it be possible for them to work toward both long-term goals simultaneously?

Answer: They will have trouble funding their retirement needs because 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.

Sec 10.4; LO 10.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

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CHAPTER 11 Instructor Manual & Solutions The Fundamentals of Investing LEARNING OBJECTIVES LO 11.1 Develop a realistic investment plan to meet your long-term financial goals, taking into account budgetary constraints, transaction costs, and taxes.

LO 11.2 Identify and define the major types of investments.

LO 11.3 Compare investment alternatives based on return and risk.

LO 11.4 Evaluate portfolio performance relative to a similarly diversified benchmark index.

SUGGESTED COURSE PLAN This chapter can be covered in one week out of a typical 15–16 week semester on this chapter. You can cover two Learning Objectives in each session over 2 sessions. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

1

LO 11.1 Developing a Realistic Investment Plan LO 11.2 Understanding Your Investment Choices LO 11.3 The RiskReturn Tradeoff LO 11.4 Diversification and Performance Evaluation

Interactive: Saving Strategies

2

Interactive: Risk Aversion Assessment

WileyPLUS Resources to Use in Class

Personal Financial Planner Assignment PFP 11.1 Setting Investment Goals

Interactive: Whose Portfolio Is It?

WileyPLUS Homework Assignment Chapter 11 Homework A: R:37; P: 1-6, 8

Chapter 11 Homework B: R:9-12; P:11-12; Case 11.2 Adaptive Practice Ch 11

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY Chapter 11 The Fundamentals of Investing LO 11.1 Develop a realistic investment plan to meet your long-term financial goals, taking into account budgetary constraints, transaction costs, and taxes.

DEVELOPING A REALISTIC INVESTMENT PLAN I.

FIRST THINGS FIRST: ESTABLISHING A FIRM FOUNDATION

II.

ESTABLISHING INVESTMENT GOALS A. How Much Do You Need, and When Do You Need It? CASE STUDY 11.1 NEWLYWEDS SET THEIR INVESTMENT GOALS B. Obtaining the Money to Invest

III.

KEY STRATEGIES FOR INVESTMENT SUCCESS A. Start Early and Be Consistent B. Take Advantage of Favorable Tax Rules C. Minimize Transaction Costs D. Be an Informed Investor E. Keep Accurate Records

LO11.2 Identify and define the major types of investments.

UNDERSTANDING YOUR INVESTMENT CHOICES I.

INVESTING BY LENDING AND OWNING A. The Advantages and Disadvantages of Lending B. The Advantages and Disadvantages of Owning

II.

MAJOR ASSET CLASSES A. Common Stock B. Bonds C. Money Market Securities D. Preferred Stock E. Real Estate F. Derivatives G. Mutual Funds

LO 11.3 Compare investment alternatives based on return and risk.

THE RISK-RETURN TRADEOFF

.

I.

RATE OF RETURN

II.

RISK

III.

HOW RISK-AVERSE ARE YOU?

IV.

FACTORS AFFECTING RISK ATTITUDES

V.

TYPES OF INVESTMENT RISK A. Inflation Risk B. Interest-Rate Risk C. Default Risk

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D. Liquidity Risk E. Market Risk LO 11.4 Evaluate portfolio performance relative to a similarly diversified benchmark index.

DIVERSIFICATION AND PERFORMANCE EVALUATION

.

I.

HOW DIVERSIFICATION WORKS

II.

ASSET ALLOCATION

III.

EVALUATING PERFORMANCE AGAINST A BENCHMARK A. Dow Jones Industrial Average B. S&P 500 Index C. Other Stock Market Indexes D. Other Asset Benchmarks

IV.

ACTIVE VERSUS PASSIVE INVESTING A. Can Active Investors Beat the Market?

B. Are Markets Efficient?

C. Passive Investing Strategies D. Does Timing Matter to Passive Investors?

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TEACHING SUGGESTIONS 1. Take a poll of the class regarding the results of the Interactive: How Risk Averse Are You? Discuss how they think their parents and grandparents would answer the same questions and whether they think their own answers will change over time. You can also use this question to see if there are observable differences in your class (gender, ethnicity, age, past experience).

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. 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 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 in Table 11.1. You can also use this example to discuss the reasonableness of the investment return assumption.

4. 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.

5. 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?

6. Discuss how the Internet has changed the investment process.

7. 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.

8. 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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CONCEPT REVIEW SOLUTIONS 1. Before you develop a plan for building your wealth, what elements of your financial plan should you consider? Why is this important?

Answer: Before developing a plan to build wealth, you should evaluate your finances, set and prioritize goals, and develop a budget that will allow you to set aside sufficient funds for investing. You need to first make sure you have sufficient emergency funds and that you have taken care of other basics, such as having adequate insurance coverage and appropriate housing.

Sec 11.1; LO 11.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

2. What does it mean to “pay yourself first,” and how can this strategy help you stick to your financial plan?

Answer: “Pay yourself first” means that at the beginning of the month you should set aside funds to apply to your financial goals rather than waiting to see if there is anything left over at the end of the month. Once the money is in your savings account, you will be more likely to leave it there, whereas had you left it in your spendable accounts, you might waste it on minor purchases throughout the month.

Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. If you don’t currently have excess cash flow in your budget to allocate to saving for future financial goals, what are some strategies for finding the funds necessary to save or invest?

Answer: Methods you can use to find funds to allocate to saving and investing include: (1) pay yourself first, (2) save half of your raise each year, (3) set aside bonuses, refunds, and other lump sums, (4) after you finish paying off a loan, shift the same payment amount to your investment plan, (5) maximize any employer match to your retirement account, (6) identify and eliminate any cash leaks, and (7) go on a financial diet once or twice a year.

Sec 11.1; LO 11.1; BT: K; Difficulty: M; TOT: 2 min; AACSB:

4. Why do riskier investments give investors the opportunity for a higher average rate of return?

Answer: When you make investments, you have a choice about where to put your money. Investors would not be willing to provide funds to a risky enterprise if they would earn the same rate of return in a much less risky enterprise. Therefore, companies that are exposed to more risk must offer a better rate of return to compensate investors and lenders for risking their money.

Sec 11.3; LO 11.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

5. Are all investors risk-averse? Why or why not?

Answer: Although most individuals are risk averse to some extent, everyone’s tolerance for risk is different.

Being risk averse doesn’t mean that you won’t take any risk, but rather that you prefer to be compensated commensurately for the risk. So, a very risk-averse person would have to get a lot more in return in order to take a risk, whereas a less risk averse person might be willing to invest for relatively less return. Gender, ethnicity, age, wealth, and family background can all affect a person’s risk aversion.

Sec 11.3; LO 11.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

6. Explain how each of the following factors can influence a person’s risk preferences.

A. Life-cycle stage Answer: When people are in the early stages of their life cycle, they are working to develop a foundation for the future, investing in education and career, and having a family. During this stage, .

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people are their building human capital, investing in themselves and their family to increase earnings potential. The focus is on liquidity and safety because there is limited excess cash flow. In the middle of the life cycle, people have established their financial foundation and are focused on wealth building for long-term goals. In this stage, the focus shifts to building financial capital, and taking some risk in order to accumulate wealth is more acceptable. In the later stages of the life cycle, when people are nearing or in retirement, they become more risk averse again because they have less time to recover from a loss in their investment portfolio.

B. Children Answer: Generally, households with children tend to be more risk averse than those without children.

C. Income and wealth Answer: Higher-income people and those with greater wealth tend to be more comfortable with taking risk than lower-income people. This is likely because they can afford to take a loss.

Sec 11.3; LO 11.3; BT: K; Difficulty: E; TOT: 2 min; AACSB:

7. Identify the type of risk described in each of the following statements.

A. Interest rates are expected to rise over the next several years.

Answer: Interest-rate risk

B. Prices of goods and services are rising rapidly.

Answer: Inflation risk

C. A company’s management is indicted for fraud, and the company declares bankruptcy.

Answer: Default risk

D. The United States declares war on another country.

Answer: Market risk Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB:

8. Why do investment advisors commonly recommend stocks for long-term investors?

Answer: Over long periods of time, stocks have outperformed other asset classes based on return.

However, they also are fairly risky, with several increases and decreases in value over the short term.

Therefore, an investor in stocks needs to have a long-term horizon to be able to benefit from the long-run upward trend.

Sec 11.3; LO 11.3; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

9. How does the diversification of a portfolio help reduce its risk?

Answer: When you invest in many different assets that differ in risk and return, downturns in one investment may be offset by upturns in another. For this to work, the assets in your portfolio must be sufficiently different from each other so that they are not similarly impacted by market events.

Sec 11.4; LO 11.4; BT: C; Difficulty: M; TOT: 1 min; AACSB:

10. Should investors change their asset allocation over their life cycle? Why or why not?

Answer: It is generally recommended that investors take more risk when they have a longer time horizon for investing, such as when they are younger. This will usually mean a higher allocation to stocks in the portfolio. As they get nearer to retirement, they should reduce the risk of their portfolio by allocating less to stocks in order to minimize the risk of large portfolio declines close to the retirement date. Since people

.

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live longer in retirement, they should not reduce their risk to zero. They should invest in some growth assets so that their assets will support their longer period of retirement.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

11. Why is it important to evaluate the performance of your investment portfolio against an appropriate benchmark?

Answer: The expected return of a given portfolio depends on the assets that are in the portfolio. Therefore, to measure the success of your investment strategy, or the quality of the investment professionals working on behalf of a mutual fund in which you are invested, you need to compare your outcomes against a benchmark that is similar in risk.

Sec 11.4; LO 11.4; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

12. What are some arguments in favor of being a passive investor?

Answer: Most people do not have the knowledge, skills, or time to be an active investor. In today’s market, most of the trading is done by professionals and institutions, so the small investor is likely to be at a disadvantage. Studies suggest that active investing strategies do not beat passive investment strategies, such as buying indexed mutual funds. For many investors, passive strategies are likely to be a lower-cost method of achieving their financial goals.

Sec 11.4; LO 11.4; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

.

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APPLICATION PROBLEM SOLUTIONS 1. You own 100 shares of stock that you bought one year ago when the stock price was $30 per share. During the year, you’ve received dividends totaling $1 per share, and the stock is now worth $32 per share. What is your pre-tax rate of return for the year? (Round to the nearest percent.)

Answer: 10% Solution: Use equation 11.1 Dividend+End price−Beginning price Pre-tax rate of return = Beginning price $𝟏+$𝟑𝟐−$𝟑𝟎 = 𝟎. 𝟏 𝒐𝒓 𝟏𝟎% $𝟑𝟎

Sec 11.3; LO 11.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic 2. You own 100 shares of stock that you bought when the stock price was $30 per share. Assume that you sell your shares for $32 per share one year after you bought them, and you’ve received dividends during the year totaling $1 per share. If you’re in the 24 percent federal income tax bracket and your dividends and capital gains both qualify for taxation at the capital gains tax rate, what is your after-tax rate of return?

A. 8.5% B. 10% C. 8% D. 15% Answer: 8.5% Solution: Use Equation 11.1 for Rate of Return, then adjust for taxes using the long-term capital gains tax rate to calculate the after-tax rate of return. Assets sold that were held longer than 1 year are taxed at special long-term capital gains tax rates (see Table 11.2) Pre-tax rate of return = =

Dividend+End price−Beginning price Beginning price

Pre-tax rate of return =

$𝟏+$𝟑𝟐−$𝟑𝟎 = 𝟎. 𝟏 𝒐𝒓 𝟏𝟎% $𝟑𝟎

If you are in the 24% federal income tax bracket, then your capital gains tax rate is 15%. (See Table 11.2.) The after-tax rate of return = Pre-tax rate of return x (1 – tax rate)) = 10% x (1 – 0.15) = 8.5%

Sec 11.3; LO 11.3; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

.

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3. You bought a corporate bond one year ago for $1,000. The bond is still worth $1,000, and you have received interest payments totaling $90 during the year. What was your pretax rate of return?

(Round to one decimal place.)

Answer: 9.0% Solution: Use equation 11.1 Current income+End price−Beginning price Pre-tax rate of return = Beginning price $𝟗𝟎+$𝟏,𝟎𝟎𝟎−$𝟏,𝟎𝟎𝟎 $𝟏,𝟎𝟎𝟎

= 𝟎. 𝟎𝟗 𝒐𝒓 𝟗%

Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 4. You bought a corporate bond one year ago for $1,000. The bond is still worth $1,000, and you have received interest payments totaling $90 during the year. If your marginal tax rate is 22 percent, what is your after-tax rate of return? (Round to two decimal places.)

Answer: 7.02% Solution: Use Equation 11.1 for Rate of Return, then subtract the marginal tax rate to calculate the after-tax rate of return. Assets sold that were held under 1 year are taxed as ordinary income, and thus the marginal tax rate.

Pre-tax rate of return =

Current income+End price−Beginning price Beginning price

$90+$1,000−$1,000 $1,000

= 0.09 𝑜𝑟 9%

The after-tax rate of return = Pre-tax rate of return - (pre-pre-tax rate of return x tax ) After-tax rate of return = $9% - (9% x 0.22) = 7.02% Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

5. You want to save up to buy a new car in four years. If you expect to need $6,000 four years from now, and your investment earns 5 percent interest after taxes, how much do you need to contribute at the end of each month to achieve your goal? (Round to the nearest dollar.)

Answer: $113 Solution: Calculate the monthly payment necessary to save $4,000 in in 4 years at 5% APY. Financial Calculator Enter PV = 0, FV = 6,000, N = 48, I/Y = (5/12), and solve for PMT = -113.18 ~ $113 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.05/12), 48, 0, 6000, 0) => -113.18 ~ $113 TVM Equation PMT =

𝐹𝑉𝐴 (1+𝑖)𝑛 -1 ( 𝑖 )

$6,000

PMT = (1+0.0041667)48 -1 = $113.18 (

.

0.0041667

Bajtelsmit, Personal Finance, 2e, Instructors Manual and Solutions

)

9

Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

6. You need to accumulate $100,000 for your child’s college education 18 years from now. How much do you need to save each year, if you can earn 2 percent after taxes on your investment, assuming that you will make annual end-of-year payments into the account?

A. $4,670.21 B. $4,270.87 C. $3,899.33 D. $3,554.62 Answer: $4,670.21 Solution: Calculate the annual payment necessary to save $100,000 in in 18 years at 2% APY. Financial Calculator Enter PV = 0, FV = 100,000, N = 18, I/Y = 2, and solve for PMT = -4,670.21 ~ $4,670.21 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT(0.02, 18, 0, 100000, 0) => -4,670.21 ~ $4,670.21 TVM Equation PMT =

𝐹𝑉𝐴 (1+𝑖)𝑛 -1 ( ) 𝑖

$100,000

PMT = (1+0.02)18 -1 = $4,670.21 (

0.02

)

Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

7. Maria contributes $150 per month to her investment account at the end of each month, earning 4 percent per year after taxes. How much will she have in the account after six years?

A. $12,183 B. $9,949 C. $9,588 D. $10,800

Answer: $12,183.38 Solution: Calculate the future value of $150 monthly contributions to an account earning 4% APY in 6 years.

Financial Calculator Enter PMT = -150, N = (6x12), I/Y = (4/12), PV= 0, and solve for FV = 12,183.38 ~ $12,183 .

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Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV((0.04/12), (6x12), -150, 0, 0) => 12,183.38 ~ $12,183 TVM Equation (1 + 𝑖)𝑛 -1 FVA = PMT 𝑥 𝑖 FVA = $150 𝑥

(1 + 0.0033333)72 -1 = $12,183.37 ~ $12,183 0.0033333

Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 8. Lavonne receives a divorce settlement of $100,000. Her marginal tax rate is 25 percent, and the capital gains tax rate is 15 percent. How much will her account be worth in 20 years under each of the following investment scenarios, assuming annual compounding of interest? (Round to the nearest dollar.)

A. Lavonne puts all the money in taxable bonds that earn 5 percent per year before taxes, and she reinvests the after-tax interest.

Answer: $208,815 Solution: She will have to pay tax on the interest earned each year, so her after-tax investment rate of return will be 3.75% [5% x (1 – 0.25)]. Calculate the future value of $100,000 over 20 years at an after-tax equivalent APY of 3.75%.

Financial Calculator Enter N = 20, I/Y = 3.75, PV= -100,000, and solve for FV = 208,815.20 ~ $208,815 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.0375, 20, 0, -100000, 0) => 208,815.20 ~ $208,815 TVM Equation

FV = PV x (1+i)n FV = $100,000 x (1+0.0375)20 = $208,815.20 ~ $208,815 Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Lavonne puts all the money in a tax-deferred account that earns 10 percent per year before taxes.

Answer: $672,750 Solution: Taxes on this account will be deferred until she takes it out in retirement, at which time she will have to pay tax based on her ordinary income tax rate. Therefore, her returns will compound at the full 10 percent rate of return, until that time. Assuming that she has not yet taken the money out of the account, you can calculate the future value of $100,000 in 20 years at 10% APY. Financial Calculator Enter N = 20, I/Y = 10, PV= -100,000, and solve for FV = 672,749.99 ~ $672,750 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.10, 20, 0, -100000, 0) => 672,749.99 ~ $672,750

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TVM Equation

FV = PV x (1+i)n FV = $100,000 x (1+0.10)20 = $672,749.99 ~ $672,750 Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 9. More than a year ago, George purchased 100 shares of Stock A for $5 per share and 50 shares of Stock B for $25 per share. During the current tax year, he sold the Stock A shares for $10 per share and the Stock B shares for $23 per share. Neither stock paid any dividends. How much will he owe in capital gains tax, assuming that he is in the highest marginal tax bracket for federal income taxes and that the applicable capital gains tax rate is 20 percent? (Round to the nearest dollar.)

Answer: $80 Solution: Calculate the capital gain/loss on each security and then apply the 20% capital gain tax.

Stock A = ($10 sale – $5 cost) x 100 shares= $500 gain Stock B = ($23 sale – $25 cost) x 50 shares= –$100 (loss) Net capital gain = $500 gain from stock A – $100 loss from stock B) = $400 net gain Taxes = $400 net gain x 20% capital gains tax rate = $80.

Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

10. The nominal risk-free rate is currently 3 percent. You are considering investing in a 20-year corporate bond. The interest rate risk premium is 2 percent, the default risk premium is 1.5 percent, and the liquidity risk premium is 1 percent. What should your yield on this bond be (rounded to one decimal place)?

Answer: 7.5% Solution: To find the yield on this bond, use Equation 11.2: Yield on debt security = Nominal risk free + Interest-rate risk premium + Default risk premium + Liquidity risk premium = 3.0% + 2.0% + 1.5% + 1.0% = 7.5%.

Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 11. Your mother received a $50,000 settlement (after taxes) from a lawsuit, and she has asked you to recommend an asset allocation strategy for investing it. She is 45 years old, divorced, and in danger of being laid off from her job in the next two years. She has an emergency fund equal to three times her monthly expenses, she doesn’t own a home, her high-interest credit card debt currently totals $5,000, and she owes $3,500 on a car loan.

A. Should your recommend that your mother invest the entire $50,000? Why or why not?

Answer: 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, if its interest rate is higher than what she can earn on a low-risk investment. She needs to increase her emergency fund to at least six months because she is at risk of being laid off.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

B. Would it be beneficial for your mother to pay for the services of an investment advisor? Why or why not?

Answer: Probably not. Most of the decisions that your mother needs to make, such as paying off debt and adding to liquid savings, are fairly simple and do not require paid advice. Furthermore, her funds .

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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. It is also possible that a paid investment advisor might encourage her to put more of the funds at his disposal because he could earn additional commissions.

