Personal Finance Skills Test Bank

Type:

Test Bank

Resource:

Personal Finance Skills

Edition:

1st Edition

Author(s):

Vickie L. Bajtelsmit

TEST BANK TO ACCOMPANY

PERSONAL FINANCE Skills for Life

Vickie L. Bajtelsmit Colorado State University

Prepared by Cheryl McGaughey Angelo State University

Chapter 1

The Financial Planning Process True-False Why Study Personal Financial Planning

1.

Personal finance is a specialized area of study that focuses exclusively on investments and retirement planning.

(f, easy, p. 3) 2.

Personal financial planning skills are only applicable in the early years of a person's life.

(f, easy, p. 3) 3.

The primary goal of personal financial planning is to develop and achieve financial goals.

(t, easy, p. 3) 4.

Good financial planning can also have a positive social and psychological benefit.

(t, moderate, p. 3) 5.

A common reason many people avoid financial planning is the lack of available information.

(f, moderate, p. 4) Personal Financial Planning: The Five Steps 6.

The first step in the personal financial planning process is to analyze your current financial position.

(t, moderate, p. 4) 7.

Long-term goals are more likely undergo change than are short-term goals.

(f, difficult, p. 5)

1

8.

Every strategy for achieving financial goals has both a cost and a benefit.

(t, moderate, p. 5) 9.

An effective financial plan should be inflexible in order to achieve the goals set.

(f, easy, p. 6) Factors that Influence Personal Financial Planning 10.

If your debts are larger than your assets, you have a negative wealth position.

(t, moderate, p. 7) 11.

50s.

The beginning of the wealth accumulation phase usually occurs in a person's mid-

(f, moderate, p. 7) 12.

When a person begins to spend their accumulated wealth, this is known as the distribution phase.

(f, moderate, p. 7) 13.

Risk can be defined as the certainty of a potential loss.

(f, moderate, p. 8) 14.

If a person is characterized as an optimist, this is a statement regarding that person's values.

(f, moderate, p. 8) 15.

Risk-takers are more likely to be male, married with children, educated, and high income.

(f, difficult, p. 8) 16.

As inflation increases, the purchasing power of money decreases.

(t, moderate, p. 9) 17.

The CPI is the effective inflation rate for all regions of the United States.

(f, moderate, p. 9)

2

18.

Wages often do not increase at the same rate as prices.

(t, easy, p. 11) 19.

Interest rates are both the cost of borrowed money as well as the return on invested money.

(t, moderate, p. 12) 20.

Interest rates are determined by the government.

(f, moderate, p. 12) 21.

The U.S. Treasury Department controls the money supply in the United States.

(f, easy, p. 12) 22.

The interest rate that banks charge each other for short-term loans is known as the fed funds rate.

(t, easy, p. 12) 23.

A change in the fed funds rate will result in a change in other short-term interest rates but not in long-term interest rates.

(f, moderate, p. 12) 24.

Both inflation and Federal Reserve actions can cause interest rates to move up or down.

(t, moderate, p. 12) 25.

Differences in interest rates on different types of loans at the same point in time are primarily due to differences in maturities of the loans. (f, moderate, p. 13) Making Effective Decisions 26.

If you are considering working part-time at a second job in addition to your regular one, you should only consider marginal costs and marginal benefits, not the total costs and benefits of both jobs.

(t, difficult, p. 16)

3

27.

A major opportunity cost for college students is the income they will forego over the years they are in college.

(t, moderate, p. 16) 29.

One of the biggest mistakes people make in their financial planning assumptions is to be overly pessimistic.

(f, easy, p. 15) Selecting Qualified Financial Planning Professionals 30.

Financial planners must have a college degree with an emphasis or major in business.

(f, moderate, p. 18)

Multiple Choice Why Study Personal Financial Planning 1.

Which of the following is not normally considered an area of personal finance?

a. b. c. d.

budgeting investments choice of a career choice of a marriage partner

(d, easy, p. 3) 2.

Which of the following is the best definition of personal finance?

a. b. c. d.

The study of individual and household financial decisions.

The study of individual investment planning.

The study of personal wealth The study of personal money management

(a, moderate, p. 3)

4

3.

Which of the following is not a typical reason people avoid financial planning?

a. b. c. d.

They believe they are too busy.

They believe their finances are in good shape.

They fear failure.

They believe their math and finance skills are lacking.

(b, difficult, p. 3-4) 4.

Which of the following is not one of the steps in the personal financial planning process?

a. b. c. d.

developing short-term and long-term financial goals identifying and evaluating alternative strategies for achieving goals implementing a plan for achieving goals determining appropriate risk level of participant

(d, moderate, p. 4-6) Factors that Influence Personal Financial Planning 5.

When people begin to spend their wealth in their retirement years, this is referred to as:

a. b. c. d.

deferring decumulating distributing disposing

(b, moderate, p. 7) 6.

A person's fundamental beliefs concerning what is important in life are referred to as:

a. b. c. d.

values attitudes opinions judgments

(a, moderate, p. 7)

5

7.

Which of the following would be expected to be in the best financial position?

a. b. c. d.

A single person with no children A married couple with children A married couple with no children A single person with children

(c, difficult, p. 8) 8.

For a person's standard of living to improve,

a. b. c. d.

their income must be above the average standard of living. their expenses must decrease. their assets must rise in value faster than their expenses their income must rise faster than the inflation rate.

(d, difficult, p. 9)

9.

Which of the following is more inclined to take risk?

a. b. c. d.

male, white-collar job, college-educated male, blue-collar job, married female, single, high income female, white-collar job, high school graduate

(a, difficult, p. 9) 10.

Your salary was $32,000 in 2003. It increased to $35,000 in 2004. What was the percentage increase in your salary from 2003 to 2004?

a. b. c. d.

8.57% 9.38% 9.14% 33.5%

(b, moderate, p. 11)

6

11.

Your salary was $28,000 in 2003 and $30,000 in 2004. In 2005, your salary was $34,000. What was the percentage increase in your salary from 2003 to 2005?

a. b. c. d.

7.14% 14.29% 21.43% 11.76%

(c, moderate, p. 11) 12.

Inflation is reported by the:

a. b. c. d.

Federal Reserve Department of Commerce Bureau of Labor Statistics U.S. Treasury

(c, moderate, p. 9) 13.

For the overall U. S. market, inflation is measured by the change in the:

a. b. c. d.

Producer Price Index Consumer Price Index GDP Wholesale Price Index

(b, easy, p. 9) 14.

You would expect a larger change in expenses than reflected by the CPI if:

a. b. c. d.

you are a college student. you are married with children you live in a high-rent area you live in an urban area

(c, moderate, p. 10) 15.

The Federal Reserve often _______ the __________ rate to stimulate the economy. a. b. c. d.

lowers; fed funds raises; fed funds lowers; prime raises; prime

(a, moderate, p. 12)

7

Making Effective Decisions 16.

You are considering adding a wood shop to your home. You enjoy woodworking and could make items for sale. In considering this addition, you only look at the extra cost of the shop and the potential benefits of having the shop. This is an example of: a. b. c. d.

opportunity cost decision-making sensitivity analysis marginal analysis reasonable assumptions

(c, moderate, p. 16) 17.

You decide to take a part-time job to help with your college expenses.

The hours available for study are thus reduced. The reduction in study hours would be your:

a. b. c. d.

fixed cost direct cost variable cost opportunity cost

(d, easy, p. 16) 18.

You are calculating your potential return on your stock investments. If you calculate different possible returns based on assuming a variety of interest rates and stock market conditions, this is an example of:

a. b. c. d.

reasonable assumptions sensitivity analysis marginal analysis opportunity cost

(b, moderate, p. 16) 19.

If you seek advice from a number of people before making a decision, you would be considered a (an):

a. b. c. d.

rational decision-maker intuitive decision-maker external decision-maker agonizer

(c, moderate, p. 17)

8

20.

Which of the following is a possible negative consequence for rational decisionmakers?

a. b. c. d.

reduced investment returns difficulty staying on a budget too much debt avoiding professional help

(a, moderate, p. 17) 21.

Individuals who make decisions spontaneously, without carefully evaluating their alternatives are: a. b. c. d.

rational decision makers. intuitive decisions makers. external decision makers. agonizers.

(b, moderate, p. 17) Selecting Qualified Financial Planning Professionals 22.

Which of the following would not be a major factor when choosing a personal financial planner?

a. b. c. d.

affiliation reputation certification education

(a, moderate, p. 18) 23.

Which of the following has completed a series of at least 8 courses covering all the financial planning areas?

a. b. c. d.

CFP AFC ChFC CPA

(c, difficult, p. 18)

9

24.

In a __________ arrangement, the planner is compensated for every financial product sold but does not receive any payment for developing a personal financial plan.

a. b. c. d.

fee only commission only fee plus commission fee offset by commission

(b, difficult, p. 19) 25.

In a fee-only arrangement, the planner is compensated with an annual fee that is usually:

a. b. c. d.

based on the number of financial products purchased. waived for large investment portfolios. a set amount for all clients. a percentage of the assets being managed.

(d, moderate, p. 19) 26.

A member can lose the CFP designation for violating any of the following requirements except:

a. b. c. d.

responsibility diligence objectivity confidentiality

(a, difficult, p. 19) 27.

Accountants specializing in financial planning are designated as ________ by the AICPA.

a. b. c. d.

L.L.M. AFCPE FCPA PFS

(d, difficult, p. 18)

10

Essay questions 1.

What is the difference between wealth and income? Why do people in the early stages of the life cycle often have more income than wealth?

Wealth is a function of your assets and debts while your income is money received. If your assets are greater than your debts, you have positive wealth. It is very possible for younger persons to have some income, usually wages received from a job, while they have not accumulated many assets yet. For example, many college students have more student loans, representing debt, than any assets acquired in the first few years out of college. But in a few years, this situation usually reverses and their wealth is greater than their income.

2.

What is sensitivity analysis and how can it be applied to personal financial planning? How does sensitivity analysis differ from reasonable assumptions?

Sensitivity analysis is the estimation of the change in outcome that results from a change in assumptions. It is used as a method to reduce the risk of a personal financial plan by considering all the possible variables and how those variables might change. Sensitivity analysis differs from reasonable assumptions in that it factors in a number of reasonable assumptions. For example, a reasonable assumption for a rate of return in the stock market may be 10 percent. Under sensitivity analysis, there might be several assumed reasonable rates of return from 5 to 15 percent based on any number of economic and financial conditions.

In effect, sensitivity analysis takes reasonable assumptions to a higher and more risk-adjusted level.

3.

What are the advantages and disadvantages to consumers of a fee only plan and a commission only plan when considering how to compensate financial planners?

A fee only plan has the advantage of being more fixed than a commission only plan since it is usually based on a hourly fee or an annual fee that is a percentage of the assets being managed. In addition, the financial planner has no incentive to sell the consumer more financial products than is necessary as he is not compensated for the number of products sold. The disadvantage of the fee only plan is that the fee may be relatively high compared to other plans.

A commission only plan is often the cheapest way to get hire a professional financial planner. Its major disadvantage is that the financial planner has an incentive to sell the consumer more financial products than is really necessary or advisable since the planner receives more compensation for more products sold.

11

4.

What are the elements of a comprehensive financial plan? Explain how these can be viewed as a “ladder to financial success.”

The four parts of a comprehensive financial plan are: (1) Establishing a firm foundation; (2) Securing basic needs; (3) Building wealth; and (4) Protecting income and assets. These are like a ladder in that you will generally take care of the earlier steps before you can go up the ladder to the next steps. For example, part of establishing a firm foundation is to develop personal financial statements so that you can evaluate your current financial position. These are necessary to be able to analyze your needs steps 2, 3, and 4. Similarly, you need to secure your basic needs for cash and credit management, housing, and insurance before you can realistically save for long-term goals.

12

Chapter 2

Financial Planning Tools: Personal Financial Statements and the Time Value of Money True-False Collecting and Organizing Your Financial Information 1.

A lockbox is considered safer than a safe deposit box for important personal documents.

(f, easy, p. 31) 2.

Since most IRS audits occur within 3 years of filing a return, it is recommended that tax records be kept 5 years.

(f, moderate, p. 31) Summarizing Your Current Financial Condition 3.

A personal balance sheet shows only a single point in time whereas a personal cash flow statement reflects transactions that occur over a period of time. (t, moderate, p. 32) 4.

For balance sheet purposes, assets should be stated in terms of original cost of the asset.

(f, moderate, p. 35)

5.

Things you own are considered your assets and amounts you owe are considered your debts.

(t, easy, 32) 6.

Another name for net worth would be income.

(f, moderate, p. 32)

7.

Real estate would not be considered a liquid asset.

(t, easy, p. 32)

13

8.

The cash surrender value on insurance policies would be counted on the debt side of the balance sheet.

(f, moderate, p. 35) 9.

College scholarships should be shown as an asset on the balance sheet.

(f, moderate, p. 37) 10.

Negative net worth only occurs if a person has no assets.

(f, moderate, p. 36) 11.

Cash flows on the cash flow statement are recorded when they are received or paid.

(t, moderate, p. 37) 12.

Gross income is the income received before any taxes are deducted.

(t, easy, p. 39) 13.

Grocery bills would be an example of a fixed expense.

(f, easy, p. 39) 14.

To get a realistic picture of actual expenditures, it is recommended that you keep a spending log for at least one year.

(f, moderate, p. 39) 15.

High income is always associated with a strong financial position.

(f, moderate, p. 40) 16.

Government benefits such as unemployment or welfare should not be counted as a cash inflow on the cash flow statement.

(f, moderate, p. 37) 14.

The debt payment ratio is the percentage of your gross income that you pay out in regular debt payments.

(f, moderate, p. 2-29)

14

15.

Car payments are the highest monthly expenditure for most individuals.

(f, moderate, p. 2-30) Using Financial Ratios to Evaluate Your Financial Standing 16.

The savings ratio will be negative if cash outflows exceed cash inflows.

(t, moderate, p. 44) 17.

The debt ratio is generally lower for older persons than for younger persons.

(t, easy, p. 43) 18.

The liquidity ratio compares liquid assets with non-liquid assets.

(f, moderate, p. 41) 19.

Borrowing at low interest rates is a major reason for the declining standard of living in the United States.

(f, difficult, p. 42) 20.

Disposable income and gross income mean the same thing in personal financial planning.

(f, moderate, p. 43) 21.

Financial planners often recommend that households try to achieve a savings ratio of at least 5 percent.

(f, moderate, p. 44) 22.

The debt payment ratio shows the percentage of after-tax income that is required to make the minimum debt payments of all types of debts.

(t, moderate, p. 2-29) Understanding the Time Value of Money 23.

The process of calculating present value is known as discounting.

(t, easy, p. 49)

15

24.

An ordinary annuity is one in which each payment occurs at the beginning of the period.

(f, moderate, p. 50) 25.

Variables must be entered in a specific order on a financial calculator for time value of money problems to ensure a correct answer.

(f, easy, p. 47) 26.

The time value of money is a good argument against saving money in a piggy bank at home.

(t, easy, p. 44) 27.

A dollar today is worth less than a dollar to be received one year from now.

(f, easy, p. 49)

Multiple Choice Collecting and Organizing Your Financial Information 1.

When saving documents, it is recommended that you keep utility bills:

a. b. c. d.

only until the next bill arrives. six months. one year.

3 years.

(c, moderate, p. 31) 2.

The IRS audits about 1 in every _______ tax returns.

a. b. c. d.

7 74 174 1, 740

(c, moderate, p. 31)

16

Summarizing Your Current Financial Condition 3.

Which of the following formulas is used to calculate personal net worth?

a. b. c. d.

Total Assets + Total Debts Total Assets - Total Debts Total Debts - Total Assets Liabilities - Unpaid Bills

(b, easy, p. 32) 4.

Which of the following would be the best definition of insolvency?

a. b. c. d.

Having more liabilities than assets.

Inability to borrow any more funds.

Having no savings Inability to pay bills on time

(d, moderate, p. 36) 5.

Which of the following assets is more likely to have a current market value that is greater than what you paid for it ten years ago?

a. b. c. d.

stamp collection car television furniture

(a, moderate, p. 35) 6.

If you borrow to buy a new car, which of the following items on the balance sheet will be affected?

a. b. c. d.

assets only debts only assets and debts unable to determine

(c, difficult, p. 35)

17

7.

If you lease a new car, which of the following items on the balance sheet will be affected?

a. b. c. d.

assets only debts only assets and debts unable to determine

(b, difficult, p. 35) 8.

If you have an insurance policy that has a cash surrender value,

a. b. c. d.

this represents an asset for you. this represents a debt for you. no value is entered on the balance sheet unless the policy is surrendered. the premiums still due are subtracted from the surrender value to arrive at market value.

(a, difficult, p. 35) 9.

A personal cash flow statement:

a. b. c. d.

shows income and expenditures at one specific point in time. uses the same information needed for the personal balance sheet. shows income and expenditures over a period of time. is necessary for calculating one's net worth.

(c, moderate, p. 37) 10.

Income before taxes and expenses is known as:

a. b. c. d.

disposable income. net income. pre-income gross income

(d, easy, p. 39)

18

11.

Which of the following items is generally the hardest to track on the personal cash flow statement?

a. b. c. d.

fixed expenses income assets variable expenses

(d, easy, p. 39) 12.

When recording inflows and outflows of cash for the cash flow statement, it is important:

a. b. c. d.

to monitor your spending for at least 2 years to get an accurate picture. not to alter your normal spending behavior. to record assets at their market value. to track inflows more than outflows.

(b, difficult, p. 39) 13.

The most common excuse given for not tracking household expenditures is:

a. b. c. d.

lack of knowledge lack of computer training insufficient time insufficient records

(c, difficult, p. 39) Using Financial Ratios to Evaluate Your Financial Standing 14.

Don has assets of $5,000, of which $1,800 are in checking and savings accounts.

His annual expenses are $15,000. Don's liquidity ratio would be:

a. b. c. d.

.333 3.00 .12 1.44

(d, moderate, p. 41; solution: Liquid assets/ Monthly expenses = 1800/1250* Monthly expenses = 15,000/12 = 1250)

19

Use the following information to answer questions 15 and 16.

Gross monthly income = $3,500 After-tax monthly income = $2,870 Total debt = $86,000 Total monthly debt payments = $402 Total assets = $113,000 15.

Based on the information given above, what is the debt ratio?

a. b. c. d.

131% 3% 47% 76%

(d, difficult, p. 43; solution = 86,000/113,000 = .76) 16.

Based on the information given above, what is the debt payment ratio?

a. b. c. d.

11.5% 14% 4.1% 21%

(b, difficult, p. 43; solution = 402/2870) 17.

The mortgage debt service is the total dollar amount of monthly mortgage:

a. b. c. d.

principal and interest. principal, interest and property taxes. principal, interest, property taxes, and homeowner's insurance. interest and taxes

(c, moderate, p. 43) 18.

Tyler's monthly gross income is $4,200 and his monthly disposable income is $3,400. He saves approximately $300 a month. What is his savings ratio?

a. b. c. d.

7.14% 8.8% 18% 38%

20

(b, moderate, p. 43; solution = 300/3400) 19.

Financial advisors commonly recommend that households target at least a _____ percent savings ratio.

a. b. c. d.

5 10 15 20

(b, moderate, p. 44) Understanding the Time Value of Money 20.

If you are investing $2,500 a year (end-of-year payments) into a retirement account that earns 9 percent interest annually, how much will you have at the end of 20 years?

a. b. c. d.

$14,011 $139,400 $127,900 $141,911

(c, moderate, p. 52; calculator solution: 20 N, 2500 PMT, 9 I, 0 PV, Solve for FV) 21.

If you receive a series of equal end-of-year payments over several years, this is an example of:

a. b. c. d.

a perpetuity an ordinary annuity an annuity due compounding

(b, moderate, p. 50) 22.

Which of the following is true regarding future value?

a. b. c. d.

The longer the term, the lower the future value.

The higher the interest rate, the lower the future value.

The shorter the term, the higher the future value.

The lower the interest rate, the lower the future value.

(d, difficult, 44)

21

23.

You deposit $200 today into a bank account. If the account earns 8 percent annually, how much will you have at the end of 10 years?

a. b. c. d.

$93 $432 $2,897 $3,329

(b, moderate, p. 47; calculator solution: - 200 PV, 8 I, 10 N, 0 PMT, Solve for FV) 24.

You want to be a millionaire when you retire in 40 years. How much would you have to invest each year if you could earn 9 percent on your invested funds yearly over the 40 years?

a. b. c. d.

$2,960 $92,960 $31,838 $42,378

(b, moderate, p. 47; calculator solution = 1,000,000 FV, 9 I, 40 N, 0 PV, Solve for PMT) 25.

You plan to invest $2000 every year (end-of-year payments) from now until you retire in 30 years. If you can earn 7 percent annually on your invested funds, how much will you have when you retire?

a. b. c. d.

$15, 225 $25,081 $188,922 $204,146

(c, moderate, p. 52; calculator solution: 0 PV, 2000 PMT, 7 I, 30 N, solve for FV) 26.

You plan to invest $1,500 every year (beginning-of-year payments) for the next 10 years. If you can earn 9 percent on your invested funds, how much will you have in 10 years?

a. b. c. d.

$22,789 $24, 840 $28,391 $22,406

(b, moderate, p. 52; calculator solution: 2nd function, begin; 1500 PMT, 10 N, 9 I, 0 PV, solve for FV)

22

27.

You want to receive payments of $20,000 each year (end-of-year payments) for 15 years. If you can earn 8 percent on your funds, how much would you have to invest today in order to reach your goal?

a. b. c. d.

$63, 055 $171,190 $184,885 $54,304

(b, moderate, p. 55; calculator solution: 2nd function end, 20000 PMT, 15 N, 8 I, 0 FV, solve for PV) 28.

You borrow $10,000 from your bank to buy a new car. If the loan is for 4 years at 7 percent annual interest and payments are made monthly, how much will your monthly payments be?

a. b. c. d.

$239 $253 $376 $421

(a, difficult, p. 57; calculator solution: 12 shift PMT, 48 N, 10000 PV, 0 FV, 7 I, solve for PMT) 29.

Loan amortization is based upon:

a. b. c. d.

future value future value of an annuity present value present value of an annuity

(d, moderate, p. 55) 30.

In order to determine how much you would need to save yearly in order to finance your child's college education in 10 years, you would use:

a. b. c. d.

future value future value of an annuity present value present value of an annuity

(b, moderate, p.50)

23

Essay Questions 1.

What does net worth represent? Why is it not especially troubling to have a negative net worth when one is a college student but it would be troubling for an older person?

Net worth represents a person's wealth. This figure is what is left over from assets after all the debt is paid. Therefore, a positive net worth is always desirable and, in general, the higher the net worth, the better off a person is. A negative net worth is not very troubling for a college student because they are just starting out and have not usually accumulated many assets but probably have some debt, especially debts related to their education. A college student's situation will usually improve greatly once they graduate and are out working full time. On the other hand, if negative net persists in the long term and after a person is graduated, this will eventually result in insolvency, the inability to pay your debts, and could lead to bankruptcy.

2.

Is all debt bad? What are some examples of "good" debt and "bad" debt? How can you tell if you have too much debt?

No, all debt is not bad. Some debt may be used to increase a person's standard of living. An example of "good" would be student loans that further a person's education and allow them to enter a better profession than without a degree. An example of "bad" debt would be some credit card debt, especially credit cards with high interest rates. If the purpose in using the credit cards was impulse shopping, for example, this would not generally raise your standard of living and add to your future opportunities. To tell if you have too much debt, you should examine your debt payment ratio. If this ratio is generally above 33-38 percent, then you probably have too much debt relative to your level of income.

3.

What does the time value of money concept assume about receiving a sum of money in the future compared to money held today and why? What is this time value of money concept called?

The time value of money concept assumes that a dollar you have today is worth more than a dollar that you will receive in the future. This is because of the lost interest on the dollar you already have. In other words, you could invest your dollar you presently have and earn some interest. This makes the dollar you receive in the future actually worth less than a dollar in today's terms. This time value of money concept is called present value because it calculates what a dollar received in the future would be worth in the present day.

24

Mini-Case Bill's Personal Balance Sheet, December 31, 2004 Assets Checking account Savings account Total liquid assets

$700 $800 $1,500

Home furnishings Clothing Market value of automobile Total Personal Property

$2600 $1200 $8900 $12,700

Market value of home Total Real Property

$88000 88,000

Total Assets

$102,200

Debts Mortgage payment Utilities Credit card payments Total current bills

$750 $230 $120 $1,100

Credit card balances Car loans Total Short-term debt

$6000 $7000 $13,000

Home mortgage balance Total Long-term debt

$54,000 $54,000

Total Liabilities

$68,100

25

Bill's Personal Cash Flow Statement Cash Inflows Salary(gross) Interest income Total cash inflow

Cash Outflows Monthly $4,100 150 $4,250

Monthly Income/payroll taxes $320 Groceries $250 Mortgage payment $750 Utilities $200 Credit card payments $120 Gas for car $200 Insurance payments $190 Clothing $ 40 Gifts $ 25 Entertainment $250 Total cash outflows $2345

Based on the information, calculate Bill's net worth, net cash flow, liquidity ratio, debt ratio, and savings ratio. How would you interpret Bill's financial position?

Answer: Net Worth = $102,200 - $68,100 = $34,100 Net Cash Flow = $4,250 - $2,345 = $1,905 Liquidity ratio = $1,500 $2,345

=

.64

Debt ratio = $68,100 $102,200

= .66 = 66%

Savings ratio = $1,905 $3,930

= .48 = 48%

Bill's financial position shows a positive net worth, which is good, and a high net cash flow, also good. However, without his income, he would not have enough liquid assets to cover his bills for even one month. He has a high debt ratio which indicates a fairly risky financial position. His savings ratio is quite high so that is an offsetting factor for the high debt. Overall, Bill appears to be financially sound as long as he maintains his income. It would be suggested he use his high savings to pay down some of his debt.

26

Chapter 3

Goal Setting, Career Planning, and Budgeting True-False Setting Short-Term and Long-Term Personal Financial Goals 1.

Financial goals should be measurable in order to track the progress made.

(t, easy, p. 69) 2.

For a college student, retirement funding would be an example of an intermediateterm goal.

(f, moderate, p. 70) 3.

Your personal financial plan should be fairly inflexible or you will not be as likely to reach your goals.

(f, moderate, p. 73) Career Planning 4.

An investment in one's human capital is likely to lead to an increase in income.

future

(t, easy, p. 74) 5.

Since there are few standardized tests designed to measure career aptitude, the best approach is to consult a jobs counselor.

(f, moderate, p. 76) 6.

Most college students have a clear perception of the actual work experience of most jobs.

(f, moderate, p. 77) 7.

Over 75 percent of all people change careers at least three times in their working life.

(f, moderate, p. 77)

27

8.

Jobs in sales are expected to have the largest increase in employment over the period from 2000-2010.

(f, difficult, p. 79) 9.

The population of the United States is expected to become less concentrated on the two coasts in the future as people desire to move to less congested areas.

(f, moderate, p. 79) 10.

Informational interviews provide information about potential jobs,but are not good tools for developing networking contacts.

(f, moderate, p. 80) 11.

It is recommended that you spend at least 2 hours a week in order to conduct an effective job search.

(f, moderate, p. 80) 12.

It is generally recommended that a resume for a recent college graduate should be no more than one page long.

(t, easy, p. 81) 14.

A cover letter is intended to include more in-depth information than is found on the resume.

(f, moderate, p. 81) 15.

The average starting salary for high school graduates in 2003 was less than half of the starting salary of a college graduate with a bachelor's degree in liberal arts.

(f, moderate, p. 3-84) 16.

Full-time child care tends to range from $50 to $100 per week.

(f, moderate, p. 78) 17.

The overall measure of human capital is the level of education attained.

(f, difficult, p. 74)

28

18.

Continued globalization is expected to impact only manufacturing and low-skilled workers.

(f, moderate, p. 79) 19.

Networking is the process of developing contacts with people who might be helpful in one's career.

(t, easy, p. 80)

Developing and Implementing a Budget 20.

The key forecasting question when preparing a budget is how changing technology will change your record keeping.

(f, moderate, p. 84) 21.

One way to estimate variable expenses is to increase current variable expenses by the expected inflation rate.

(t, moderate, p. 85) 22.

Reconciling a budget is the process of adjusting the budget for unexpected expenditures.

(f, difficult, p. 85) 23.

House payments, property taxes and homeowner's insurance payments would all be considered fixed expenses.

(f, moderate, p. 85)

Monitoring and Controlling Your Budget 24.

Expenditures for movie tickets would be an example of discretionary spending.

(t, easy, p. 89) 25.

Married couples with children are more likely to file for bankruptcy than single, childless people.

(t, moderate, p. 90)

29

26.

Twenty percent of all bankruptcies are triggered by divorce.

(f, difficult, p. 90) 27.

The principle of paying yourself first is based on the idea of "easy come, easy go."

(f, easy, p. 89) 28.

Mental accounting is the process of constantly thinking about how to improve your financial position.

(f, difficult, p. 89) Money Attitudes and Household Budgeting 29.

Financial planners recommend that debts of one spouse that precede the marriage become the debt of both spouses after the marriage.

(f, moderate, p. 92) 30.

A postnuptial agreement is not as legally binding as a prenuptial agreement.

(f, difficult, p. 92)

Multiple Choice Setting Short-Term and Long-Term Personal Financial Goals 1.

Regarding financial goals, which of the following statements is false?

a. b. c. d.

Goals should be stated in precise terms Goals should be fixed.

Goals should be within one's control Goals should be measurable.

(b, easy, p. 69-70)

30

2.

Intermediate-term goals usually take up to ________ to accomplish.

a. b. c. d.

6 months 1 year 3 years 5 years

(d, moderate, p. 70) 3.

The second step in establishing a set of goals is to:

a. b. c. d.

make a wish list reevaluate regularly prioritize break big goals into smaller steps

(c, moderate, p. 71) 4.

Which of the following steps in goal setting actually motivates people to stick with their plan?

a. b. c. d.

making a wish list reevaluating regularly prioritizing breaking big goals into smaller steps

(d, difficult, p. 71) 5.

How much would you have to save monthly in order to have $15,000 in 5 years if you can earn 11 percent on your invested funds?

a. b. c. d.

$188.64 $200.71 $289.11 $326.14

(a, difficult, p. 72; calculator solution: 15,000 FV, 60 N, 11/12 I, 0 PV, solve for PMT)

31

6.

What would your monthly payments be on a $5,000, 3-year loan if the interest rate was 14 percent?

a. b. c. d.

$112.55 $170.89 $170.47 $187.63

(b, difficult, p. 72; calculator solution: 5,000 PV, 0 FV, 36 N, 14/12 I, solve for PMT) 7.

You need $25,000 in four years to start your own business. If you can earn 8 percent on your funds, how much do you need to invest today in order to reach your goal?

a. b. c. d.

$7,548 $15, 854 $18, 376 $34,012

(c, difficult, p. 72; calculator solution: 0 PV, 8 I, 4 N, 25,000 FV, solve for PMT) 8.

Your standard of living will decline if:

a. b. c. d.

you spend more than you earn. you are faced with an unexpected emergency. you fail to save enough. your wages do not keep up with inflation.

(d, difficult, p. 74) Career Planning 9.

The best definition of human capital is:

a. b. c. d.

the skills brought to a job by a worker. the education brought to a job by a worker. the sum total of a worker's talents and experience the sum total of a worker's productive capacity.

(d, moderate, p. 74)

10

When determining how much a college education is worth, it is important to:

32

a. b. c. d.

compute the future value of expected earnings compute the present value of future increase in earnings consider marginal revenue consider the interest cost of money

(b, difficult, p. 74-75) 11

Which of the following is not a popular assessment tool used by career advisors?

a. b. c. d.

the Strong Interest Inventory the Keirsey Character and Temperament Sort the McIvins Aptitude Survey the Myers-Briggs Type Indicator

(c, difficult, p. 76) 12.

A government-sponsored website that offers useful career information, updated job outlook information, and a library of articles and videos is:

a. b. c. d.

America's Career Infonet Monster.com U.S. JobNet Federal Jobline

(a, moderate, p. 77) 13.

Approximately ________ of all people actually change careers in their life.

a. b. c. d.

one quarter one third one half three-quarters

(b, moderate, p. 77) 14.

Which of the following occupational groups is expected to experience the largest increases in employment from the years 2000-2010?

a. b. c. d.

Agriculture Service Business/financial Professional

(d, difficult, p. 79)

33

15.

Which of the following is not one of the trends occurring that might affect your career?

a. b. c. d.

aging of the population increasing importance of manufacturing continued globalization concentration of the population

(b, moderate, p. 79) 16.

A travel agent is an example of a job in the _________ sector.

a. b. c. d.

manufacturing professional service multinational

(c, easy, p. 79) 17.

If you ask an vice president of a bank about their responsibilities on the job, this would be considered a(an):

a. b. c. d.

informational interview occupational interview informal interview personal interview

(a, moderate, p. 80) 18.

The skill that was considered the most important for employees in a recent employer survey was:

a. b. c. d.

computer skill sales skill communication skill teamwork skill

(c, moderate, p. 82)

34

19.

A letter of introduction that is sent with a resume to a prospective employer is known as a:

a. b. c. d.

vita cover letter dossier preface

(b, easy, p. 82) 20.

One reason for the decrease in manufacturing jobs is that:

a. b. c. d.

we are buying fewer manufactured goods. it takes fewer workers to produce goods. incomes are falling. workers are less productive.

(b, difficult, p. 3-24) Developing and Implementing a Budget 21.

A plan for spending and saving is known as a(an):

a. b. c. d.

balance sheet vita income statement budget

(d, easy, p. 83) 22.

Which of the following is not one of the steps in the budgeting process?

a. b. c. d.

Prioritizing Implementing Monitoring Evaluating

(a, moderate, p. 84)

35

23.

The process of adjusting income, expenses and savings in order that more is not spent than is earned is known as:

a. b. c. d.

monitoring a budget. reevaluating a budget. reconciling a budget. adjusting a budget

(c, moderate, p. 85)

24.

One approach to forecasting variable expenses is to:

a. b. c. d.

increase them by the expected inflation rate. keep them constant. use a wide range of estimates. assign probabilities to different outcomes.

(a, moderate, p. 3-39) Monitoring and Controlling Your Budget 25.

Which of the following is not one of the main reasons for tracking budget variances?

a. b. c. d.

to ensure that large, irregular cash expenses do not cause financial hardship. to determine the largest categories of expenditures for future reductions. to identify small cash leakages before a major shortfall. all of the above are correct.

(b, difficult, p. 876) 26.

Which of the following is not one of the seven "budget busters?"

a. b. c. d.

too little life insurance too many children too much house too much tuition

(a, difficult, p. 90)

36

27.

Which of the following is suggested if you have "too much car?"

a. b. c. d.

Buy a cheaper car than your current one Use public transportation Don’t trade a car before it's paid for Put as big a down payment as possible when purchasing

(c, difficult, p. 90) 28.

If you are a very careful spender with your paycheck but spend recklessly with lottery winnings, this is an example of:

a. b. c. d.

a split personality obsessive-compulsive behavior opportunity cost mental accounting

(d, moderate, p. 89) 29.

Which of the following is not one of the recommended psychological actions in budgeting?

a. b. c. d.

rewarding yourself for successes. punishing yourself for failures. paying yourself first avoiding pain

(b, moderate, p. 89)

37

Essay Questions 1.

What are the five steps in choosing a career and how do you implement those steps?

First, you must assess your abilities and interests. This can be done by investigating the Career Service office at your college and by using assessment tools such as the Myers-Briggs Type Indicator, the Strong Interest Inventory, and the Keirsey Character and Temperament Sort tests. The second step is to identify alternatives that fit your interests. This can be achieved by first listing characteristics of your ideal job coupled with your interests and abilities. Again, information. The third step is to evaluate the costs, benefits and risks of the career you've chosen. This evaluation should include your future life choices such as having children, which might limit your choices and slow your career progress. You should give serious thought to what you have to give up in order to pursue this career and the risks involved. The fourth step in the process is to thoroughly research employment trends in order to see what the future prospects for your chosen career are. A good source for employment trends is the U.S. Department of Labor's Occupational Outlook Survey. Consider demographic trends, such as an aging population and concentration of the population, in your evaluation of future prospects. The final step in choosing a career is to prepare yourself for the job market. This entails acquiring the necessary job skills and experience and conducting an effective job search. Although a college education is quite valuable, you may find that you need extra courses or skills in order to fulfill the requirements of your chosen profession. Internships are a good way to acquire experience and also provide you with a network of potential job contacts.

Use all available resources, especially your college's Career Service offices, in your job search. Your resume and cover letter should be carefully written to accentuate your positive attributes.

2.

What are the two major reasons for tracking budget variances and what should you do when you identify these variances?

The two major reasons for tracking budget variances is to identify small cash variances as soon as possible so that they do not become major problems and to ensure that large irregular cash expenses do not cause financial hardship. Small variances can usually be corrected by small changes in behavior. For example, if you are exceeding your budgeted amount for food, you can probably eliminate this variance by less restaurant meals and more at-home dining. However, large variances usually require more attention and planning. First, you should determine if these large cash expenses are predictable or not. Your college tuition is a predictable amount that is due on a known date. Knowing it is upcoming, you can build a fund for this purpose. Unknown expenses, such as car repairs or medical bills, can be funded from an emergency fund that you contribute to monthly. In the event that your emergency fund is not sufficient to cover the emergency, you can obtain a short-term loan.

38

3.

What are the seven "Budget Busters" and what are some possible solutions to these budget busters?

1. Too much house . Expensive houses usually come with larger utility bills, maintenance, taxes and insurance. The solution is to downsize.

2. Too many children. Children are expensive. The solution is to live more frugally and couples must accept they can't spend as they did when they were childless.

3. Too much tuition. Private K-12 schools and college are expensive. Consider less expensive options such as community college. Make your child pay for some of the cost.

4. Too much car. This can lead to high payments or may owe more than the car's worth. The solution is not to trade a car until it's paid for and consider shorter-term car loans.

5. Too many marital troubles. Separation and divorce can mean supporting two households instead of one. Consider marriage counseling before separating.

If you do separate, close joint accounts and refinance mortgages.

6. Too little health insurance. Accidents and illnesses can lead to financial ruin in a very short time. Budget in order to afford some health insurance.

Possibly consider a plan with a high deductible to protect against catastrophic illnesses and accidents.

7. Too little emergency cash. Living paycheck to paycheck can be disastrous if you have a car breakdown, lost job or other emergency. The solution is to start an emergency fund now with regular deposits and deposit any refunds or windfalls.

Mini-Case Joe Cool is a high school senior and is considering whether to attend college or just go to work after graduation. He has been offered a job making $18,000 a year. If he goes to college, he plans to major in business and he expects to earn at least $37,000 a year when he graduates. Joe expects raises in both jobs to keep pace with inflation, which he estimates at 3 percent annually. If Joe expects to work 40 years at either job, what will the college degree be worth to him? What other factors should Joe consider?

Answer: Annual difference between 2 jobs = $37,000-18,000 = 19,000 Financial calculator solution: 19000 payment, 40 N, 3 I, 0FV, solve for PV = $439,181 The college degree should be worth approximately $439,181 over Joe's 40-year career.

Other factors for Joe to consider is the cost of college, benefits offered and which career choice would lead to the greatest job satisfaction based on Joe's interests and abilities.

39

Chapter 4

Income Tax Planning True-False The Federal Income Tax System 1.

It is estimated that the average American works more than 4 months out of the year just to pay their federal income taxes.

(t, moderate, p. 101) 2.

Federal income taxes were instituted originally to pay national security expenses associated with the Civil War.

(f, easy, p. 101) 3.

Our current federal tax rates are considered to be the highest ever relative to historical rates.

(f, moderate, p. 101) 4.

The sales tax is considered a regressive tax.

(t, moderate, p. 101) 5.

As defined by the IRS, taxable income is the same as net income.

(f, difficult, p. 102) 6.

The lowest federal tax bracket is currently 15 percent.

(f, moderate, p. 103) 7.

The marginal tax rate applies to one's entire taxable income.

(f, moderate, p. 103) 8.

A taxpayer's marginal tax rate will always be less than their average tax rate.

(f, moderate, p. 104)

41

9.

Each year the income levels that trigger an increase in the tax rate are automatically increased for inflation.

(t, easy, p. 104) 10.

When considering the tax effects of tax-savings plans, such as employer-provided retirement plans, the relevant tax rate is the average tax rate.

(f, moderate, p. 105) 11.

The Federal Reserve Bank is the government agency responsible for collecting federal income taxes and enforcing tax laws.

(f, easy, p. 105) Filing Requirements 12.

Not all married couples file under the "married filing jointly" filing status.

(t, moderate, p. 106) 13.

A member of a household who receives at least half of his or her support from the head of the household is classified as a dependent.

(t, moderate, p. 106) 14.

Earned income is the same as investment income

(f, moderate, p. 106) 15.

A commission received by a salesman would be an example of earned income.

(t, moderate, p. 106) 16.

An exemption and a deduction are the same thing in tax terms.

(f, easy, p. 106-107) 17.

Taxpayers should itemize deductions only when expenses in certain allowable categories exceed the standard deduction.

(t, moderate, p. 107) 18.

Tax credits, like exemptions and deductions, represent adjustments to income.

(f, difficult, p. 107)

42

19.

The standard deduction decreases with age.

(f, moderate, p. 107) 20.

If you fail to file your return by April 15, you will be granted an automatic extension to July 15.

(f, moderate, p. 108) 21.

One of the advantages of e-filing is a lower chance of being audited.

(f, difficult, p. 108) Calculating Taxable Income and Taxes Owed 22.

If you sell shares of stock that you have owned for at least one year, any profit made on the sale would be classified as a capital gain.

(t, moderate, p. 113) 23.

Sale of one's primary residence is treated differently for tax purposes than other assets sold.

(t, moderate, p. 113) 24.

A $1,000 tax credit would be more beneficial than a $1,000 tax deduction.

(t, moderate, p. 121) 25.

Credit card interest paid is not an allowable deduction if you itemize deductions.

(t, moderate, p. 117) 26.

Even non-cash contributions, such as food or clothing, given to charitable organizations are allowed as deductible contributions.

(t, easy, p. 118) 27.

Exemptions increase annually with inflation and are phased out for taxpayers with high incomes.

(t, moderate, p. 119)

43

28.

The child tax credit is for children under 17 and varies with the parent's income.

(f, difficult, p. 121) Paying Taxes 29.

The amount of taxes withheld from your paycheck depends on your expected income and amount of standard deductions.

(f, difficult, p. 122) 30.

Overpaying taxes is generally recommended in order to reduce the chance of being audited.

(f, difficult, p. 123) Tax Planning Strategies 31.

Both tax evasion and tax avoidance are against the law and are subject to criminal penalties.

(f, moderate, p. 124) 32.

For most taxpayers, their biggest tax shelter is their home.

(t, moderate, p. 127) Enforcement of the Tax System and Recent Trends 33.

All tax audits are conducted in person by IRS auditors.

(f, moderate, p. 127) 34.

A flat tax would influence consumer behavior more than our current tax system.

(f, moderate, p. 129)

44

Multiple Choice The Federal Income Tax System 1.

Which of the following amendments to the U.S. Constitution allowed Congress to impose an income tax?

a. b. c. d.

14th amendment 15th amendment 16th amendment 17th amendment

(c, moderate, p. 102) 2.

When was the IRS created?

a. b. c. d.

1789 1861 1913 1953

(d, moderate, p. 102) 3.

The U.S. income tax is considered:

a. b. c. d.

illegal. progressive. regressive transgressive

(b, easy, p. 101) 4.

A progressive tax is one in which:

a. b. c. d.

you pay more if you earn more. you pay less if you earn more. you pay the same regardless of earnings. taxes are used for progressive services.

(a, easy, p. 101)

45

5.

___________ taxes are used to finance Social Security and Medicare.

a. b. c. d.

FSSA FDIC SIS FICA

(d, moderate, p. 101) 6.

Which of the following statements regarding the U.S. income taxes is false?

a. b. c. d.

Taxable income is not all taxed at the same rate.

Marginal tax rates decrease as income increases.

Not all income is taxable.

Tax rate schedules show taxes for different ranges of income.

(b, moderate, p. 102) 7.

What act lowered the maximum marginal tax rate to 35 percent?

a. b. c. d.

Tax Reform Act of 1986 Fairness in Tax Relief Act of 2000 Economic Growth and Tax Relief Reconciliation Act of 2001 Tax Reform, Recovery and Reconciliation Act of 1999

(c, moderate, p. 102) 8.

If your taxable income falls in the lowest tax bracket,

a. b. c. d.

you pay no taxes. your taxes are computed based on the alternative minimum tax. you receive an Earned Income Credit. all of your taxable income is taxed at the same rate..

(d, difficult, p. 103) 9.

Which of the following is the formula for calculating the average tax rate?

a. b. c. d.

Taxes paid/Taxable income Taxes paid/ Adjusted Gross Income Adjusted Gross Income/ Taxes paid Taxable income/Taxes paid

(a, moderate, p. 104)

46

10.

If your taxable income is $86,000 and you paid taxes of $18,000, your average tax rate is:

a. b. c. d.

48 percent 26 percent 21 percent 17 percent

(c, moderate, p. 104; solution = 18000/86000 = 21%) 11.

The reduction in taxes owed as a result of a financial decision is known as the:

a. b. c. d.

average tax effect marginal tax effect progressive tax effect opportunity cost

(b, moderate, p. 105) 12.

A compilation of all statutes, regulations and court decisions relating to the U.S. income tax is the

a. b. c. d.

Internal Revenue Service Federal Tax Law Federal Revenue Code Internal Revenue Code

(d, moderate, p. 105) Filing Requirements 13.

Which of the following is not one of the filing status classifications?

a. b. c. d.

Married filing separately Qualifying widow(er) with dependent child Single with dependent child Head of household

(c, moderate, p. 105)

47

14.

A widow whose husband died 5 years ago and who has a dependent child would file as:

a. b. c. d.

Qualifying widow with dependent child Single Single with dependent child Head of household

(d, difficult, p. 106) 15.

Interest earned on bank deposits would be classified as:

a. b. c. d.

earned income investment income interest income capital gains

(b, moderate, p. 106) 16.

The "marriage penalty" resulted from the:

a. b. c. d.

exemption differences between married couples and singles. itemized deduction differences between married couples and singles. standard deduction differences between married couples and singles. tax credit differences between married couples and singles.

(c, difficult, p. 108) 17.

The dollar amount of a standard deduction depends upon:

a. b. c. d.

the number of members in the household. income level. the amount of itemized deductions. filing status.

(d, moderate, p. 107)

48

18.

Unlike the standard deduction, itemized deductions:

a. b. c. d.

always consider the number of members in the household. deduct actual expenses in certain categories. are not allowed for single filers. consider the filing status.

(b, difficult, p. 107) 19.

If you cannot meet the April 15 deadline for filing your tax return, you can apply for an automatic extension that extends the deadline to:

a. b. c. d.

June 15 July 15 August 15 September 15

(c, moderate, p. 108) 20.

More than _______ percent of all individual federal tax returns are now submitted electronically.

a. b. c. d.

20 40 60 80

(b, moderate, p. 108) 21.

Which of the following tax forms is known as the long form?

a. b. c. d.

1040A 1040B 1040C 1040

(d, easy, p. 109) 22.

If you made a mistake on last year's tax return, you would file a:

a. b. c. d.

1040A 1040EZ 1099 1040X

(d, moderate, p. 111)

49

Calculating Taxable Income and Taxes Owed 23.

College scholarships for tuition expenses would:

a. b. c. d.

be included in gross taxable income. show as a deduction from gross income. not be reported. show as a deduction from adjusted gross income.

(c, moderate, p. 112) 24.

If you own rental property, any rent received would be classified as:

a. b. c. d.

unearned income. a capital gain. adjusted gross income. a deduction from gross income.

(a, easy, p. 112) 25.

Which of the following would never qualify as an expense deducted from total income to arrive at adjusted gross income?

a. b. c. d.

IRA contributions child care expenses unreimbursed teacher expenses college tuition

(b, moderate, p. 113) 26.

Which of the following filing status categories receives the largest standard deduction?

a. b. c. d.

Single Married filing separately Head of household Qualified widower

(d, moderate, p. 114)

50

27.

With regard to itemized deductions, the percentage of people who itemize deductions:

a. b. c. d.

increases with age. increases with income. decreases with age. decreases with income.

(b, difficult, p. 116) 28.

Medical expenses that add up to more than ____ percent of adjusted gross income can be deducted.

a. b. c. d.

5 7.5 10 12.5

(b, moderate, p. 116) 29.

Which of the following types of taxes paid are not allowable deductions?

a. b. c. d.

property taxes personal property taxes state income taxes use taxes

(d, moderate, p. 116-117) 30.

Ordinary and necessary job-related expenses are deductible if they exceed ________ percent of AGI.

a. b. c. d.

1 2 3 4

(b, difficult, p. 118)

51

Paying Taxes 31.

The amount of taxes withheld from your paycheck depends on:

a. b. c. d.

expected income and expected deductions. number of exemptions and filing status. filing status and expected income. expected income and number of exemptions.

(d, difficult, p. 122) 32.