Sec 11.1; LO 11.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

C. Assuming that she does have some funds left to invest, what proportion of the funds, if any, should she invest in stocks? Explain your reasoning.

Answer: She probably shouldn’t invest in any stocks at this time because her current circumstances make it inadvisable to risk losing any money. 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 towards the purchase of a home. Not only would she be able to build home equity, but she may receive some tax advantages as well. Until she has developed a more detailed financial plan, she should put her money in short-term debt securities.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking 12. Consider each of the following financial goals, and discuss whether stocks would be an appropriate investment choice for some or all of the funds allocated to that goal.

A. Saving to go to graduate school in five years Answer: Stock investing exposes you to greater risk of short-term fluctuations so this would not be an appropriate choice for a goal with such a short time horizon. You don’t have enough time to bear the risks of ups and downs in the stock market.

B. Building a college fund for your two-year-old child Answer: You will be saving for a fairly long time, so you can take on some risk. Allocating some of funds to stocks can increase the average rate of return that you earn so that your account can grow faster. However, as your child gets older, you will want to reduce the allocation to stocks so that you are not exposed to any big market declines just before he/she needs to start school.

C. Funding your retirement in 40 years Answer: This is a very long-term goal, so it is advisable to invest at least some of your funds in stocks.

You will be saving for a fairly long time, so you can take on some risk. However, as you get older, you will want to reduce the allocation to stocks.

D. Establishing an emergency fund Answer: No. An emergency fund needs to be invested in safe, highly liquid assets. Stocks would not be an appropriate investment for this purpose.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB:

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CASE APPLICATION SOLUTIONS 1. Terrie and Jeff Sanders recently sold a vacant lot next to their home and have $35,000 available to invest. They’ve been married for three years and have two young children. Their combined after-tax income is $45,000 per year, and their net cash flow each month is close to zero. They have not established a household budget. Their home is worth $110,000, and they have a mortgage of $80,000.

They have a $4,000 emergency fund. Both Terrie and Jeff contribute to employer-sponsored retirement plans, and they have adequate health and life insurance through employee benefit plans.

Their two biggest investment goals are to buy a bigger house and to start a college fund for the kids.

Terrie would like to take the $35,000 and invest it in a stock mutual fund, because she’s heard that this will give them the biggest return on investment. Jeff thinks they should consider taking care of some of their other needs first. Even if they invest the money, he would like to put some of it in less risky assets. He also wonders whether it would make sense to pay off their credit cards and add to their retirement accounts, because they currently aren’t contributing the maximum allowed.

A. Based on the information provided, have Terrie and Jeff established all the foundation elements of their financial plan? If not, what do they still need to do?

Answer: No, they have not completed the foundation components of their financial plan. Before investing, they need to develop a budget, pay off any high-interest debt, establish an adequate emergency fund, and make sure that they have 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 addressed.

Sec 11.1; LO 11.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

B. Do you agree with Terrie or Jeff, regarding the way the money should be invested? Explain your reasoning.

Answer: Neither. Once 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 prudent. They have a long investment horizon for retirement, but will need access to college funds sooner. Savings targeted for the purchase of a bigger home should be invested in short-term low risk investments such as CDs or a money market account.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

C. In this case, would it be advisable to invest some of the money in retirement accounts? Why or why not?

Answer: Provided that they have taken care of their emergency fund needs and paid off high-interest credit, it makes sense to add to their retirement plans. Early contributions make the biggest difference because they can grow tax deferred for a longer period of time. Also, since they are not currently maximizing their contributions, this would reduce their taxes in the current year, which would increase their after-tax income. One disadvantage of putting the money in the retirement plans is that they will not be able to access it in an emergency.

Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Refective Thinking

D. Jeff suggests to Terrie that they use some of the money to pay $8,000 in credit card debt, on which they pay an average finance charge of 18 percent. Would this be a good use of their money? Explain why or why not. .

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Answer: 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 percent return on their investments after taxes, so they will have a net gain in after-tax income by paying off the credit card debt.

Sec 11.1; LO 11.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

2. Winken, Blinken, and Nod are triplets, but they have very different attitudes toward investing.

Five years ago, each began an investment program with $10,000. Winken, a risk taker, invested the entire amount in a high-growth stock mutual fund. Blinken is extremely conservative and invested his $10,000 in a high-grade, low-risk, corporate bond fund. Nod took a personal finance class in college, so she’s invested half her money in the stock fund and half in the bond fund. Taking into account both income and growth, the after-tax annual returns on the funds over the last five years have been as follows: Year

Stock Fund (% )

Bond Fund (% )

50/50 (% )

1 2 3 4 5

5.0 -8.0 18.0 -2.0 25.0

8.0 10.0 2.0 7.0 4.0

6.5 1.0 10.0 2.5 14.5

A. What was the average annual return for each fund and for the 50/50 combination? Which investment was the riskiest? Explain.

Answer: The average annual return for the stock fund was 7.6% [(5 + –8 + 18 + –2 + 25)/5]. The average annual return for the bond fund was 6.2% [(8 + 10 + 2 + 7 + 4)/5]. The average for the 50/50 fund was 6.9% [(6.5 + 1 + 10 + 2.5 + 14.5)/5]. The stock fund was the riskiest because it had the largest variation in annual returns over the five years.

Year

Stock Fund (% )

Bond Fund (% )

50/50 (% )

1 2 3 4 5

5.0 -8.0 18.0 -2.0 25.0

8.0 10.0 2.0 7.0 4.0

6.5 1.0 10.0 2.5 14.5

average

7.6

6.2

6.9

Sec 11.4; LO 11.4; BT: Ap; Difficulty: H; TOT: 3 min; AACSB: Analytic

B. At the end of the five years, what was the value of each of the triplets’ portfolios?

Answer: Winken: $13,964; Blinken: $13,484; Nod: $13,887

Solution:

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$10,000 Investment

Year

Winken

Blinken

100% Stock Fund earnings balance

1 2 3 4 5

500 (840) 1,739 (228) 2,793

Total

3,964

Nod

100% Bond Fund earnings balance

10,500 9,660 11,399 11,171 13,964

800 1,080 238 848 519

50/50 Fund earnings balance

10,800 11,880 12,118 12,966 13,484

3,484

650 107 1,076 296 1,759

10,650 10,757 11,832 12,128 13,887

3,887

Excel Spreadsheet Year 1 2 3 4 5 End Amount

Winken $10,000 x 1.05 $10,500 x 0.92 $9,660 x 1.18 $11,399 x 0.98 $11,171 x 1.25 $13,964

Blinken $10,000 x 1.08 $10,800 x 1.1 $11,880 x 1.02 $12,118 x 1.07 $12,966 x 1.04 $13,485

Nod [(($5,000 x 1.05) + ($5,000 x 1.08))]/2 [(($5,325 x 0.92) + ($5,325 x 1.1))]/2 [(($5,378 x 1.18) + ($5,378 x 1.02))]/2 [(($5,916 x 0.98) + ($5,916 x 1.07))]/2 [(($6,064 x 1.25) + ($6,064 x 1.04))]/2 $13,887

Sec 11.4; LO 11.4; BT: Ap; Difficulty: H; TOT: 4 min; AACSB: Analytic

C. Did diversifying across two funds provide any advantages to Nod? Explain.

Answer: 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.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

3. The Herring family recently had dinner at Great-Grandma Anna’s house. Present at the gathering were Great-Grandma Anna, age 96; Grandma and Grandpa Herring, both age 70; their five children, Vickie, Jill, Ron, Ken, and Holly (ages 30 to 50), with their respective spouses; and grandchildren ranging in age from 5 to 25. The conversation turned to investment risk, and Anna, who is still sharp as a tack, commented that she would never have put any money in the stock market. “It’s like gambling!” she said. “I’m not even sure you can trust the banks to keep your money safe. That’s why I always keep some cash in my freezer.” Grandma and Grandpa Herring chuckled, because they’d long ago given up on getting Anna to keep all her cash in the bank. Talking more to his kids than to her, Grandpa argued that everyone should invest in the stock market, citing how he’d been able to almost double the value of an inheritance received by Grandma from an elderly aunt several years before. “Why earn 5 percent when you can earn 10?” he asked. “Besides,” said Grandpa, “assuming I live to be as old as Great-Grandma Anna, my investment horizon is pretty long, so I can afford to take a little risk.” The adult children were amazed to hear their dad talk this way, because they all tended to be a bit more risk-averse in their investing. Not a single one had more than 50 percent of his or her investments in the stock market. But the oldest great-grandchild, Kristopher, said, “Way to go, Grandpa! If I had any money, I’d take your advice.”

A. Did the members of each generation of the Herring family demonstrate typical attitudes toward investment risk for their age and life-cycle stage? Why or why not?

Answer: Great-Grandma Anna is probably typical of someone in her 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 because she has little time to make up any losses. Grandpa seems to be a bit of a risk-taker relative to his age. .

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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 than he should be about stock investing. 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 short-term losses.

Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

B. If it’s true that Great-Grandma Anna has kept a significant amount of her cash savings in her freezer over the years, has she avoided all investment risk? If not, what kind of risk has she been exposed to?

Answer: Great-Grandma didn’t avoid inflation risk. Although inflation has been relatively low over the last decade, she might 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 earned in an insured savings account.

Sec 11.3; LO 11.3; BT: C; Difficulty: M; TOT: 1 min; AACSB:

C. Is Grandpa Herring right in saying that everyone should invest in the stock market? Why or why not?

Answer: Grandpa Herring is right, but the allocation shouldn’t be the same for everyone.

Sec 11.3; LO 11.3; BT: C; Difficulty: M; TOT: 1 min; AACSB:

D. If you knew that both Grandpa and Grandma Herring had government pensions that would provide them with a reasonable income for life, would this help explain Grandpa’s risk attitude?

Why or why not?

Answer: The fact that he has a government pension is an important factor in his household investment allocation. It reduces his need for liquidity and helps ensure that he will have a lifetime income, so he doesn’t need to worry about outliving his assets.

Sec 11.3; LO 11.3; BT: C; Difficulty: M; TOT: 1 min; AACSB:

E. Should Kristopher follow through on his stock-investing strategy if he suddenly comes into some money? Why or why not?

Answer: Before beginning his investment plan, Kristopher probably has some other elements of his financial plan that deserve his attention. At this stage in his life, he probably has not done much planning for the future. He should identify and prioritize his goals and make sure that he has taken care of the other foundational elements of his plan. 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 might 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 might have unrealistic expectations of doubling his investment in a short period of time. He should take a more diversified approach rather than investing only in stocks.

Sec 11.1; LO 11.1; BT: C; Difficulty: M; TOT: 1 min; AACSB:

4. A recent college graduate, Jeff Goldberg, is currently working as an office supply store manager. He wants to save money for a down payment on a home in a few years, and he’s heard that stock investing will help him quickly build his investment portfolio. Jeff can invest about $3,000 at the end of each of the next three years, and he thinks he’ll need to save $15,000 to $20,000 for the down payment. Jeff will hold this money in a taxable account, and his marginal tax rate is 15 percent.

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A. If Jeff puts the money in a CD earning 5 percent per year, how much will he have accumulated by the end of five years after taxes?

Answer: $16,330 Solution: He will have to pay tax on the interest earned each year, so his after-tax investment rate of return will be 4.25% [5% x (1 – 0.15)]. Calculate the future value of $3,000 in annual contributions to the CD account that pays 4.25% APY after-tax over 5 years.

Financial Calculator Enter PMT = -3,000, N = 5, I/Y = 4.25, PV = 0, and solve for FV = 16,330.35 ~ $16,330 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.0425, 5, -3000, 0, 0) => 16,330.35 ~ $16,330 TVM Equation

(1 + 𝑖)𝑛 -1 FVA = PMT 𝑥 𝑖 (1 + 0.0425)5 -1 FVA = $3,000 𝑥 = $16,330.35 0.0425

Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. An investment advisor has suggested that Jeff can earn at least 10 percent per year in stocks.

If he earns 10 percent, how much will he have accumulated by the end of five years before taxes?

Answer: $17,776 Solution: Calculate the future value of $3,000 in annual contributions to the brokerage account that is expected to earn 10% APY before taxes over 5 years. Jeff will not owe taxes on his gains until he sells the stock, at which time it will be taxed at the capital gains tax rate.

Financial Calculator Enter PMT = -3,000, N = 5, I/Y = 10, PV = 0, and solve for FV = 18,315.30 ~ $18,315 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.10, 5, -3000, 0, 0) => 18,315.30 ~ $18,315

TVM Equation

FVA = PMT 𝑥

(1 + 𝑖)𝑛 -1 𝑖

FVA = $3,000 𝑥

(1+0.1)5 -1 0.1

= $18,315.30 ~ $18,315

Sec 11.3; LO 11.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. Would you advise Jeff to invest in stocks, given his investment objective and time horizon?

Why or why not?

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Answer: His investment horizon is relatively short and doesn’t allow him much time to recover from a stock market decline. The projected difference in outcomes isn’t large enough ($17,776 – $16,330 = $1,446) to take the risk.

Sec 11.4; LO 11.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. If Jeff does decide to invest in stocks, what types of stocks would you recommend? Explain.

Answer: 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 market risk. He might not be able to diversify sufficiently because $3,000 per year doesn’t allow him to buy very many shares. He will also have to pay a commission on each transaction.

Sec 11.2; LO 11.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Analytic

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CHAPTER 12 Instructor Manual and Solutions Investing in Stocks and Bonds LEARNING OBJECTIVES LO 12.1 Describe the characteristics and classifications of common stock.

LO 12.2 Describe the characteristics and classifications of bonds.

LO 12.3 Compare the features of preferred stock with those of common stock and bonds.

LO 12.4 Describe the operation and regulation of the securities markets.

SUGGESTED COURSE PLAN You will probably need to allocate more than one week out of a typical 15–16 week semester to this chapter. For 50-minute classes, you can cover one Learning Objective in each session over 3 sessions. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS Pre-Class Assignments

WileyPLUS Resources to Use in Class

1

LO 12.1 Investing in Common Stock

DP 12.1 Stock Returns

2

LO 12.2 Investing in Bonds LO 12.3 Investing in Preferred Stock LO 12.4 Securities Markets

Interactive: Stock splits Interactive: Stock Valuation Measures Interactive: Bond terms

Reflection Question: Insider trading

Interactive: Selling short

3

DP 12.2 Bond YTM

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

PFP12.1 Bond YTM

Chapter 12 Homework A: R:1-4; P:1,2,4-6 Chapter 12 Homework B: R:11-14; P:10,11,13; Case 12.2 Adaptive Practice Ch 12

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY Chapter 12 Investing in Stocks and Bonds LO 12.1 Describe the characteristics and classifications of common stock.

INVESTING IN COMMON STOCK I.

WHAT IS COMMON STOCK? A. Why Do Companies Issue Stock?

B. What Are the Rights and Obligations of Stock Ownership?

II.

ADVANTAGES OF STOCK INVESTING A. No Management Responsibility B. Higher Long-Run Returns C. Liquidity D. Low Interest Rate Sensitivity E. Diversifiable Risk

III.

DISADVANTAGES OF STOCK INVESTING A. Risk B. No Control

IV.

CLASSIFICATION OF COMMON STOCK A. Income versus Growth Stocks B. Blue Chip Stocks C. Cyclical versus Defensive Stocks D. Industry and Sector E. Market Capitalization

V.

MEASURES OF COMMON STOCK PERFORMANCE

LO12.2 Describe the characteristics and classifications of bonds.

INVESTING IN BONDS I.

WHAT IS A BOND? A. The Purpose of Bonds

II.

TYPES OF BONDS A. Classification by Type of Issuer ETHICS IN ACTION: MORTGAGE-BACKED SECURITIES B. Classification by Bond Characteristics

.

III.

BOND TERMINOLOGY A. Prospectus B. Trustee C. Face Value D. Maturity Date E. Coupon Rate and Payment F. Callable Bonds G. Convertible Bonds

IV.

BOND VALUATION

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V.

WHY DO INVESTORS BUY BONDS? A. Predictable Income Stream B. C. D. E.

Matching Timing of Cash Flow Needs Lower Risk Diversification Profit on Price Changes

LO 12.3 Compare the features of preferred stock with those of common stock and bonds.

INVESTING IN PREFERRED STOCK I.

WHAT IS PREFERRED STOCK?

II.

PREFERRED STOCK VALUATION

III.

CONTRACT TERMS AFFECTING PREFERRED STOCK CASH FLOWS A. Callability B. Cumulative Dividends C. Fixed versus Adjustable Dividends D. Convertibility

IV.

THE BENEFITS AND RISKS OF PREFERRED STOCK

LO 12.4 Describe the operation and regulation of the securities markets.

SECURITIES MARKETS

.

I.

PRIMARY VERSUS SECONDARY MARKET

II.

SECURITIES EXCHANGES A. The Rise of Electronic Trading B. Listing of Securities

III.

BUYING AND SELLING STOCKS AND BONDS A. Bid and Ask Price B. Types of Orders C. Long versus Short D. Types of Brokerage Accounts

IV.

REGULATION OF SECURITIES MARKETS A. Information Disclosure Requirements B. Insider Trading C. Circuit Breakers D. Other Regulations

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TEACHING SUGGESTIONS 1. Discuss the long-term investment results of investing $1 in either T-Bills or the S&P500, and the how much better you could do if you always knew which of these investments would do better in a given year, as explained in the chapter opener. You can use this example to illustrate several important facts: a) information is very valuable; b) no one is very good at timing the market; c) just missing a few of the bad years or a few of the good years can also make a big difference.

2. Use the Walmart and IBM comparison graph in Figure 12.1, 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 period. This can also be used to illustrate the beneficial effects of diversification.

3. Have students interview an account executive for a local brokerage firm (or have one come into your class as a guest speaker). Ask students to find out how the broker is paid, what they like and dislike about their job, whether they provide additional financial planning services to clients, and whether discount brokers have affected their business over the last few years.

4. 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 (e.g., Coke, Facebook, Google, Apple). Discuss the problems with assuming that a good product (or good prices) from a consumer’s perspective always makes a good investment. 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?

5. Discuss the ethics of insider trading. You can motivate this discussion by giving an example that might seem to be legal to the novice investor. For example, your neighbor tells 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 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. If you have access to the Internet in your classroom, it is useful to demonstrate the investor tools that are widely available and easy to use. 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.

7. You may want to review some basic time value of money concepts and calculations before starting the bond section of this chapter. Valuation of bonds is a great application of these principles.

8. 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?

9. Discuss whether it’s possible to make money based on the inverse relationship that exists 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 when the Federal Reserve is expected to increase or decrease rates). However, 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 no one else did.

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CONCEPT REVIEW SOLUTIONS 1. Why do companies issue stock?

Answer: Companies issue stock to acquire funds to help their companies grow. The original owners will have a smaller proportional ownership interest after selling more shares, but they anticipate that the company will grow larger, so that they will own a smaller percentage of a much bigger enterprise.

Sec 12.1; LO 12.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

2. What is the difference between a stock dividend and a cash dividend, and which is preferable?

Answer: When a company is profitable, it sometimes distributes some of its profits to its shareholders in the form of a dividend. If the dividend is paid in cash, it is called a cash dividend. With a stock dividend, the company gives its shareholders additional shares in proportion to the number of shares they already own.

The stock dividend doesn’t immediately provide as much benefit to the investor as a cash dividend, but it has potential to produce continued benefits in the future if the company’s stock increases in value.

Sec 12.1; LO 12.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

3. What is a stock split, and why would a company take this action?

Answer: A stock split is similar to a stock dividend in that each shareholder gets a number of new shares in proportion to the number of shares already held. After the split, each shareholder will hold more shares, but the value per share will be lower. A company might do this if it thinks that the price of its shares is getting too high. By splitting each share into two or three shares, it can reduce the value of the shares to make them more affordable to investors.