Which of the following occupations would be the most likely to pay estimated taxes?

a. b. c. d.

public school teacher hospital aide hairdresser corporate lawyer

(c, difficult, p. 122) Tax Planning Strategies 33.

Many company retirement plans minimize taxes by:

a. b. c. d.

increasing itemized deductions. reducing taxable income. maximizing tax credits. increasing the number of exemptions.

(b, moderate, p. 125) 34.

Reimbursement accounts for qualified medical and child care expenses are known as:

a. b. c. d.

flexible spending accounts. cafeteria plans. deferred compensation plans. option plans.

(a, easy, p. 125)

52

35.

Which of the following retirement accounts allows tax-free withdrawals at retirement?

a. b. c. d.

401(k) plans traditional IRAs Roth IRAs 403(b) plans

(c, moderate, p. 126) 36.

One reason to give investment accounts to children is that:

a. b. c. d.

children pay no taxes. accounts of children are not audited by the IRS. their income would be subject to lower tax rates. all of the above are correct.

(c, moderate, p. 126) Enforcement of the Tax System and Recent Trends 37.

The primary disadvantage of a flat tax is:

a. b. c. d.

it requires more record keeping that the current system. it would not raise as much revenue as the current system. it is less progressive than the current system. it would encourage more tax evasion than the current system.

(c, moderate, p. 129) 38.

Which of the following is not an IRS audit "trigger?"

a. b. c. d.

child care tax credit claimed. taxpayers who should have paid the alternative minimum tax. earned income tax credit claimed. receipt of substantial cash income.

(a, moderate, p. 128)

53

Essay Questions 1.

Define the five income tax filing statuses. If a woman gets married December 1, 2004, can she file jointly with her husband in 2005 when they prepare their 2004 return?

The single filing status is for taxpayers who are unmarried or legally separated from their spouse. Married filing jointly status is for married couples filing a single tax return, even if only one spouse had income. Married filing separately is for married couples where each spouse files and individual tax return and reports his or her own income and allowable deductions. Head of household status is for single people who live with and provide more than half of the support for a dependent child or relative. Lastly, qualifying widow(er) status is for a taxpayer whose spouse died within two years of the tax year and who lives and pays more than half of the support for a dependent child. One's filing status is determined based on the filing status as of the last day of the year. Since the woman was married as of the last day of the year, she can file with her husband under the married filing jointly for their 2004 return.

2.

What is the major disadvantage of getting a tax refund? Since there is a major disadvantage, why do so many people overpay their taxes and get a refund?

A major disadvantage of getting a tax refund is that you are, in effect, loaning money to the government. Unfortunately, unlike other types of loans, you are not getting any interest on the money. From a personal financial perspective, it is recommended that you try to achieve the best return possible on any money you have. However, many people are willing to forego the interest they could have earned and overpay their taxes for several reasons. First, they view tax refunds as windfalls whereas they would feel pain if they had to pay a big tax payment all at once. Secondly, by getting one big payment, people can indulge in "mental accounting," which means putting the money into fun things such as vacations. If people received only a little bit each month, they would be more likely to use it for everyday items.

54

Mini-Case 1.

Charlie Brown and Lucy are a married couple with one child, Linus, age 3.

Charlie manages a baseball team and Lucy is a psychiatrist. Their combined wages for 2003 were $80,000. They have collected the following information in preparation for filing their tax return: Mortgage interest $3,500 Property taxes $2,000 Student loan interest $2,000 Church donations $1,500 Interest received on deposits $1,000 Calculate the Browns’ taxable income for 2003, assuming their filing status is married filing jointly. Are the Browns eligible to take any tax credits? If so, which ones?

Answer: Gross Income - Adjustments to Gross Adjusted Gross Income - Standard Deduction - Exemptions Taxable Income

$81,000 (wages + interest received) - 2,000 (student loan interest) $79,000 - 9,500 * - 9,150 (3 exemptions - Charlie, Lucy, Linus) $60,350

* Even though mortgage interest, property taxes and church donations are allowed deductions, they do not total more than the standard deduction.

The Browns are eligible for the child tax credit for Linus since he is under 17.

They may be eligible for the child care expense credit if they pay for child care for Linus.

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Chapter 5

Cash Management and Financial Institutions True-False Questions The Objectives of Cash Management 1.

Cash management is the same as checking account management.

(f, easy, p. 139) 2.

The opportunity cost of holding cash is the higher rate of return on other investments.

(t, easy, p. 139) 3.

It is suggested that you should have enough liquid assets to cover 3-4 months of regular expenses.

(f, moderate, p. 140) Rules of Effective Cash Management 4.

An ATM is now considered an effective alternative to reconciling a checkbook.

(f, moderate, p. 142) 5.

Paying yourself first is not recommended by most financial planners.

(f, easy, p. 144) Providers of Cash Management Services 6.

A credit union is a type of depository institution.

(t, moderate, p. 144) 7.

A savings and loan association is a type of non-depository institution.

(f, moderate, p. 144) 8.

Personal accounts held in commercial banks are insured up to $1 million per depositor.

(f, easy, p. 145)

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9.

A major distinction between commercial banks and savings and loan associations is that banks can offer credit cards and savings and loans do not.

(f, difficult, p. 145) 10.

A mutual savings institution is owned by its depositors.

(t, moderate, p. 145) 11.

Credit unions often have lower loan rates and higher interest rates on deposits than banks.

(t, moderate, p. 145) 12.

Personal accounts at credit unions are not insured.

(f, moderate, p. 145) 13.

Accounts offered by mutual fund companies are not insured.

(t, moderate, p. 147) 14.

The major source of revenue for brokerage firms is the commission charged on security transactions made by its customers.

(t, moderate, p. 147) Cash Management Products and Services 15.

Checking accounts and savings accounts at commercial banks are both types of demand deposits.

(t, moderate, p. 150) 16.

Regular checking accounts usually pay higher interest rates than demand deposits.

(f, difficult, p. 150) 17.

Checking accounts that pay interest are technically called a NOW account.

(t, moderate, p. 150) 18.

Time deposits generally pay lower interest rates than demand deposits.

(f, moderate, p. 151)

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19.

A certificate of deposit is a type of demand deposit at a commercial bank.

(f, easy, p. 153) 20.

If you withdraw funds from a CD before the end of the term, you will lose a portion of your principal.

(f, difficult, p. 153) 21.

The interest rate on indexed CDs is tied to the cost of living index.

(f, difficult, p. 154) 22.

Money market accounts have unlimited checkwriting privileges just as a regular checking account but pay higher interest rates than a regular checking account.

(f, moderate, p. 151) 23.

Unlike money market mutual funds, money market accounts offered by commercial banks are federally insured.

(t, moderate, p. 151) 24.

Series EE savings bonds are called discount bonds because they can be purchased at a price below face value.

(t, moderate, p. 155) 25.

Series EE savings bonds mature in 10 years but can be redeemed prior to maturity.

(f, difficult, p. 155) 26.

Debit cards are like credit cards in that both involve borrowing from a financial institution.

(f, moderate, p. 157) 27.

ATM transactions are generally free only when you use a terminal owned by your financial institution.

(t, easy, p. 158)

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28.

The primary advantage of traveler's checks is that they are more readily accepted than cash in foreign countries.

(f, difficult, p. 159) 29.

Accounts that are more liquid usually pay lower rates of interest but have lower monthly service charges and fees.

(f, moderate, p. 160) 30.

In order to compare interest rates of different accounts, you should use the annual rate differential (ARD).

(f, moderate, p. 161) Resolving Cash Management Problems 31.

Stop payment orders are usually good for a one-month period.

(f, moderate, p. 163) 32.

Using Western Union is a faster and cheaper way to send money to someone located across the country than a bank wire transfer.

(f, moderate, p. 164)

Multiple Choice The Objectives of Cash Management 1.

Cash management is best defined as the management of:

a. b. c. d.

checking and savings accounts. all cash inflows and cash outflows. cash payments and liquid investments. short-term assets and short-term liabilities.

(c, moderate, p. 139)

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2.

Which of the following is not one of the major reasons for holding cash?

a. b. c. d.

avoiding unnecessary taxes managing transactions needs. making temporary investments preparing for cash emergencies

(a, moderate, p. 139) 3.

Which of the following would be considered a transaction account?

a. b. c. d.

checking account savings account certificate of deposit mutual fund account

(a, easy, p. 139) 4.

From a conservative viewpoint, it is generally recommended that you have enough liquid assets to cover _______ months of regular expenses.

a. b. c. d.

2-3 3-6 5-8 7-10

(c, moderate, p. 140) Rules for Effective Cash Management 5.

Which of the following rules are not recommended for better cash management?

a. b. c. d.

Transfer funds from non-earning accounts into earning accounts when possible.

Pay yourself first.

Develop a system to ensure bills are paid on time.

Use sound criteria to evaluate financial institutions and products.

(a, moderate, p. 142)

6.

Paying yourself first means:

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a. b. c. d.

buying items desired before bills are paid. setting aside a reasonable sum for entertainment before bills are paid.. putting money into savings before making other monthly expenditures. keeping separate accounts from your spouse for personal needs.

(c, easy, p. 144) Providers of Cash Management Services 7.

Which of the following is a non-depository institution?

a. b. c. d.

commercial bank mutual fund company savings and loan association credit union

(b, moderate, p. 144) 8.

Which federal agency insures bank deposits?

a. b. c. d.

FSLIC SEC Federal Reserve FDIC

(d, easy, p. 145) 9.

Personal accounts in commercial banks are insured for:

a. b. c. d.

$100,000 per account $100,000 per depositor $1 million per account $1 million per depositor

(b, moderate, p. 145) 10.

Savings and loan associations primarily make __________ loans.

a. b. c. d.

car signature mortgage business

(c, moderate, p. 145)

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11.

Which of the following is a major difference between commercial banks and credit unions?

a. b. c. d.

Commercial banks earn higher profits than credit unions.

Credit unions are not allowed to offer credit cards and banks are.

Commercial banks are depository institutions and credit unions are not.

Credit unions have nonprofit status and banks do not.

(d, difficult, p. 145-146) 12.

One reason credit unions often have lower costs of operation than commercial banks is that they:

a. b. c. d.

tend to be more local in nature than banks. do not offer all the services as banks. may rely on volunteer workers. save from lower regulatory costs.

(c, moderate, p. 145) 13.

Which of the following insures deposits in credit unions?

a. b. c. d.

FDIC SEC NCUSIF CUNA

(c, moderate, p. 145) 14.

The primary source of funds for life insurance companies is:

a. b. c. d.

interest earned on investments. policy premiums. fees collected. policy liabilities.

(b, moderate, p. 147)

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15.

Which of the following is not one of the four areas that should be rated when evaluating financial institutions?

a. b. c. d.

Place Price Principle People

(c, moderate, p. 147) 16.

Which of the following is not one of the price factors that should be evaluated when judging financial institutions?

a. b. c. d.

Interest paid on loans Interest earned on liquid assets Fees paid for cash management services All of the above are correct

(a, moderate, p. 148) Cash Management Products and Services 17.

Which of the following is normally a disadvantage of a money market account?

a. b. c. d.

No interest paid on balances May impose higher fees for various services Higher minimum balance required than other checking alternatives Cannot be redeemed in first six months.

(c, moderate, p. 151) 18.

Which of the following types of account is not federally insured?

a. b. c. d.

Money market mutual fund Certificate of deposit Regular savings NOW account

(a, moderate, p. 153)

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19.

Which of the following had the highest before-tax average rate of return in March 2004? a. b. c. d.

1-year CD Money market account U.S. Series EE Savings Bond Money market mutual funds

(c, difficult, p. 153) 20.

Which of the following U.S. Savings bonds adjusts the rate of return for rising prices?

a. b. c. d.

Series EE Series I Series H Series P

(b, moderate, p. 156) 21.

What is the APY of an account that has a 6 percent quoted rate and is compounded quarterly?

a. b. c. d.

6.06% 6.12% 6.14% 6.24%

(c, difficult, p. 161; calculator solution: 4 pmts per year; 1 PV, 6 I, 0 PMT, solve for FV = 6.14%) 22.

The term "NOW" account stands for a:

a. b. c. d.

not of withdrawal account negligible order of withholding account notice of withholding account negotiated order of withdrawal account

(d, difficult, p. 150)

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23.

Regarding time deposits, which of the following statements is generally true?

a. b. c. d.

The higher the amount deposited, the higher the interest rate paid.

The longer the time restriction, the higher the interest rate paid.

The lower the amount deposited, the higher the interest rate paid.

The shorter the time restriction, the higher the interest rate paid.

(b, moderate, p. 151) 24.

Regular savings accounts were once called:

a. b. c. d.

statement accounts. ledger accounts. passbook accounts. book-entry accounts.

(c, easy, p. 152) 25.

If you withdraw funds from a CD before the end of the term, you will generally:

a. b. c d.

forfeit your principle. receive a reduced interest rate. pay a service fee. receive no interest.

(b, moderate, p. 153) 26.

If you deposit $2,000 in a 1-year CD, $2,000 in a 2-year CD, $2,000 in a 3-year CD and $2,000 in a 4-year CD, this is known as the strategy of:

a. b. c. d.

"laddering." "stacking." "segmenting" "layering"

(a, moderate, p. 154) 27.

If you do not instruct your financial institution otherwise, when CDs mature your financial institution will automatically:

a. b. c. d.

send you the principal and interest earned send you the interest and reinvest the principal. roll over the funds into a comparable CD. roll over the funds into a money market account.

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(c, moderate, p. 154) 28.

If the interest paid on a CD increases at stated intervals, this is an example of:

a. b. c. d.

an indexed CD. a rising-rate CD. a callable CD. an extended CD.

(b, moderate, p. 154) 29.

If your financial institution has the right to cancel your CD at some point in the future, this is an example of:

a. b. c. d.

an indexed CD. a rising-rate CD. a callable CD. a convertible CD.

(c, moderate, p. 154) 30.

Which of the following types of CDs will earn lower interest when the stock market is falling?

a. b. c. d.

an indexed CD. a rising-rise CD. a bear market CD. a callable CD.

(a, moderate, p. 154) 31.

Which of the following money market accounts would usually be federally insured?

a. b. c. d.

a money market account offered by an insurance company. a money market account offered by a brokerage firm. a money market account offered by a credit union. all of the above would be federally insured.

(c, moderate, p. 155)

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32.

If you want to calculate how long it will take a sum of money to double based on a certain interest rate, you would use the:

a. b. c. d.

Rule of 32 Rule of 52 Rule of 72 Rule of 92

(c, easy, p. 155) 33.

Which of the following statements regarding Series EE savings bonds is correct?

a. b. c. d.

They accrue interest monthly.

They are tied to the inflation rate.

They pay regular interest income after they reach face value.

They pay no interest until the bonds are redeemed.

(d, moderate, p. 155) 34.

The rate of interest on Series EE bonds is linked to rates on:

a. b. c. d.

short-term federal debt. short-term CDs. long-term federal debt. long-term CDs.

(a, moderate, p. 156) 35.

The only way to purchase Series HH bonds is:

a. b. c. d.

to use Series EE bonds to buy Series HH bonds. to use Series I bonds to buy Series HH bonds. by automatic purchase plans at participating financial institutions. by purchasing the bonds directly from the Treasury Department.

(a, moderate, p. 156) 36.

The face value of Series I bonds:

a. b. c. d.

is always $1,000. adjusts with market interest rates. adjusts with the CPI index. is calculated only when the bond is redeemed.

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(c, moderate, p. 156) 37.

Which of the following statement is true regarding debit cards?

a. b. c. d.

They are now accepted at all retail stores.

They usually have a service charge higher than checking account service fees.

Most banks select the PIN on debit cards for the customer.

If used, they cause an immediate electronic withdrawal from a bank account.

(d, moderate, p. 157) 38.

A personal check drawn on your own account and guaranteed by the financial institution in which you have the account is known as a:

a. b. c. d.

traveler's check. certified check. cashier's check. money order.

(b, moderate, p. 159) 39.

A check drawn on the account of a financial institution and made out to a party specified by the customer is known as a:

a. b. c. d.

traveler's check. certified check. cashier's check. money order.

(c, moderate, p. 159) Resolving Cash Management Problems 40.

An arrangement by which a bank places funds into a depositor's checking account if there are insufficient funds to cover all checks written is known as:

a. b. c. d.

check kiting. an insufficient fund charge. a check protection plan. overdraft protection.

(d, moderate, p. 162)

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41.

Which of the following statements regarding stop payment orders is true?

a. b. c. d.

They are usually made for 1-2 days.

They must be made in person and in writing.

They usually charge a $10-$25 fee.

They cannot be extended beyond their original term.

(c, difficult, p. 163) 42.

The electronic transmittal of cash from an account in another location is known as:

a. b. c. d.

a cash wire a wire transfer a money order an electronic pass

(b, easy, p. 164)

Essay Questions 1.

Compare and contrast commercial banks, savings institutions and credit unions.

Which institution is often the best for individuals?

All three institutions are depository institutions, who all accept deposits and make loans. Commercial banks generally offer a wider variety of accounts and services, including mortgage and personal loans and credit cards. Personal bank accounts are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $100,000 per depositor. Savings institutions are very similar to banks in types of accounts they offer but specialize more in mortgage loans than in other types of loans. Savings accounts, like bank accounts, are insured up to $100,000 per depositor. Unlike banks, which are corporations, some savings institutions are savings institutions. Mutual savings institutions pay a dividend rather than interest on accounts. Credit unions are also owned by depositors, known as members. However, credit unions have a common bond requirement that depositors must meet in order to become a member. This common requirement may be an employment or occupational affiliation, religious affiliation or geographic requirement. Therefore, unlike banks and savings institutions, not everyone can open an account in a credit union. Fortunately, many credit unions are not very restrictive on membership so many people can find one they can join.

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Credit unions are classified as non-profit organizations by the government . Their non-profit status and use of volunteers means that credit unions often have a lower cost of operation than banks and savings institutions. This low cost advantage is often passed on to members in the form of higher rates on deposits and lower rates on loans. For these reasons, credit unions are often the best choice for consumers.

2.

Define and discuss the "Four P's" used to evaluate financial institutions.

The four P's are products, price, people and place. Products refer to the accounts and services offered by the institution. The ideal institution would offer all the types of accounts and services you need to effectively manage your cash effectively. Consumers should list all the products they would like to have and then evaluate the institutions to see which ones meet all the products desired. In addition to having the right products available, consumers should make sure they evaluate the products qualitatively for risk and service. Price should be evaluated from two perspectives - the interest earned on accounts and the fees paid for services. You are looking for the best rates on deposits but should also evaluate any hidden costs or restrictions such as minimum balances that must be held in order to be paid interest. Service fees can differ substantially from institution to institution and should be considered along with the interest paid. People refers to the level of customer service you receive from the institution. If you plan to do business at the institution, you want hours that fit your schedule. You should evaluate the waiting time and abilities of the personnel of the institution. Place factors that should be evaluated include the location of the main office as well as branches and ATMs. You may sacrifice location for better interest rates but consider if the inconvenience outweigh the rate differential.

71

-Chapter 6

Purchasing Strategies and Credit Cards True-False Introduction 1.

8 out of 10 consumers interviewed at the end of 2003 indicated that debt reduction was one of their New Year's resolutions for 2004.

(t, easy, p. 176) Consumer Purchases and Your Financial Plan 2.

Luxuries are things that we must have in order to live.

(f, easy, p. 177) 3.

A new car would be considered a necessity.

(f, moderate, p. 177) 4.

Before making any purchase, you should decide if the item purchased is consistent with your financial plan.

(t, easy, p. 177) 5.

When analyzing excess spending, it is recommended that you ignore the small dollar item purchases.

(f, moderate, p. 177) 6.

A home equity loan is considered a type of consumer credit.

(t, moderate, p. 179) 7.

If you can earn a higher interest rate on savings than you will pay on credit cards, then it makes sense to use the credit card instead of taking money from savings.

(t, moderate, p. 179) 8.

Used goods are generally not recommended when considering all your purchase alternatives.

(f, easy, p. 180)

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9.

Extended warranties are a type of insurance and should be purchased whenever offered.

(f, moderate, p. 181) 10.

Even if a product does not come with an express warranty, there is an implied warranty that it will work as intended.

(t, moderate, p. 181) The Advantages and Disadvantages of Consumer Credit 11.

When you purchase an item on credit, the item should last at least as long as the time period over which you make payments.

(t, moderate, p. 182) 12.

A major advantage of using credit is the ability to purchase more expensive items than if paying with cash.

(t, moderate, p. 182) 13.

Although there is a potentially higher cost of purchasing using credit than with using cash, the risk aspect is the same with both types of purchases.

(f, difficult, p. 182) 14.

Increased credit now may actually decrease your ability to use credit in the future.

(t, moderate, p. 183) 15.

Higher outstanding debt may increase your auto or homeowner's insurance premiums.

(t, moderate, p. 183) 16.

The average debt ratio in the United States has actually declined over the past two decades.

(f, moderate, p. 183)

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Types of Consumer Credit 17.

A car loan would be considered a type of open-end credit.

(f, moderate, p. 184) 18.

An installment contract would be considered a type of closed-end credit.

(t, moderate, p. 185) 19.

A credit card issued by Home Depot would be both a retail card and an open-end type of credit.

(t, moderate, p. 185) Credit Cards 20.

Bank credit cards, such as MasterCard and Visa, set a maximum credit limit and consumers may access this line of credit until the maximum limit is reached.

(t, moderate, p. 184) 21.

A smart card is actually a combination of several bank credit cards and can be used in more retail locations.

(f, difficult, p. 187) 22.

In the future, smart cards could include driver's license, checking account and credit card information.

(t, easy, p. 187) 23.

The Fair Credit Act requires lenders to report the APY on all types of loans and credit arrangements.

(f, moderate, p. 188) 24.

Federal law requires that credit card bills be mailed at least 1 month before the next due date.

(f, moderate, p. 188)

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25.

The minimum payment on a credit card bill may not always be enough to pay the interest due on the account for the period.

(f, moderate, p. 189) 26.

Cardholders with premium credit cards are usually not charged overlimit charges if they exceed their credit limit.

(f, difficult, p. 189) 27.

The most common method for calculating the account balance owed is the average daily balance with a grace period.

(f, difficult, p. 190) 28.

The two-cycle average daily balance method will generally result in higher finance charges for cardholders who are gradually paying off account balances.

(t, difficult, p. 191) 29.

When comparing credit card terms, always compare the nominal rate rather than the APY.

(f, moderate, p. 192) The Advantages and Disadvantages of Credit Card Use 30.

All forms of consumer credit have the disadvantage of loss of privacy.

(f, difficult, p. 193) 31.

Credit cards that calculate finance charges without including new charges during the billing cycle allow cardholders to borrow without paying interest if paid by the end of the grace period.

(t, moderate, p. 193) 32.

For identification purposes, it is recommended that you print your Social Security number on your checks.

(f, moderate, p. 195) 33.

Over a quarter of all identify theft cases involve family members.

(f, moderate, p. 195)

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34.

Interest rates on credit cards are relatively insensitive to market interest rate movements.

(t, easy, p. 194) 35.

Within the first year of being a credit card holder, one in five college freshmen owes more than $10,000.

(t, moderate, p. 194)

Multiple Choice Consumer Purchases and Your Financial Plan 1.

Which of the following items would not be considered a necessity?

a. b. c. d.

a hamburger a cell phone a pair of shoes a house

(b, moderate, p. 177) 2.

You might be shopping for the wrong reasons if:

a.. b. c. d.

you prefer to buy "sale" items. you like to shop in better quality shops. you consider shopping a preferred leisure activity. you buy things that are not in season.

(c, difficult, p. 179) 3.

Which of the following situations would be the best use of consumer credit instead of taking cash from a savings account?

a. b. c. d.

home equity loan at 6%; savings account at 3%. student loan at 4 %; savings account at 3%. credit card at 7.9%; savings account at 10 %. auto loan at 8.2%, savings account at 8 %.

(c, easy, p. 179)

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4.

Which of the following periodicals provides information about a wide variety of household products, including comparison of features and reliability.

a. b. c. d.

Wall Street Journal Underwriter's Laboratory Good Housekeeping Consumer Reports

(d, moderate, p. 180) 5.

In recent years, consumers in rural areas have more access to product markets through: a. b. c. d.

UPS ebay Fed Ex cell phones

(b, easy, p. 180) 6.

Most warranties come from:

a. b. c. d.

manufacturers. retailers. consumer groups. insurance companies.

(a, easy, p. 181) The Advantages and Disadvantages of Consumer Credit 7.

Which of the following is not an advantage of using credit?

a. b. c. d.

a source of emergency cash convenience lower cost safety

(c, moderate, p. 183)

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8.

Which of the following is the most likely effect credit has on insurance premiums?

a. b. c. d.

Paying insurance premiums by credit cards reduces the amount due.

High credit balances may result in an increased insurance premiums.

Insurance premiums will not be affected by your credit history.

Buying insurance through credit card companies may result in lower premiums.

(b, moderate, p. 183) 9.

Which of the following statements concerning household debt in recent years is true?

a. b. c.

Home mortgage debt as a share of total debt has increased in recent years.

Total household debt relative to total wealth has remained stable in recent years.

The greatest change in household debt has been relative to disposable income in recent years.

Households have not increased their standard of living by increasing household debt in recent years.

d.

(c, difficult, p. 183) Types of Consumer Credit 10.

If a bank loans you money for a new car, this is a type of:

a. b. c. d.

closed-end credit. open-end credit. revolving credit. cash advance.

(a, easy, p. 184) 11.

Credit cards, such as MasterCard and Visa, are examples of:

a. b. c. d.

closed-end credit. open-end credit. collateralized credit. wholesale credit.

(b, easy, p. 184)

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12.

Which of the following would be considered an example of a travel and entertainment credit card?

a. b. c. d.

Visa MasterCard Discover American Express

(d, easy, p. 185) Credit Cards 13.

The first credit cards were issued for the purpose of:

a. b. c. d.

paying for airline tickets. paying for restaurant meals. keeping records for expense accounts. paying for hotel rooms.

(b, moderate, p. 185) 14.

Visa and MasterCard are actually:

a. b. c. d.

not credit cards but a form of debit cards. not issued by Visa or MasterCard but by a financial institution. types of installment loans. types of retail credit cards.

(b, moderate, p. 186) 15.

Which of the following statements regarding retailers and bank credit cards is true?

a. b. c. d.

All retailers now accept some type of bank credit card.

More retail stores accept Visa than MasterCard.

Retailers incur a cost for accepting credit cards.

Retailers will either accept retail credit cards or bank credit cards but not both.

(c, moderate, p. 186)

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16.

Which of the following is not an advantage of retail credit cards to retailers?

a. b. c. d.

They may encourage greater spending at the retailer's stores.

They provide protection from bank credit cards for retailers.

They can offer a marketing opportunity for retailers.

They can be quite profitable for retailers.

(b, moderate, p. 187) 17.

The major reason that a credit card may not charge an annual fee is that:

a. b. c. d.

it charges a higher interest rate. it is not allowed to under certain state laws. competition has forced it to drop the fee. it is not allowed to under retail store agreements.

(c, difficult, p. 188) 18.

Which of the following is the formula for calculating the APR on a credit card?

a. b. c. d.

Average annual finance charges/ Average loan balance (Total annual finance charges - Annual fee)/Average loan balance (Average annual finance charges + Annual fee)/ Average loan balance (Total annual finance charges + Annual fee)/ Average loan balance

(d, difficult, p. 188) 19.

An interest rate on credit cards that is below the market rate and often offered to new customers is known as a(an):

a. b. c. d.

con rate. advance rate. teaser rate. transfer rate.

(c, easy, p. 188)

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20.

Which of the following statements concerning credit card dates is true?

a. b. c. d.

The transaction date and billing date are usually the same.

A credit card bill must be mailed at least 14 days before the due date.

The billing date often varies from month to month.

The billing date must be either the first or last day of the month.

(b, moderate, p. 188) 21.

Making the minimum payment on a credit card bill:

a. b. c. d.

ensures that the bill will be repaid in the minimum time period. ensures that late payment penalties will not be imposed. will not reduce the overall debt significantly. gives you the best credit standing available.

(c, moderate, p. 189) 22.

Which of the following actions may affect your ability to get future credit?

a. b. c. d.

paying less than the minimum payment paying late exceeding the credit limit all may affect your ability to get future credit

(d, moderate, p. 189) 23.

Which of the following methods is the most commonly used for calculating the account balance on credit cards?

a. b. c. d.

average daily balance method without a grace period average daily balance method with a grace period two-cycle average daily method previous balance method

(a, moderate, p. 190) 24.

Which of the following methods essentially gives the consumer free credit from the date of purchase until the beginning of the next billing cycle?

a. b. c. d.

average daily balance method without a grace period average daily balance method with a grace period two-cycle average daily method previous balance method

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(b, moderate, p. 191)

25.

Which of the following methods for calculating credit card account balances does not account for payments made during the current billing cycle?

a. b. c. d.

average daily balance method without a grace period average daily balance method with a grace period two-cycle average daily method previous balance method

(d, difficult, p. 191) 26.

Which of the following methods for calculating credit card account balances is used by some credit card issuers any time the balance has not been paid in full.

a. b c. d.

average daily balance method without a grace period average daily balance method with a grace period two-cycle average daily method previous balance method

(c, moderate, p. 191) 27.

If you are gradually reducing your credit card debt, you should avoid cards that use:

a. b. c. d.

average daily balance method without a grace period. average daily balance method with a grace period. two-cycle average daily method. adjusted balance method.

(c, difficult, p. 192) The Advantages and Disadvantages of Credit Card Use 28.

Which of the following is an advantage credit cards have over other forms of consumer credit?

a. b. c. d.

buy now, pay later source of emergency cash safe alternative to cash easier to return merchandise

(d, moderate, p. 193)

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29.

Which of the following is not an advantage of credit cards?

a. b. c. d.

free credit tax advantage ability to make remote purchases record keeping

(b, moderate, p. 193) 30.

Which of the following is a disadvantage of credit cards but not of all consumer credit?

a. b. c. d.

Financial statement impact Risk of overspending Risk of fraud and identify theft Increases cost of consumer purchases

(c, difficult, 193) 31.

To use your credit card number, a thief only needs:

a. b. c. d.

the credit card number and the expiration date. the credit card number and Social Security number. the credit card number and birth date. the credit card number, expiration date, and address

(a, moderate, p. 195) 32.

Which of the following is not a suggested way to avoid identity theft?

a. b. c. d.

Do not carry extra credit cards and IDs Do not add your name to no-call lists.

Mail bill payments at the post office.

Cancel unused credit card accounts.

(b, moderate, p. 195)

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33.

If you are a victim of credit card fraud or theft, your maximum liability for charges made without your authorization is ______, provided you report your loss promptly.

a. b. c. d.

0 $25 $50 $100

(c, moderate, p. 196) 34.

A new feature offered by MasterCard and Visa to reduce the risk of making purchases over the Internet is:

a. b. c. d.

a personalized ID remote confirmation voice print identification transaction verification

(d, moderate, p. 195) 35.

A survey by the American Savings Education Council found that ____ percent of college students have at least one major credit card.

a. b. c. d.

15 35 55 75

(c, moderate, p. 194)

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Essay Questions 1.

You are considering buying a new car. Discuss how you would identify your alternatives in this purchase decision.

First, gather knowledge about various makes and models of cars from all available sources. These sources would include information from the dealerships as well as outside, unbiased sources such as Consumer Reports and car rating services. In addition, use the Internet to get more information including price comparisons. Don't overlook used cars in your alternatives and again use sources such as Consumer Reports for used car reliability reports.

2.

How does credit affect the U.S. economy?

In general, consumer credit benefits the U.S. economy. When consumers spend more, businesses profit, employment increases and the overall economy gains.

This is true even if the spending is done with borrowed funds. Some industries such as new home construction are very dependent on credit as most people borrow to buy a new home. As mortgage interest rates move, the construction industry is directly affected. Low interest rates encourage more consumer spending than high interest rates. Since consumer spending is a major factor in the overall growth of the economy, recessions can be lessened by continued or increased consumer spending.

3.

What are the major differences between closed-end and open-end credit?

Closed-end credit is credit for a specific purpose and set amount such as a car loan or house loan. There is also a set period of time for the loan to be repaid (usually in monthly payments). In contrast, open-end credit is generally not for a specific purpose and a set amount to be borrowed is not specified. What is specified is the maximum amount you may borrow, known as the credit limit or credit line. You may use this credit until you've reached your credit limit. Credit cards are a good example of open-end credit. Monthly payments are made, as in closed-end credit agreements, but there is no set term. You keep paying until the debt is paid off.

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Mini-Case Cathy Coed wants to calculate what her monthly finance charges would be on her credit card, assuming her credit card company uses the average daily balance without a grace period method. Use the following information to calculate Cathy's monthly finance charge for the Sept. 30 billing date on her credit card.

30th of the month = billing date Annual interest rate = 21 percent Account balance on August 31 = $2,200 Purchases charged on Sept. 10 = $700 Amount paid on account and received by lender on Sept. 20 = $200 Answer: Average Daily Balance without a Grace Period

Aug. 31 - Sept. 9

Account Balance $2,200 X

Time Involved 10/31 =

$709.68

Sept. 10 - Sept. 19

$2,900

X

10/31

=

$935.48

Sept. 20 - Sept. 30

$2,700

X

11/31

=

$958.06 $2,603.22

Monthly Finance Charge = $2,603.22 X .21/12 = $2,603.22 X .0175 = $45.56

87

Chapter 7

Consumer Loans and Credit Management True-False Consumer Loans 1.

Interest rates on car loans are more likely to be fixed than variable.

(t, easy, p. 201) 2.

Fixed-rate loans usually carry lower initial interest rates than do variable-rate loans.

(f, moderate, p. 201) 3.

With a single-payment loan, both interest and principal are repaid at the same point in the future.

(t, easy, p. 201) 4.

An installment loan is considered in default when two consecutive payments have been missed.

(f, moderate, p. 201) 5.

If an installment loan is in default, the lender may enforce an acceleration clause, which shortens the term of the loan and raises the interest rate.

(f, moderate, p. 201) 6.

Prepayment penalties are only enforced if the minimum payment is not met on an installment loan.

(f, moderate, p. 201) 7.

Secured loans normally carry lower rates of interest than comparable unsecured loans.

(t, easy, p. 202) 8.

Home equity loans are often referred to as third mortgages.

(f, easy, p. 202)

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9.

The maximum amount that can be borrowed under a home equity loan is 90 percent.

(f, moderate, p. 202) 10.

Home equity loans are usually installment loans with terms from 5 to 15 years.

(t, moderate, p. 202) 11.

The tax advantage of home equity loans is comparable to the tax advantage of credit cards.

(f, moderate, p. 202) 12.

Below-market interest rates on car loans are often offset by higher prices and additional fees.

(t, moderate, p. 203) 13.

About one-third of all student financial aid comes from federal programs.

(f, difficult, p. 204) 14.

Repayment on Stafford and Perkins student loans begins six months after graduation.

(f, difficult, p. 205) 15.

The maximum term for all Stafford and Perkins student loans is 10 years.

(f, difficult, p. 205) 16.

Unsubsidized Stafford loans accrue interest from the time they are awarded.

(t, moderate, p. 205) 17.

Teaching in an inner-city public school may result in loan forgiveness with Perkins loans.

(t, moderate, p. 205)

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18.

Consumer finance companies offer the widest variety of consumer loans.

(f, moderate, p. 206) 19.

Commercial banks make more consumer loans than any other type of financial institution.

(t, moderate, p. 206) 20.

Borrowers who might not qualify for loans at commercial banks are often able to obtain loans at consumer finance companies.

(t, moderate, p. 206) 21.

Interest rates on loans made by sales finance companies are likely to be lower than those charged by consumer finance companies.

(t, difficult, p. 207) 22.

In most cases, the shorter the term on a consumer loan, the higher the interest rate charged.

(f, moderate, p. 208) 23.

Most depository institutions use the bank discount interest method to determine finance charges on consumer loans.

(f, difficult, p. 209) 24.

Unlike some credit cards, the only finance charge on consumer loans is the annual interest charge.

(t, moderate, p. 209) 25.

The add-on interest method of calculating finance charges will always result in a higher APR that the simple interest method.

(t, easy, p. 211) 26.

Interest is paid on funds not available to you under the add-on interest method of calculating finance charges.

(t, difficult, p. 211)

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27.

Credit insurance is a relatively inexpensive way to get increased life and disability insurance.

(f, moderate, p. 212) 28.

Most consumer loans specify that the lender can collect the amount of debt owed but cannot recoup any collection costs in the case of a default on the loan.

(f, moderate, p. 212) 29.

To determine the amount of interest remaining to be paid on an add-on installment loan, you would use the Rule of 72.

(f, moderate, p. 213) 30.

Balloon loans are more useful if funds are needed for a longer period of time and the borrower wants to reduce the monthly payment.

(f, moderate, p. 213) Building Your Creditworthiness 31.

In order to assess the borrower's capacity, the lender will evaluate the economic conditions in the area.

(f, difficult, p. 216) 32.

Borrowers who have higher levels of assets are less likely to default on a loan.

(t, easy, p. 216) Understanding Your Consumer Credit Rights 33.

Lenders may consider the marital status of applicants in community property states only.

(f, difficult, p. 220) 34.

A FICO credit score of 500 or more is considered good.

(f, moderate, p. 221)

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35.

Under the Consumer Credit Reporting Reform Act of 1997, the burden of proof for accuracy of credit information is placed on consumers rather than creditors.

(f, difficult, p. 221) Managing Consumer Credit 36.

It is recommended that borrowers take the shortest loan they can afford to take when obtaining debt consolidation loans. (t, moderate, p. 224) 37.

A Chapter 13 bankruptcy requires the liquidation of most of the debtor's assets.

(f, moderate, p. 227)

Multiple Choice Consumer Loans 1.

When real property is used as collateral to secure a loan, the lender records a _______ against the property.

a. b. c. d.

deed judgment lien mortgage

(c, easy, p. 201) 2.

The equity in a home is defined as the:

a. b. c. d.

the market value of the home. the market value of the home less the current loan balance. the appraised value of the home less the current loan balance. the appraised value of the home.

(b, moderate, p. 202)

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3.

The current market value of a home is $200,000 with a mortgage balance of $140,000. If the lender requires a 75% loan to value ratio, what is the home equity credit limit on this house?

a. b. c. d.

$10,000 $45,000 $105,000 $150,000

(a, moderate, p. 203; solution: 200,000 x .75 = 150,000 - 140,000 = 10,000) 4.

Which of the following statements is true concerning home equity loans?

a. b. c. d.

Home equity loan proceeds are generally restricted as to purpose.

Home equity loans are generally installment loans with a 1-10 year term.

Home equity loan interest is tax-deductible up to a maximum of $100,000.

All of the above are true

(c, difficult, p. 206-207) 5.

Which of the following is not a requirement to be eligible for a federal student loan?

a. b. c. d.

Comply with Selective Service registration Be enrolled in a federally accredited college Be taking courses to fulfill degree or certificate requirements Be a U.S citizen with a high-school diploma or equivalent

(b, moderate, p. 204-205) 6.

On a PLUS loan, repayment begins:

a. b. c. d.

6 months after graduation 9 months after graduation 2 months after disbursement 6 months after disbursement

(c, difficult, p. 205)

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7.

Which of the following is not one of the situations that can defer student loan payments?

a. b. c. d.

economic hardship Peace Corps service postsecondary study change in citizenship

(d, moderate, p. 205) 8.

Which of the following is not considered a depository institution?

a. b. c. d.

savings and loan finance company credit union banks

(b, easy, p. 206) 9.

Ford Motor Credit, which finances Ford autos for customers, is an example of a:

a. b. c. d.

consumer finance company sales finance company retail finance company wholesale finance company

(b, moderate, p. 207) 10.

The legal document that specifies the terms and conditions of a consumer loan is the:

a. b. c. d.

lien judgment promissory note trust agreement

(c, easy, p. 207) 11.

The formula to calculate the APR is the:

a. b. c. d.

average loan balance divided by the total annual finance charges total annual finance charges divided by average loan balance total annual finance charges divided by outstanding loan balance outstanding loan balance divided by total annual finance charges

(b, moderate, p. 210)

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12.

The method most commonly used by financial institutions to determine finance charges on consumer loans is the:

a. b. c. d.

simple interest method add-on interest method discount interest method compound interest method

(a, moderate, p. 209) 13.

Which of the following statements concerning the add-on interest method is true?

a. b.

This method usually results in a lower APR than the simple interest method.

With this method, the lender subtracts the interest due from the principal before the borrower receives the loan proceeds.

With this method, interest is added to the amount borrowed before the payments are calculated.

This method usually results in a higher APR than the discount interest method.

c. d.

(c, difficult, p. 210-11) 14.

To calculate an approximate APR on an add-on loan, you would use the:

a. b. c. d.

Rule of 78 Rule of 72 M-ratio method N-ratio method

(d, easy, p. 211) Building Your Creditworthiness 15.

The formula used to calculate the debt payment ratio is:

a.

total monthly payments (including mortgage payments) divided by monthly disposable income. total monthly payments (excluding mortgage payments) divided by monthly disposable income. total monthly payments (including mortgage payments) divided by monthly gross income. total monthly payments (excluding mortgage payments) divided by monthly gross income.

b. c. d.

(a, difficult, p. 215)

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16.

The debt ratio is calculated as the:

a. b. c. d.

total outstanding loan balances divided by net worth. total outstanding loan balances divided by total assets. net worth divided by total outstanding loan balances. total assets divided by total outstanding loan balances.

(b, moderate, p. 215) 17.

Which of the following is not one of the five C's of credit?

a. b. c. d.

conditions capacity credibility capital

(c, easy, p. 216) 18.

When lenders evaluate your sources of income and your expenses, they are considering your:

a. b. c. d.

capacity capital collateral character

(a, moderate, p. 216) 19.

A person who agrees to take responsibility for repayment of a loan if the primary borrower defaults is known as a:

a. b. c. d.

mentor guarantor cosigner benefactor

(c, easy, p. 216)

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Understanding Your Consumer Credit Rights 20.

Lenders can deny credit based on:

a. b. c. d.

receipt of public benefits age income any of the above factors.

(c, moderate, p. 219) 21.

You have the right to know what is contained in your credit report under the:

a. b. c. d.

Equal Credit Opportunity Act Truth in Lending Act Fair Credit Billing Act Fair Credit Reporting Act

(d, easy, p. 220) 22.

Which of the following is not one of the factors considered in the FICO credit scoring system?

a. b. c. d.

level of debt employment history variety of debt sources length of credit history

(b, moderate, p. 221) 23.

Which of the following FICO credit scoring factors is carries the greatest weight?

a. b. c. d.

payment history debt variety of debt sources recent credit activity

(a, moderate, p. 221)

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24.

Negative credit information, with the exception of bankruptcies, must be removed from a credit report after ______ years.

a. b. c. d.

3 5 7 10

(c, moderate, p. 221) 25.

In order to contest an error on a billing statement, you must notify the lender within ________ days of the billing error.

a. b. c. d.

30 60 90 120

(b, easy, p. 221) Managing Consumer Credit 26.

Which of the following is not one of the recommended solutions if you are having trouble making payments on your consumer credit?

a. b. c. d.

take a second job live with your parents or other family members transfer balances to another credit card sell some assets

(c, moderate, p. 224-225) 27.

A budget that starts with the absolute necessities and debt payments and then adds expenditures until there is no more cash is known as a:

a. b. c. d.

net sum budget pro forma budget line item budget zero-based budget

(d, moderate, p. 226)

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28.

The number of bankruptcies has been increasing at an average of ______ percent per year since the early 1990s.

a. b. c. d.

5 10 20 30

(c, difficult, p. 226) 29.

Which type of bankruptcy requires the liquidation of most of your assets?

a. b. c. d.

Chapter 5 Chapter 7 Chapter 11 Chapter 13

(b, easy, p. 227) 30.

Which type of bankruptcy implements a payment plan for the debtor and generally allows the debtor to keep all of his or her assets?

a. b. c. d.

Chapter 5 Chapter 7 Chapter 11 Chapter 13

(d, easy, p. 227)

100

Essay Questions 1.

Discuss the characteristics of home equity loans. What is a major tax difference between home equity loans and other types of consumer loans?

Home equity loans are based on the equity built up in one's home. Home equity is the difference between the market value of the home and the mortgage loan balance. A home equity loan is secured by the home. The home equity lender's position is secondary to the primary mortgage lender which is why home equity loans are often referred as second mortgages. The amount of the loan depends on the amount of the home equity and the percentage the lender is willing to lend.

Some lenders will loan up to 100 percent of the home equity but most lenders will only loan 80-90 percent of the home equity amount. Home equity loans are typically installment loans with terms of 5 to 15 years. Some home equity loans are established as a line of credit that the borrower can access as needed. Home equity loans can generally be used for any purpose. A major tax difference between home equity loans and other types of consumer loans is that the interest on home equity loans is tax deductible up to a maximum of $100,000. This tax break on home equity loans makes them significantly less costly than other types of consumer loans.

2.

Compare and contrast Stafford and Perkins student loans with regard to requirements, annual limits and repayment schedules.

Stafford loans can be subsidized or unsubsidized. Subsidized loans are based on need and do not require repayment until 6 months after graduation.

Unsubsidized loans are not based on need and accrue interest from the time they are awarded and payment may begin immediately or may be deferred until 6 months after graduation. If the total Stafford loan amount is greater than $30,000, the maximum schedule for repayment is 25 years. The Federal Perkins loans are based on need and have larger annual limits for dependent students at the undergraduate level than the Stafford loans. Repayment on Perkins loans starts 9 months after graduation and the maximum term for repayment is 10 years.

3.

Discuss the 5 C's of credit and how lenders assess each of these credit factors.

The 5 C's of credit are capacity, capital, collateral, character and conditions.

Capacity is the ability to repay the loan. Lenders assess capacity by looking at sources of income and level of expenses. The debt payment ratio is one way to assess capacity. Capital refers to the borrower's net worth and is assessed by subtracting total debt from total assets. A higher net worth indicates a higher capital position. Collateral is the property or asset that is pledged to secure the loan. The market value of the collateral would be assessed by the lender.

Character is the borrower's traits and behavior relative to borrowing. Lenders would look at the previous credit, employment and education history of the borrower in order to assess character. Conditions refers to the economic and

101

personal conditions that could impact on the borrower's ability to repay the loan.

Lenders would look at the local employment picture and any special circumstances relevant to the borrower.

Mini-Case Mike Morgan is considering buying a new car and estimates he will need to borrow $15,000 to finance the car. He currently earns $2,200 a month after taxes.

He has one credit card with a balance of $1,700 and makes monthly payments on the card of $50 a month. In addition, he has a student loan with a balance of $12,000 and monthly payment of $225. Calculate Mike's debt payment ratio at the present time. If Mike can secure financing on the new car at a 6.5% simple interest rate for 5 years, how much will his monthly car payments be? What would his debt payment ratio be if he bought the new car? Would Mike be likely to obtain credit? Why or why not?

Answer: Mike's debt payment ratio at the present time = Total monthly debt payments After-tax monthly income = $275 $2200 = 12.5% Monthly car payments = calculator solution = 12 payments per year, 60 month term, 6.5 interest rate, 15,000 PV, 0 FV, solve for payments = $293.49 Mike's debt payment ratio after buying the car =

$568.49 $2200 = 25.8%

Mike would likely obtain credit as most banks commonly require that total debt payments not exceed 33 to 38 percent of gross income so the debt payment ratio based on after-tax income could be even higher. Even after the car payments, Mike is well below the bank requirement for the debt payment ratio.

102

Chapter 8

Automobile and Housing Decisions True-False The Automobile Decision 1.

For all purchase decisions, the first question is whether you can afford the item.

(f, moderate, p. 237) 2.

Renting a car on an occasional basis is not a practical alternative to owning a car, especially for urban consumers.

(f, moderate, p. 237) 3.

When estimating the cost of automobile ownership, the only relevant cost is the monthly lease or loan payment.

(f, easy, p. 238) 4.

The loan payment on an auto loan would be an example of a fixed expense of auto ownership.

(t, easy, p. 238) 5.

Depreciation causes a decline in the value of an automobile and, therefore, a decline in one's net worth.

(t, moderate, p. 238) 6.

If you already have car insurance, the relevant insurance cost to consider when purchasing a new car is the new total insurance premium.

(f, moderate, p. 239) 7.

Gasoline would be considered a variable expense of owning a car.

(t, easy, p. 239) 8.

The cost per mile to operating an automobile increases with the mileage driven.

(f, moderate, p. 239)

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9.

If an auto dealer sells a car for $100 over the invoice price, then $100 is the maximum profit that can be made by the dealer.

(f, moderate, p. 240) 10.

One reason for the availability of relatively new, low-mileage cars is the decline in market value of used cars in recent years.

(t, moderate, p. 241) 11.

Due to the higher purchase price of a hybrid car, it is likely to take a long number of years to recover the additional cost of buying a hybrid.

(f, moderate, p. 242) 12.

SUVs have been tested and shown to be the safest type vehicle in a collision.

(f, moderate, p. 242) 13.

An express warranty must be in writing by the seller in order to be enforceable.

(f, moderate, p. 243) 14.