Sec 12.1; LO 12.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

4. What is a blue chip stock, and why is it considered to be less risky than other classifications of stocks?

Answer: A blue chip stock is one issued by a large, stable, mature company. The earnings and growth of these large companies, tend to track the growth of the overall market. They are considered less risky than other classifications of stocks because they are consistent performers and are often leaders in their respective industries. They also commonly pay dividends to investors.

Sec 12.1; LO 12.1; BT: C; Difficulty: E; TOT: 1 min; AACSB:

5. What is a limit order, and under what circumstances would you want to place this type of order?

Answer: A limit order specifies the price at which you are willing to buy or sell a specific amount of stock.

When you place a limit order to sell, you specify the minimum price that you are willing to accept from a buyer. When you place a limit order to buy, you specify the maximum price you are willing to pay for the stock. This is a common practice because stock prices move quickly and may be volatile, and the limit set assures your price is met (or better) throughout the day, until the order is completed.

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

6. What is a stop order, and under what circumstances would you want to place this type of order?

Answer: A stop order is an order to buy or sell a specific amount of stock when the market price reaches your stop level. As soon as the stock actually trades at the “stop” price, the stop order becomes either a limit or market order. It is typically used to minimize losses or protect gains on existing holdings. For example, a stop-loss order at $25 means that as soon as the stock trades down to $25, the order becomes .

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a market-sell order and will immediately execute a sell at the best price, whereas a stop-limit sell order means that when the stock trades at $25, then it becomes a limit sell order. The difference, is that a stoploss order is meant to immediately exit the stock when the stop price is reached. There is no guarantee that the entire limit sell order can be executed, but $25 is the only price, or better, that can be executed.

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

7. What does it mean to sell short, and under what circumstances would an investor want to do this?

Answer: When you sell short, you sell stock that you currently do not own. In a short-sale, you essentially borrow the stock from your broker and sell it in anticipation that the stock will fall in price, at which time you buy the stock back in the open market and return to your broker. You do have to pay interest on the value of the stock that was borrowed until returned and pay for any dividend that was paid. Hence, selling short is an investment strategy that is used by investors who think that a stock will decline in value. Essentially, they are attempting to sell high and buy low, making a profit on the difference.

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

8. In what ways is short selling a riskier strategy than taking a long position in a stock?

Answer: When you have a long position in a stock, you own the shares, and the only opportunity cost is the time value of money. Stock ownership has the fundamental proposition that you gain in exact proportion to how much wealth the company that you own creates in value; upside is unlimited. The downside of owning a public company is limited to what you invest. The issues with short selling are: (1) You must pay interest on the value of the borrowed stock and reimburse for dividends paid during the short sale, (2) You have unlimited downside risk (the opposite of ownership). If the price unexpectedly rises you proportionately lose because the cost to buy back the stock can indefinitely go up; downside is unlimited, When you sell short, your gain is limited to the difference between the sell price and the price of the stock (which could theoretically go to zero), while your loss is potentially unlimited (to the point where your broker will close your account out when you have nearly no equity left in your account).

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

9. Why is the securities market so heavily regulated?

Answer: Before the current system of securities regulation was put in place, the securities market was a very dangerous place for investors. It was very difficult to get financial information about potential investments, and the information that was available was often fraudulent. Current securities regulations are designed to level the playing field, providing all investors with access to accurate information, and to protect investors from the fraudulent actions of others. Without investor trust and confidence in the integrity of the marketplace, there would be no securities marketplace, and this would have negative consequences for U.S. businesses that need investors’ funds to grow and prosper.

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

10. Why is it illegal for insiders to trade on nonpublic information, and who gets hurt by this activity?

Answer: Insider trading occurs when people who have nonpublic information about a company buy or sell shares of the company’s stock to make a profit. This is bad for financial markets because it causes other investors to lose confidence in the fairness of the system. Anytime an insider sells at a high price just before bad news about a company comes out, the loser is the buyer who didn’t have this information and therefore paid too much for the stock.

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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11. Why is debt financing cheaper than equity financing for a firm?

Answer: Debt financing is cheaper than equity financing for the issuing firm because: (1) Paying interest on debt is tax-deductible for the firm, (2) Debt capital leverages (magnifies) the profitability or loss of the firm, thus amplifying return on ownership (equity), as well as cash flows, (3) Equity capital essentially dilutes current ownership (pro-rata based on the equity capital raised) and lowers your return on equity.

Debt financing is more efficient and engineered to fit needs, but it has its limits when too much is borrowed and you can’t support the debt service.

Sec 12.2; LO 12.2; BT: C; Difficulty: E; TOT: 1 min; AACSB:

12. Why is a bond with a call provision less attractive to an investor than one without a call provision?

What effect does a call provision have on the yield for a callable bond?

Answer: A call provision allows the issuing firm to redeem the bonds from investors at some point prior to the bond maturity at a pre-defined price. This will normally happen when interest rates fall and the company believes that it can refinance the bonds at a lower coupon rate. Callable bonds have significant reinvestment risk. Non-callable bonds have permanence and definition; the cash-flow is certain, maturity is certain and the principal is certain. Callable bonds have uncertainty because if rates fall and your bonds are redeemed, you will not be able to replace the yield on the redeemed bond, especially if rates declined so much that the issuer can refinance. New issue callable bonds will have a slight relative premium in yield to compensate for the call risk. However, callable bonds that are at a premium to par, will trade with a considerable higher yield compared to comparable non-callable issues. This is because redemption is typically at or slightly above par, and you will take a loss on the bonds at redemption.

Sec 12.2; LO 12.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

13. Under what circumstances, would you want to have a bond with a convertibility feature? What effect does a convertibility feature have on bond yield? Explain.

Answer: Convertible bonds can be converted into a specific number of shares of stock at some point in the future. This would be beneficial if the value of the shares was greater than the value of the bonds. You could convert bonds into shares of stock and immediately sell them for a profit. Alternatively, if you thought the company would continue to do well, you could wait and sell later. Because this feature is obviously valuable, convertible bonds have a lower coupon rate than otherwise similar bonds that are not convertible.

However, the yield is likely to be lower, because the bond’s price will rise when the stock price rises.

Convertible bonds are also attractive for high growth companies because in the event of failure, bonds are considered obligations and will be paid back before any residual value is left for equity holders.

Sec 12.2; LO 12.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

14. Why do bond investors normally focus more on yield than on value in making their investment decisions?

Answer: The most fundamental reason that investors buy bonds is because fixed-income debt obligations have permanence and definition. The cash flows on a bond are permanent and defined: coupon payments and principal payments are on an exact schedule. If you hold a bond to maturity, you will get the yield to maturity that was in effect at the time you bought the bond. All the price movements from the time you bought the bond until maturity is not relevant if you hold the bond to maturity. Most bonds are purchased for the income.

Sec 12.2; LO 12.2; BT: C; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

15. In what ways is preferred stock similar to bonds, and in what ways is it similar to common stock?

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Answer: Preferred stock is like bonds and common stock in that it is issued by companies to raise capital to fund ongoing operations or expansion. Like bonds, preferred stock pays a fixed cash flow to investors, although payments are usually made quarterly, whereas bondholders generally receive semiannual payments. However, while bonds have a defined maturity, most preferred stock has no maturity. This is the reason it’s not a bond. Preferred stock is permanent capital like equity, and the company is not required to repay the original investment amount. This distinction allows dividends on preferred stock to share the same special tax rates as on common stock dividends. Preferred stock does not have voting rights like common stock. Preferred stock also typically trades much more like the high-yield bond than the common stock of the issuer; tends to be correlated to interest rates, but also sensitive to the company’s credit/business risk.

Sec 12.3; LO 12.3; BT: C; Difficulty: E; TOT: 1 min; AACSB:

16. If a firm gets into financial trouble and can’t make good on all its obligations, what rights does a preferred stockholder have compared with the rights of bondholders and common stockholders?

Answer: In the event of liquidation, the bondholders are repaid first, followed by the preferred stockholders.

The last in line to be paid are the common stockholders, which usually means that they will not get back any of their original investment. If a company isn’t going bankrupt, but experiences a cash shortfall, preferred stockholders must be paid their dividends before the company can pay any dividends to common stockholders.

Sec 12.3; LO 12.3; BT: K; Difficulty: M; TOT: 2 min; AACSB:

17. What are the primary risk exposures for preferred stock investors? How do these risk exposures differ from the risk exposures for common stock investors?

Answer: The main risks of holding preferred stock include interest rate risk, liquidity risk, call risk, and default risk. While, common stock investors are also exposed to default risk, but the other risks are less important to them. Interest rate risk is a problem because the value of preferred stock is the present value of the fixed dividend income. If interest rates go up, the value of preferred stock will go down, just like bonds. Preferred stock is less liquid than common stock because there is no active secondary market for trading these securities. If preferred stock is callable, investors can expect that it will be called when interest rates go down, which is bad for the investors because lower interest rates increase the value of the stock.

Both common and preferred stock are affected by the inherent risk of the company. Preferred stock also typically trades much more like the high-yield bond than the common stock of the issuer. It tends to be correlated to interest rates, but also sensitive to the company’s credit/business risk. Preferred stock will drop sharply if investors question the company’s ability to make dividend payments, and/or solvency of the company. The daily volatility of preferred stock, outside of business risk events, will be sensitive to longterm interest rates.

Sec 12.3; LO 12.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

18. How has electronic trading changed the securities market? In what ways has this benefited small investors?

Answer: Electronic trading makes it easier and cheaper to execute trades. This has brought down trading costs. Today, even small investors pay less than $10 per trade at most discount brokers. The downside to electronic trading is it has given rise to high-speed institutional trading, which has increased risk and volatility in the market.

Sec 12.4; LO 12.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

19. What is the difference between the primary market and the secondary market, and in which market are you most likely to trade in the future?

Answer: The primary market is where stocks and bonds are sold to the public for the first time.

The secondary market is where stocks and bonds that have already been issued are traded .

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between investors. Most individual investors trade in the secondary market only, although they can, on occasion, participate in an initial public offering for a stock.

Sec 12.4; LO 12.4; BT: K; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

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APPLICATION PROBLEM SOLUTIONS 1. You are considering three potential stock investments. Stock X is a blue chip stock issued by a company with $12 billion in market capitalization. Its dividend yield has been about 6 percent per year for several years, but its price hasn’t appreciated much. It has a P/E ratio of 8. Stock Y has a $3 billion market cap, pays a very small dividend, and has seen an average annual price appreciation of 15 percent over the last several years. Its P/E ratio is 14. Stock Z has a $500 million market cap and pays no dividend. Although it has yet to show a profit since it went public three years ago, its price has increased 25 percent per year in each of the last two years.

Identify the capitalization and income/growth classifications for each company.

A. Stock X is a _________cap company [drop down choices, Large-, mid-, small-] B. Stock Y is a_________cap company [drop down choices, Large-, mid-, small-] C. Stock Z is a_________cap company [drop down choices, Large-, mid-, small-] D. Stock X is a(n) _______ investment [drop down choices: Income, growth, growth and income] E. Stock Y is a(n) _______ investment [drop down choices: Income, growth, growth and income] F. Stock Z is a(n) _______ investment [drop down choices: Income, growth, growth and income] Answer: A. Stock X is a large-cap, B. Stock Y is a mid-cap, C. Stock Z is a small-cap., D. Stock X is an income investment; E. Stock Y is a growth and income investment; F. Stock Z is a growth investment Solution (for A –F): Blue chip stocks are all large-cap. In this case, Stock X has a market cap of $12 billion, which places it in the large-cap category (over $10 billion). Mid-cap stocks are from $2 to $10 billion, so Stock Y is a mid-cap ($3 billion). Small cap is less than $2 billion, so Stock Z is small cap ($500 million). An income stock is one that gets most of its return from dividend yield, and a growth stock gets most of its return from capital gains yield. Stock X has 6 percent dividend yield but minimal growth, so is an income stock. Stock Y pays a small dividend and has had annual appreciation of 15% over the last several years, so it is a growth and income stock. Stock Z does not pay a dividend, so it is a growth stock. (for A – F above) Sec 12.1; LO 12.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: G. Classify each of the companies as income or growth, if applicable.

Answer: Stock X is an income stock, Stocks Y and Z are growth stocks.

H. If you’re an aggressive stock investor, which stock would be most appropriate for you, and why? .

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Answer: Stock Z is best for aggressive investors because it has the greatest risk and growth potential.

It will not provide investors with any income to offset short-term losses. Small-cap growth stocks typically require capital to fund their growth, so they will not provide a dividend.

I. If you’re a conservative stock investor, which stock would be most appropriate for you, and why?

Answer: Stock X is best for conservative investors because blue-chip stocks are typically issued by mature companies that are well established and offer little uncertainty about future earnings. Stock X will have less variability over time and its dividend will provide a stable income.

J. If you have a five-year time horizon for achieving your investment objectives, would any of these investments be appropriate? Explain.

Answer: If you have a five-year time horizon, stocks are not the best choice, because they expose you to greater risk of short-term declines in value. Of these three stocks, Stock X will expose you to the least risk of loss of principal. You definitely wouldn't want to invest in Stock Z, because it currently has negative income and has already experienced a large price appreciation.

(For G-I above) Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

2. For each of the following companies, identify the classifications that apply to its stock—sector, industry, income versus growth, and market capitalization. If you don’t have sufficient information about the company, check the company website for more details.

A. The Gap (ticker: GPS) Answer: Sector: Consumer cyclical; Industry: Apparel retailers; Style: Income (dividend yield 5.6%); Capitalization: large-cap ($6.4B)

B. Intel Corporation (ticker: INTC) Answer: Sector: Technology; Industry: Semiconductors; Style: Income (dividend yield 2.5%); Capitalization: Large-cap ($224.7B)

C. Ford Motor Company (ticker: F) Answer: Sector: Consumer cyclical; Industry: Auto manufacturing; Style: Income (dividend yield 6.5%); Capitalization: Large-cap ($36.6B)

D. Chipotle Mexican Grill, Inc. (ticker: CMG) Answer: Sector: Consumer cyclical; Industry: Restaurants & Bars; Style: Growth; Capitalization: Largecap ($23.1B) Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

3. You bought 150 shares of ABC Corporation stock at $70 per share. When the stock price rose to $90 per share, the company management announced a three-for-one stock split. How many shares will you own after the split? _______shares

[Dropdown choices: 50, 75, 300, 450] .

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Answer: 450 shares Solution: You will get three shares for each of your original shares, so you will have 3 x 150 shares = 450 shares.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 4. You bought 150 shares of ABC Corporation stock at $70 per share. When the stock price rose to $90 per share, the company management announced a three-for-one stock split. What will the price per share be immediately after the split, rounded to the nearest dollar? $______per share [Drop down choices: 23.33, 30, 45, 90] Answer: $30 per share Solution: With a three-for-one split, you will receive three shares for each of your original shares, so you will now have 3 x 150 shares = 450 shares. The company is still worth about the same as before, so your three shares should worth the same as the original one share. Divide the stock price immediately before the split ($90) by 3 to find the new price per share: $90/3 = $30 per share.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 5. Marian buys $3,000 in stock and holds the shares for one year. If she pays $50 per share in cash, receives no dividend, and sells the shares for $55 per share one year later, what will be her return on investment, ignoring transaction costs?

A. 10% B. 5% C. 15% D. 20% Answer: 10% Solution: Use Equation 11.1 to calculate the investment return.

Rate of return =

Current income + End price − Beggining price Beginning price

Rate of return =

0 + $55 − $50 = 0.10 ~ 10% $50

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 6. Juanita buys $3,000 in stock and holds the shares for one year. If she pays $50 per share, with 50 percent margin, receives no dividend, and sells the shares for $55 per share one year later, what is her return on investment, ignoring transaction costs?

A. 20% B. 10% C. 60% D. 25% Answer: 20%

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Solution: Juanita is using 50% margin. Thus, the amount she paid to buy the stock is only 50% of the actual price, and the rest is borrowed funds. Her return on investment before transaction costs (interest on the margin loan plus any commissions) can be calculated using Use Equation 11.1: Rate of return =

Current income + End price − Beggining price Beginning price

Rate of return =

0 + $55 − $50 = 0.20 ~ 20% $25

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 7. The current price of a stock is $25 per share. You place a market order for 100 shares with a discount broker who charges $10 per transaction. By the time the order can be executed, the price has risen to $25.50. How much will you pay per share, including any commission charge?

A. $25.60 per share B. $25.50 per share C. $25.40 per share D. This order will not be executed because the price has risen above your maximum.

Answer: $25.60 per share

Solution: Total cost = (100 shares x $25.50 cost per share) + $10 commission = $2,560. The cost per share is $2,560 total cost of transaction divided by 100 shares = $25.60 per share.

Sec 12.4; LO 12.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 8. The current price of a stock is $25 per share. You place a limit order for 100 shares at $25.25 with a discount broker who charges $10 per transaction. By the time the order can be executed, the price has risen to $25.50. How much will you pay per share, including any commission?

A. $25.25 per share B. $25.35 per share C. $25.50 per share D. This order will not be executed because the price has risen above your maximum.

Answer: This order will not be executed because the market price has risen above your maximum. A limit order is an order to buy or sell the respective stock at the limit price or better for the trading day. Although the transaction price must be at the limit price or better, there is no assurance that the order can be completely fulfilled.

Sec 12.4; LO 12.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

9. A stock is currently selling for $30 per share, representing a price increase of $3 for the year, and there are 1 million shares outstanding. The company recently reported net income of $2 million.

The annual dividend per share is $1. What is the company’s earnings per share?

A. $2 per share B. $3 per share C. $1 per share D. 10% per share Answer: $2

.

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Solution: Earnings per share is the respective company’s net earnings, or net income divided by the total number of shares outstanding. It is also represented by Equation 12.4: After − tax net income Earnings per share = Number of outstanding shares Earnings per share =

$2,000,000 = $2/share 1,000,000 shares

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

10. A stock is currently selling for $30 per share, representing a price increase of $3 for the year, and there are 1 million shares outstanding. The company recently reported net income of $2 million. The annual dividend per share is $1. What is the company’s P/E ratio?

A. 15 times B. 1.5 times C. $15 per share D. $3 per share Answer: 15 times Solution: The P/E ratio is a measure of a company’s valuation based on a payback concept, or multiple of earnings to reach stock price. It represents how many years, based on the current net earnings it will take to equal (or payback) the current stock price. It is also represented by Equation 12.5: Price − to − earnings ratio = Price − to − earnings ratio =

Price per share Earnings per share $30 per share

$2,000,000 earnings ) 1,000,000 shares outstanding

(

= 15

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

11. You bought a stock for $27 per share one year ago and the share price is now $30. There are 1 million shares outstanding. The company recently reported net income of $2 million. The annual dividend per share is $1. What is the dividend yield over the last year?

A. 3.7% B. 3.3% C. $2 per share D. $1 per share Answer: 3.7% Solution: The dividend yield is the total dividends for the year (per share) divided by the stock price at the beginning of the respective year. It is also represented by Equation 12.2:

.

Dividend yield =

Annual dividend Beginning stock price

Dividend yield =

$1 = 0.037 ~ 3.7% $27

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Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

12. You bought a stock for $27 per share and the share price is now $30. There are 1 million shares outstanding. The company recently reported net income of $2 million. The annual dividend per share is $1. If you bought the stock one year ago, what was your total rate of return for the year?