Bumper-to-bumper warranties on new cars cover all mechanical problems and most routine maintenance.

(f, moderate, p. 243) Automobile Financing Alternatives 15.

Even though the monthly payments are higher on a lease than with a purchase, leases are increasingly popular due to the ability to get a new car every two or three years.

(f, difficult, p. 244) 16.

In a closed-end lease, the lessor bears the risk that the value of the car at the end of the term is less than originally estimated.

(t, moderate, p. 244)

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17.

The most common type of auto lease is the open-end lease.

(f, moderate, p. 244) 18.

Up-front fees on an auto lease include the down payment and rent charge.

(f, difficult, p. 245) 19.

In a lease agreement, the value of the vehicle is known as the market capitalization value.

(f, moderate, p. 245) Getting the Most For Your Money 20.

A smart suggestion when shopping for a new car is to get the oldest salesperson at the dealership to help you as they are more likely to be the most knowledgeable.

(f, difficult, p. 247) 21.

In the negotiation phase of buying a car, you should know what your bottom line is and make that offer first.

(f, moderate, p. 247) The Housing Decision 22.

Renting provides greater mobility than owning a home.

(t, easy, p. 249) 23.

By law, all leases for houses have to be in writing.

(f, moderate, p. 250) 24.

Most lenders require that the mortgage debt service ratio of a borrower be no more than 50 percent.

(f, moderate, p. 255) 25.

A mortgage insurance premium is charged if your loan-to-value ratio is less than 80 percent.

(t, moderate, p. 256)

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26.

If you are required to pay a mortgage insurance premium, you must continue paying this premium until the loan is paid off.

(f, difficult, p. 256) Buying a Home 27.

Real estate brokers are paid on a commission basis, usually 8-10 percent of the negotiated sale price of the house.

(f, difficult, p. 258) 28.

The square footage of a house is the most important determinant to its value.

(f, moderate, p. 258) Mortgage Financing 29.

A mortgage is a long-term amortized loan that is secured by real or financial property.

(f, difficult, p. 259) 30.

If a financial institution makes a home loan and then sells the loan, this is a type of secondary mortgage market transaction.

(t, moderate, p. 260) 31.

Both the Veterans Administration and the Federal National Mortgage Association offer insurance for conventional loans under certain circumstances.

(f, difficult, p. 260) 32.

The initial interest rate on an adjustable rate mortgage is generally 1-3 percentage points lower than on conventional mortgages.

(t, moderate, p. 261) 33.

A type of mortgage that carries a fixed interest rate but increases payments over the life of the loan is a lender buy-down mortgage.

(f, difficult, p. 261)

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34.

Under a growing equity mortgage, the loan balance is paid off more quickly than under a conventional mortgage.

(t, moderate, p. 261) 35.

Older homeowners who have built up substantial equity in their homes can use a shared appreciation mortgage as a way to finance their retirement expenses and still leave their homes to their families after they die.

(f, difficult, p. 262) 37.

One discount point is equal to one percent of the home purchase price.

(f, moderate, p. 262) 38.

Refinancing a home incurs substantially lower mortgage-related finance charges than a new mortgage.

(f, difficult, p. 264) Completing the Real Estate Transaction 39.

A reserve account held by the lender used to pay property taxes and insurance as they come due is known as an escrow account.

(t, easy, p. 266) 40.

Closing costs are not known to the buyer until the actual date of closing.

(f, moderate, p. 266) 41.

The purpose of title insurance is to verify the seller's legal ownership of the property and to ensure that there are no other claims on the property that would interfere with the buyer's future ownership.

(f, moderate, p. 267)

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Multiple Choice The Automobile Decision 1.

Which of the following is not one of the fixed expenses of owning a car?

a. b. c. d.

depreciation maintenance licenses loan payments

(b, easy, p. 238) 2.

The decline in value of an asset over time is known as:

a. b. c. d.

amortization minimization depreciation discounting

(c, easy, p. 238) 3.

Which of the following is a variable operating expense of an automobile?

a. b. c. d.

taxes incremental insurance premiums finance charges toll fees

(d, moderate, p. 239) 4.

What is normally referred to as the "sticker price" on a new car is actually the:

a. b. c. d.

manufacturer's suggested retail price dealer's invoice manufacturer's invoice dealer's retail price

(a, easy, p. 240)

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5.

Jim owns a SUV which gets approximately 18 miles per gallon. If Jim drives 13,000 miles in a year and the average cost of a gallon of gasoline is $2.50, what is Jim's approximate annual gasoline cost?

a. b. c. d.

$289 $1,805 $2,137 $9,360

(b, moderate, p. 241-242; solution: 13,000/18 = 722.22 x 2.50 = $1,805) 6.

Which of the following statements about hybrid cars is true?

a. b. c. d.

They currently qualify for a $5,000 tax credit.

The current models have a limited range.

They typically cost about $3,000 more than similarly equipped non-hybrid cars.

All of the above are correct

(c, difficult, p. 242) 7.

Which car manufacturer is testing new technology that senses when your car is getting too close to a car in front of you?

a. b. c. d.

Ford Motor Co. General Motors Toyota Honda

(d, moderate, p. 242) 8.

A warranty that is made by the seller either in writing or orally is known as a(an):

a. b. c. d.

express warranty implied warranty limited warranty guaranteed warranty

(a, easy, p. 243)

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9.

Which of the following statements concerning extended warranties is true?

a. b, c. d.

They generally are more comprehensive in coverage than original warranties.

They can only be purchased from manufacturers.

They often cost more than expected costs of covered repairs.

They are not transferable.

(c, difficult, p. 243) Automobile Financing Alternatives 10.

The person who pays money for the privilege of using someone else's vehicle for a set period of time is known as a:

a. b. c. d.

lessor lessee renter party of the first part

(b, easy, p. 244) 11.

A walk-away lease is a(an):

a. b. c. d.

closed-end lease. open-end lease. contingent lease. capitalized lease.

(a, easy, p. 244) 12.

Which type of lease makes you responsible for any difference between the actual and estimated depreciation on the car you lease?

a. b. c. d.

closed-end lease open-end lease contingent lease depreciated lease

(b, moderate, p. 244)

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13.

Under a lease agreement, the value of the vehicle is referred to as the:

a. b. c. d.

rent charge residual value gross capitalized cost lease value

(c, moderate, p. 245) 14.

The total dollar finance charges for the term of a lease are known as the:

a. b. c. d.

gross capitalized cost capitalized cost reduction up-front fees rent charge

(d, moderate, p. 245) 15.

The expected depreciated value of the vehicle at the end of a lease term is known as the:

a. b. c. d.

capitalized value residual value depreciated value rent value

(b, moderate, p. 245) 16.

If you must pay a fee at the end of the lease term if you choose not to purchase the vehicle, this is known as a:

a. b. c. d.

capitalized cost reduction purchase fee back-end fee disposition fee

(d, moderate, p. 245) 17.

Which of the following is not one of the main sources of auto dealer profits?

a. b. c. d.

manufacturer allowances profit to be on traded vehicle licensing fees service contracts

(c, difficult, p. 247)

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18.

When buying a car, which of the following is part of the negotiation phase?

a. b. c. d.

Test driving vehicles Comparison shopping Making an offer on the vehicle Arranging for financing

(c, easy, p. 247) 19.

State laws that protect consumers against defective vehicles are known as:

a. b. c. d.

plum laws. orange laws. lemon laws. apple laws.

(c, easy, p. 248) The Housing Decision 20.

Which of the following is not one of the advantages of renting a home?

a. b. c. d.

greater certainty mobility lower monthly payments less responsibility

(a, moderate, p. 249) 21.

Which of the following is not one of the disadvantages of renting a home?

a. b. c. d.

no tax deduction no investment value higher up-front fees increasing costs over time

(c, moderate, p. 250)

22.

The property tax rate is often called the:

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a. b. c. d.

assessed rate. valuation rate. mil rate. legal rate.

(c, moderate, p. 252) 23.

The two ratios most commonly used by mortgage lenders to evaluate the ability to pay a mortgage loan are the:

a. b. c. d.

total debt service ratio and mortgage debt service ratio. debt ratio and debt payment ratio. total debt service ratio and debt ratio. mortgage debt service ratio and debt payment ratio.

(d, difficult, p. 255) 24.

In mortgage terms, the term PITI stands for:

a. b. c. d.

mortgage payment, interest, property taxes and homeowner's insurance. mortgage payment, interest, transfer fees and homeowner's insurance. mortgage principal, interest, property taxes and homeowner's insurance. mortgage principal, interest, transfer fees and homeowner's insurance.

(c, moderate, p. 255) 25.

Tim's monthly gross income is $2,900. He is buying a house that requires a $660 monthly payment. Property taxes would be $120 per month and insurance premiums of $45 per month. What is Tim's mortgage debt service ratio?

a. b. c. d.

17.07% 28.45% 35.15% 58.59%

(b, difficult, p. 255; solution: 660 + 120 + 45 = 825/2900 = 28.45%)

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26.

Sam's mortgage payment is $750 per month. He also has other monthly debt payments of $440. If his monthly gross income is $3,950, what is Sam's debt payment ratio?

a. b. c. d.

8.27% 29.14% 30.13% 33.19%

(c, difficult, p. 255; solution: 750 + 440 = 1190/3950 = 30.13%) 27.

If your loan-to-value ratio is less than 80 percent,

a. b. c. d.

you are required to make a larger down payment. you will be charged additional discount points. you must have a cosigner or guarantor on the loan. you will be charged a mortgage insurance premium.

(d, moderate, p. 256) Buying A Home 28.

A real estate broker is considered a(an):

a. b. c. d.

agent principal dealer intermediary

(a, moderate, p. 257) 29.

The principal for whom a real estate broker works is the:

a. b. c. d.

buyer. seller. agent. intermediary.

(b, moderate, p. 258)

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Mortgage Financing 30.

Joe buys a new house with a loan obtained from a bank. This transaction is an example of:

a. b. c. d.

disintermediation. a primary mortgage market transaction. a secondary mortgage market transaction. a dealer mortgage market transaction.

(b, easy, p. 260) 31.

A mortgage loan that has a fixed rate, fixed term and fixed payment is a(an):

a. b. c. d.

conventional mortgage.

ARM. growing equity mortgage. fixed mortgage.

(a, easy, p. 260) 32.

Which of the following statements is true of adjustable-rate mortgages?

a. b. c. d.

They generally carry higher initial interest rates than conventional mortgages.

They cannot be converted to fixed-rate loans.

The interest rate changes on ARMs are limited per year and per lifetime.

There is no limit as the amount of payment change on an ARM.

(c, difficult, p. 261) 33.

Which of the following mortgage loans does not have the possibility of negative amortization?

a. b. c. d.

balloon mortgage graduated payment mortgage adjustable rate mortgage lender buy-down mortgage

(d, difficult, p. 261)

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34.

Which type of mortgage loan results in repayment of the loan balance before the ending term?

a. b. c. d.

adjustable rate mortgage graduated payment mortgage growing equity mortgage shared appreciation mortgage

(c, moderate, p. 261) 35.

The bi-weekly mortgage is a common type of a:

a. b. c. d.

balloon mortgage. graduated payment mortgage. lender buy-down mortgage. growing equity mortgage.

(d, moderate, p. 261) 36.

The type of mortgage that allows homeowners to stay in their homes but receive a stream of cash flow from their homes is the:

a b. c. d.

insured mortgage. graduated mortgage. reverse annuity mortgage. shared appreciation mortgage.

(c, moderate, p. 262) 37.

Which of the following is not one of the terms that affect mortgage payments?

a. b. c. d.

economic factors employment factors location interest rates

(b, moderate, p. 262) 38.

An amount paid to lenders in order to secure a lower interest rate is known as a:

a. b. c. d.

buy-down. contingent fee. discount point. recovery fee.

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(c, moderate, p. 262) 39.

A good reason to refinance your home is to:

a. b. c. d.

reduce your outstanding debt. reduce the term of your mortgage. increase your line of credit. all of the above are correct.

(b, moderate, p. 264) 40.

Refinancing makes sense only if:

a. b. c. d.

you will stay in the house long enough to recoup the refinancing costs. you can get a reduction in rates of at least 2 percent. you can reduce your term in half. all of the above.

(a, moderate, p. 264) Completing the Real Estate Transaction 41.

An account held by the mortgage lender and used to cover property taxes and homeowner's insurance is known as an:

a. b. c. d.

reserve account. escrow account. tax account. assessed account.

(b, easy, p. 271) 42.

Which of the following is not one of the usual costs a homebuyer pays at closing?

a. b. c. d.

appraisal fee property tax escrow title insurance and title search recording fees

(c, moderate, p. 267)

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Essay Questions 1.

What is a warranty? Discuss the various types of automobile warranties. Which type of warranty may not be recommended for purchase?

Warranties are a legal promise made by the seller with regard to the quality of the car being sold. Most new vehicles and late-model used cars come with a warranty.

An express warranty is made by the seller either in writing or orally. An implied warranty is not written or verbally expressed but is implied by the sale of the car.

It implies that the auto is suitable for its intended use. This type of warranty would be true of all cars sold unless the seller is selling "as is" which means the seller makes no warranties. Express warranties usually promise to repair certain defects within a certain time period or number of miles. A full warranty would mean the seller must fix any problems, or if the problem is not fixable, replace the vehicle. Most auto dealers and manufacturers only provide a limited warranty, which cover parts and repairs for a specified time. Extended warranties are often offered by auto dealerships and manufacturers and this warranty extends the length of time of the original limited warranty or adds additional services or coverage. Extended warranties often cost more than the expected cost of covered repairs and often exclude coverage for the problems most likely to occur. For these reasons, extended warranties are not always recommended.

2.

Discuss the advantages and disadvantages of renting a house versus buying a house.

Renting a house has the advantage of lower monthly payments. Rent payments are usually less than the house payments for a comparable house because, as a renter, you don't pay property taxes and homeowner's insurance. As a renter, you have greater mobility and the ability to move on short notice if needed. The last advantage of renting versus buying is the lower level of responsibility as a renter.

Renters are not responsible for maintenance of the property. In addition, renters have less legal liability for injuries that occur on the property. The disadvantages of renting a house include a greater cost over the long term. Since rent payments are generally increased over time to account for inflation, renters often end up paying larger payments over the long term whereas mortgage payments are usually fixed for the life of the loan. Renting a house does not give a renter any investment value but a homeowner benefits if the house appreciates.

Homeowners get a tax deduction on mortgage interest and property taxes but renters do not. Renters are usually restricted in how they can use the property but homeowners can do anything they like as to the property. Renters can have the rent house sold or can lose the lease at the end of the lease term. Homeowners are certain they can stay in the house as long as they make the payments.

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3.

What are the similarities and differences between conventional and insured mortgages?

Both types of mortgages are fixed-rate, fixed-term loans. Both types are typically for 15, 20, 25 or 30 year terms. A major difference between the two types of mortgages is the requirement to obtain the loan. Insured mortgages, which are conventional loans that are insured by either the Veterans Administration or the Federal Housing Authority, are only available to certain home buyers, such as veterans and some lower-income buyers. The lenders are willing to accept buyers with higher loan-to-value ratios and less income since the federal agencies will pay the interest and principal if the buyer defaults. These homebuyers might not qualify for a conventional loan. In addition, the minimum down payment on insured mortgages is in the 3-5 percent range compared to 10-20 percent for a conventional loan.

Mini-Case Mary McDonald is considering buying a home. She has $1,200 per month she can pay toward her housing costs. She has saved $13,000 that she could use for a down payment and closing costs. She estimates that property taxes would be $175 per month and homeowner's insurance would be $150 per month. Closing costs are expected to be approximately $4,000. Current mortgages are available at a 6.5% interest rate for a 30year term. Based on her financial situation and expected costs, what is the maximum Mary can afford to pay for a home?

Answer: Monthly amount for housing - expected property taxes - expected homeowner's insurance Total available for financing

$1,200 - 175 - 150 $875

Maximum affordable mortgage - calculator solution 12 payments per year, 875 payment, 360 term, 6.5 interest rate, 0 fv, solve for pv = $138,434 is the maximum mortgage Mary can afford Maximum Mary can afford = Maximum mortgage + Down payment available - Closing costs = $138,434 + 13,000 - 4,000 = $147,434

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Chapter 9

Risk Management True-False Risk Management 1.

Speculative risk is defined as the exposure to risk of loss.

(f, moderate, p. 277) 2.

The first step to managing risk is to buy insurance.

(f, easy, p. 277) 3.

Young people, in general, tend to underestimate the probability of their own risk of loss.

(t, moderate, p. 278) 4.

Liability risk is the risk of being held responsible for actions of others.

(f, moderate, p. 278) 5.

The severity of loss involves estimating the likelihood that loss will occur.

(f, moderate, p. 278) 6.

To determine the expected loss, multiply the expected frequency times the expected severity.

(t, moderate, p. 279) 7.

It is impossible to avoid some risks if you own property or go beyond your property limits.

(t, moderate, p. 280) 8.

Wearing a helmet when bike riding is an example of risk avoidance.

(f, difficult, p. 281) 9.

Purchasing insurance is a common loss control technique.

(f, moderate, p. 281)

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10.

If you choose not to buy collision insurance for your older automobile, this is an example of risk retention.

(t, moderate, p. 281) How Insurance Works 11.

Risk pooling is based on the “law of averages”.

(f, moderate, p. 283) 12.

The price an insurer charges a policyholder for insurance protection is called the commission.

(f, easy, p. 283) 13.

Correlated risks are risks that affect large numbers of policyholders at once in the same area.

(t, moderate, p. 283) 14.

A suicide would be classified as a nonrandom risk.

(t, easy, p. 283) 15.

A provision in your homeowner's policy that specifically states that losses from floods are not covered is an example of an omission.

(f, moderate, p. 284) 16.

The principle of reciprocity says you should never be able to recover more from your insurance than the amount of the loss.

(f, moderate, p. 284) Managing Homeowner's Risk 17.

The risk of liability is much greater that physical or personal property risk on a homeowner's insurance policy.

(t, moderate, p. 285)

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18.

A swimming pool on your property normally invokes a special liability standard known as a negligence standard.

(f, difficult, p. 285) 19.

If a person bears some fault for his or her own injury, this is known as contributory negligence.

(t, moderate, p. 286) Homeowner's Insurance 20.

HO-1 and HO-2 types of homeowner's insurance policies are no longer sold in most areas.

(t, moderate, p. 287) 21.

The standard homeowner's insurance policy pays for replacement value of your home.

(f, moderate, p. 288) 22.

A laptop computer that is stolen while you are on vacation is covered under your homeowner's policy, subject to the deductible.

(t, moderate, p. 288) 23.

Due to increased litigation in recent years, most homeowner's insurance policies now provide $1 million in basic personal liability coverage.

(f, difficult, p. 288) 24.

Homeowner's insurance premiums are based on the replacement amount of coverage you select.

(f, difficult, p. 289) Automobile Insurance 25.

If you have a low credit score, you will probably pay a higher rate for your auto and homeowner’s insurance.

(t, moderate, p. 289)

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26.

State laws that require proof of ability to cover the cost of injury caused by an auto accident are known are mandatory responsibility laws.

(f, moderate, p. 291) 27.

States with no-fault automobile insurance laws have seen substantial reductions in medical expenses and litigation costs.

(f, moderate, p. 295) 28.

If you are married and do not smoke cigarettes, you will probably have a lower auto insurance premium than if you were single and a smoker. (t, moderate, p. 295-296) Buying Insurance and Filing Claims 29.

An insurance agent that works directly for a specific insurer is known as a captive agent.

(t, easy, p. 297) 30.

To evaluate the quality of an insurance company, consult the Standard and Poor's Insurance Rating Guide.

(f, moderate, p. 297)

Multiple Choice Risk Management 1.

An exposure to risk of loss or gain is known as a:

a. b. c. d.

pure risk. speculative risk. investment risk. calculated risk.

(b, easy, p. 277) 2.

A car accident would be an example of a:

a. b. c. d.

pure risk. speculative risk. physical risk. calculated risk.

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(a, easy, p. 277) 3.

The first step in managing risk is to:

a. b. c. d.

evaluate potential losses. choose the appropriate risk management tool. implement a risk management plan. identify risk exposures.

(d, moderate, p. 277) 4.

In order to evaluate your potential losses, you must:

a. b. c. d.

identify your risk exposures and estimate the dollar cost of potential losses. estimate the dollar cost of potential losses and transfer the risk. estimate the probability the loss will occur and estimate the dollar cost of the loss. avoid the risk or reduce the risk.

(c, difficult, p. 278) 5.

The likelihood or probability that a loss will occur is known as the:

a. b. c. d.

frequency of loss. severity of loss. chance of loss. cycle of loss.

(a, easy, p. 278) 6.

If you have a 30 percent chance of having your car stolen next year and the average loss of a stolen car is $12,000, then the expected cost of the loss to you would be:

a, b. c. d.

$8,400 $400 $3,600 $171

(c, moderate, p. 279) 7.

A non-smoker is practicing which of the following methods of risk management?

a. b. c.

avoid the risk reduce the risk transfer the risk

125

d.

retain the risk

(a, moderate, p. 280) 8.

When you purchase homeowner's insurance, you are:

a. b. c. d.

avoiding the risk. reducing the risk. transferring the risk. retaining the risk.

(c, moderate, p. 281) 9.

Self-insurance is another name for:

a. b. c. d.

risk reduction. risk retention. risk avoidance. risk acceptance.

(b, moderate, p. 281) How Insurance Works 10.

The concept of risk pooling is based on:

a. b. c. d.

the laws of probability. the law of averages. the law of large numbers. statistical variation.

(c, moderate, p. 282) 11.

Insurers use __________ to price policies fairly.

a. b. c. d.

statistical analysis probability calculations risk basis risk classifications

(d, easy, p. 283)

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12.

An oil spill is an example of a(an):

a. b. c. d.

correlated risk. nonrandom risk. unpredictable risk. escalating risk.

(c, moderate, p. 283) 13.

An insurance contract addendum is called a(an):

a. b. c. d.

waiver. rider. inclusion. exclusion.

(b, easy, p. 284) 14.

If your home has a value of $75,000, you cannot insure it for $100,000. based on:

a. b. c. d.

the law of reciprocity. the law of averages. the principle of insurability. the principle of indemnity.

(d, moderate, p. 284) 15.

The amount of a loss that must be paid by an insured before the insurance company will pay any insurance benefit is known as the:

a. b. c. d.

coinsurance deductible premium up-front fee

(b, easy, p. 284)

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This is

Managing Homeowner's Risk 16.

Which of the following is not a necessary condition to prove negligence of a homeowner?

a. b. c. d.

The homeowner had a duty to another person.

The other person depended on the homeowner to do his/her duty.

The homeowner did not fulfill his/her duty.

The homeowner's failure to do his/her duty directed caused the other person or the person's property to suffer a loss.

(b, moderate, p. 285) 17.

Whenever children are injured by an "attractive nuisance" on a homeowner's property,

a. b. c. d.

negligence is assumed. the principle of indemnity applies. strict liability applies. the "attractive nuisance" is removed.

(c, difficult, p. 285) 18.

If Tom drives into Bill's car when Bill falls asleep at the wheel and veers into Tom's lane, Bill's actions would be an example of:

a. b. c. d.

negligence. an assumption of risk. double indemnity contributory negligence

(d, moderate, p. 286) 19.

If a visitor to your home decides to climb on your roof and jump off, this is known as:

a. b. c. d.

an assumption of risk. an " attractive nuisance." contributory negligence. involuntary negligence.

(a, moderate, p. 286)

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Homeowner's Insurance 20.

Which of the following types of homeowner's policies provides coverage for renters?

a. b. c. d.

HO-2 HO-3 HO-4 HO-6

(c, moderate, p. 287) 21.

With regard to coverage for building and structures under homeowner's policies, which of the following statements is not true?

a. b. c.

Detached buildings on your property are not typically covered.

Unless you pay extra, polices pay on the basis of depreciated value of structures.

Fire, lightning, windstorm, hail, explosion and vandalism are all perils normally covered.

HO-8 policies are recommended for historic homes that would be more expensive to restore to original value.

d.

(a, difficult, p. 288) 22.

No-fault coverage in the liability section of a homeowner's policy means:

a.

that no fault is assumed on the part of the homeowner and any other person injured on the property must file under their own policy. both parties are assumed to be equally at fault and no claims are filed. the insurer will pay the loss without requiring the injured party to prove negligence. none of the above.

b. c. d.

(c, difficult, p. 288) 23.

In order to increase your personal liability coverage, it is recommended that you:

a. b. c. d.

decrease your deductible. purchase an omnibus policy. institute a self-insurance program. purchase an umbrella policy.

(d, moderate, p. 288)

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24.

When you apply for homeowner's insurance, the insurance company will normally look up your loss history on a national electronic database called the:

a. b. c. d.

National Loss Database.

Comprehensive National Underwriting Association.

National Underwriters' Exchange Registry.

Comprehensive Loss Underwriting Exchange.

(d, difficult, p. 290) Automobile Insurance 25.

Which of the following statements regarding state automobile insurance laws is true?

a.

All states have compulsory automobile insurance laws and all states have financial responsibility laws.

Some states have compulsory automobile insurance laws but all states have financial responsibility laws.

All states have compulsory automobile insurance laws and some states have financial responsibility laws.

Some states have compulsory automobile insurance laws and some states have financial responsibility laws.

b. c. d.

(b, difficult, p. 291) 26.

The part of the automobile insurance policy that relates to bodily injury liability is:

a. b. c. d.

Part A Part B Part C Part D

(a, moderate, p. 293)

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27.

If your auto insurance provides coverage from a tree falling on your car as it sits in your driveway, you have:

a. b. c. d.

bodily injury liability. property damage liability coverage. collision coverage. comprehensive physical damage coverage.

(d, moderate, p. 293) 28.

Which of the following statements concerning no-fault automobile insurance is false?

a.

No fault laws were designed to provide prompt and adequate compensation of accident victims.

No fault laws were intended to result in reduced auto premiums for state residents.

The majority of states have some form of no-fault auto insurance laws.

No-fault insurance has not significantly reduced litigation costs.

b. c. d.

(c, moderate, p. 294-295) 29.

Which of the following does not have an effect on your auto insurance premium?

a. b. c. d.

where you live where you are employed what type of vehicle you drive who your insurer is

(b, moderate, p. 295-296) Buying Insurance and Filing Claims 30.

An insurance agent that works directly for a specific insurer and sells only that insurer's products is known as:

a. b. c. d.

a captive agent. an inclusive agent. a restricted agent. an in-house agent

(a, easy, p. 297)

131

Essay Questions 1.

Explain the differences between risk avoidance, risk reduction, risk transfer and risk retention and what risks are appropriate for which risk management tool.

Risk avoidance is simply avoiding the situation that produces that risk. For example, you can avoid the risk of boat accidents by never being in a boat. This risk management strategy is best for high-risk situations or behaviors that you can avoid, such as skydiving or smoking cigarettes. This strategy is not appropriate for everyday situations such as driving a car or owning property. Risk reduction is the strategy of reducing the severity of the loss or probability of loss occurring.

If you wear seat belts, you reduce the severity of any injuries sustained in a car accident. By driving the speed limit, you actually reduce the probability of having a car accident. Risk transfer is the most common method for dealing with pure risk. This involves shifting the risk onto another party, usually an insurance company. You can't easily avoid or reduce the risk to your home from natural disasters, such as storms and floods, so you shift the risk to the insurance company. Risk retention is the alternative to insurance. Instead of the insurance company paying for losses, you pay for the losses yourself. This strategy would be appropriate for small losses that are rather predictable. For example, you may choose not to carry collision insurance on an older car. If you have an accident, the cost of repairing or replacing the car may be relatively small.

2.

Explain the two legal rules that may be used as a defense by a homeowner in a negligence lawsuit and give examples.

One legal rule is contributory negligence. This defense would be appropriate when the injured person actually contributed to his or her own injury. If the person injured bears some of the fault of the injury, he or she may not be able to hold the homeowner financial responsible. An example of this would be a person who comes to your home intoxicated and falls on the front steps. If being intoxicated was a contributory factor in the person's fall, you may not be financially responsible for the injuries sustained. Another legal defense for homeowners is the assumption of risk. This defense is based on the injured person knowing about the risk and voluntarily exposing himself to that risk. If you kept a dog chained and in a pen with signs warning the dog might bite and a person entered the pen and was bitten, you could claim the assumption of risk defense.

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3.

Explain the three types of protection offered in the bodily injury coverage of an automobile insurance policy.

Part A, which is required by the state, protects the you from legal liability by covering financial costs (including judgments), legal defense costs and court costs. This liability insurance also covers bodily injury costs and damages to property for the other vehicle. Part B covers medical costs for you and any passengers in your car. Part C, which is required in some states, provides uninsured motorist protection. If you have an accident that is the fault of another driver and that driver is uninsured, this coverage will cover the cost of your injuries.

Mini Case Marvin Martin is trying to decide if he should buy flood insurance. There is a 1 in a 500 chance that his house will be flooded. But if it does flood, Marvin thinks there is a 40 percent chance he will lose everything on the first floor of his house, and a 60 percent chance that he will just have to replace the carpet and repaint at a cost of $6,000. He estimates the value of the first floor furnishings at $25,000. Calculate Marvin's expected loss. If flood insurance cost $120 per year, should Marvin buy it?

Answer: Expected Loss = Expected frequency X Expected severity Expected frequency = 1/500 = .002 Expected severity = .40 x 25,000 = 10, 000 + .60 x 6,000 = 3,600 13,600 Expected Loss = .002 X 13,600 = $27.20 Even though the insurance is greater than the expected loss, Marvin should buy the insurance. If he is actually flooded, he could have losses of $25,000 and probably would not be able to repair the first floor without the insurance.

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Chapter 10

Analyzing Jobs and Employee Benefits: Health, Disability and Retirement Plans True-False The Components of Employee Compensation 1.

Education reimbursement offered by your employer is an example of an intangible benefit.

(f, moderate, p. 307) 2.

The working environment on the job is an example of an intangible benefit.

(t, moderate, p. 307) 3.

If employee benefits are wholly paid by the employer, this is a noncontributory plan.

(t, moderate, p. 307) 4.

On average, large firms offer more benefits than small employers.

(t, moderate, p. 308) 5.

If you were diagnosed with a serious disease, your health insurance premiums would rise under both individual and group plans.

(f, moderate, p. 309) 6.

Group insurance is generally cheaper than equivalent individual policies, in part due to lower administrative expenses.

(t, moderate, p. 310) 7.

Group insurance cannot be cancelled for the entire group but individual members of the group can have their coverage cancelled.

(f, moderate, p. 310) 8.

Employers who offer employee benefits generally qualify for higher tax deductions than if they had offered equivalent cash compensation to employees.

(f, moderate, p. 310) 135

9.

All noncash benefits received by employees must be reported as taxable income.

(f, moderate, p. 310) Health Insurance and Your Financial Plan 10.

More than 40 million people in the United States have no health insurance.

(t, easy, p. 311) 11.

Flexible spending accounts are most often set up to take care of medical and educational expenses.

(f, moderate, p. 312) 12.

A health savings account can earn interest whereas a flexible spending account cannot.

(t, difficult, p. 313) Types of Health Insurance 13.

A fee-for-service plan, also known as an indemnity plan, controls your access to medical services in order to control costs.

(f, moderate, 314) 14.

HMOs and PPOs are both examples of fee-for-service health insurance plans.

(f, moderate, p. 314) 15.

The most common type of employer-based health insurance plan today is the feefor-service plan.

(f, moderate, p. 314) 16.

A preferred provider organization is less restrictive on its members than a health maintenance organization.

(t, difficult, p. 314)

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17.

Basic health-care insurance benefits include hospital and surgical expenses but not physician expenses.

(f, moderate, p. 314) 18.

Major medical insurance plans often have high maximum limits and no deductible.

(f, difficult, p. 315) 19.

If you must pay 20 percent of your medical costs and the insurer pays the other 80 percent, this is an example of coinsurance.

(t, moderate, p. 315) 20.

HMOs provide relatively comprehensive services, encourage preventive medicine and discourage excessive medical tests.

(f, difficult, p. 316) 21.

The primary disadvantage of HMOs is the fact they are not widely available in many parts of the United States.

(f, difficult, p. 317) 22.

Physicians in a point of service plan are affiliated with an exclusive provider organization.

(f, difficult, p. 317) 23.

If you health insurance plan is an EPO, you must use an affiliated provider in order to have any of your costs covered.

(t, moderate, p. 317) 24.

Unlike Medicare, which is a federal insurance program, Medicaid is run by the states.

(t, moderate, p. 318) 25.

State workers' compensation laws provide for rehabilitation costs, lost wages and lump-sum death benefits in addition to payment for medical expenses.

(t, easy, p. 318)

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26.

In addition to providing retirement income, Social Security also provides disability insurance, income for surviving spouses and children, health insurance and unemployment compensation.

(f, moderate, p. 319) 27.

You must purchase a Medicare Supplement plan within 6 months of enrolling in Medicare Part B in order to get supplemental coverage.

(f, difficult, p. 319) 28.

Under COBRA, you are eligible to purchase health insurance through a previous employer for as long as you remain unemployed.

(f, moderate, p. 321) 29.

COBRA coverage is available for divorced spouses that were previously covered under their former spouse's employer.

(t, moderate, p. 321) Planning for Disability Income Needs 30.

In order to be eligible for Social Security disability coverage, you must be unable to work at any job and must be out of work at least one year and expect to remain disabled for at least another year.

(f, difficult, p. 324 31.

Short-term disability insurance from employers typically have a 15-30 waiting period and replace income for 6 to 12 months.

(t, moderate, p. 324) 32.

The majority of long-term disability insurance plans offered by employers pay benefits for the rest of the policyholder's life.

(f, moderate, p. 324) Employer-Sponsored Retirement Plans 33.

Under a tax-qualified retirement plan, you pay no taxes on any income or capital gains earned unless you withdraw funds prior to retirement.

(f, difficult, p. 326)

138

34.

A defined benefit retirement plan that includes an investment component similar to a defined contribution plan is a variable benefit plan.

(f, moderate, p. 326) 35.

IRS rules for a tax-qualified plans set a minimum normal retirement age at 59 1/2.

(t, easy, p. 328) 36.

A retirement plan for employers of l00 employees or less is a Keogh plan.

(f, moderate, p. 330) Comparing Compensation Packages 37.

Even though the cost of living is higher in urban areas, urban salaries are generally high enough to offset the increased cost of living.

(f, moderate, p. 331) 38.

The first step in comparing job offers is to evaluate cost-of-living differences.

(t, easy, p. 331) 39.

In order to compare fringe benefits of different jobs, you should only consider those benefits that are valuable to you.

(t, moderate, p. 332) 40.

Comparing compensation packages is usually quite straight-forward and simple.

(f, moderate, p. 335)

139

Multiple Choice Components of Employee Compensation 1.

Which of the following employee benefits would be considered tangible?

a. b. c. d.

job location flexible work hours sick leave opportunities for training

(c, moderate, p. 307) 2.

Which of the following employee benefits would be considered intangible?

a. b. c. d.

working environment personal leave use of a company car wellness programs

(a, moderate, p. 307) 3.

If you pay a portion of your employee benefits costs, this is:

a. b. c. d.

illegal under federal laws. a cafeteria plan. a contributory plan. a noncontributory plan.

(c, easy, p. 307) 4.

If you get to select which benefits you want from a variety of benefits offered in the employer plan, this is:

a. b. c. d.

illegal under federal laws. a cafeteria plan. a contributory plan. a noncontributory plan.

(b, easy, p. 307)

140

5.

The major reason employers offer benefits to employees is:

a. b. c. d.

government regulations forcing employers to offer them. to receive those benefits for themselves. a purely altruistic motive to help their employees. to attract and retain highly qualified workers.

(d, moderate, p. 307) 6.

When an insurance policy premium is based on the risk of a group instead of an individual member of the group, this is known as:

a. b. c. d.

collective bargaining. group underwriting. group bargaining. collective underwriting.

(b, moderate, p. 309) 7.

Two important features of group insurance are:

a. b. c. d.

everyone pays the same premium and everyone has equal access to the insurance. better coverage than individual insurance and lower premiums. equal access for all and no group member can have their insurance cancelled. better coverage than individual insurance and equal access for all.

(c, difficult, p. 309) 8.

From the employer's perspective,

a.

there is no tax difference between offering cash compensation or offering employee benefits. there is a tax advantage in offering employee benefits rather than offering cash compensation. there is a tax advantage in offering cash compensation rather than offering employee benefits. tax advantages for employee benefits are only available for larger employers.

b. c. d.

(a, moderate, p. 310)

141

Health Insurance and Your Financial Plan 9.

Recent evidence on health care costs shows that:

a. b. c. d.

Wages have risen at a faster rate than health costs.

The share of health insurance premiums paid by employers has remained stable.

The share of health insurance premiums paid by employers has decreased.

The rise in health insurance premiums has corresponded closely to the inflation rate.

(b, difficult, p. 311) 10.

Which of the following is not a recommended strategy for controlling your health care costs?

a. b. c. d.

Take advantage of beneficial tax rules.

Budget for small expenditures.

Invest in your own health.

Choose a low-cost provider.

(d, difficult, p. 312-313) 11.

A major difference between a flexible spending account (FSA) and a health savings account (HSA) is that:

a. b. c. d.

a HSA has a higher annual contribution limit than most FSAs. a FSA can rollover unused amounts from year to year; a HSA cannot. a HSA can earn interest on amounts in the account; a FSA does not. a FSA contribution is made from pretax dollars; a HSA contribution is made from after-tax dollars.

(c, difficult, p. 312-313) Types of Health Insurance 12.

Which of the following health plans reimburses you for actual medical costs incurred?

a. b. c. d.

fee-for-service plan managed-care plan HMO plan PPO plan

(a, moderate, p. 314)

142

13.

Which of the following health plans limits your choice of doctors to those under contract with the plan?

a. b. c. d.

Indemnity plan HMO plan PPO plan all limit your choice of doctors

(b, moderate, p. 314) 14.

Basic health-care insurance covers:

a. b. c. d.

hospital expenses only. hospital and surgical expenses. hospital, surgical and physician expenses. there is no basic health-care insurance.

(c, moderate, p. 314) 15.

Which of the following is not one the typical features of major medical insurance?

a. b. c. d.

annual deductible high maximum limits choice of doctors restricted coinsurance provisions

(c, moderate, p. 315) 16.

A stop-loss limit means:

a. b. c. d.

there are no out-of-pocket expenses for the insured. the insurer will cover 100 percent of covered charges after this limit is reached. there is no copay and no deductible. the insurer will bear 100 percent of the expense if the illness is deemed catastrophic.

(b, moderate, p. 315)

143

17.

A major difference between major medical insurance and comprehensive medical insurance is that:

a. b. c. d.

Comprehensive plans usually have a lower deductible than major medical.

Major medical usually has a lower deductible than comprehensive plans.

Comprehensive plans usually have higher maximum limits than major medical.

Major medical usually has higher maximum limits than major medical.

(a. difficult, p. 316-317) 18.

Which of the following is not one the ways HMOs attempt to control costs?

a. b. c. d.

encouraging preventive medicine. discouraging second medical opinions. giving health-care provider financial incentives to control costs. providing relatively comprehensive health insurance.

(b, moderate, p. 316-317) 19.

Which of the following health care plans does not pay any of your costs if you use a non-affiliated provider?

a. b. c. d.

PPO POS EPO all pay some of your costs even if you use a non-affiliated provider.

(c, difficult, p. 317) 20.

A health plan that provides financial incentives for the insured to practice preventive care and invest in their own health is called a:

a. b. c. d.

preventive care plan. managed care plan. consumer choice plan. healthy living plan.

(c, moderate, p. 317)

144

21.

Workers' compensation insurance:

a. b. c. d.

Is not available in all states.

Only pays for medical expenses. holds the employer responsible for injuries if it was the employer's fault. limits the right of the employee to sue for additional damages.

(d, moderate, p. 318) 22.

Which of the following statements is true concerning Part B of Medicare?

a. b. c. d.

It covers hospital expenses and prescription drugs.

The monthly premium varies with age.

There is both a deductible and coinsurance payment. all of the above are true

(c, moderate, p. 319) 23.

Insurance policies designed to pay costs not covered by Medicare are called:

a. b. c. d.

Part C policies.

Medicare Plus plans.

Medigap policies. complete coverage policies.

(c, easy, p. 319) 24.

Which of the following statements is true concerning Medicaid?

a. b. c. d.

It is a federally run program that provides coverage to low income individuals.

It is sometimes difficult to find participating providers.

It is not possible to qualify for both Medicare and Medicaid.

All of the above are true

(b, moderate, p. 320) 25.

Which of the following are not subject to COBRA regulations?

a. b. c. d.

religious institutions. state governments. employers with more than 20 employees. privately-held corporations.

(a, moderate, p. 321)

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26.

Under COBRA, if you lose or quit your job, you can purchase insurance coverage through your previous employer for up to: a. b. c. d.

6 months 12 months 18 months 24 months

(c, moderate, p. 321) 27.

Which of the following laws eliminates waiting periods for preexisting conditions if you move from one plan to another?

a. b. c. d.

COBRA MPDIMA ERISA HIPPA

(d, moderate, p. 322) Planning for Disability Income Needs 28.

Which of the following is required in order to qualify for Social Security disability insurance?

a. b. c. d.

you must be unable to work at your normal job. you must have been out of work for at least 5 months. you must be expected to remain out of work for at least two years. you must be expected to remain out of work permanently.

(b. moderate, p. 324) 29.

Short-term disability insurance typically replaces income for:

a. b. c. d.

3 to 6 months.

6 to 12 months.

12 to 18 months.

18 to 24 months.

(b, moderate, p. 324)

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30.

When purchasing disability insurance from your employer, it is generally recommended that:

a. b. c. d.

you use a cafeteria plan. you purchase using pretax dollars. you purchase using after-tax dollars. you purchase the largest amount available.

(c, moderate, p. 324) 31.

Which is not one of the key features to look for in disability insurance policies?

a. b. c. d.

renewability convertibility waiting period benefit duration

(b, moderate, p. 324) Employer-Sponsored Retirement Plans 32.

If your employer promises to pay you 50 percent of your final monthly salary upon your retirement, this is a:

a. b. c. d.

defined benefit plan. defined contribution plan.

401(k) plan money-purchase plan.

(a, moderate, p. 326) 33.

Which of the following retirement plans does not shift the risk of poor investment performance on the employee?

a. b. c. d.

defined benefit plan. defined contribution plan.

401(k) plan cash balance plan

(a, moderate, p, 326)

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34.

The rules that define employees' rights to accrued retirement plan contributions and benefits are known as:

a. b. c. d.

portability rules defined contribution rules vesting rules guaranteed benefits.

(c, easy, p. 327) 34.

Which of the following retirement plans is generally the least portable?

a. b. c. d.

401 (k) plans defined benefit plans defined contribution plans money-purchase plan

(b, moderate, p. 328) 35.

The cash-or-deferred arrangement plan for employees of non-profit organizations is a:

a. b. c. d.

401(k) plan.

402 (h) plan.

403 (b) plan.

404 (c) plan.

(c, moderate, p. 329) 36.

Which of the following types of retirement plans requires the employer to contribute a set percentage of salary to the plan?

a. b. c. d.

cash-balance plan. money-purchase plan. profit-sharing plan. cash-or-deferred arrangement.

(b, difficult, p. 329)

148

37.

Which of the following laws set the maximum tax-deductible employer contribution to employee retirement plans at 25 percent of compensation, with a maximum of $40,000 per year?

a. b. c. d.

ERISA PBGCCA Tax Reform Act of 1986 The Economic Growth and Tax Relief Reconciliation Act of 2001

(d, moderate, p. 329) 38.

Which of the following guarantees pension benefits to participants in most private defined benefit plans?

a. b. c. d.

FDIC SEC PBGC SEP

(c, moderate, p. 328) 39.

Which of the following is not a retirement plan for self-employed individuals and small business owners?

a. b. c. d.

SEP ESOP SIMPLE Keogh

(b, moderate, p. 329-330) Comparing Compensation Packages 40.

Which of the following statements is true concerning cost-of-living differences?

a. b

There are few sources that allow for comparison of these differences.

It is generally more expensive in rural areas than urban areas due to higher transportation costs.

It is generally more expensive to live on the coasts than in the middle of the country.

Although housing varies by geographic area, food and clothing is relatively constant.

c. d.

(c, moderate, p. 331)

149

41.

You are comparing a $45,000 job offer in St. Paul to a $57,000 job offer in San Francisco. St. Paul's costs are 92 percent of the national average whereas San Francisco's costs are 150 percent of the national average. What is the equivalent high-cost salary?

a. b. c. d.

$34,960 $73,370 $92,935 $27,600

(b, difficult, p. 331; solution: 1.5 x 45000/.92 = $73,370)

Essay Questions 1.

Discuss some of the strategies for reducing your out-of-pocket costs for health insurance premiums and other health-care expenses.

Invest in your own health. By taking preventive measures such as exercising, eating right and not smoking, you can reduce both your insurance premiums and healthcare costs. Choose an employer that offers generous health insurance benefits. Before accepting a position, check out the coverage offered by the employer. Budget for small expenditures. By opting for higher deductibles, you can save on insurance premiums. But this means being able to cover small health care expenses. Take advantage of beneficial tax rules. Set up flexible savings accounts if offered by your employer. This lets you set aside pre-tax income for qualified medical expenses. You may be able to set up health savings accounts similar to FSA. Take advantage of opt-out rules. If you have cheaper coverage through your spouse's employer, you may be able to opt out of your employer's plan and receive either cash or other benefits.

2.

What are the main characteristics of major medical insurance? What are the differences between major medical and comprehensive medical insurance?

Major medical insurance provides additional coverage beyond basic health insurance. Major medical plans typically have high maximum limits, such as $1 million, that the insurer will pay over the insured's lifetime. These plans also tend to have annual deductibles and coinsurance provisions. Coinsurance provisions are often in the 10 to 30 percent range and the insured will pay this percentage of their medical costs up to some stop-loss limit. The stop-loss limit is a maximum annual out-of-pocket limit and once this limit is reached, the insurer will pay 100 percent of the covered charges. Both major medical and comprehensive medical plans are similar in that both provide broader coverage than basic health plans.

But comprehensive plans tend to have lower deductibles and cover more inpatient and outpatient services than major medical plans.

150

3.

Compare and contrast defined-benefit and defined-contribution retirement plans.

Defined-benefit plans promise to pay a benefit when you retire based on some formula. Sometimes the formula is a set amount and sometimes it is based on a percentage of your salary. The financial risk lies with the employer in a definedbenefit plan as the employer must invest the contributions and earn a high enough return to pay the promised benefit. The employer chooses the investments of the plan. A defined-contribution plan has a certain amount contributed into the plan but makes no promise as to the benefit you will receive upon retirement. The actual benefit you will receive depends on the return earned by the contributions.

Employees often have some choice as to how the contributions are invested. The risk of financial loss lies with the employee, not the employer.

Mini-Case Tom and Jerry are both getting ready to retire. Both have worked for 40 years. Tom has worked for Mega Corporation which has a defined benefit retirement plan and Tom will receive an annual benefit. The annual retirement benefit is based on the following formula: 2.3 x number of years of service = percentage. The percentage calculated will be multiplied by the annual salary at time of retirement in order to determine the annual retirement benefit. Tom's current salary is $50,000. Jerry has worked for Mighty Company which has a defined contribution retirement plan and he will receive a lump sum when he retires. He contributed 6 percent of his salary, which averaged $40,000 annually over his career. Jerry's retirement contributions have earned, on average, 8 percent annually. Now that he is retiring, Jerry thinks he can invest the lump sum and still earn 8 percent annually. He plans to only spend the amount earned yearly.

Which of the two, Tom or Jerry, will have the highest annual retirement benefit? Which of the two will have the most stable retirement income?

Answer: Tom - annual benefit = 2.3 x 40 years = 92 percent. 92% x 50,000 = $46,000 Jerry = annual contribution = .06 x 40,000 = $2,400 lump sum = calculator solution = 2,400 pmt, 40 n, 8 I, 0 PV, FV = $621,736 annual benefit = 621,736 x .08 = $49,739 Jerry has the highest annual retirement benefit based on the projections. However, Tom has the most stable retirement income as he is promised this retirement benefit. Jerry's annual retirement income depends on the rate of return earned. If he earns less than 8 percent, his retirement income will be less than projected.

151

Chapter 11

Fundamental Concepts in Investing True False Developing Realistic Investment Goals 1.

Before begin to invest, you should make sure you have both adequate insurance coverage and emergency funds in cash or savings accounts.

(t, easy, p. 347) 2.

If you are investing to meet short-term goals, you can afford to take on greater risk than if you are investing to meet long-term goals.

(f, easy, p. 347) 3.

The first step in the investment planning process is to evaluate your risk tolerance.

(f, moderate, p. 348) 4.

Investment goals should be realistic, specific and measurable.

(t, moderate, p. 348) 5.

Determining how much is needed for retirement is generally easier than determining how much is needed to finance the purchase of a new house.

(f, moderate, p. 349) 6.

Saving your next raise is a recommended way to find the funds to invest.

(t, moderate, p. 350) 7.

Investments generally grow more quickly under employer-sponsored retirement plans due to the tax advantage of these plans.