Answer: 14.8% Solution: The total return for the year is the total of annual percentage change of the stock and the dividend yield. It can also be referred to as rate of return and calculated using Equation 11.1:

Rate of return =

Current income + End price − Beggining price Beginning price

Rate of return =

$1 + $30 − $27 = 0.148 ~ 14.8% $27

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

13. You have the following information about several potential stock investments:

Company Name Vixen, Inc. Denicorp Ferengi Oil Luke Enterprises

Beta 2.5 1.2 0.8 0.5

A. Which of these stocks has the most market risk?

[Drop down choices: all 4 company names] Answer: Vixen, Inc. Solution: Vixen, Inc. has the most market risk, because its beta (2.5) is the highest. Beta is a measure of the correlation between the stock price and a market index, most commonly the S&P 500.

A beta of 1 means that this stock moves 100% in-line with the market index. A beta greater than 1 means that the stock tends to swing greater than the market index by the beta multiple. For example, a beta of 2.5 would mean that the stock price tends to move 250% more (in the same direction) as the index. A beta less than 1 means that the stock price tends to swing less than the market index by the beta multiple. Furthermore, a beta of 0.5 means that the stock price tends to move 50% of the index (in the same direction). Hence, beta is a measure of how much volatility the stock has in comparison to its index. It is a common measure of how much unsystematic risk (business risk) a company has compared to the systematic risk (market risk). A beta that is negative means that the stock moves inversely to the respective index.

Sec 12.1; LO 12.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

B. Which of these companies has the least market risk?

.

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[Drop down choices: all 4 company names] Answer: Luke Enterprises Solution: Luke Enterprises has the least market risk, because its beta (0.5) is the lowest. Beta is a measure of the correlation between the stock price and a market index, most commonly the S&P 500.

A beta of 1 means that this stock moves 100% in-line with the market index. A beta greater than 1 means that the stock tends to swing greater than the market index by the beta multiple. For example, a beta of 2.5 would mean that the stock price tends to move 250% more (in the same direction) as the index. A beta less than 1 means that the stock price tends to swing less than the market index by the beta multiple. Furthermore, a beta of 0.5 means that the stock price tends to move 50% of the index (in the same direction). Hence, beta is a measure of how much volatility the stock has in comparison to its index. It is a common measure of how much unsystematic risk (business risk) a company has compared to the systematic risk (market risk). A beta that is negative means that the stock moves inversely to the respective index.

Sec 12.1; LO 12.1; BT: C; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

C. If the S&P 500 Index increased by 20 percent, which of these stocks would you expect to increase the most?

[Drop down choices: all 4 company names] Answer: Vixen Inc. Solution: Vixen, Inc. has a beta (2.5), the highest of the group. Beta is a measure of the correlation between the stock price and a market index, most commonly the S&P 500. A beta of 2.5 would mean that the stock price tends to move 250% more (in the same direction) as the index. Hence, a 20% move in the S&P 500 index would mean that a stock with a 2.5 beta would move 2.5 times that amount, or 50%. A positive beta means that the stock price moves in the same direction as the respective index, and a negative beta means that the stock price has an inverse relationship with the respective index.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

D. If the S&P 500 Index declined by 20 percent, which of these stocks would you expect to decline the least?

[Drop down choices: all 4 company names] Answer: Luke Enterprises Answer: Luke Enterprises has the least market risk, because its beta (0.5) is the lowest. Beta is a measure of the correlation between the stock price and a market index, most commonly the S&P 500.

A beta of 1 means that this stock moves 100% in-line with the market index. A beta greater than 1 means that the stock price tends to swing greater than the market index by the beta multiple. For example, a beta of 2.5 would mean that the stock price tends to move 250% more (in the same direction) as the index. A beta less than 1 means that the stock price tends to swing less than the market index by the beta multiple. Furthermore, a beta of 0.5 means that the stock price tends to move 50% of the index (in the same direction). A beta that is negative means that the stock price moves inversely to the respective index. Luke Enterprises’ 0.5 beta would mean that if the S&P 500 index declined by 20%, then the stock price would decline by 0.5 times, or 50% of the respective index; down 10%.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

.

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14. You own 400 shares of a blue chip company’s stock, which you bought last year for $65 per share.

The company pays a quarterly dividend of $0.90 for a total of $3.60 per year. How much will your dividend check be this quarter?

Answer: $360 Solution: To find the dividend income this quarter, multiply the number of shares you own by the quarterly dividend per share: 400 shares x $0.90 pre share dividend = $360.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic 15. You own 100 shares of a dividend-paying stock and receive total dividends for the year of $360.

What tax rate will be applicable to these dividends if the stock is held in a taxable account for at least one year, and you’re in the 12 percent federal income tax bracket in 2019?

[Drop down menu: 0%, 10%, 15%, 20%] Answer: 0% Solution: If you hold common or preferred stock long enough to be entitled to a dividend, it is subject to the same special lower tax rate that applies to long-term investment capital gains. Table 11.2 details the federal long-term capital gains tax rates applicable in 2019.

If you are in the 12 percent bracket for federal income taxes, your dividends will be taxed at the capital gains tax rate of 0 percent.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

16. You own 100 shares of stock for which you paid $65 per share. If the company pays a dividend of $3.60 per share, what is the dividend yield on this stock?

Answer: 5.5% Solution: The dividend yield is the total dividends for the year (per share) divided by the stock price at the beginning of the respective year. It is also represented by Equation 12.2: Dividend yield =

Annual dividend Beginning stock price

Dividend yield =

$3.60 = 0.055 ~ 5.5% $65

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

.

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17. Ariel bought 100 shares of Puck Stores stock for $20 per share one year ago. Before the market opened today, she placed a limit order to sell her stock at a price of $26 per share. The stock price at the market open was $25.50; it hit a high of $27 at around noon but was back down to $25.50 by the close. Her trading costs were $10 per transaction, and the stock paid no dividends during the year. What was Ariel’s return on investment on this stock for the year? If she had placed a market order instead, how much would she have sold her shares for, and what would her return on investment be?

Answer: Her return on investment with the limit order was 28.9%. If she had placed a market order instead, her return on investment would have been 26.4% Solution: The total return for the year is the total of annual percentage change of the stock and the dividend yield. It can also be referred to as rate of return and calculated using Equation 11.1:

𝑅ate of return =

Current income + End price − Beggining price Beginning price

Limit-Order Sale Sale proceeds = ($26 per share x 100 shares) - $10 transaction fee = $2,590.

Cost = ($20 per share x 100 shares) + $10 transaction fee = $2,010.

Rate of return =

$0 + $2,590 − $2,010 = 0.289 ~ 28.9% $2,010

Market-Order Sale Sale proceeds = ($25.50 per share x 100 shares) - $10 transaction fee = $2,540.

Cost = ($20 per share x 100 shares) + $10 transaction fee = $2,010.

Rate of return =

$0 + $2,540 − $2,010 = 0.264 ~ 26.4% $2,010

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic 18. A corporation issued a fixed-rate coupon bond that pays a coupon rate of 7.65 percent in semiannual payments and has a maturity date of March 2033. The face value of the bond is $1,000.

How much will each bondholder receive every six months?

[Dropdown choices: $38.25, $3.85, $7.65, $76.50] Answer: $38.25 Solution: The annual coupon payment is based on the original yield of the bond and the original issuance price of the bond (par or face value). It is also represented by Equation 12.6: Coupon payment = Coupon rate × Face value Coupon payment = 0.0765 x $1,000 = $76.50 Semi-annual coupon payment = $76.50 annual coupon / 2 payments in a year = $38.25 Sec 12.2; LO 12.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

19. A corporation issues fixed-rate coupon bond that pays a coupon rate of 7.65 percent in semiannual payments, and has a maturity date of March 2033. The face value of the bond is $1,000. At maturity, how much will the bondholders be paid? .

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Answer: $1,038.25 Solution: Bonds pay the stated interest every six months. The last payment of interest will be on the date of maturity, at which time the bondholder will also be repaid the face value of the bond. The semiannual interest payments are (7.65% x $1,000)/2 = $38.25.

Therefore, at maturity, these bondholders will be paid the face value of $1,000 + 38.25 = $1,038.25.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic 20. ABC Corp. has two coupon bond issues outstanding: each bond has a face value of $1,000 and semiannual coupon payments. Bond 1 has 20 years to maturity, a 5 percent coupon rate, and a current price of $850. Bond 2 has 10 years to maturity, a 6 percent coupon rate, and a current price of $1,000.

A. Calculate the current yield for each bond.

Answer: The current yield for Bond 1 is 5.9%, and the current yield for Bond 2 is 6%.

Solution: Current yield is the annual coupon divided by the price. To find the current yield, multiply the face value by the coupon rate to obtain the annual income, and then divide by the price.

Bond 1 Annual coupon = 0.05 x $1,000 face = $50 Current yield = $50 annual coupon / $850 current price = 0.059 ~ 5.9% Bond 2 Annual coupon = 0.06 x $1,000 face = $60 Current yield = $60 annual coupon / $1,000 current price = 0.060 ~ 6.0% Sec 12.2; LO 12.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

B. Given that both of these bonds are issued by the same company, why is the 20-year bond so much cheaper ($850) than the 10-year bond ($1,000)?

Answer: The price of a coupon bond will fall below the face value when the coupon rate being paid on that bond is lower than market rates. The price of a bond will be equal to its face value, only if the market rate of interest is the same as the coupon rate (as is the case with the 10-year bond here). If you buy the lower-priced bond, you can expect to earn not only the coupon yield, but also a capital gains yield if held to maturity. Notice that the current yield for Bond 2 is exactly the same as the coupon rate (6%), and you will make zero capital gains if you hold it to maturity ($1,000 – $1,000 = 0). In contrast, the current yield for Bond 1 is 5.9%. That’s lower than 6%, but you will also make a $150 capital gain if you hold that bond to maturity.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking 21. You buy a fixed-rate coupon bond that has a face value of $1,000 and 10 years to maturity. The current market price is $910, and the coupon rate is 8 percent with semiannual payments. What is the yield to maturity for this bond?

A. 9.4% B. 4.7% C. 8% D. 4% Answer: 9.41% Solution: Calculate the interest rate required to make a $910 present value grow to $1,000 future value, if you also receive 4% of the future value in semi-annual annuity payments for 10 years. .

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Financial Calculator Enter PV = -910, FV = 1,000, N = 20, PMT = (1,000 x 0.04), and solve for I = 4.704 (semi-annual) Excel Spreadsheet =Rate(nper,pmt,pv,fv,type) => =Rate(20, (1000*0.04), -910, 1000, 0) => 4.704% (semi-annual) Yield to Maturity = 4.704% semi-annual yield x 2 = 9.41% Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

22. You are deciding between two bonds. Both are issued by the same highly rated company, have a coupon rate of 6 percent (with semiannual payments), and a face value of $1,000. Bond A has 10 years to maturity (current price $928.94) and Bond B has 20 years to maturity (current price $802.07).

A. If both bonds are issued by the same company and pay the same coupon rate, why is one cheaper than the other?

Answer: Bonds with longer maturities have a greater time-value-of-money discount. Cash flows such as coupons and principal are worth progressively less, further out in time. The largest cash-flow from a bond is the principal, which is also the last cash flow paid out. In addition, if a bond is issued by a company, there is a credit-risk premium that increases as the maturity is extended to reflect further uncertainty that exists with a longer period of time.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

B. Calculate the yield to maturity for each bond.

Answer: Bond A = 7.0%; Bond B = 8.0%.

Solution: Calculate the interest rate required to make the present value grow to $1,000, if you also receive a semi-annual payment of $30 (6% of $1,000 / 2) over 10 and 20 years.

BOND A Financial Calculator Enter PV = -928.94, FV = 1,000, N = 20, PMT =30, and solve for I = 3.50 (semi-annual) Excel Spreadsheet =Rate(nper,pmt,pv,fv,type) => =Rate(20, 30, -928.94, 1000, 0) => 3.50% (semi-annual) Yield to Maturity = 3.50% semi-annual yield x 2 = 7.00% BOND B Financial Calculator Enter PV = -802.07, FV = 1,000, N = 40, PMT = 30, and solve for I = 4.0 (semi-annual) Excel Spreadsheet =Rate(nper,pmt,pv,fv,type) => =Rate(40, 30, -802.07, 1000, 0) => 4.0% (semi-annual) Yield to Maturity = 4.0% semi-annual yield x 2 = 8.0% Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

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C. Assume that one year later, the yields on comparable investments have risen to 8 percent and 9 percent, respectively. Which of these two bonds would be expected to experience a greater decline in value?

Answer: Bond B

Solution: Bonds with longer maturities will have greater interest rate risk and larger price changes, for a given change in interest rates, than shorter maturity bonds. This is because the principal, the largest cash-flow, is paid at maturity, and changes in rates will affect the discounting over a greater period of time. In this case, you can calculate the new price after the interest rate change, and determine that Bond A fell by 6% and Bond B fell by 9%.

BOND A Financial Calculator Enter I = (8/2), FV = 1,000, N = 18, PMT =30, and solve for PV = -873.41 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV((0.08/2), 18, 30, 1000, 0) => -873.41 Change in Price =

$873.41−$928.94 = −0.060 ~ − 𝟔. 𝟎% $928.94

BOND B Financial Calculator Enter I = (9/2), FV = 1,000, N = 38, PMT =30, and solve for PV = -729.25 Excel Spreadsheet =PV(rate,nper,pmt,fv,type) => =PV((0.09/2), 38, 30, 1000, 0) => -729.25 Change in Price =

$729.35−$802.07 = −0.091 ~ − 𝟗. 𝟏% $802.07

Sec 12.2; LO 12.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

23. Simone owns 10 bonds from the same bond issuer. Each has a $1,000 face value and a 6 percent coupon rate. If Simone has a marginal tax rate of 25 percent, what is her annual after-tax interest income from these bonds?

Answer: $450.00 Solution: The annual coupon payment is based on the original yield of the bond and the original issuance price of the bond (par or face value). It is also represented by Equation 12.6: Coupon payment = Coupon rate × Face value Coupon payment = 0.06 x $1,000 = $60 Annual interest income = $60 per bond x 10 bonds = $600 After-tax income is calculated using Equation 4.2: After-tax income = Before-tax income × (1 − Tax rate) After-tax income = $600 x (1 - 0.25) = $450 Sec 12.2; LO 12.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

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24. For each of the following investments, calculate the after-tax yield, assuming that the marginal federal income tax rate is 24 percent and the marginal state tax rate is 6 percent. (Round to the nearest 0.1%)

A. Corporate bond held in a taxable account with an 8 percent pretax yield Answer: 5.6% Solution: Interest income is taxed at the ordinary income tax rate, in this case the sum of the federal and state marginal rates (24% + 6% = 30%). Using Equation 4.2 for yield instead of income, calculate the after-tax yield.

After-tax yield = Before-tax yield × (1 – Combined tax rate) After-tax yield = 8.0% x (1 - 0.30) = 5.6% Sec 12.2; LO 12.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

B. Municipal bond (issued in the purchaser’s state of residence) held in a taxable account with a 7 percent pretax yield.

Answer: 7.0%.

Solution: Interest on municipal bonds is exempt from federal tax, and if issued in the purchaser’s state of residence, is exempt from state tax as well. Therefore, the after-tax yield is equal to the pretax yield.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

C. U.S. Treasury bond held in a taxable account with a 5 percent pretax yield Answer: 3.8%

Solution: Interest on Treasury bonds is not taxable by the state, so the applicable marginal tax rate is only the 24% federal rate. Using Equation 4.2 for yield instead of income, calculate the after-tax yield.

After-tax yield = Before-tax yield × (1 – Combined tax rate) After-tax yield = 5.0% x (1 - 0.24) = 3.8% Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

25. A company’s preferred stock has a par value of $25 and a dividend rate of 7.5 percent. How much will be paid per share each year?

Answer: $1.88 Solution: To find the dividend per share, multiply the dividend rate by the par value = 7.5% x 25 = $1.875.

Sec 12.3; LO 12.3; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

26. You are considering the purchase of shares of preferred stock that pay an annual dividend of $10.

A. If the market price of the preferred shares is currently $111, what is the yield?

Answer: 9% Solution: To find the dividend yield, use Equation 12.2:

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Dividend yield =

Annual dividend Beginning stock price

Dividend yield =

$10 = 0.09 ~ 9.0% $111

Sec 12.3; LO 12.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

B. If market interest rates increase so that investors in these securities now require 1 percentage point more in yield, how will this affect the price of the stock?

[Drop down choices: Increase, Decrease, Stay the Same] Answer: If required yields on preferred stock go up, the price of these shares will go down.

Annual dividend

Dividend yield = Beginning stock price

=>

Stock price ? =

Annual dividend remains same Dividend yield GOES UP

Looking at Equation 12.2, you can see that if the dividend remains the same in the numerator and the yield goes up in the denominator, then the stock price must go down.

C. If the market price goes down from $111 to $100 in one year, what is the capital gain or loss for investors?

Answer: $11 capital loss Solution: To find the capital gain or loss, subtract the net sales proceeds of the investment by the net cost of the investment. “Net” means that all transaction costs associated with the buy or sale in included. $100 sale - $111 cost = - $11 ~ $11 capital loss.

Sec 12.3; LO 12.3; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

27. Bonnie wants to buy zero-coupon bonds as a means of saving for retirement. She finds that the current price of a zero-coupon bond with a face value of $1,000 and 30 years to maturity is $231.40.

A. If she buys this bond and holds it to maturity, what is Bonnie’s annual yield to maturity before taxes?

Answer: 5% Solution: A zero-coupon bond does not pay a coupon, or annuity payment. Thus, it is simply a lumpsum TVM calculation.

Financial Calculator Enter PV = -231.40, N = 30, FV = 1,000 = , and solve for I = 5.0 Excel Spreadsheet =Rate(nper,pmt,pv,fv,type) => =Rate(30, 0, -231.40, 1000, 0) => 5.0 TVM Equation FV = PV x (1 + i)n

$1,000 = $231.40 x (1+i)30 .

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($1,000/$231.40)1/30 -1 = i = 0.05 ~ 5% Sec 12.2; LO 12.2; BT: C; Difficulty: M; TOT: 1 min; AACSB: Analytic

B. Explain why it is advisable that Bonnie hold these bonds in a tax-deferred or tax-exempt retirement account.

Answer: The annual 5 percent return is taxable even though the return has not actually been realized.

The IRS treats the annual appreciation in the value of zero coupon bonds as undistributed interest and requires that investors report it as taxable income each year. If the bonds are held in a tax-exempt account, no money will be due ever. If the bonds are held in a tax-deferred account, then the interest is still realized, but will not be recognized for taxation purposes until it leaves the tax-deferred account.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

28. Lenore is subject to a 30 percent marginal tax rate. She has purchased 6.5 percent municipal bonds, which are exempt from federal and state taxes. What yield would she need to earn before tax on a taxable investment to obtain an after-tax interest yield equivalent to what she is earning on the municipals?

Answer: 9.29%

Solution: To find the yield she would need to earn, use Equation 4.2.

After-tax income = Before-tax income × (1 − Tax rate) Before-tax income = After-tax income / (1-tax rate) Before-tax income = 6.5%/(1-0.30) = 0.0929 ~ 9.29% Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

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CASE APPLICATION SOLUTIONS 1. One year ago, Joe and Marissa Morini made several large-cap stock investments. They used no margin, and their trading costs were $8 per transaction. Their purchases included the following:

100 shares of Stock A at $26 (annual dividend, $0.16) 100 shares of Stock B at $35 (annual dividend, $0.60) 100 shares of Stock C at $40 (annual dividend, $0.50) 100 shares of Stock D at $15 (no dividend) The current stock prices are as follows: Stock A, $29; Stock B, $33; Stock C, $41; and Stock D, $18.