(t, moderate, p. 350) 8.

Replacing a car that gets 10 miles per gallon with one that gets 30 miles per gallon is an example of paying yourself first.

(f, moderate, p. 350)

153

Understanding Your Investment Alternatives 9.

An investor that has an ownership interest in a business is debt investor.

(f, easy, p. 351) 10.

If you buy a stock at $50 and one year later, the price of the stock is $60, you have a $10 capital gain.

(t, easy, p. 351) 11.

It is generally less risky to be a lender than it is to be an owner.

(t, moderate, p. 352) 12.

Companies are obligated to make payments to their equity investors.

(f, moderate, p. 352) 13.

Stockholders are owners of businesses and thus are entitled to vote on all operating issues facing the business.

(f, moderate, p. 353) 14.

Dividends represent current income for stockholders; interest represents current income for bondholders.

(t, moderate, p. 353) 15.

Most bonds pay a fixed periodic payment of interest with payments made quarterly.

(f, moderate, p. 353) 16.

Both the interest payments on a bond and the bond value are fixed for the life of the bond.

(f, moderate, p. 353) 17.

Unlike common stock, preferred stock has both a fixed dividend and fixed maturity date.

(f, moderate, p. 354)

154

18.

Mutual fund owners are considered lenders to the fund and expect to share in the income of the fund.

(f, moderate, p. 354) 19.

Derivative securities derive their value from the price fluctuations of other assets.

(t, moderate, p. 354) 20.

The buyer of a call option has the right to sell the underlying asset at a set price on or before the call's expiration date.

(f, moderate, p. 354) 21.

Both options and futures are considered speculative investments.

(t, easy, p. 354) The Risk-Return Tradeoff 22.

A risk-averse investor will not invest in any high-risk securities.

(f, difficult, p. 355) 23.

You are more likely to take on riskier investments during the early life-cycle stages than during the wealth accumulation phase.

(f, difficult, p. 356) 24.

In general, families with children tend to be less willing to take financial risk.

(t, moderate, p. 357) 25.

Studies have shown a substantial difference in the risk-taking behavior of those with and those without a college education.

(f, moderate, p. 357) 26.

The rate of return on any investment includes both current income and any capital gains earned.

(t, moderate, p. 357)

155

27.

Equity investors usually demand a risk premium before they will invest, but debt investors usually do not.

(f, moderate, p. 358) 28.

If the inflation rate increases, your purchasing power decreases.

(t, moderate, p. 358) 29.

There is generally a positive relationship between interest rates and security prices.

(f, difficult, p. 359) 30.

The risk of a company becoming bankrupt is also called its market risk.

(f, moderate, p. 359) Diversification and Asset Allocation 31.

Diversification reduces not only the risk of the entire portfolio but also the risk of individual securities in the portfolio.

(f, moderate, p. 361) 32.

It is possible to completely diversify away all risk if securities are carefully selected.

(f, difficult, p. 362) 33.

If your investment portfolio consists of common stock in 20 different companies, you are practicing asset allocation.

(f, moderate, p. 362) Establishing Your Investment Strategy 34.

Active investors typically try to outperform the market whereas passive investors attempt to perform as well as the market.

(t, moderate, p. 364) 35.

Actively managed portfolios, such as those run by professional money managers, tend to outperform the market as a whole.

(f, moderate, p. 364)

156

36,

If a market is truly efficient, security prices reflect all publicly available information.

(t, moderate, p. 364) 37.

Although women are generally more conservative investors, they often achieve a better overall return than men due to reduced trading costs.

(t, moderate, p. 364) 38.

A buy-and-hold strategy would be considered an example of an active investment strategy.

(f, moderate, p. 365) 39.

Dollar cost averaging involves buying the same dollar amount of securities at regular intervals.

(t, moderate, p. 365) 40.

In the long run, dollar cost averaging will weight your portfolio with more lowcost shares than high-cost shares.

(t, difficult, p. 366) 41.

DRIPs allow investors to receive higher dividends than investors who are not in the program.

(f, moderate, p. 367) 42.

The major advantage of direct investment programs is the avoidance of brokerage commissions.

(t, moderate, p. 367) 43.

The problem with timing strategies is that small investors are often unable to get in or out of the market when they want to due to institutional control.

(f, difficult, p. 367)

157

Key Strategies for Investment Success 44.

Capital gains are taxed at normal tax rates whereas dividends are taxed at the lower current income tax rate.

(f, moderate, p. 368) 45.

Interest earned on municipal bonds is generally tax deferred until the bonds are sold.

(f, moderate, p. 368) 46.

Publicly held companies are required to report their financial performance to the owners of the company in an annual report.

(t, easy, p. 369) 47.

The American Association of Investment Clubs is the recommended source for information about forming a group to jointly manage an investment fund.

(f, moderate, p. 369) 48.

A common pitfall for many investors is taking too long to recover from prior losses.

(f, moderate, p. 370)

Multiple Choice Developing Realistic Investment Goals 1.

Which of the following is not one of the recommended questions to ask yourself prior to investing?

a. b. c. d.

Have I established my financial goals?

Have I paid off all my credit cards?

Am I living within my budget and meeting my basic needs?

Do I have adequate insurance?

(b, moderate, p. 347)

158

2.

Which of the following is the first step in the investment planning process?

a. b. c. d.

Estimate how much you need to accumulate.

Evaluate your risk tolerance Identify your goals Learn about investment alternatives

(c, moderate, p. 348) 3.

Which of the following is not one of the steps in the investment planning process?

a. b. c. d.

Monitor your investment planning.

Diversify your investment portfolio.

Select appropriate investments.

Estimate how much can apply to your investment program.

(b, difficult, p. 348) 4.

You want to have $1,000 accumulated in 3 years and you already have $250 in a savings account earning 6 percent. If you don’t contribute any additional funds, how much will you be short in three years?

a. b. c. d.

$407 $750 $702 $634

(c, moderate, p. 349; calculator solution, 250 pmt, 3 n, 6 interest rate, 0 pv, fv = 298; 1000 - 298 = 702 remaining) 5.

You want to invest annual amounts over the next 15 years. If your goal is to have $15, 000 at the end of that time and if you can earn 8 percent on your invested funds, how much do you need to invest annually to reach your goal?

a. b. c. d.

$552 $1,093 $1,752 $4,728

(a, moderate, p. 349; calculator solution: 15 n, 8 interest rate, $15000 fv, 0 pv, pmt = $552)

159

6.

Which of the following is not one of the suggested ways to find money to invest?

a. b. c. d.

Continue a payment plan Set aside bonuses and tax refunds Use existing home equity Take a second job

(c, moderate, p. 350) 7.

If you start doing your own laundry instead of taking it to the cleaners, this is an example of:

a b. c. d.

paying yourself first. going on a financial diet. stopping up a cash leak. continuing a payment plan.

(c, moderate, p. 350) Understanding Your Investment Alternatives 8.

Which of the following would an example of a fixed-income investment?

a. b. c. d.

common stock bonds futures options

(b, easy, p. 351) 9.

Which of the following is a disadvantage of debt investments?

a. b. c. d.

They tend to be riskier than many other types of investments.

They tend to have lower liquidity than many other types of investments.

They tend to have lower rates of return than many other types of investments.

All of the above are disadvantages of debt investments.

(c, moderate, p. 351)

160

10.

An investment in which the investor contributes a sum of money to a common enterprise with the intention of making a profit through the efforts of others is known as:

a. b. c. d.

speculation a security an indirect investment a risk-free investment

(b, moderate, p. 352) 11.

Which of the following is a major difference between stock and bond investments?

a. b. c. d.

It is possible to earn current income on bonds but not on stock.

Stocks have a fixed maturity but bonds do not.

Bonds can be issued by governments but stock cannot. all of the above are correct.

(c, difficult, p. 352) 12.

Which of the following types of security has the highest priority in case of financial difficulties of the issuer?

a. b. c. d.

common stock preferred stock bonds mutual funds

(c, moderate, p. 352) 13.

Which of the following would be considered a pooled investment?

a. b. c. d.

common stock preferred stock bonds mutual funds

(d, easy, p. 354)

161

14.

Which of the following statements is true regarding speculative investments?

a. b. c. d.

In general, you must hold the investment for a long period to earn a return.

In general, the major type of return on these investments is capital gain.

Real estate and indexed securities are good examples of speculative investments.

The size of potential return on these investments is usually limited.

(b, difficult, p. 354) 15.

Which of the following would be considered a commodity?

a. b. c. d.

a government bond an option soybeans real estate

(c, easy, p. 354) The Risk-Return Tradeoff 16.

A risk-averse investor

a. b. c. d.

will not accept any risk. will accept any risk. will only accept the risk of inflation. will only accept higher risk to gain higher returns.

(d, moderate, p. 355) 17.

Which of the following is not one of the factors affecting risk tolerance?

a. b. c. d.

Consumer confidence Residency Life cycle effects Education

(b, moderate, p. 356-357)

162

18.

Which of the following statements concerning risk tolerance is true?

a.

College educated investors are lower risk-takers than investors without a college education.

Investors in the early life-cycle stages tend to be the biggest risk-takers.

There is some evidence that women are less inclined to take risk than men.

As investors approach retirement years, they take on more risk.

b. c. d.

(c, difficult, p. 357) 19.

You invest $250 into ABC Corp. stock (currently selling at $62.50 per share). At the end of one year, the stock is at $70.50 and has paid a $1.10 per share dividend during the year. What is your return on investment for this period?

a b. c. d.

14.56% 13.24% 11.04% 12.36%

(a, moderate, p. 357; solution: 250/62.50 = 4 shares; 70.50-62.50 = 8 x 4 shares = $32 capital gain; 1.10 x 4 shares = $4.40 dividends; 32 + 4.40 /250 = 36.40/250 = 14.56%) 20.

Which of the following is not one of the risks equity investors normally face?

a. b. c. d.

inflation risk reinvestment risk maturity risk market risk

(c, moderate, p. 358-359) 21.

The minimum rate of return is usually called the:

a. b. c. d.

nominal inflation rate. nominal risk-free rate. expected rate of return. expected required return.

(b, easy, p. 358)

163

22.

Which of the following statements regarding interest rate risk is true?

a. b. c. d.

There is a positive relationship between interest rates and security prices.

The longer the term of a security, the more it is affected by interest rate risk.

The shorter the term of a security, the more it is affected by interest rate risk.

Preferred stock is less affected by interest rate risk than common stock.

(b, moderate, p. 359) 23.

Reinvestment risk is greatest for:

a. b. c. d.

short-term securities. long-term securities. bonds. common stock.

(a, moderate, p. 359) 24.

Which of the following statements regarding default risk is true?

a. b. c. d.

This risk is greater for long-term securities than for short-term securities.

This risk is greater for short-term securities than for long-term securities.

In a bankruptcy proceeding, the value of a debt investment is likely to be zero.

In a bankruptcy proceeding, the value of an equity investment is likely to be zero.

(d, moderate, p. 359) 25.

When investors are worried about a possible "bear market," this is an example of:

a. b. c. d.

interest-rate risk. default risk. liquidity risk. market risk.

(d, easy, p. 359) 26.

The risk of not being able to convert an asset to cash without losing value is:

a. b. c. d.

reinvestment risk. liquidity risk. default risk. market risk.

(b, easy, p. 359)

164

Diversification and Asset Allocation 27.

The statement, "Don't put all your eggs in one basket" best defines:

a. b. c. d.

active investing. market timing. diversification. portfolio management.

(c, easy, p. 360) 28.

Financial advisors recommend you invest no more than ______ percent of your total portfolio in any single investment.

a. b. c. d.

5 10 15 20

(b, moderate, p. 362) 29.

Which of the following statements regarding asset allocation is false?

a.

If you have invested in several broad investment classes, you are practicing asset allocation.

Studies have shown as much as 90 percent of overall long-term performance of a portfolio is attributable to the asset allocation mix.

An investor's asset allocation mix should not change over time.

All of the above statements are true.

b. c. d.

(c, moderate, p. 362-363) Establishing Your Investment Strategy 30.

An extreme form of an active investor would be a:

a. b. c. d.

commodities trader. day trader. mutual fund investor. money market investor.

(b, easy, p. 364)

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31.

Active investors

a. b. c. d.

are willing to accept much higher risk than passive investors. believe the market is inherently efficient whereas passive investors do not. are more interested in short-term gains than passive investors. are more likely to invest in stock than passive investors.

(c, moderate, p. 364) 32.

If a market is truly efficient,

a. b. c. d.

all securities will be priced the same. no brokers or middlemen would be necessary. all risk would be eliminated. securities would always be correctly priced.

(d, moderate, p. 364) 33.

A major advantage of a buy-and-hold strategy is:

a. b. c. d.

greater expected return. buying securities at their lowest price. lower transaction cost. lower default risk.

(c, moderate, p. 365) 34.

If you purchase $100 of stock every month, you are practicing:

a. b. c. d.

asset allocation. diversification. market timing. dollar cost averaging.

(d, moderate, p. 365)

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35.

Dollar cost averaging will result in

a. b. c. d.

a greater return than a buy-and-hold strategy if prices are rising. a smaller return than a buy-and-hold strategy if prices are rising. a lower average purchase price than the average price over the long term. a higher average purchase price than the average price over the long term.

(c, moderate, p. 366) 36.

A program that allows investors to receive dividends in the form of additional shares of stock instead of cash is a:

a. b. c. d.

DIP DRIP ESOP DROP

(b, easy, p. 367) 37.

The biggest problem with timing strategies is:

a. b. c.

their high cost. that it is difficult to correctly predict the market. that small investors are usually not able to get and get out during market highs and lows as are institutional investors. all of the above.

d.

(b, moderate, p. 367) Key Strategies for Investment Success 38.

One advantage of capital gains over interest and dividend income is that:

a. b. c. d.

capital gains are more predictable. capital gains are always larger. capital gains are not taxed until the security is sold. capital gains result in lower trading costs.

(c, moderate, p. 368)

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39.

An example of an tax-deferred investment would be a(an):

a. b. c. d.

IRA account.

U.S. Treasury bond. mutual fund. municipal bond.

(a, easy, p. 368) 40.

Which of the following statements concerning federal and municipal debt is true?

a.

Interest on federal and municipal debt is tax exempt from all federal, state and local income taxes.

Interest on federal debt is tax exempt from all federal, state and local income taxes and municipal debt is exempt only from federal income taxes.

Interest on municipal debt is tax exempt from federal income taxes and federal debt is exempt from state and local income taxes.

Interest on municipal debt is tax exempt from both federal and state income taxes and federal debt is tax exempt only from federal income taxes.

b. c. d.

(c, difficult, p. 368) 41.

A useful organization for small investors to join is the:

a. b. c. d.

National Association of Small Investors National Association of Security Investors.

American Association of Security Investors.

American Association of Individual Investors.

(d, moderate, p. 369) 42.

Which of the following is not one of the general rules of thumb to become a better investor?

a. b. c. d.

Be flexible Do your homework Start early Keep good records

(a, moderate, p. 370-371)

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43.

Which of the following is not one of the common pitfalls in investing?

a. b. c. d.

Failing to rebalance Relying on other's advice Ignoring asset allocation Holding on at all costs

(b, moderate, p. 371)

Essay Questions 1.

Compare and contrast debt and equity investments.

Debt investments, also referred to as fixed-income investments, provide regular cash flows in the form of interest to the investor as well as the repayment of the amount borrowed (the principal) at the end of the term. The regular payments are an advantage of this type of investment. Debt investments can rise in value so there is a potential for capital gains if you sell before maturity. . Debt investors are given a higher position in the corporation than equity investors. This means that the company has to pay the interest to debtholders before paying any return, such as dividends, to the equityholders. The major disadvantage of debt investors tends to be the lower return relative to equity investments. If the borrowing company does well and earns high profits, the debt investor will not share in this profit. There is also the risk that the borrower will get into financial difficulty and be unable to pay the interest and principal payments Equity investments represent ownership in a business. The major advantage is the potential return that can be quite high if the business does well. Equity investors get to share in the profits of the company and should see their investment rise if the earnings of the company rises. The major disadvantage is the uncertain cash flows from this type of investment. There is no fixed-income stream for equity investments as there is for fixed-income investments. In addition, the risk can be quite high and there is no guaranteed return.

2.

Discuss interest-rate risk and reinvestment risk and which securities are most affected by each.

Interest-rate risk is the risk that when interest rates rise, the price of securities falls. This type of risk affects fixed-income securities, such as bonds and preferred stock, more since their cash flow is fixed. Of course, if interest rates fall, the prices of these securities would rise and there would be a potential capital gain.

Long-term securities are more affected by this type of risk than shorter-term securities and the prices of long-term bonds would fall more than the price of short-term bonds if interest rates rose, all else being equal. Investors expect to be compensated for this type of risk with a higher interest rate. This is known as the

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interest-rate risk premium. Related to interest rates is another risk, reinvestment risk. This is the risk that you may have to reinvest at a time when interest rates have fallen. Reinvestment risk is greatest for short-term securities rather than long-term securities as you have to reinvest more often with short-term securities.

As securities mature, reinvestment risk is always present and depends on the current market rates at the time of reinvestment.

3.

How do direct investment and dividend reinvestment plans work and what are some of the advantages of these plans?

Direct investment plans allow investors to buy stock directly from the company instead of from another investor in the market. Most of the plans allow the investor to enroll in an automatic program that invests a certain amount periodically. In this way, the investor bypasses a stockbroker. Dividend reinvestment plans (DRIPs) are similar in that the investor is buying stock directly from the company. With a DRIP, cash dividends that would have been paid to the investor are used to buy additional shares in the company. With both direct investment plans and DRIPs, the investor is not paying a brokerage commission and thus saving that cost of investing.

Mini Case Logan wants to start his own business in 10 years. He would prefer to have the money saved and not borrow any. He figures it will take at least $500,000 to start the business.

He currently has $10,000 saved. If Logan can earn 9 percent on his invested funds, how much does Logan need to invest yearly to meet his goal? If Logan can only save $12,000 a year, how much would he have to borrow?

Answer: To meet his yearly goal, solve for payment: 1 payment per year, 10 N, 9 I, 500000 FV, -10000 PV, solve for payment: $31,352 If Logan can only save $12,000 a year, he will have *$205,989 at the end of 10 years and will need to borrow $294,011** * 12,000 PV, 9 I, 10 N, 10000 PV, solve for FV = 205,989 ** 500,000 - 205,989 = 294,011

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Chapter 12

Investing in Stocks True-False Common Stock 1.

Sole proprietorships generally have less personal liability than owners of corporations.

(f, moderate, p. 381) 2.

If you buy 100 shares in a corporation that has issued 1,000 shares, your proportionate share in the company is 10 percent.

(t, easy, p. 381) 3.

The major reason companies issue stock is to spread the risk among a large number of investors.

(f, moderate, p. 381) 4.

Stockholders vote on major issues such as election of the board of directors as well as daily operational decisions.

(f, moderate, p. 382) 5.

A stock dividend is generally as beneficial to a stockholder as a cash dividend.

(f, moderate, p. 382) 6.

The right of existing stockholders to buy into new issues is known as the residual claim.

(f, moderate, p. 382) 7.

If you own 100 shares of stock currently selling at $50 and the company does a 3 for 1 split, you will have 300 shares selling at $16.67 after the split.

(t, moderate, p. 383) 8.

Stocks tend to have more volatility of return over the short run than debt investments.

(t, moderate, p. 384)

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9.

One advantage of stocks is that they are not sensitive to interest rate changes.

(f, moderate, p. 385) 10.

It is commonly said that stockholders "vote with their pocketbook."

(f, easy, p. 386) 11.

An IPO is sold in the primary market.

(t, moderate, p. 386) 12.

A document that gives financial information about a new stock issue and the issuing company to potential investors is a proxy.

(f, easy, p. 387) 13.

One listing requirement for the NYSE is that companies have at least 1 million shareholders.

(f, moderate, p. 388) 14.

Since the majority of seats on the exchanges are owned by brokerage firms, individual investors rarely trade in listed securities.

(f, moderate, p. 388) 15.

The bid price represents the price at which the seller is willing to sell a security.

(f, moderate, p. 388) 16.

The most frequently traded OTC stocks are traded on the AMEX.

(f, moderate, p. 389) Classifications of Common Stock 17.

Income stocks generally have relatively low price appreciation.

(t, moderate, p. 389) 18.

Coca-Cola would be a good example of an income stock.

(f, moderate, p. 390)

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19.

Cyclical firms are more likely to produce consumer durable goods than defensive companies, who often produce consumer non-durable goods.

(t, moderate, p. 390) 20.

If a company has 25,000,000 shares outstanding and its stock is priced at $40, the current market capitalization for the company is $625,000.

(f, moderate, p. 391) Buying and Selling Stocks 21.

If you place an order to buy 100 shares of stock, this is a round lot.

(t, easy, p. 393) 22.

A limit order is more likely to have a rapid execution than a market order.

(f, moderate, p. 393) 23.

An order that expires if it is not immediately filled is known as an all or none order.

(f, moderate, p. 393) 24.

You would only want to place an order to sell short if you anticipated a price decline.

(t, moderate, p. 393) 25.

The major advantage of margin trading is the low interest rate on the borrowed funds.

(f, moderate, p. 394) 26.

A margin call occurs when a brokerage firm informs a margin customer of their potential buying power from the profits made in the margined stock.

(f, moderate, p. 395)

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Regulation of the Securities Market 27.

Only stocks listed on exchanges are registered with the SEC.

(f, moderate, p. 397) 28.

Mutual funds are required to register with the SEC under the provisions of the Maloney Act of 1938.

(f, moderate, p. 399) Stock Selection and Performance Evaluation 29.

A stock paying an annual dividend of $1.10 and selling at a price of $27.50 would have a dividend yield of 2.5%.

(f, moderate, p. 400) 30.

To measure the relationship between earnings and market price, you would use the EPS ratio.

(f, moderate, p. 400) 31.

High P/E stocks are almost always a better investment in the long term than low P/E stocks.

(f, difficult, p. 400) 32.

Since market risk is nondiversifiable, beta is a more relevant risk measure than standard deviation for a diversified portfolio.

(t, difficult, p. 403) 33.

The theory of time diversification suggests that investors should be in stocks for the long run as they are actually less risky than government securities over long holding periods.

(t, moderate, p. 404) 34.

The discounted dividend model assumes dividends remain stable over time.

(f, moderate, p. 405) 35.

The DJIA is so widely followed since it is considered the most accurate gauge of the stock market available.

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(f, difficult, p. 406) 36.

The S&P 500 is considered more representative of the overall stock market than the DJIA.

(t, moderate, p. 406) 37.

If a small company's stock was selling at $40 and a large company's stock was selling at $40, both would be weighted the same on the S&P 500 Index.

(f, moderate, p. 406) 38.

The S&P 500 Index is the largest and most reliable stock market indicator available.

(f, moderate, p. 407) Sources of Information for Stock Investors 39.

Value Line is a company that provides fundamental analysis about companies and provides opinions from security analysts.

(t, moderate, p. 409) 40.

Reports filed with the SEC are not available to the public unless you pay for a subscription to government documents.

(f, moderate, p. 409)

Multiple Choice Common Stock 1.

Which of the following statements regarding corporations is false?

a. b. c. d.

Corporations are legal entities separate from its owners.

Corporations can be classified as either private or public.

Each shareholder in a corporation owns a proportionate share of the firm.

Each shareholder has personal liability for the debts of the corporation.

(d, moderate, p. 381)

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2.

Common stockholders' right to the firm's assets and income after all other claimholders are paid is known as a:

a. b. c. d.

prior claim. preemptive right. residual claim. right of equity.

(c, moderate, p. 381) 3.

A written agreement that gives your common stock voting rights to someone else is known as a:

a. b. c. d.

preemptive right. proxy. forfeit agreement. voting assignment.

(b, easy, p. 382) 4.

If a company fails, the stockholders cannot lose more than the value of the stock they hold. This is known as:

a. b. c. d.

a residual claim. the preemptive right. limited liability. vested responsibility.

(c, moderate, p. 382) 5.

Which of the following statements regarding dividends is false?

a. b. c. d.

Stock dividends benefit stockholders the same as a cash dividend.

Corporations are not required to pay dividends.

It is possible to receive both dividends and a capital gain from a stock.

The dividend amount can vary over time.

(a, moderate, p. 382) 6.

The reason corporations give the preemptive right to stockholders is to:

a. b. c. d.

entice them into buying more shares of stock. reduce the dividend payments to the common stockholders. allow them to maintain their percentage interest in the firm. keep control of the company within a small number of investors.

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(c, difficult, p. 382) 7.

Which of the following statements concerning stock splits is true?

a. b. c. d.

After a stock split, the total value of shares increases.

The major reason for a stock split is to increase the shares outstanding.