A. What was the total start-up cost for their investment portfolio?

Answer: $11,632 Solution: The cost of each position is the number of shares of each stock purchased multiplied by the purchase price of the respective stock and the commission for the trade. The cost of the portfolio is the sum of all the purchases.

Stock A: (100 shares x $26 per share) + $8 transaction cost = Stock B: (100 shares x $35 per share) + $8 transaction cost = Stock C: (100 shares x $40 per share) + $8 transaction cost = Stock D: (100 shares x $15 per share) + $8 transaction cost = Total cost

$2,608 $3,508 $4,008 $1,508 $11,632

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Analytic

B. What is the current value of the Morini’s portfolio?

Answer: $12,100 Solution: The value of each position is the number of shares of each stock owned multiplied by the current price of the respective stock. The value of the portfolio is the sum of all the positions.

Stock A: (100 shares x $29 per share) = Stock B: (100 shares x $33 per share) = Stock C: (100 shares x $41 per share) = Stock D: (100 shares x $18 per share) = Total cost

$2,900 $3,300 $4,100 $1,800 $12,100

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. Calculate the dividend yield and capital gains yield for each of the Morini’s stocks, ignoring transaction costs.

Answer: Stock A: dividend yield, 0.62%; capital gains yield, 11.5%. Stock B: dividend yield, 1.7%; capital gains yield, –5.7%. Stock C: dividend yield, 1.25%; capital gains yield, 2.5%. Stock D: dividend yield, 0; capital gains yield, 20%.

Solution: The dividend yield is the annual dividend as a percentage of the purchase price of the respective stock (Equation 12.2). The capital gains yield is the annual change in stock price as a percentage of the purchase price of the respective stock (Equation 12.3).

Dividend Yield Stock A: ($0.16 annual dividend / $26 per share cost) = 0.062 ~ 0.62% dividend yield Stock B: ($0.60 annual dividend / $35 per share cost) = 0.0171 ~ 1.71% dividend yield .

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Stock C: ($0.50 annual dividend / $40 per share cost) = 0.0125 ~ 1.25% dividend yield Stock D: (no dividend) Capital Gains Yield Stock A: ($29 current - $26 cost)/$26 cost = 0.1154 ~ 11.54% Stock B: ($33 current - $35 cost)/$35 cost = -0.0571 ~ -5.71% Stock C: ($41 current - $40 cost)/$40 cost = 0.0250 ~ 2.50% Stock D: ($18 current - $15 cost)/$15 cost = 0.2000 ~ 20.00% Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Analytic

D. Calculate the annual return on investment for the Morini’s investment portfolio.

Answer: 5.1% Solution: The annual return for the portfolio is the total dividends and capital gains for the portfolio as a percentage of the total cost of the portfolio.

Total Annual Return Stock A: $0.16 dividend + ($29 current - $26 cost) x 100 shares - $8 = Stock B: $0.60 dividend + ($33 current - $35 cost) x 100 shares - $8 = Stock C: $0.50 dividend + ($41 current - $40 cost) x 100 shares - $8 = Stock D: no dividend + ($18 current - $15 cost) x 100 shares - $8 = Total annual return

$308.00 -$148.00 $142.00 $292.00 $594.00

Total Cost of Portfolio Stock A: (100 shares x $26 per share) + $8 transaction cost = Stock B: (100 shares x $35 per share) + $8 transaction cost = Stock C: (100 shares x $40 per share) + $8 transaction cost = Stock D: (100 shares x $15 per share) + $8 transaction cost = Total cost

$2,608 $3,508 $4,008 $1,508 $11,632

ANNUAL % RETURN = Total Annual Return / Total Cost of Portfolio $594 / $11,632 = 0.0511 ~ 5.11% annual percentage return of portfolio Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 4 min; AACSB: Analytic

E. Based on their stock selections, what index or market average would you recommend the Morinis use as a benchmark for their portfolio?

Answer: Because the Morini’s are holding large-cap stocks, they should compare their performance with an index that includes only large-cap stocks, such as the S&P 500.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Reflective Thinking

F. Assuming that the return on the S&P 500 Index for the same period was 12 percent, how well did the Morinis do?

Answer: The Morinis’ portfolio performed poorly relative to the S&P 500 index. Their 5.1 percent return was much lower than the 12 percent market return.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB:

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G. If the Morinis would like to add to their current stock portfolio, in what ways could they improve its diversification?

Answer: The Morinis only have four large cap stocks in their portfolio, which isn't enough to diversify the individual business risks associated with each holding. The Morini’s should consider their sector and industry diversification. While Stock A and Stock B performed in-line with the S&P 500, the other 2 stocks did not. By adding more stocks to the portfolio that represent the entire economy, much like the 500 companies in the S&P 500, the performance of a few stocks should not drag down the entire portfolio’s performance In addition, they are not very diversified based on market capitalization, so they might want to add some smaller growth companies to their portfolio. They might also consider purchasing stock mutual funds or indexed securities to get better diversification.

Sec 12.1; LO 12.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

2. Ernie and Belinda Maxwell often tell people that they’re “68 years young.” They have an active lifestyle, playing golf, regularly volunteering at their church, and traveling around the country in their RV to visit their three children and five grandchildren. But as they approach their 50th wedding anniversary, they are beginning to worry about their finances. When Ernie retired 10 years ago, his retirement fund accumulation of over $1 million had seemed more than sufficient to support their lifestyle. Their home mortgage was paid off, and their children were grown. After investing all of the retirement fund in corporate bonds with a laddered maturity structure of 20 years (because they didn’t want to risk their money in the stock market), they were happy to find that their nest egg produced income of about $80,000 a year before taxes. Ten years later, the Maxwells (who are in the 25 percent tax bracket) are finding that it’s harder ‘to live on that amount of income each year. They’ve gradually been selling bonds, so they now have less to invest.

Their portfolio includes bonds with about $850,000 in total face value, and it is generating only $60,000 in before-tax income. As they’ve reinvested money from maturing bonds, Ernie and Belinda have been dismayed to find that market yields have fallen since they originally retired, to a current level of 5.5 percent for 20-year corporate bonds. The Maxwells, who are in excellent health, expect to live into their 90s based on their family histories and are worried about outliving their money.

A. What was the average coupon rate on the original bonds in the Maxwells’ portfolio? What is it now?

Answer: 8% on the original bonds and 7.06% now Solution: The coupon rate is the rate that the bonds are producing in fixed income every year. Their initial portfolio of $1 million produced $80,000 in annual income. Using Equation 12.6 we can calculate the coupon rate: Coupon payment = Coupon rate x Face value.

The original coupon rate = $80,000 coupon payments / $1,000,000 value of bonds = 0.08 ~ 8% The current coupon rate = $60,000 coupon payments / $850,000 value of bonds = 0.0706 ~ 7.06% Sec 12.2; LO 12.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

B. Why has the income from the Maxwells portfolio fallen over the past 10 years?

Answer: The income from a fixed-income portfolio essentially stays the same. A risk of holding very long-term bonds is that the income (coupon) is fixed and that the cash-flow will not keep up with inflation.

Thus, over 10 years it’s not a surprise that they cannot keep up their standard of living on the exact same fixed-income. Hence, they were forced to use principal. This creates a negative multiplier effect as the more principal is reduced, the less bonds are available to generate income.

The Maxwells tried to reduce the potential effects of reinvestment risk in a lower interest rate environment by laddering the bonds over 20 years (buying bonds in staggered maturities to avoid reinvestment risk).

However, if rates declined over the 10 year period that they held the bonds, they would still experience a decline in fixed-income. The declining fixed-income from reinvested bonds and the inflation effects on .

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their standard of living that caused the Maxwells to sell the bonds, resulting in lost interest income from the sold bonds, all contributed to their current situation.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. If market interest rates rise, will the Maxwells’ income rise accordingly? Why or why not?

Answer: If market rates rise, the Maxwells will not immediately see any increase in their income, because they will still be receiving the fixed coupon payments on their existing portfolio. The market value of their bonds will go down, but this should not be a problem, because they are holding all the bonds to maturity and will still receive the face value at maturity. The time at which bonds mature will determine when higher coupon bonds can be added to their portfolio.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. Are the Maxwells correct to worry about outliving their assets? Explain.

Answer: Yes, the Maxwells are right to worry. They now only have $850,000 in face value, which is providing them with only $60,000 in income. They seem to need more than that to maintain their current lifestyle, so they need to reduce their expenses. Otherwise, they will have to continue to sell bonds or not reinvest them as they mature. This will further reduce their interest income.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

E. Is the Maxwells’ present asset allocation (100 percent corporate bonds) appropriate for their lifecycle stage and risk preferences? Why or why not?

Answer: Given that the Maxwells anticipate living another 20 years, they need to make some changes if they want to avoid the risk of running out of money. They probably should have some of their money invested for growth. Although this will increase the risk of their portfolio, it might be riskier for them to continue to erode their nest egg. They should also think about whether they want to spend all of 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.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

F. Did the Maxwells make a good decision 10 years ago when they chose to invest exclusively in fixed-income securities?

Answer: No. The Maxwells anticipated living into their 90s when they retired at 58 years old; that’s 32 years. The time horizon of 32 years meant that their biggest concern should have been inflation (purchase power parity) and not the markets. The economy lives on cycles and 32 years would mean they would live through at least 3 economic cycles. Whereas, even at a historically low 2% inflation rate, purchasing power would be cut in half if living on a fixed income. Owning fixed-income securities would guarantee pay-cuts every year, based on maintaining your current living standard. Stocks are the only asset class that has maintained growth over inflation in the long-run. Think about what inflation is. A rise in essential services, food, entertainment, housing, consumer appliances and electronics are all reflected in increased revenue for the corporations that provide the goods and services. While some companies can increase prices above inflation and some cannot, a diversified portfolio of stocks will maintain revenue and earnings above inflation. 32 years is a lot of time to make it through market swings.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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G. If the Maxwells continue to buy and hold bonds, is their investment strategy fairly low risk? What risk exposures do they still face?

Answer: Although they thought that they were opting for low risk, they are currently facing reinvestment rate risk and inflation risk. As they reinvest their maturing bonds, they may have to buy new bonds with lower coupon rates, resulting in reduced income. They also face inflation risk. Although their interest income on existing bonds is fixed, the purchasing power of that income is declining over time.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. Mike Hettwer was pleased to find that his great-uncle Clyde, who lived to the ripe old age of 87, had remembered all his nieces and nephews in his will. Instead of leaving them cash, however, Clyde’s will said that he wanted them all to get a taste of investing. Clyde’s bequest to Mike was a portfolio of bonds issued by different corporations, with a total face value of $60,000. Mike is 25 years old and earns $40,000 per year. His marginal tax rate is 15 percent, and he has no other investments at the moment. Mike asked you for advice on his investments, and you requested that he look up some information on them first. He has summarized the information as follows: Bond 1 2 3 4 5 6

Number of Bonds 10 10 10 10 10 10

Bond Rating Aaa Aaa Ba Ba B B

Coupon Rate 5.3 6.7 7.5 8.2 9.0 7.8

Term to Maturity 25 13 20 10 17 5

Yield

Price

6.0 5.2 7.5 7.0 8.5 8.0

$910 $1,140 $1,000 $1,085 $1,045 $992

A. Based on Mike’s information about the bonds, estimate the market value of his portfolio.

Answer: $61,720 Solution: Calculate the market value of each bond by multiplying the number of bonds by the price.

Bond 1: 10 bonds x $910 = $9,100 Bond 2: 10 bonds x $1,140 = $11,400 Bond 3: 10 bonds x $1,000 = $10,000 Bond 4: 10 bonds x $1,085 = $10,850 Bond 5: 10 bonds x $1,045 = $10,450 Bond 6: 10 bonds x $992 = $9,920 Total Portfolio Value

$61,720

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: Analytic

B. Mike is pretty excited to find out how high the average yield on these bonds is. Do you agree that these are good investments for him? Why or why not? Explain your reasoning.

Answer: Although the average yield is fairly high, most of these bonds are junk bonds (as indicated by their B-ratings). Because 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. If he is willing to take on that much business risk, then he should consider stocks. While both

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stocks and junk bonds have equal downside risk (full investment), bonds have a capped upside of return of principal, where stocks have no limit to the upside.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. Mike asks you why the two bonds with Aaa ratings don’t have the same yield. Explain.

Answer: The two Aaa-rated bonds have yields of 6.0 percent and 5.2 percent. The reason for the difference is that the higher-yielding bond has 25 years to maturity and the lower one has only 13 years to maturity. Because longer maturities imply greater risk, the yields are higher on such bonds. The longer maturity bonds will also have a lower price reflecting the lower value of the present value of the extended cash flows that include the principal.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

D. Are the differences in yield between the Aaa-rated bonds and the other bonds reasonable?

Answer: Yes, the differences in yields are reasonable, given the current term structure of interest rates (time value of money). The higher yield due to credit risk seems reasonable. The difference between the 25-year Aaa (6.0 percent) and the 20-year Ba (7.5 percent) is 1.5 percent, whereas the 25-year Aaa bond is yielding 2.5 percent less than the 17-year B-rated bond. The difference between the 13-year Aaa (5.2 percent) and the 10-year Ba (7.0 percent) is 1.8 percent, implying that the risk premium for a moderate increase in default risk is between 1.5 and 1.8 percent, whereas the risk premium is a little greater for the lower-rated bonds.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

E. How diversified is Mike’s portfolio, based on default risk? Assuming that he decides to stay invested in bonds, should he consider any changes in asset allocation?

Answer: Mike is not very diversified. He is very young, and therefore he should be invested in some growth assets, such as stocks. He might want to sell some of his bonds to diversify into other asset classes. At a minimum, he could take his interest income and invest it in stocks as he receives it, as well as investing in stocks as his bonds mature. If he decides to remain invested in bonds, he should probably consider some reallocation. Two-thirds of his entire portfolio is invested in riskier bonds.

Sec 12.2; LO 12.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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CHAPTER 13 Instructor Manual & Solutions Investing in Mutual Funds and Real Estate LEARNING OBJECTIVES LO 13.1 Distinguish different types of investment companies based on key characteristics.

LO 13.2 Explain the advantages and costs of investing in mutual funds versus individual securities.

LO 13.3 Identify the advantages and disadvantages of direct and indirect real estate investments.

LO 13.4 Explain why investments in precious metals, gems, collectibles, cryptocurrency, and derivatives are speculative.

SUGGESTED COURSE PLAN You can easily cover this chapter in one week out of a typical 15– to 16- week. For 50-minute classes, you can cover two Learning Objectives in each session over 2 sessions. Some instructors may choose to assign only LO1 and LO2 (mutual funds) for their course. Here is a suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS PreClass Assignments

WileyPLUS Resources to Use in Class

Personal Financial Planner Assignment

WileyPLUS Homework Assignment

1

LO 13.1 Types of Mutual Funds LO 13.2 investing in Mutual Funds LO 13.3 Real Estate LO 13.4 Speculative investments

Reflection: Socially Responsible Investing

DP13.1

PFP 13.1 Mutual Fund Comparison

Chapter 13 Homework A: R:1,3,4,7,8; P:1,4-7

Reflection: Investing in rentals

DP13.2, DP13.3

PFP 13.2 Real Estate Investment Return

Chapter 13 Homework B R:11-13; P:12-14

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Adaptive Practice Ch 13

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE Chapter 13 Investing in Mutual Funds and Real Estate LO 13.1 Distinguish different types of investment companies based on key characteristics.

WHAT IS A MUTUAL FUND? I.

WHAT DOES A FUND INVESTOR ACTUALLY OWN?

II.

TYPES OF INVESTMENT COMPANIES A. Open-End Funds B. Closed-End Funds C. Exchange-Traded Funds D. Unit Investment Trusts E. Real Estate Investment Trusts

III.

GROWTH IN THE MARKET

IV.

CLASSIFICATION OF MUTUAL FUNDS A. Classification by Investment Objective B. Classification by Portfolio Composition

LO13.2 Explain the advantages and costs of investing in mutual funds versus individual securities.

MUTUAL FUND INVESTING I.

THE ADVANTAGES OF MUTUAL FUND INVESTING A. Diversification B. Professional Money Management C. Liquidity D. Dividend Reinvestment E. Beneficiary Designation F. Withdrawal Options

II.

THE COSTS OF MUTUAL FUND INVESTING A. Shareholder Fees B. Fund Expenses C. Comparing Costs D. Mutual Fund Classes by Fee Structure

III.

SELECTING AND EVALUATING FUNDS A. The Mutual Fund Selection Process B. How Many Funds?

C. The Mutual Fund Transaction

LO 13.3 Identify the advantages and disadvantages of direct and indirect real estate investments.

REAL ESTATE INVESTMENT

.

I.

YOUR HOME AS AN INVESTMENT

II.

DIRECT REAL ESTATE INVESTMENT A. Advantages of Direct Real Estate Investment B. Disadvantages of Direct Real Estate Investment

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III.

INDIRECT REAL ESTATE INVESTMENT A. Real Estate Investment Trusts B. Mortgage-Backed Securities C. Limited Partnership

LO 13.4 Explain why investments in precious metals, gems, collectibles, and derivatives are speculative.

SPECULATIVE INVESTMENTS I.

PRECIOUS METALS AND GEMS

II.

COLLECTIBLES AND ART

III.

CRYPTOCURRENCY

IV.

.

FINANCIAL DERIVATIVES A. Advantages of Investing in Derivatives B. Risks of Investing in Derivatives C. Using Derivatives to Reduce Risk

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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. 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 statistics on number of households owning openend funds, the number of open-end funds in existence, and the total net assets of open-end funds reported in the text to the more recent statistics. Use this to motivate a discussion in class about market and demographic changes that have impacted mutual funds (e.g. Baby Boomers reaching retirement age, increase in employer offerings of 401(k) plans).

3. Break the class into groups and assign half of 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. Using your own retirement plan servicer’s information, create a summary table of several fund choices in your plan, including large-cap, small-cap, bond, target date, real estate, SRI, international, and money market funds. Most plans have a summary page that will give the expense ratios, ratings, and past performance statistics. This comparison can be used in the lecture discussion of expenses and fund categorization. Ask students to imagine they have taken a new job and must make some decisions for their retirement account. They should first decide: a) percentage of salary to contribute, b) broad asset allocation to stocks bonds and cash, and c) percentage of US versus international investments. After making those decisions, ask them to review the mutual fund choices and write down their allocation percentages for each. The discussion that follows can touch on many interesting topics, such as the bias of spreading money based on a 1/n rule, home bias (toward US stocks and bonds), and risk aversion (based on allocation percentage to bonds and cash).

5. Illustrate the advantages of leveraged real estate investments by giving a simple home purchase example.

6. 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.)

7. 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? Are there any special tax issues that will apply?

8. Find out how many students have ever purchased collectibles with the objective of investment gains. If the class is large enough, it may be entertaining to see how many have purchased different types: Barbie dolls; Beanie Babies; action figures; comic books; trading cards; sports memorabilia. Discuss the pros and cons of investing in collectibles. Check 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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CONCEPT REVIEW SOLUTIONS 1. Describe the similarities and differences between open-end and closed-end funds.

Answer: An investment company pools investors’ money and invests the funds for them. The cash flows generated by the assets in the pool are distributed to the investors either as dividends, capital gain distributions, or as an increase in the value of the shares. A closed-end fund has a fixed number of shares and trades on a securities exchange or in the over-the-counter market. Its share price is determined by what investors are willing to pay. Shares of open-end funds are not publicly traded, and the fund can continue to grow by selling more shares. The share price for open-end funds is usually the net asset value plus trading costs. Open-end funds are required to redeem (buy back) shares from investors at their request, usually at the net asset value, and there is no secondary market for trading between investors.

This is the type of fund commonly available through employer retirement plans.

Sec 13.1; LO 13.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

2. How is a mutual fund’s net asset value calculated, and what is its relationship to share price?

Answer: The net asset value is the total market value of the assets in the fund, less any liabilities that are owed by the fund, divided by the total number of shares. For open-end funds, this is essentially the value or price, but for closed-end funds, the market price of the shares can be more or less than the net asset value.

Sec 13.1; LO 13.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

3. Identify the main advantages of mutual fund investing for individual investors.

Answer: The most important advantage of mutual fund investing for individual investors is diversification. With small dollar investments, investors can achieve much better diversification than they could on their own. Individual investors also have the benefits of professional asset selection and fund management, liquidity, the ability to automatically reinvest dividends, and flexible withdrawal options.

Sec 13.2; LO 13.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

4. In what ways can a mutual fund provide better diversification of your portfolio than you can get by investing in individual stocks and bonds?

Answer: Mutual funds are typically invested in a large number of securities, more than would be feasible for a typical small investor to purchase and actively track. For example, an individual investor who wants to allocate only $300 per month to his stock portfolio would be able to buy only a few shares of stock each month. Buying a few shares of a mutual fund instead would give him a proportionate ownership interest in 50 to 100 stocks or more. In addition, some types of mutual funds, such as bonds or real estate funds, invest in securities with high denominations that would otherwise keep individual investors from buying them.

Sec 13.2; LO 13.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

5. Identify the major categories of expenses paid by shareholders in mutual funds.

Answer: Shareholders in mutual funds pay some expenses directly. These can include (1) a one-time sales charge assessed at the time of purchase, (2) a redemption fee when the investor sells shares back to the fund, (3) an exchange fee when an investor transfers money between funds, and (4) an account maintenance fee. Shareholders also pay some expenses indirectly, in that the expenses are paid for out of the fund’s assets, such as (1) an annual management fee charged by the fund’s investment advisor for .

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managing the portfolio, usually calculated as a percentage of the assets being managed; (2) annual distribution fees, commonly known as 12b-1 fees, to compensate sales professionals for marketing and advertising fund shares; and (3) other operational expenses, such as the costs of maintaining computerized customer account services, maintaining a website, record-keeping, printing, and mailing.

Sec 13.2; LO 13.2; BT: K; Difficulty: E; TOT: 2 min; AACSB:

6. Why do some mutual funds have much higher expense ratios than other mutual funds?

Answer: The main reasons some mutual funds have higher fees are sales charges, asset class of investment, size of fund and whether the fund is actively-managed. No-load funds do not charge a front-end load and typically have very low 12b-1 expenses indirectly charged. They will still have some fund expenses, but the expense ratio is generally low, usually less than 0.25 percent. Some investment asset classes have higher transaction and research costs, such as international investments and real estate, versus money market and investment-grade bonds. Large funds, such as Vanguard S&P 500 Index Fund (0.14% expense ratio) which has over ½ trillion in assets, have economies of scale in managing the assets. A fund with very active trading strategies that require high turnover and analyst expertise to achieve its goals will have higher expenses than a passive index fund.

Sec 13.2; LO 13.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

7. What is the difference between a front-end load and a back-end load?

Answer: A front-end load is a sales charge for buying the shares, similar to a commission, and a back-end load is a charge to sell or redeem the shares back to the mutual fund. Typically, the back-end load only applies if you redeem the shares within a few years of buying them.

Sec 13.2; LO 13.2; BT: K; Difficulty: M; TOT: 2 min; AACSB:

8. Explain the difference between each of the following pairs of mutual fund classifications: A. Growth versus value Answer: The primary objective of growth funds is capital appreciation, so these funds will invest most of their money in companies that are expected to achieve above-average growth over time. A value fund invests in companies that have good fundamentals, but are perceived to be undervalued by the market. Value funds consist primarily of mature blue-chip companies that generate stable profits and distribute dividends. Growth funds tend to be riskier than value funds.

B. Large cap versus small cap Answer: A large-cap fund invests in stock issued by large companies, usually defined as those with market capitalization greater than $10 billion (see Chapter 12). Market capitalization is the stock price times the number of shares outstanding. A small-cap fund invests in companies with lower market capitalization, less than $2 billion.

C. Equity versus debt Answer: Equity funds invest in stocks, and debt funds invest in bonds, mortgages, and other debt securities.

Sec 13.2; LO 13.2; BT: C; Difficulty: E; TOT: 2 min; AACSB:

9. What is a life-cycle fund, and why is this type of fund useful from a financial planning perspective?

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Answer: A life-cycle fund is designed to meet the investing needs of investors based on their age. Funds for younger investors will have a higher allocation to stocks than funds for older investors. The idea is that an investor can buy shares in a fund at a given age and will not have to sell or rebalance the holding, because the fund will do that automatically as the investor gets older. This is useful from a financial planning perspective because of its simplicity. An investor can buy into the fund at 30 years old and never worry about changing the asset allocation as he or she gets older.

Sec 13.2; LO 13.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

10. Describe the process you should use to select mutual funds for your portfolio.

Answer: The steps in the process are: (1) identify your investment objective; (2) decide which fund classifications are appropriate for your objective; (3) compare funds based on risk and return, cost, and service; and (4) buy shares in the selected funds. This process is described in more detail in Figure 13.6 Sec 13.2; LO 13.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

11. In what ways is your home an investment? What impact does your home have on your portfolio diversification?

Answer: A home can increase in value over time but may expose you to some price risk. Many people buy homes with borrowed funds, making it a highly leveraged investment; small changes in value can have a large impact on the rate of return. For many households, home equity is a large share of their wealth, which may make their asset allocation less diversified than they should be.

Sec 13.3; LO 13.3; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

12. What are the advantages and disadvantages of investing in rental real estate properties?

Answer: Rental properties can generate cash flows to the owner as well as capital gains if real estate property values increase. This investment can help diversify the owner’s portfolio and supplement retirement income with rental cash flows, which generally increase with inflation. The disadvantages include the large initial investment, lack of liquidity, transaction costs, hassles of managing tenants, and the risk of real estate value declines and slack rental markets.

Sec 13.3; LO 13.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

13. Identify the various ways to invest indirectly in real estate. Explain why these might be better for the average investor, as compared with direct real estate investing?

Answer: You can invest indirectly in real estate through real estate investment trusts (REITs), mortgage-backed securities, and limited partnerships. Each of these types of investments allows you to buy a share of a pooled investment, so you end up with more diversification and no managerial responsibility. Also, there are lower transaction costs with funds than with direct investments.

Sec 13.3; LO 13.3; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

14. Explain what it means to say that investments in precious metals, gems, collectibles, cryptocurrencies, and derivatives are speculative.

Answer: Speculative assets expose you to the risk of losing your entire investment. They usually do not provide any regular cash flow, and their values are highly volatile. The markets for these assets are unstable, and they may involve high transaction costs.

Sec 13.4; LO 13.4; BT: C; Difficulty: E; TOT: 2 min; AACSB: .

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15. In what ways are investors in precious metals, collectibles, and gems exposed to liquidity risk?

Answer: Liquidity risk is the risk of not being able to quickly convert an investment into cash, without the loss of value. Investors typically buy the assets at retail prices, but may have to sell at a discount or through a dealer who imposes high transaction costs. The resale market for precious metals, collectibles, and gems is relatively small, and the value of specific assets depends a lot on supply and demand. For many of these items, internet sales are not practical because buyers need to closely inspect the merchandise.

Sec 13.4; LO 13.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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APPLICATION PROBLEM SOLUTIONS 1. The ABC Small-Cap Fund, a closed-end fund, has total assets of $240 million, total liabilities of $10 million, and 15 million shares outstanding. Calculate the net asset value per share.

Answer: $15.33 Solution: Net asset value = (Market value of assets – Market value of liabilities) / Number of shares Net asset value = ($240,000,000 – $10,000,000) / 15,000,000 = $15.33 per share.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

2. You estimate that the net asset value per share of a particular closed-end fund is $16. If the current share price is $17, is this price a good deal? Explain your reasoning.

Answer: The $17 price is $1 higher than the closed-end fund’s net asset value. This means that you would pay $1 more than the portfolio is worth, in the open market. On top of this, you will have to pay a broker fee. Whether this is a good deal depends on whether you expect the price of the fund’s shares to continue to rise in the future.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. The Verity Large-Cap Value Fund has total assets of $50 million, total liabilities of $500,000, and 5 million shares outstanding. If you bought the shares in this fund one year ago, when the net asset value was $8 per share, what was the annual percentage increase in the net asset value?

Answer: 23.75% Solution: Net asset value = (Market value of assets – Market value of liabilities)/Number of shares.

Net asset value = ($50,000,000 – $500,000)/5,000,000 = $9.90 per share. The net asset value has increased by $1.90 per share ($9.90 current – $8.00 cost). This is a change of 23.75% ($1.90 gain / $8.00 cost).

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

4. Cruella owns shares in a fund that has a net asset value of $40 per share. The expenses are $1 per share. What is the expense ratio?

Answer: 2.5% Solution: To find the expense ratio, divide the expenses per share by the net asset value per share.

Expense ratio = $1 expenses / $40 NAV = 0.025, or 2.5%.

Sec 13.2; LO 13.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

5. You are buying 50 shares of the Xavier Fund at $35 per share. The sales charge is 4 percent.

How much commission will you pay?

Answer: $70 Solution: The total cost of the investment is 50 shares x $35 = $1,750. The commission is $70 (0.04 commission x $1,750 cost = $70 commission.

Sec 13.2; LO 13.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

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6. You plan to invest $10,000 in a no-load fund that has a 0.5 percent expense ratio. The net asset value of the fund is $100 million. How much will you pay directly in shareholder fees?

Answer: $0 Solution: A no-load fund does not charge a sales load (direct fee). Indirect fees may be assessed through the 12b-1 fee, which is taken out of the investment returns each year on the entire fund.

Sec 13.2; LO 13.2; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Analytic

7. You plan to invest $10,000 in a no-load fund that has a 0.5 percent expense ratio. The net asset value of the fund is $100 million. How much are the total annual fund expenses (in dollars)?

A. $500,000 B. $50,000 C. $5,000 D. $5 million Answer: $500,000 Solution: Fund expenses are 0.5 percent of the net asset value Fund expenses = .005 expense ratio x $100,000,000 NAV = $500,000.

Sec 13.2; LO 13.2; BT: Ap; Difficulty: E; TOT: 1 min; AACSB: Analytic

8. You purchased $3,500 worth of shares in a mutual fund that does not have a front-end load.

However, there is a back-end load of 5 percent if you sell in the first year, and it decreases one percentage point per year. You sell $1,000 worth of shares in the third year. How much will your back-end load be?

Answer: $30 Solution: If you sell in the third year, the back-end load will be 5% - 2%= 3%. The deferred sales charge will therefore be $1,000 fund value x 0.03 charge = $30.

Sec 13.2; LO 13.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

9. For each of the following people, suggest some mutual fund classifications consistent with the stated investment objective and time horizon. Explain your reasoning.

A. 20-year-old woman saving for a down payment to buy a home within 5 years Answer: A 20-year-old woman saving for a down payment would benefit from a money market fund because she needs to preserve capital and she has a short time horizon.

B. 60-year-old retired couple looking for a regular source of income Answer: A 60-year-old retired couple looking for a regular source of income would benefit from a corporate bond fund for income or a state municipal bond fund that would provide taxfree income. They could also consider a fund that invests in dividend-paying stocks, or some combination of the above for asset diversification.

C. 30-year-old couple saving for their 5-year-old child’s college education

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Answer: A 30-year-old couple saving for their 5-year-old child’s college education would benefit from an equity fund because they need capital appreciation, and they have a fairly long time horizon.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

10. You bought 60 shares of a mutual fund one year ago for $50 per share. The front-end load is 5 percent. The fund paid $1.50 per share in dividends during the year. If the fund’s net asset value increased 12 percent during the year, what is the percent return for the year?

Answer: 15% Solution: Percent return for the year is the increase in net asset value (12%) plus the dividend yield.

Using Equation 12.2:

Dividend yield = Dividend yield =

Annual dividend Beginning stock price

$1.50 = $0.03 ~ 3% $50 + $2.50

Thus, the percent return for the year = 12% NAV increase + 3% dividend yield = 15%.

Sec 13.2; LO 13.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

11. You own 100 shares of a mutual fund that you purchased two years ago for $31 per share.

The shares are currently worth $36 each, and the fund has paid you a dividend of $2 per year. What is your return on investment for the whole two-year period and your annualized return on investment?

A. Two year holding period return 29.0%, annualized return 13.6% B. Two year holding period return 29.0%, annualized return 14.5% C. Two year holding period return 22.6%%, annualized return 10.72% D. Two year holding period return 16.1%, annualized return 7.8% Answer: A. 29%, 13.6% Solution: Using Equation 11.1, calculate the rate of return for the two-year holding period.

Rate of return =

Current income + End price − Beginning price Beginning price

Rate of return =

($2 + $2) + $36 − $31 = 0.2903 ~ 29.03% $31

Then using Equation 1.2, calculate the annualized equivalent return.

Annual % change = (1+ %change)1/N – 1 Annual % change = (1+ 0.2903)1/2 – 1 = 0.1359 ~ 13.59% Sec 13.1; LO 13.1; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

12. You purchased a rental property for $180,000 at the beginning of last year. The net rental income for the year was $12,000. The value of the property increased to $190,000 by the end of that year. If you paid cash for the property (no mortgage), what is your return on investment for the first year? (Round to the nearest 0.1%.) .

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Answer: 12.2% Solution: Using Equation 13.3, the return on real estate investment is calculated as: Increase in value+Net rental income – Interest expense Beginning investment

=

($190,000−$180,000)+$12,000−0 $180,000

= 0.122 or 12.2%

Since you did not borrow any of the purchase price, your beginning investment is the full amount and you do not have any interest expense to subtract in the numerator of the equation.

Sec 13.3; LO 13.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

13. You purchased a rental property for $180,000 at the beginning of last year. The net rental income for the year was $12,000. The value of the property increased to $190,000 by the end of that year. If you borrowed 50 percent of the purchase price from a local bank to finance the purchase, paying 6 percent, interest-only, what was your return on investment for the first year? (Round to the nearest 0.1%) Answer: 18.4% Solution: First, find the annual interest on the loan by multiplying the interest rate by amount borrowed = 6% x 90,000 = $5,400. Then, using Equation 13.3, the return on real estate investment is calculated as: Increase in value+Net rental income – Interest expense Beginning investment

=

($190,000−$180,000)+$12,000−$5,400 $90,000

= 0.184 or 18.4%

Note that, since you borrowed half of the purchase price, your beginning investment is $90,000, not the full $180,000 purchase price.

Sec 13.3; LO 13.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Analytic

14. You purchased a rental property for $180,000 at the beginning of last year. The net rental income for the year was $12,000. What expenses will you probably incur if you choose to sell the property for $190,000 after one year? Assuming that you paid cash for the property, how will this affect your return on investment?

Answer: You will probably have to pay a real estate commission and closing costs. This will reduce the net selling price and decrease the return on investment. If the commission is 6 percent and the closing costs are 2 percent, the rate of return will be less by that amount. With a 6 percent commission and $3,000 closing costs, the net sales price (End price) will be $190,000 x (1– 0.06) – $3,000 = $175,600. If closing costs were $3,000, the rate of return will be:

Rate of return = Rate of return =

Current income + End price − Beginning price Beginning price

$12,000 + $175,600 − $180,000 = 0.0422 ~ 4.22% $180,000

Sec 13.3; LO 13.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective thinking

15. You bought an original painting at an art auction 10 years ago for $1,000. You have been offered a price of $2,500 for it today. If you sell for that price, what was your annual return on investment? (Rounded to the nearest 0.1%.)

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Answer: 9.6% Solution: Using Equation 11.1, calculate the rate of return. 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝐸𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =

$0 + $2,500 − $1,000 = 1.50 ~ 150% $1,000

Then using Equation 1.2, calculate the annualized equivalent return.

Annual % change = (1+ %change)1/N – 1 Annual % change = (1+ 1.50)1/10 – 1 = 0.096 ~ 9.6% Sec 13.4; LO 13.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Analytic

16. You bought one bitcoin in January 2018 for $14,000 and sold it two years later for $10,000.

What was your holding period return and your annualized rate of return?

A. – 40.0% holding period return and – 20% annualized return B. – 28.6% holding period return and – 15.5% annualized return C. – 28.6% holding period return and – 14.3% annualized return D. – 14.3% holding period return and – 28.6% annualized return Answer: B Solution: Using Equation 11.1, calculate the rate of return.

Rate of return =

Current income + End price − Beginning price Beginning price

Rate of return =

$10,000 − $14,000 = −0.2857 ~ − 𝟐𝟖. 𝟓𝟕% $14,000

Then using Equation 1.2, calculate the annualized equivalent return.

Annual % change = (1+ %change)1/N – 1 Annual % change = (1 – 0.2857)1/2 – 1 = -0.1548 ~ -15.48% Sec 13.4; LO 13.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

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CASE APPLICATION SOLUTIONS 1. Elena Musinski is divorced and has two daughters, ages five and six. Her ex-husband is paying $100 per child per week in child support in accordance with a court order. Because her daughters are in school full-time, Elena has returned to work as a high-school math teacher at a salary of $50,000 per year. Since her income is enough to support the family, she has decided to put the child support money in a college fund for the girls. For the last year, she’s been depositing the money in a savings account earning only 1 percent annual interest, and she’s accumulated $10,600. She realizes that she needs to invest this money to earn a better return.

A. What is Elena’s specific investment goal and what types of mutual funds might be appropriate to meet this goal? Should Elena consider tax-exempt investments? Explain.

Answer: Elena’s investment goal is to develop a college fund for her two girls that will be sufficient to cover their future education costs. Because her children are ages 5 and 6, she has 12 and 13 years, respectively, before they will be going to college. She needs to decide whether the fund is intended to pay for part or all of the expected costs.

She should consider diversified growth equity funds or a combination of diversified growth and value equity funds. As the time horizon gets shorter, she should shift to more conservative funds that will protect against loss of principal. Her taxable income ($50,000 less $18,350, the standard deduction for head of household) will put her in the 22 percent marginal tax bracket (for 2019). She may want to consider investing the money through a Section 529 plan that will allow her to avoid taxes on the investment earnings.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

B. Elena is considering keeping the money in a bank savings account that earns 1 percent after taxes. Assuming that Elena’s ex-husband will continue to pay the same amount of child support for each daughter until they reach the age of 18, calculate how much Elena will be able to accumulate using this investment strategy. For ease of computation, you can assume end-of-year child support payments of $5,200 per year for each child. What is the risk of this type of investment strategy?

Answer: $71,921 for the six-year-old; $77,840 for the five-year-old Solution: Calculate the future value of the $5,300 accounts ($10,600/2) for each child with annual contributions of $5,200 earning 1% APY, until they reach 18 years old.

5 year-old child Financial Calculator Enter PMT = -5,200, N = (18-5), I/Y = 1, PV = -5,300 and solve for FV = 77,840.40 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.01, (18-5), -5200, -5,300, 0) => 77,840.40 TVM Equation (1 + 𝑖)𝑛 -1 FVA + FV = (PMT 𝑥 ) + (𝑃𝑉 𝑥 (1 + 𝑖)𝑛 ) 𝑖

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Bajtelsmit, Personal Finance, 2e, Instructors Manual & Solutions

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(1 + 0.01)13 -1 ) + ($5,300 𝑥 (1 + 0.01)13 ) = $77,840.40 0.01

FVA + FV = ($5,200 𝑥 6 year-old child

Financial Calculator Enter PMT = -5,200, N = (18-6), I/Y = 1, PV = -5,300 and solve for FV = 71,921.19 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.01, (18-6), -5200, -5,300, 0) => 71,921.19 TVM Equation FVA + FV = (PMT 𝑥 FVA + FV = ($5,200 𝑥

(1 + 𝑖)𝑛 -1 ) + (𝑃𝑉 𝑥 (1 + 𝑖)𝑛 ) 𝑖

(1 + 0.01)12 -1 ) + ($5,300 𝑥 (1 + 0.01)12 ) = $71,921.19 0.01

Although this investment strategy reduces the risk that Elena will experience a loss of principal, she is exposed to significant inflation risk and she will probably have lower after-tax returns than if she invested differently. If her portfolio only earns 1 percent after taxes, but college inflation is greater than 1 percent per year, she will have lost purchasing power.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. What difference would it make if Elena chooses to invest in a balanced mutual fund that earns 6 percent after taxes? Assuming that Elena’s ex-husband will continue to pay the same amount of child support for each daughter until they reach the age of 18, calculate how much Elena will accumulate. For ease of computation, you can assume end-of-year child support payments of $5,200 per year for each child.

Answer: $109,492 for the five-year-old; $98,388 for the six-year-old Solution: 5 year-old child: Financial Calculator Enter PMT = -5,200, N = (18-5), I/Y = 6, PV = -5,300 and solve for FV = 109,491.64 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.06, (18-5), -5200, -5,300, 0) => 109,491.64 TVM Equation FVA + FV = (PMT 𝑥 FVA + FV = ($5,200 𝑥

(1 + 𝑖)𝑛 -1 ) + (𝑃𝑉 𝑥 (1 + 𝑖)𝑛 ) 𝑖

(1 + 0.06)13 -1 ) + ($5,300 𝑥 (1 + 0.06)13 ) = $109,491.64 0.06

6 year-old child:

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Financial Calculator Enter PMT = -5,200, N = (18-6), I/Y = 6, PV = -5,300 and solve for FV = 98,388.34 Excel Spreadsheet =FV(rate,nper,pmt,pv,type) => =FV(0.06, (18-6), -5200, -5,300, 0) => 98,388.34 TVM Equation FVA + FV = (PMT 𝑥 FVA + FV = ($5,200 𝑥

(1 + 𝑖)𝑛 -1 ) + (𝑃𝑉 𝑥 (1 + 𝑖)𝑛 ) 𝑖

(1 + 0.06)12 -1 ) + ($5,300 𝑥 (1 + 0.06)12 ) = $98,388.34 0.06

As compared with the bank savings account, Elena will be able to accumulate significantly more towards her daughters’ college funds if she invests in a diversified mutual fund that earns 6% annually.

Although she will not be exposed to the same level of inflation risk, this investment strategy does expose her to market risk.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

2. Right before the financial crisis that began in 2007, Gabe Lopez made the big decision to retire at the age of 60, from his 35-year career as manager of the auto parts department at a large dealership. He and his wife, Della, also 60, decided that she would continue to work until she would qualify for Social Security benefits at 62. Gabe transferred the investments from his 401(k) retirement plan and bought shares in a long-term, AAA-rated corporate bond fund, because he wanted to be conservative with their retirement nest egg. Stock market declines earlier in the decade had reinforced his belief that stocks are too risky. At the time he made this decision, 20-year AAA corporate bonds were yielding about 5 percent. Because they owned their home free and clear, the Lopezes figured that the income from their bond fund, combined with Della’s income, would be plenty to live on. The first year, Gabe’s mutual funds generated $30,000 in income before taxes. Although this was about half of what he had earned at his job, he was pleased to find that they didn’t have to dip into the principal to support their lifestyle. As rates on AAA corporate bonds fell over the next few years, the value of his bond portfolio shares went up a little, but the annual interest income went down.

He and Della were confused—they thought that bonds were safe investments. Gabe recently read an article that warned of a coming crash in bond values. He wondered if they should switch to a different type of investment.

A. Does mutual fund investing make sense for the Lopezes, compared with investing directly in bonds or stocks? Explain.

Answer: Yes. Gabe and Della are not experienced investors, so mutual funds make sense for them.

Mutual funds allow them to achieve better diversification at a relatively low cost compared with investing in bonds directly.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

B. Is the asset allocation chosen by the Lopezes appropriate for their life situation and risk tolerance? Explain.

Answer: Although Gabe and Della have relatively low risk tolerance, they probably have too much in bonds. They have an investment horizon of at least 15 to 20 years, so they should have some growth .

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investments. In their current situation, they will receive income from their bond funds and eventually from Social Security, but they have very little chance for price appreciation to keep up with inflation.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 1 min; AACSB: Reflective Thinking

C. Explain why the value of the Lopezes’ bond mutual fund went up when interest rates went down.

Answer: Bond values have an inverse relationship with interest rates. When current interest rates on any fixed-income investment goes down, the present value (current price) of the investment goes up in value to compensate for the high fixed interest income that the investment pays. The value will go up so that the yield based on the new higher price is equal to a comparable bond. Conversely, the value of a bond must decline to a price that would yield what the comparable bond is yielding when interest rates go up. The Lopezes’ AAA long-term bond fund values increased because bond yields declined during that time period.

Sec 13.1; LO 13.1; BT: C; Difficulty: M; TOT: 1 min; AACSB: Analytic

D. If the Fed acts to increase interest rates, will the Lopezes’ bond portfolio value take a big hit? Why or why not?

Answer: The Lopez portfolio will decline in value as the Fed raises interest rates. However, their income from the bond fund may eventually rise if the fund managers buy new bond issues with higher coupon rates. If the Lopezes hold the portfolio long enough for another interest rate cycle, the value may return.

Bond values have an inverse relationship with interest rates. When current interest rates on any fixedincome investment goes up, the present value (current price) of the investment must go down in value to compensate for the relatively lower fixed interest income that the investment pays. The value will go down to the point where the yield based on the lower price is equal to a comparable bond.

Sec 13.1; LO 13.1; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

E. Would it be a good idea for the couple to move their money to a different type of investment? Why or why not? If you think they should, what would you recommend they invest in?

Answer: They might consider shifting some of their money to a diversified stock fund (growth and income). They seem to be basing their expectations about the stock market on the recent decline, but the longer-term performance of equities has been much better than that of bonds. If they do decide to take more risk, however, they should 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 fund is relatively low, so they will take losses on their investment.

Sec 13.1; LO 13.1; BT: An; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

F. Do you think that a financial planner would have recommended that the Lopezes put 100 percent of their money in a bond mutual fund in 2007? Explain.

Answer: Probably not. Most financial advisors recommend a more diversified portfolio for retirees who anticipate a fairly long-term retirement period. Using the 100 minus age rule of thumb discussed in Chapter 11, a 60-year old person might want to have 40% of their portfolio in stocks. At the time the Lopezes retired, the 20-year corporate bonds had an average yield of 5 percent, which is a little lower .

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than the long-run average. A financial planner may have explained that rates could rise in the future, which would cause the value of their portfolio to decline.

Sec 13.1; LO 13.1; BT: An; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

3. Janelle McClatchey is a single lawyer, age 30. Her income is substantially more than her expenses, and she wants to begin an investment plan. Although she has considered investing in stocks, she doesn’t feel that she has the expertise or time to make well-informed decisions. She has a 401(k) plan with her employer in which she has accumulated $50,000 in a diversified stock mutual fund. She thinks she’d like to leverage her knowledge of the legal aspects of real estate by using her savings to invest in some rental property. Janelle is considering the purchase of a small house that has two rental units and is located near the local university campus. She estimates that she’ll need to invest about $10,000 for new carpet, paint, and a few repairs before she can rent the apartments. Her rental income will be $15,000 per year. The purchase price of the property is $145,000. She has $42,000 to cover the $3,000 closing costs, remodeling costs, and a 20 percent down payment. She’ll finance the rest with a 6 percent mortgage. Interest on the mortgage for the first year will total $6,921.

A. How much will Janelle’s mortgage payment be, assuming a fixed-rate mortgage with monthly payments for 30 years, not including property taxes and insurance?

Answer: $695.48 Solution: To find the mortgage payment, first subtract the 20% down payment from the purchase price: $145,000 price – $29,000 down payment = $116,000 mortgage. Then calculate the monthly payment necessary to pay off a $116,000 loan in 360 months at a 6% APR. Financial Calculator Enter PV = 116,000, FV = 0, N = 360, I/Y = (6/12), and solve for PMT = -695.48 ~ $695.48 Excel Spreadsheet =PMT(rate,nper,pv,fv,type) => =PMT((0.06/12), 360, 116000, 0,0) => -695.48 ~ $695.48 TVM Equation 𝑖

PMT = PVA 𝑥

1

1 − ((1+𝑖)) PMT = $116,000 𝑥

𝑛

0.005 1

360

= $695.48

1 − ((1+0.005))

Sec 13.3; LO 13.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

B. Assuming Janelle incurs $2,500 in expenses per year, calculate her pretax net cash flow for the first year, after financing costs.

Answer: $5,579 Solution: Net cash flow = Rental income – Expenses – Mortgage interest.

Net cash flow = $15,000 – $2,500 – $6,921 = $5,579 (before tax)

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Sec 13.3; LO 13.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. If the property increases in value to $165,000 after one year, and the apartments were rented for the full 12 months, what is Janelle’s pretax return on investment, taking into account the additional investment she has made in the property? (Round to the nearest percent.)

Answer: 32% Solution: Increase in Value = Current value – Purchase price – Expenses Increase in value = ($165,000 – $145,000 – $13,000) = $7,000 Net rental income = Rental income – Expenses Net rental income = $15,000 - $2,500 = $12,500 Beginning investment = $29,000 down payment + $10,000 improvements

Return on investment =

Increase in value+Net rental income – Interest expense Beginning investment

Return on investment =

+$7,000 + $12,500 – $6,921 = 0.3225 ~ 32.25% $39,000

Sec 13.3; LO 13.3; BT: Ap; Difficulty: H; TOT: 2 min; AACSB: Analytic

D. Is this investment more or less risky for Janelle than stocks and bonds? Explain.

Answer: Janelle’s legal background makes this considerably less risky for her than for the average investor. However, the answer 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. Because rental properties can produce regular cash flow, they are somewhat less risky than stocks. If the university location provides her with a steady flow of tenants and regularly increasing rents, her investment will be less risky. The size of the property investment may present considerable business risk, because until Janelle can grow a portfolio of other investments, she is heavily concentrated in this one investment (no diversification).

Sec 13.3; LO 13.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

E. Given her life situation, is Janelle sufficiently diversified? Explain your reasoning.

Answer: Janelle is 30 years old, so it makes sense for her portfolio to have a fair amount of equity risk.

Janelle has about $50,000 invested in a stock mutual fund, and now she has nearly that much invested in a single real estate property. Most financial planners recommend that you not have more than 10 percent of your assets in any single investment. Although Janelle’s stock portfolio is sufficiently diversified because it is in a mutual fund, she only has one rental property, so she could be exposed to greater real estate risk than average. We also don’t know whether she 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, Janelle would be hurt by her lack of diversification.

Sec 13.3; LO 13.3; BT: An; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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4. Barbie is one of the most popular categories of collectibles. Although literally millions of “normal” Barbie dolls have been sold worldwide, 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 10 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.

Answer: Values of collectibles depend highly on being able to find a willing buyer. The values in Beverly’s books are possible retail values, but she is unlikely to be able to sell her dolls at those values.

She might, for example, sell to a dealer who will expect a steep discount for buying a lot of her dolls. If she does sell them at retail prices, she might also incur costs for advertising and shipping. It is also possible that Mattel, Inc., has an incentive to list inflated prices in the book in order to encourage investors to buy the collectible dolls.

Sec 13.4; LO 13.4; BT: Ap; Difficulty: E; TOT: 2 min; AACSB:

B. Identify the risks Beverly is exposed to when she invests in Barbies.

Answer: Beverly’s risks include the risk of damage to her doll collection while it is in storage, reduced demand for Barbies, and oversaturation of the market, which could lead to declines in value. The values of her dolls are also likely to be sensitive to economic conditions, given that doll collecting might decline in a recession.

Sec 13.4; LO 13.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

C. Assume that Beverly bought a Holiday Barbie for $50, ten years ago. If she sells it this year for $75, incurring $5 in transaction costs, what is her holding period return and her annualized return on investment?

Answer: 40% holding period return; 3.4% annualized return Solution: Using Equation 11.1, calculate the rate of return.

Rate of return =

Current income + End price − Beggining price Beginning price

Rate of return =

$0 − ($75 − $5) − $50 = 0.400 ~40.0% $50

Then using Equation 1.2, calculate the annualized equivalent return.

Annual % change = (1+ %change)1/N – 1 Annual % change = (1 + 0.40)1/10 – 1 = 0.034 ~ 3.4% Note that this does not include any holding costs or storage costs during the 10 years that she owned the Holiday Barbie.

Sec 13.4; LO 13.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Analytic

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D. 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?

Answer: Before eBay, collectible investors generally did not have access to a large market of potential buyers. They primarily sold at flea markets and specialized merchandise markets. Sellers and buyers sometimes traveled long distances to attend these events, adding to the cost of collectible investing.

Although the Internet provides much easier connections between buyers and sellers, it also creates much more competition and price transparency.

Sec 13.4; LO 13.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

E. If collectibles make up about 10 percent of Beverly’s investments, with the rest invested in diversified tax-deferred retirement accounts, evaluate whether her investment in Barbies is a good use of her funds.

Answer: It is unlikely that Beverly’s overall return on investment in her Barbies will be comparable to what she could have achieved in a diversified mutual fund. Her Barbie investments are less liquid and potentially more sensitive to economic conditions than her other investments. However, Beverly may get other, less quantifiable benefits from her collectibles, including the enjoyment of owning the dolls and interacting with other collectors.

Sec 13.4; LO 13.4; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

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CHAPTER 14 Instructor Manual & Solutions Estate Planning LEARNING OBJECTIVES LO 14.1 Identify key components of an estate plan and determine whether you need one.

LO 14.2 Explain the importance of having a valid will and arranging in advance for easy transfer of assets to your heirs.

LO 14.3 Explain recent changes to federal estate and gift taxation laws that will significantly reduce the number of estates that have to pay these taxes.

LO 14.4 Understand how trusts, gifts, and charitable contributions can reduce estate taxes.

SUGGESTED COURSE PLAN Most instructors will at least want to cover LO1 (estate planning) and LO2 (wills). These can be covered in one session as suggested below. If desired, LO3 (estate tax) and LO4 (trusts) can be taught in another 50-minute session or lightly covered in conjunction with the others in a 75-minute session. A suggested course plan for a class that meets twice per week: Class Period

Topic and Reading Assignment (by Learning Objective)

Suggested WileyPLUS PreClass Assignments

WileyPLUS Resources to Use in Class

1

LO 14.1 Estate Planning LO 14.2 Wills LO 14.3 Estate Tax

Interactive: Valid Will

Reflection Question: Living Wills

Personal Financial Planner Assignment

WileyPLUS Homework Assignment Chapter 14 R: 1-5; P: 2,4,6; C1 Adaptive Practice Ch 14

File-based assignments for each of the Personal Financial Planning Worksheets have been set up in WileyPLUS so that you can easily assign these.

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CHAPTER OUTLINE AND SUMMARY Chapter 14 Estate Planning LO 14.1 Identify key components of an estate plan and determine whether you need one.

WHAT IS ESTATE PLANNING? I. II. III. IV. V. VI.

THE ESTATE PLANNING PROCESS WHO NEEDS AN ESTATE PLAN? CASE STUDY 14.1 ESTATE PLANNING CHANGES OVER THE LIFE CYCLE KEY COMPONENTS OF AN ESTATE PLAN ETHICS IN ACTION: TERRI SCHIAVO’S LIFE-OR-DEATH EXPERIENCE ORGANIZING FINANCIAL AND LEGAL DOCUMENTS

LO14.2 Explain the importance of having a valid will and arranging in advance for easy transfer of assets to your heirs.

METHODS OF TRANSFERRING PROPERTY I.

PREPARING A VALID WILL A. Capacity to Make the Will B. Common Elements of a Will C. Should a Lawyer Draft Your Will?

D. Making Changes to Your Will

II.

PASSING PROPERTY OUTSIDE OF A WILL A. Ownership of Assets B. Beneficiary Designation

LO 14.3 Explain recent changes to federal estate and gift taxation that significantly reduce the number of estates that have to pay these taxes.

ESTATE AND GIFT TAXES I. II. III. IV.

FEDERAL GIFT TAXES FEDERAL ESTATE TAXES CASE STUDY 14.2 LISA CALCULATES HER TAXABLE ESTATE STATE DEATH TAXES

LO 14.4 Understand how trusts, gifts, and charitable contributions can reduce estate taxes.

REDUCING TAXES THROUGH TRUSTS AND GIFTS I. II.

III.

.

WHEN ARE TRUSTS USEFUL? TYPES OF TRUSTS A. Revocable versus Irrevocable Trusts B. Living versus Testamentary Trusts C. Charitable Trusts GIFTING ALTERNATIVES

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TEACHING SUGGESTIONS 1. This is a chapter that will seem the least relevant to typical undergraduate students, but may resonate with nontraditional students who have had more life experience. 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? Some students may recall their parents taking care of another relative’s estate. The important thing to draw out of this discussion is that when people do not plan for their own death, it can be more complicated and expensive for their survivors.

2. 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. Discuss whether the most common reasons for them not having a will are also likely to be explanations for the large percentage of adults in the U.S. who don’t have wills. What factors would be most likely to motivate them to have a will drawn up (e.g., getting married, having a child)?

3. Use the example provided in the Ethics in Action feature 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. Discuss the political factors surrounding the estate tax. Why didn’t Congress simply repeal the estate tax or increase the exemption amount permanently instead of putting in a sunset provision for 2025? Ask the class to identify the economic impact of an estate tax and to make arguments for and against its repeal.

6. Ask 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?

7. If your class includes students who are involved in family-owned businesses or who have entrepreneurial career plans, you can also motivate the discussion of estate planning by walking through the tax implications of the death of a business owner who wants to leave the business to his or her children. As an example, assume a family business that is worth $20 million, currently owned by a widowed mother. If she dies without sufficient planning, the estate may owe several million in estate tax, and this might mean that the children would have to sell the business to pay the estate tax. How could they avoid this scenario?

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CONCEPT REVIEW SOLUTIONS 1. What is an estate plan, and why is it important for everyone to include one in his or her personal financial plan?

Answer: An estate plan is a plan for what happens to someone’s property and dependents after their death. Wealthy people need an estate plan to reduce the taxes that their estate may owe after their death since these taxes will reduce the amounts that will be transferred to their heirs. If someone is not wealthy, they will still need an estate plan because it can make the process of distributing their assets after their death much quicker and easier for their loved ones. Including instructions regarding preference for end-oflife medical treatment, funeral arrangements, and distribution of personal assets can also make the process easier for survivors.

Sec 14.1; LO 14.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

2. What are some of the adverse consequences that can result from the failure to do any estate planning?

Answer: The process of settling your estate may take a lot longer. Children could be assigned a guardian by the court. Family members may not be aware of the wishes with respect to end-of-life care. Dependents may suffer financial hardship, and the estate may be significantly reduced due to state and federal taxes.

Sec 14.1; LO 14.1; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

3. How might your estate plan be expected to change over your life cycle?

Answer: When you are young and have no assets or dependents, estate planning will be less important for you. As you accumulate wealth and have dependents, you will need to make sure you have a valid will in place and that you have established joint ownership of household assets with your spouse. When you have children, it is crucial to identify who will be their guardian in the event that both parents die. You may also need to establish a trust and buy life insurance to help fund the costs of their care. The wealthier you are, and the more assets you own, the more you need to do estate tax planning.

Sec 14.1; LO 14.1; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

4. Identify and explain the key components of an estate plan.

Answer: The key components of estate plans are the will, living will, durable power of attorney, letter of last instruction, and trusts. A will is a legal document that transfers property upon your death. A living will specifies what kind of medical treatment you want to receive in the event that you cannot make decisions for yourself. A durable power of attorney appoints someone to make specific medical decisions on your behalf if you are incapacitated. A letter of last instruction provides your survivors with instructions about your funeral wishes and distribution of specific personal items. It can also be used to pass on bank account numbers, logins, passwords, or anything else that might make things easier for your family. In some cases, you may need to establish a trust, a legal entity that holds and manages assets on behalf of someone else.

Sec 14.1; LO 14.1; BT: C; Difficulty: E; TOT: 3 min; AACSB:

5. What is a living will, and what are the advantages of having one?

Answer: In a living will, you specify the kind of medical care you want to receive in the event that you can’t make decisions for yourself due to terminal illness, physical disability, or mental disability. For example, some people do not want to have extraordinary measures taken to resuscitate them if they sustain an injury that leaves them without normal brain function. It is much easier for family members to make this difficult decision when they know it is in accordance with the injured person’s wishes.

Sec 14.2; LO 14.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking .

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6. What types of information would you probably want to include in a letter of last instruction?

Answer: You could use this document to communicate your personal wishes regarding funeral arrangements, to identify people who should be notified of your death, and to list important information, such as bank accounts and PINs, contact information for insurance companies and brokerage firms, and safe deposit box locations and numbers. You might use it to suggest how to distribute your minor personal assets.

Sec 14.2; LO 14.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

7. If a letter of last instruction is not a legally binding document, why should you bother to draft one?

Answer: Although these instructions are nonbinding, and specific bequests of your assets must be written into your will to be legally enforced, your survivors might appreciate knowing your wishes regarding distribution of your minor personal assets (your old football jersey, comic book collection, or family memorabilia) that have sentimental but not financial value.

Sec 14.2; LO 14.2; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

8. Why do so many people not have valid wills?

Answer: The most likely reason that so many people do not have valid wills is that they prefer not to think about difficult subjects such as death. It is also possible that they do not understand how much more trouble it will be for their survivors and how much more it will cost to settle the estate if they die without a will. They may also incorrectly believe that everything would pass to their spouse.

Sec 14.2; LO 14.2; BT: C; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

9. How are estate and gift taxes related to each other?

Answer: Gifts and bequests are alternative ways to transfer wealth to the next generation. Gifts are transfers prior to death, and estates are transfers after death. If you give a gift in excess of the annual limit, the excess is applied to reduce the amount of your estate that is exempt from estate tax when you die.

Sec 14.3; LO 14.3; BT: C; Difficulty: M; TOT: 2 min; AACSB:

10. Does a husband ever have to pay estate tax on an inheritance from his wife? Why or why not?

Answer: The husband will not have to pay any estate tax at the death of his wife because there is an unlimited marital deduction. However, his estate will owe taxes upon his death, assuming he hasn’t spent all the earlier inheritance by that time.

Sec 14.3; LO 14.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB:

11. What are the two primary ways of reducing the size of your taxable estate?

Answer: The primary ways of reducing the size of your taxable estate are to move money to trusts or to give it away, either before you die or through charitable bequests in your will.

Sec 14.4; LO 14.4; BT: C; Difficulty: M; TOT: 2 min; AACSB:

12. What is a trust, and what are the purposes of such an arrangement in the context of estate planning?

Answer: A trust is a legal entity that holds and manages assets on behalf of someone else. If a trust is irrevocable, the funds in it are not subject to probate or to federal or state estate taxes.

Sec 14.4; LO 14.4; BT: C; Difficulty: M; TOT: 2 min; AACSB: .

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13. Make a list of estate-planning objectives, given your current life-cycle stage and family situation.

Next, pretend that it’s 20 years in the future. Redo the list for the life-cycle stage and anticipated family situation that will be applicable at that time.

Answer: Answers will vary.

Sec 14.4; LO 14.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

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APPLICATION PROBLEM SOLUTIONS 1. Identify estate-planning goals that would be appropriate, considering life-cycle stage and family circumstances, for each of the following people:

A. Single college student, age 20, with a negative net worth Answer: A single, 20-year-old college student with a negative net worth should have a valid will and a living will in place.

B. Married couple, both age 30, with two dependent children and a net worth of $500,000 Answer: The married couple should have the following: joint title to household assets (home, bank accounts), valid wills that transfer their assets and provide for children’s guardianship and support until age 18 (or older), living wills, and durable powers of attorney. They may want to include a trust in their will to manage their assets on behalf of their children if they both suffer an untimely death.

C. Retired couple with independent adult children and a net worth of $1 million Answer: The retired couple should have valid wills, living wills, and durable powers of attorney in place.

They will not need trusts to avoid estate taxes, but may want to set them up for other reasons, for example to manage charitable gifts or assets on behalf of their children or grandchildren.

D. Retired widower with dependent children and a net worth of $10 million Answer: The retired widower should have a valid will, living will, and durable power of attorney in place.

Because he has a net worth in excess of the unified exemption, he may want to consider gifts during his lifetime, charitable bequests in his will, or trusts in order to minimize estate taxes owed.

Sec 14.1; LO 14.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

2. For each of the following estate-planning goals, indicate the type of estate-planning tool or strategy that could be used to help accomplish the goal:

A. Ensure that your daughter ends up with the family china (instead of your sister, who lives closer and who will likely come to help clean out your belongings after you die).

Answer: You could give your daughter the china now and tell your sister, or you could specify the china bequest in your will or a letter of last instruction.

B. Ensure that you aren’t kept alive by artificial means when there’s no chance of your recovery from a terminal illness or mental incompetence.

Answer: You should create a living will with your specific requests for treatment. You should also give a durable power of attorney to a person you trust to direct your medical treatment according to your wishes.

C. Provide for your children’s college education after you die.

Answer: You have several options for accomplishing this goal. You could set up a trust and put enough assets in the trust to fund the college costs. You could buy life insurance in an amount sufficient to cover their college costs in addition to other life insurance needs. You could hold some assets jointly with your children so that they will pass directly to the children upon your death. You could fully fund a Section 529 prepaid tuition or college savings plan.

D. Make sure your children don’t have to pay estate taxes on their inheritance from you.

Answer: You could reduce your taxable estate by moving assets to a trust, gifting to your children each year during your lifetime, or owning assets with them jointly.

Sec 14.1; LO 14.1; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

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3. For each of the following situations, identify what type of trust, if any, would be appropriate to accomplish the stated goal.

A. You want to be able to make changes to the trust while you are living.

Answer: Use a revocable living trust

B. You want to donate assets to a charity while you are living but continue to receive income from those assets while you are living.

Answer: Use a charitable remainder trust

C. You want to give income from your investment account to a charity while you are living and have the account pass to your heirs when you die.

Answer: Use a charitable income trust Sec 14.4; LO 14.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

4. Ryan Stern died in 2019 and left an estate valued at $13,000,000 after the payment of his debts. His will gave $50,000 to the Humane Society, $100,000 to the University of Missouri, $150,000 to the Boy Scouts of America, and the remainder to his sister Mindy. The expenses of settling the estate were $10,000 for the funeral, $5,000 to his brother as executor, and $3,000 to accountants and lawyers.

A. Calculate Ryan’s gross estate.

Answer: $13,000,000 Solution: To find the gross estate, subtract excluded assets from net worth. Since there are no excluded assets, gross estate is $13,000,000.

B. Calculate Ryan’s adjusted gross estate.

Answer: $12,982,000 Solution: To find the adjusted gross estate, subtract estate expenses from gross estate.

Adjusted gross estate = $13,000,000 gross estate – $10,000 funeral – $5,000 executor fee – $3,000 professional fees = $12,982,000.

C. Calculate Ryan’s taxable estate.

Answer: $12,682,000 Solution: To find the taxable estate, subtract unlimited deductions to spouse and charity from the adjusted gross estate.

Taxable estate = $12,982,000 adjusted gross estate – $50,000 Humane society donation – $100,000 University donation – $150,000 Boy Scouts donation = $12,682,000. Note that the amount Ryan left to his sister is not a deduction from his adjusted gross estate.

D. What is the applicable exemption amount?

Answer: The applicable exemption amount in 2019 was $11,400,000.

Solution:

E. What amount of Ryan’s estate will be subject to federal estate tax?

Answer: $1,282,000

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Solution: The applicable exemption amount in 2019 was $11,400,000. The estate will owe tax on the taxable amount in excess of the exemption: $12,682,000 taxable estate – $11,400,000 exemption = $1,282,000.

All parts A-E: Sec 14.2; LO 14.2; BT: Ap; Difficulty: M; TOT: 5 min; AACSB: Analytic

5. Keira’s rich uncle committed suicide and left behind a handwritten suicide note and a will stating that he left all of his wealth to his very attractive young nurse. A previous will had named Keira and her brother as the sole heirs. The new will was witnessed by the uncle’s maid and butler, who were good friends of the nurse. On what grounds can the family contest the will?

Solution: Wills usually have to be typed to be valid, although there are exceptions. The best case for the family will be if they can show that their uncle had diminished mental capacity at the time he wrote the will.

The fact that he committed suicide could be used as evidence of his mental state.

Sec 14.3; LO 14.3; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

6. If you don’t currently have a will, write a first draft to present to a lawyer for finalizing. If you already have a will in place, review its terms and update it as necessary. To help you formulate the contents of your will, answer the following questions:

• To whom do you want to leave your assets in the event of your death? Do you have any special items that you would like to give to certain people?

• If you have children, who would you like to be their guardian, should that be necessary? How will you provide (financially) for your children’s care and education?

• If you have pets, how will they be taken care of after you die?

• Do you have adequate life insurance? Have you named a beneficiary and a contingent beneficiary?

• Have you named a beneficiary for your pension or retirement plan?

Answer: Answers will vary.

Sec 14.3; LO 14.3; BT: Ap; Difficulty: M; TOT: 6 min; AACSB: Reflective Thinking

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7. At the age of 30, Lotta Cache, a successful entrepreneur, has already accumulated $20 million in wealth. She has no husband or children, but she wants to minimize the amount of estate taxes her estate would owe upon her death, and she wants to have some control over the distribution of the wealth that she has worked so hard to accumulate. She has decided to use her wealth to benefit her favorite charity, Wikipedia. How can she use gifts and trusts to do this?

Solution: Lotta can reduce her taxable estate while she is living by making gifts to Wikipedia or other charities, either during her lifetime or through her will, upon her death. If she wants to establish a trust that will benefit a charity during her lifetime, it can either be irrevocable or revocable. Funds in an irrevocable trust will not be subject to federal or state estate taxes after her death, but she will not be able to make any changes to the trust after it is created. If she creates a revocable trust, the assets in the trust will bypass probate, but will still be subject to estate taxation. If she wants Wikipedia to benefit from the assets in the trust while she is living, she can establish a living trust.

She could put money in the charitable lead trust which would allow the charity to use the income from the trust assets during her lifetime, after which she could pass the assets to someone else in her will. Lotta’s will can also designate Wikipedia as a beneficiary. There is an unlimited deduction for charitable gifts, so Lotta could set the gift amount at a level that will keep her estate from being subject to any estate tax.

Sec 14.3; LO 14.3; BT: Ap; Difficulty: M; TOT: 6 min; AACSB: Reflective Thinking

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CASE APPLICATION SOLUTIONS 1. Mina Bhatti is a successful entrepreneur. She started a small bakery when she graduated from college and has turned it into a multimillion-dollar business. Mina is divorced and has had sole custody of her daughter Naitra, age 10, since divorcing her ex-husband six years ago. He provides no financial support for Naitra. Mina has spent a great deal of time running her business—so much that she has sometimes neglected her financial plan. Recently, though, she consulted a financial planner, who was adamant that she immediately take care of a few very important elements of her financial plan. First and foremost, he wants her to make a will right away. Mina and her ex-husband had made wills many years ago, but they predated Naitra’s birth. In her old will, Mina left all her wealth to her husband. Mina’s current assets are as follows: Equity in the family home Business assets Retirement account Other investments Total net worth

$ 250,000 $ 750,000 $1,250,000 $ 500,000 $2,750,000

In the event of her death, Mina would want her sister Janna to be Naitra’s guardian. Janna is aware of Mina’s wish and has agreed to act in this capacity. Mina’s brother Sanjay was named as the executor in her prior will, and will probably be willing to continue in that role.

A. Does Mina need a will? What would happen if she died today (before drafting a new will)?

Solution: Yes. She needs a will. If she dies before a new will is written, her ex-husband could inherit all her property. Note that in some states, the divorce would nullify the previous will, and Mina’s estate would be treated as if she had died intestate. In either case, the guardianship of her daughter would be uncertain.

Sec 14.2; LO 14.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

B. What should Mina include in her will?

Solution: She needs to name Janna as Naitra’s guardian and someone else as a contingent guardian.

She needs to name Sanjay as the executor for the will and specify the payment he will receive. She needs to designate Naitra as the beneficiary of the will, perhaps putting the assets in trust for her care until she reaches the age of 18 (or older).

Sec 14.2; LO 14.2; BT:C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. Does Mina need to establish a trust in her will? Why or why not?

Solution: Because her estate is less than the unified exemption, a trust isn’t needed for the purpose of reducing estate taxes. However, if Mina’s assets continue to grow, she should reconsider this decision at a later date. Because she is leaving her assets to an underage daughter, a trust can be used to ensure that Naitra does not have access to the funds until she is older. She could name Naitra as the beneficiary of the trust but appoint her sister or brother as the trustee to manage the funds on her behalf.

Sec 14.4; LO 14.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking

D. If Mina names Janna as Naitra’s guardian but Janna dies before Mina does, who will end up being guardian?

Solution: This is the reason that Mina needs to name a contingent guardian. If the named guardian is no longer living at the time of Janna’s death, the guardianship will be decided by the courts.

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Sec 14.2; LO 14.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

E. What duties will Sanjay have to perform as executor of the estate?

Solution: 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, pay all taxes owed, and manage any assets in Mina’s estate, until they are completely distributed.

Sec 14.2; LO 14.2; BT: C; Difficulty: M; TOT: 2 min; AACSB:

2. Crystal and Richard Ball are wealthy retirees who have an estate worth $15 million. They have five adult children. Four of them, ages 32 to 40, are financially secure professionals, but their youngest child, Ricky, age 26, is a struggling rock musician. Since Richard always wished he had pursued a music career, Crystal and Richard have been providing continued support for their youngest, in the hope that he might realize his dream. His siblings have not always been supportive of their parents on this issue, thinking that Ricky should “get a real job.” Crystal’s will currently leaves everything to her husband and names their five children as equal contingent beneficiaries. Richard’s will similarly leaves everything to Crystal. The Balls have recently consulted an estate-planning attorney and would like to put in place an estate plan that will minimize the estate taxes that might be payable upon their deaths and also achieve some other goals: • • • •

Provide continued support for Ricky as long as he is actively pursuing his music career.

Leave a modest inheritance ($100,000) to each of their ten grandchildren, currently ages 2 to 11, to be received when they reach the age of 30.

Provide for the income needs of the spouse who outlives the other.

Leave the remainder of their estate to the National Endowment for the Arts.

A. Do Crystal and Richard need to write new wills to accomplish their objectives? Explain.

Solution: Yes. Their existing wills do not accomplish any of their stated goals.

Sec 14.2; LO 14.2; BT: Ap; Difficulty: E; TOT: 2 min; AACSB: Reflective Thinking

B. If they have done no additional estate planning and each have a life insurance policy on the other, with a face value of $500,000 and with the other as a beneficiary, will any estate taxes be payable when one of them dies?

Solution: Since 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 by then.

Sec 14.3; LO 14.3; BT: Ap; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

C. If the Balls simply rewrote their wills designating their grandchildren as the beneficiaries, would any estate tax be payable when either of them dies? Explain your reasoning.

Solution: 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. .

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Sec 14.2; LO 14.2; BT: C; Difficulty: M; TOT: 2 min; AACSB: Reflective Thinking

D. What types of trusts, if any, would you recommend the Balls establish to meet their objectives?

Solution: They should set up and fund the following trusts: • 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.

Sec 14.4; LO 14.4; BT: Ap; Difficulty: M; TOT: 3 min; AACSB: Reflective Thinking E. What might be the Balls’ motivation for not giving their grandchildren any inheritance until they reach the age of 30?

Solution: They might feel that the children would not be ready to manage a sizable inheritance at younger ages.

Sec 14.4; LO 14.4; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

F. To minimize family strife that might occur later, would you recommend that the Balls discuss their estate plan with their children now? Why or why not?

Solution: Yes. This is a lot of money, and it is possible that the adult children have been assuming they will be the recipients of some of it. There might be hard feelings about their parents’ decision to single out Ricky for support and to leave the bulk of the estate to charity. Being transparent and upfront with everyone will help reduce family strife later.

Sec 14.4; LO 14.4; BT: Ap; Difficulty: E; TOT: 3 min; AACSB: Reflective Thinking

3. Roberta and Harry Caruso have two children: Mary, age 5, and Harry Jr., age 15. They are in the process of writing their wills and need to decide whom to appoint as guardian for their children, in the event that they both die. Roberta thinks that they should have her parents be the guardians. Harry would prefer to have his sister and brother-in-law as guardian because they have two children who are close in age to Mary and Harry Jr. A. What factors should Roberta and Harry consider in making this important decision?

Solution: Although Roberta’s parents might be highly capable of taking care of the children right now, they may not want that responsibility, particularly as they get older. Likewise, it is possible that Harry’s sister might find four children to be too much to handle. Would it require buying a larger home? How much money would Roberta and Harry’s estate be able to put toward the cost of raising the children?

B. Do they need to get permission from the prospective guardians? Why or why not?

Solution: Because raising another person’s children is such a large responsibility, it is important to include prospective guardians in the discussion. If no arrangement is made, the courts will decide who should take on the responsibility, but it’s much better to have willing participants in this plan.

C. Harry Jr. is 15, and 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 be different if the Carusos have a very large estate? .

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Solution: Roberta and Harry would have to decide whether they want to burden Harry Jr. with that much responsibility. They could decide to make him the guardian when he reaches age 21 or some older age.

If they had a large estate, they would have to consider whether Harry Jr. would be responsible enough, at that age, to manage it.

4. Buddy and Carol have recently married. It is Buddy’s second time to the altar and Carol’s third. Both Buddy and Carol are fairly wealthy, and they are understandably cautious about commingling their assets because their previous divorces were costly. To further complicate their situation, each of them has 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 because both Buddy and Carol are working professionals.

A. Do Buddy and Carol need to do any estate planning?

Solution: Although both Buddy and Carol have estates that are less than the exemption amount, they certainly need to have wills if they want to accomplish their goal of passing wealth to their children. An estate planning professional would also recommend that they take care of end-of-life planning. They should also have a living will and durable powers of attorney.

B. Assume that both Buddy and Carol want to leave their wealth to their own children, but not to the other’s children. Suggest alternative ways this might be accomplished.

Solution: They could leave their wealth to their children by will, or they could begin to gift it to them while they are living. They should also consider ways to bypass probate for some of their assets, either by joint ownership of assets or by the creation of trusts.

C. If Carol were to die today (without having done any estate planning), how much would her estate owe in estate taxes?

Solution: Carol would not owe any federal estate taxes because her net worth is less than the exemption amount, but she might owe some state estate taxes, depending on her state of residence.

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