Stock splits are like stock dividends as both increase the value of the firm.

Announcement of a stock split often causes the price to rise.

(d, difficult, p. 383) 8.

Which of the following is not an advantage of stock investing?

a. b. c. d.

higher short-run returns no management responsibility low interest-rate sensitivity diversifiable risk.

(a, moderate, p. 383-384) 9.

Which of the following is not a disadvantage of stock investing?

a. b. c. d.

risk lack of control illiquidity lower return

(c, moderate, p. 385-386) 10.

A stock purchase that takes place on the NYSE would be an example of:

a. b c. d.

a primary market trade. a secondary market trade. an over-the-counter trade. an initial public offering.

(b, moderate, p. 386) 11.

New stock issues are advertised in financial periodicals in a format called a(an):

a. b. c. d.

obituary. slab ad. tombstone ad. prospectus.

(c, easy, p. 387)

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12.

If you wanted to know more about a new stock issue, you would ask the company for a:

a. b. c. d.

proxy. indenture. digest. prospectus.

(d, easy, p. 387) 13.

Which of the following is not a listing requirement for the NYSE?

a. b. c. d.

at least $100,000,000 market value of shares. at least 1,100,000 shares outstanding at least $5 million in gross sales in each of the last 2 years at least $2 million in pretax earnings in each of the last 2 years

(c, difficult, p. 388) 14.

A membership on an organized exchange is known as a:

a. b. c. d.

specialist's post. seat. directorship. broker's post.

(b, easy, p. 388) 15.

The price offered by a buyer in a stock transaction is the:

a. b. c. d.

bid price. ask price. listing price. market price.

(a, moderate, p. 388) 16.

The exchange member that matches up buy and sell orders is the:

a. b. c. d.

broker. dealer. specialist. arbitrager.

(c, easy, p. 388)

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17.

Which of the following is a major difference between organized exchanges and the OTC market?

a. b. c. d.

More stocks are traded on the organized exchanges than on the OTC market.

OTC stocks are generally more liquid than stocks traded on organized exchanges.

Organized exchanges have a physical location; the OTC market does not.

Organized exchanges are more technologically advanced than the OTC market.

(c, moderate, p. 389) Classifications of Common Stock 18.

A stock issued by a large, stable, mature company is known as a (an):

a. b c. d.

income stock. growth stock. large cap stock. blue chip stock.

(d, moderate, p. 390) 19.

Which of the following would be considered a defensive stock?

a. b. c. d.

Home Depot Coca-Cola Ford Motor Company Delta Airlines

(b, moderate, p. 390) 20.

A small-cap company generally has a market capitalization of less than:

a. b. c. d.

$1 billion $100 million $10 million $1 million

(a, moderate, p. 391)

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21.

Which of the following statements is false concerning small cap firms?

a. b. c. d.

They tend to be more sensitive to market movements.

They often pay small cash dividends and larger stock dividends.

They are generally young, growing companies.

They have historically seen larger investment returns.

(b, moderate, p. 391) Buying and Selling Stock 22.

If a firm has a P/E of 12 and a current price of $48, then its EPS would be:

a. b. c. d.

$.25. $4.00. $576. impossible to determine.

(b, moderate, p. 392; solution: $48/12 = $4) 23.

On stock quotes, the net change is calculated as the difference:

a. b. c. d.

between the high and low price for the day. between the high price today and high price yesterday. between the closing price today and the closing price yesterday. between the opening price today and the closing price today.

(c, moderate, p. 392) 24.

Which of the following is generally an advantage of a market order over a limit order?

a. b. c. d.

lower commission charged faster execution receiving a better price being able to trade in larger quantities

(b, difficult, p. 393)

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25.

An order that expires if it is not immediately executed is a (an):

a. b. c. d.

fill or kill order. all or none order. day order. contingent order.

(a, moderate, p. 393) 26.

If your stock has made a profit and you want to protect your gains, you would most likely do a:

a. b. c. d.

market order. limit order. stop order. fill or kill order.

(c, moderate, p. 393) 27.

What is a short seller trying to do?

a. b. c. d.

Buy low and sell high.

Sell high and buy low.

Buy on margin and repay with borrowed funds Sell on margin and repay with borrowed funds

(b, easy, p. 393) 28.

Brokerage accounts are insured by the:

a. b. c. d.

FDIC. SEC. SIPC. brokerage accounts are not insured.

(c, moderate, p. 394) 29.

Which of the following statements regarding trading on margin is false?

a. b. c. d.

Margin trading is less risky than trading on a cash basis.

Margin trading allows you to buy more stock than on a cash account.

Margin trading can increase your return on investment more than a cash trade.

Margin trading requires an interest payment on funds borrowed.

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(a, moderate, p. 94-395) 30.

When brokers engage in excessive trading of customers accounts in order to increase their commissions, this is called:

a. b. c. d.

insider trading. discretionary trading. churning. whipsawing.

(c, moderate, p. 395) Regulation of the Securities Market 31.

State securities laws are referred to as:

a. b. c. d.

silver lining laws. cloudy day laws. rainy day laws. blue sky laws.

(d, easy, p. 397) 32.

Which of the following must be registered with the SEC?

a. b. c. d.

all stocks all stocks and bonds all stocks, bonds and mutual funds all traded securities

(d, moderate, p. 397) 33.

It is illegal for insiders to:

a. b. c. d.

to own stock in the company in which they are insiders. to sell stock in the company as long as they are insiders. trade on company information not available to the public. trade on any information about the company in which they are insiders.

(c, moderate, p. 397)

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34.

The security industry now temporarily halts trading in the event of an unusually large drop in the market using:

a. b. c. d.

stop-loss orders. circuit breaker rules. specialists' limit order books. trading halts.

(b, moderate, p. 399) Stock Selection and Performance Evaluation 35.

If a stock is trading at $50 and has a quarterly dividend of $.55, the dividend yield on this stock is:

a. b. c. d.

1.1% 2.2% 3.3 4.4%

(d, moderate, p. 400; solution .55 x 4 = 2.20/45 = 4.4%) 36.

If you buy a stock at $46 and sell it one year later for $57, your capital gains yield will be:

a. b. c. d.

19.3% 21.4% 23.9% 41.8%

(c, moderate, p. 400; solution 57-46/46 = 23.9%) 37.

Which of the following is false regarding EPS?

a. b. c. d.

It provides a rough measure of a company's profitability.

It provides a useful tool to compare different companies.

It is perhaps the most-watched ratio for investors.

Better than expected EPS will usually cause the stock price to rise.

(b, difficult, p. 400)

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38.

The ratio most often seen as a measure of future earnings potential is the:

a. b. c. d.

EPS. P/E ratio. dividend yield. capital gains yield.

(b, moderate, p. 400) 39.

The average P/E ratio for large company stocks is usually between;

a. b. c. d.

1 and 5.

5 and 10.

15 and 25.

25 and 40.

(c, moderate, p. 406) 40.

The more variation around an average,

a. b. c. d.

the lower the standard deviation and the lower the risk. the lower the standard deviation and the higher the risk. the higher the standard deviation and the lower the risk. the higher the standard deviation and the higher the risk.

(d, moderate, p. 402) 41.

A measure of market or nondiversifiable risk the:

a. b. c. d.

standard deviation. variation. beta. coefficient of variation.

(c, easy, p. 403) 42.

According to Jeremy Siegel, the author of Stocks for the Long Run, for long holding periods,

a. b. c. d.

stocks are actually less risky than T-bills or corporate bonds. stocks are actually more risky than T-bills or corporate bonds. stocks are more risky but more profitable than T-bills and corporate bonds. stocks are more risky and less profitable than T-bills and corporate bonds.

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(a, moderate, p. 404) 43.

The primary objective in fundamental analysis is to:

a. b. c. d.

determine the riskiness of a particular security. keep transactions costs and taxes as low as possible. determine whether the stock price is likely to increase in the future. build a diversified portfolio that will withstand the ups and downs of the market.

(c, difficult, p. 404) 44.

Which of the following is not one of the variables of the discounted dividend model?

a. b. c. d.

dividend per share earnings per share growth rate in dividend discount rate

(b, moderate, p. 405) 45.

XYZ Corp. paid a dividend of $1.20 last year. The dividend grows at a rate of 5 percent a year. If you require a 12 percent rate of return for this stock, the value of the stock should be:

a. b. c. d.

$10.50 $17.14 $18.00 $25.20

(c, moderate, p. 405; solution: 1.20 (1-.05)/.12-.05 = 1.26/.07 = $18) 46.

How many stocks are in the DJIA?

a. b. c. d.

10 30 50 100

(b, easy, p. 406)

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47.

Which of the following statements regarding the DJIA is false?

a. b. c. d.

Its price-weighting method is considered superior to value-weighted systems.

The DJIA was a true average in the beginning but is not now.

The companies in the DJIA represent a significant percentage of market value.

The first Dow average only contained 12 stocks.

(a, difficult, p. 406) 48.

Which of the following is true concerning the Standard & Poor indexes?

a. b. c. d.

The most popular S&P index is the S&P 100.

Companies with higher market prices have more weight in the indexes.

The S&P is probably a better indicator of market performance than the DJIA. The market value of companies in the indexes is not considered.

(c, moderate, p. 406) 49.

Which of the following is a major advantage of indexing?

a. b. c. d.

a consistently superior return a smaller investment greater marketability lower transaction costs

(d, moderate, p. 408) Sources of Information for Stock Investors 50.

Which is not one the major categories of information that investors should follow?

a. b. c. d.

industry information international trends general economic conditions company information

(b, moderate, p. 409)

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51.

Which of the following sources gives an overview of industry trends in addition to company data?

a. b. c. d.

The Wall Street Journal Money Fortune Value Line

(d, moderate, p. 409) 52.

Which of the following federal agencies has an Office of Internet Enforcement?

a. b. c. d.

Federal Trade Commission Federal Reserve SEC NASD

(c, moderate, p. 410)

Essay Questions 1.

What is market capitalization? How are companies classified regarding market capitalization and what is the size of the companies in each classification? What size companies have the largest return potential?

Market capitalization is the total value of the company's shares at its current market price. It can be calculated by multiplying the current market price by the number of shares outstanding. Companies are classified as either large-cap, midcap or small-cap. Large-cap companies have a market capitalization of $5 billion or more. These are the largest and usually best known companies in the country.

They typically are older companies and are generally less risky than other size companies. Mid-cap companies have market capitalization of $1 to $5 billion.

Small-cap companies have market capitalization of less than $1 billion and annual revenues of less than $250 million. Small caps are the riskiest as they are generally the most sensitive to market movements. But they have historically had the largest investment returns relative to the other size classifications.

2.

When is it recommended that investors place market orders? When is it recommended that investors place limit orders or stop orders? Give details and examples of all 3 types of orders.

Market orders, which are executed at the current market price, are recommended for most orders as the order will be transacted quickly. For most securities, the

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price will not change significantly between when the order is placed and the order is executed.

An example of a market order is an order to buy 100 shares of Microsoft. The investor does not set a price and, in most cases, the stock will be bought at or very close to the price at the time the order was placed. However, for securities that may be volatile or that the investor wants a specific price, then a limit order, which must be executed at the set price or a better price, is recommended.

Unfortunately, the stock may not reach that price and the order may not be executed. An example would be an order to buy 100 shares of Microsoft at $25.

The stock can only be purchased at a price of $25 or less. If the stock is currently at $26, the order will not be executed. An investor can choose to leave the order in effect until it is executed or cancelled. A stop order is recommended in order to protect profits or minimize losses and only is executed once a price reaches a certain level. An example would be a stock that was purchased at $30 and now has risen to $50. An investor might decided to see if the stock will go higher but wants to protect his profit. He could place a stop order to sell if the stock goes below $48. If the stock continues to rise, the stop order will not be executed but provides protection if the stock falls quickly.

3.

What is the beta of a stock? How is it interpreted and how do investors use the beta in stock selection?

The beta is a measure of market risk and can be used to assess how much an individual stock tends to move with the market. A beta of 1 indicates that the stock has the same degree of risk as the overall market and moves up and down as the market does. A beta less than 1 indicates the stock is less risky than the overall market but would return less than the market when the market was moving up. A beta greater than 1 would indicate a stock that moves faster than the market, either up or down. This would be a stock that would return more than the market when the market was moving up but would be riskier as it would fall more than the market when the market was headed down. Investors can use betas to include stocks with high, low or average risk in their portfolio. For example, a very conservative investor would want low beta stocks while an aggressive investor would prefer high beta stocks.

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Mini Case Mario is considering investing in Midwest Microchip. The stock is currently selling at $71 and paid an annual dividend this year of $2.30 per share. Mario has looked at the company's financial statements and learned the firm made $3 million in net income this year and has 525,000 shares of common stock outstanding. Based on this data, calculate the earnings per share, dividend yield, and price-earnings ratio of this stock. The earnings and dividends of the company are expected to grow at an 8 percent annual rate. If Mario requires a return of 12 percent on this investment, calculate the value of the stock based on the discounted dividend model. Based on its current price, would you recommend Mario buy this stock? State your reasons.

Answer: Earnings per share = $3,000,000/525000 = $5.71 dividend yield = 2.30/71 = 3.24% price-earnings ratio = 71/5.71 = 12.43 times Value (based on dividend model) = 2.30 (1 + 08) .12 - .08 = 2.48/.04 = $62.10 It would not be recommend that Mario buy the stock as its calculated value is only $62 and it is currently selling at $71 so the stock is overvalued and the price is likely to fall.

189

Chapter 13

Investing in Bonds and Preferred Stock True-False Bonds 1.

When you buy bonds issued by a company, you are then an owner of the company.

(f, easy, p. 419) 2.

Selling bonds is less costly to a firm than selling stocks in term of issuance expenses.

(t, moderate, p. 419) 3.

Both interest and dividend payments made by a company are tax deductible.

(f, moderate, p. 419) 4.

Increasing the amount of debt in a company can actually increase the return to the stockholders.

(t, moderate, p. 420) 5.

Many investors buy bonds in order to diversify their portfolios and reduce the risk of the portfolio.

(t, moderate, p. 420) 6.

A trustee of a bond issue is usually the investment banker that sold the issue.

(f, moderate, p. 428) 7.

Like mortgages, bonds are amortized over the life of the issue.

(f, moderate, p. 422) 8.

The coupon rate is the fixed interest rate on the bond and is quoted as a percentage of par value.

(t, moderate, p. 422)

191

9.

Callable bonds are more likely to be called in when interest rates rise.

(f, difficult, p. 422) 10.

The price of a convertible bond is more likely to rise when the underlying stock price rises.

(t, moderate, p. 423) Types of Bonds 11.

A U.S. government security that has an original maturity of 8 years would be a Treasury bond.

(f, moderate, p. 424) 12.

Agency issues are issued in larger denominations than Treasury securities and are more commonly bought by individual investors than are Treasury securities.

(f, moderate, p. 425) 13.

The interest paid on municipal bonds is always exempt from federal and state income taxes.

(f, moderate, p. 425) 14.

A revenue municipal bond is generally riskier than a general obligation municipal bond.

(t, difficult, p. 426) 15.

Debentures are more commonly issued by municipalities than by corporations.

(f, moderate, p. 427) 16.

Secured bonds would be considered safer investments than debentures.

(t, moderate, p. 427) 17.

A bond that has its interest payments tied to current market interest rates is called a market value bond.

(f, moderate, p. 428)

192

18.

The only return on a zero-coupon bond is from capital gains; there is no current income potential.

(t, moderate, p. 428) 19.

Ratings agencies, such as Standard & Poor's and Moody's, rate the business, financial and interest rate risk of a bond issue.

(f, difficult, p. 428) 20.

Bonds that pay interest at a favorable rate unless a major disaster, such as a hurricane, occurs are known as catastrophe bonds.

(t, moderate, p. 430) Evaluating and Selecting Bonds 21.

The value of a bond is the discounted present value of both the interest to be received and the par value of the bond.

(t, moderate, p. 430) 22.

A bond with a $1,000 par value that is selling at $1,075 will have a current yield that is less than the coupon rate.

(t, difficult, p. 431) 23.

If a bond is selling at its face value, both the current yield and yield to maturity will be equal to the coupon rate.

(t, difficult, p. 431) 24.

There is an inverse relationship between market interest rates and bond prices.

(t, moderate, p. 434) 25.

Long-term bonds are less sensitive to interest rate changes than short-term bonds.

(f, moderate, p. 435) 26.

If you buy bonds and hold until maturity, you will be certain of receiving the yield to maturity calculated at time of purchase.

(t, moderate, p. 437)

193

27.

With a bond laddering strategy, you will always have one bond from each maturity in your portfolio.

(t, moderate, p. 437) 28.

The difference between the yield on a corporate bond and a Treasury security of comparable term to maturity is known as the government spread.

(f, moderate, p. 439) Preferred Stocks 29.

A preferred stockholder would prefer an issue to be non-cumulative and nonparticipating.

(f, difficult, p. 440-441) 30.

Callable preferred stock generally pays a higher dividend than comparable noncallable preferred stock.

(t, moderate, p. 440) 31.

Convertible preferred stock allows the stockholder to convert into either common stock or bonds of the company.

(f, moderate, p. 441) 32.

You would expect convertible preferred stock to carry a higher dividend rate than comparable nonconvertible preferred stock.

(f, moderate, p. 441) 33.

Preferred stock values, like bonds, generally move up when interest rates fall.

(t, moderate, p. 442) 34.

The primary reason to invest in preferred stock is the potential for large capital gains.

(f, moderate, p. 442) 35.

For bond and preferred stock investors, a major emphasis should be placed on interest rate movements in the market.

(t, easy, p. 442)

194

Sources of Information for Bond and Preferred Stock Investors 36.

It is generally easier to obtain pricing information on bonds than on stocks.

(f, moderate, p. 443) 37.

To find out information about municipal bonds, it is recommended that you contact the state and local governments directly.

(t, moderate, p. 443)

Multiple Choice Bonds 1.

Which of the following is not one of the reasons businesses issue bonds instead of stock to raise funds?

a. b. c. d.

lower cost tax advantage greater marketability favorable leverage

(c, moderate, p. 419-420) 2.

The issuing firm’s after-tax cost of paying bond interest to investors

a. b. c. d.

is greater than the after-tax cost of paying dividends to stockholders is lower than the after-tax cost of paying dividends to stockholders is greater than the before-tax cost of paying dividends to stockholders is lower than the before-tax cost of paying dividends to bondholders

(b, moderate, p. 419) 3.

Favorable leverage occurs when:

a. b. c. d.

the interest rate on a bond is less than the dividend rate on a stock. the dividend rate on a stock is less than the interest rate a on bond. the interest rate on a bond is less than the rate of return earned by the firm. the rate of return earned by the firm is less than the interest rate on a bond.

(c, difficult, p. 420)

195

4.

Which of the following is not one of the reasons for owning bonds?

a. b. c. d.

to provide short-term gains. to increase diversification. to match investment term to investment time horizon desire to lower risk

(a, moderate, p. 420) 5.

The bond contract is known as a(an):

a. b. c. d.

debenture indenture commitment writ

(b, easy, p. 422) 6.

A corporate bond has a 9.4 percent coupon rate. The bond has a $1,000 face value and is currently selling at $900. The annual coupon payment on this bond

is: a. b. c. d.

$84.60 $108.70 $97.83 $94.00

(d, moderate, p. 422; solution = .094 x 1000 = 94) 7.

Which of the following statement is false concerning callable bonds?

a. b. c. d.

If a bond is called, the investor receives an amount greater than the face value.

Call provisions may include restrictions on how soon the bond can be called.

Bonds will most likely be called when interest rates rise.

All of the above are true.

(c, moderate, p. 422-423) 8.

Which of the following bonds is preferable, assuming the same yield to maturity?

a. b. c. d.

A callable bond A convertible bond A callable, convertible bond A noncallable, nonconvertible bond

(b, difficult, p. 423)

196

Types of Bonds 9.

A Treasury bond has a maturity of:

a. b. c. d.

between 1 and 10 years. between 1 and 30 years. less than 10 years. more than 10 years.

(d, moderate, p. 424) 10.

The federal government auctions Treasury bonds:

a. b. c. d.

once a year twice a year. four times a year. every month.

(c, moderate, p. 424) 11.

A municipal bond that is repaid from normal operating cash flows is a(an):

a. b. c. d.

operational bond. secured bond. revenue bond. general obligation bond.

(d, moderate, p. 426) 12.

An unsecured bond is a (an):

a. b. c. d.

indenture mortgage bond general bond debenture

(d, easy, p. 427) 13.

Which of the following is an advantage of floating-rate bonds?

a. b. c. d.

higher interest rates greater resale value not being called increased marketability

197

(c, moderate, p. 428) 14.

Which of the following is false regarding zero-coupon bonds?

a. b. c. d.

They are issued by both corporations and governments.

They may sell at either a premium or a discount.

Their entire yield comes from capital gains. all of the above are true

(b, moderate, p. 428) 15.

Which of the following is not a disadvantage of zero-coupon bonds?

a. b. c. d.

federal income tax treatment liquidity risk inflation risk interest rate risk

(b, difficult, p. 428) 16.

Bonds that are rated BBB or better by Standard & Poor's are referred to as:

a. b. c. d.

top-notch bonds. risk-free bonds. investment-grade bonds. recession-proof bonds.

(c, easy, p. 428) Evaluating and Selecting Bonds 17.

What is the value of a semiannual coupon bond if it has a 12 percent interest rate, a $1,000 face value and 9 years to maturity, assuming your discount rate is 14 percent?

a. b. c. d.

$899.41 $901.07 $934.85 $1,325.76

(a, difficult, p. 431; calculator solution: 1000 FV, 14/12 I, 18 N, 60 PMT, PV = $899.41)

198

18.

If a semiannual coupon bond has a coupon rate of 8.4 percent, a face value of $1,000, a 15 year term and a current price of $922, what it its current yield?

a. b. c. d.

4.56% 9.11% 9.38% 9.89%

(b, moderate, p. 431; solution: $84/922 = .0911 = 9.11%) 19.

A 7.8 percent semiannual coupon bond is selling at $872, has a face value of $1,000 and matures in 12 years. What is the bond's yield to maturity?

a. b. c. d.

8.52% 8.55% 9.62% 9.65%

(c, difficult, p. 432; calculator solution: 1000 FV, -872 PV, 24 N, 39 PMT, Solve for I/2 = 4.81 x 2 = 9.62%) 20.

Which of the following is not a major risk of investing in bonds?

a. b. c. d.

default risk tax risk maturity risk inflation risk

(b, moderate, p. 44-435) 21.

Which of the following types of bonds has the lowest liquidity risk?

a. b. c. d.

Treasury bonds corporate bonds municipal bonds all have equal liquidity risk

(a, moderate, p. 434)

199

22.

Which of the following statements regarding bonds and inflation risk is true?

a. b. c. d.

Bonds are less influenced by inflation risk than are common stocks.

Rising inflation will generally cause bond prices to also rise.

Bond investors will require higher yields on bonds if inflation rises.

Long-term bonds have less inflation risk than short-term bonds.

(c, moderate, p. 435) 23.

Which of the following statements regarding bonds and changes in required return is true?

a.

The longer the time to maturity, the smaller the percentage change in bond value for a given change in the required return.

The longer the time to maturity, the greater the percentage change in bond value for a given change in the required return.

The higher the bond rating, the smaller the percentage change in bond value for a given change in the required return.

The higher the bond rating, the larger the percentage change in bond value for a given change in the required return.

b. c. d.

(b, difficult, p. 44-435) 24.

If you determine the maximum maturity for your bond portfolio will be 4 years and you allocate 25 percent of your portfolio to one-year bonds, 25 percent of your portfolio to two-year bonds, 25 percent of your portfolio to three-year bonds and 25 percent of your portfolio to four-year bonds, you are practicing:

a b. c. d.

bond spreading. maturity matching. laddering. timing.

(c, moderate, p. 437) 25.

If investors pull out of the stock market when it goes down and buy fixed-income securities such as bonds, this is known as:

a. b. c. d.

asset allocation "beating the market" "a rainy day" strategy "flight to quality"

(d, moderate, p. 437)

200

26.

One basis point is:

a. b. c. d.

1/10 percent.

1/100 percent.

1/1000 percent.

1/20 percent

(b, moderate, p. 439) Preferred Stocks 27.

Preferred stock that pays any missed dividends to stockholders before paying current dividends is known as:

a. b. c. d.

cumulative preferred stock. participating preferred stock. adjustable preferred stock. convertible preferred stock.

(a, moderate, p. 440) 28.

Preferred stock that may receive an additional dividend if there are residual profits is known as:

a. b. c. d.

cumulative preferred stock. participating preferred stock. residual preferred stock. adjustable preferred stock.

(b, moderate, p. 441) 29.

Which of the following is not a major risk faced by preferred stock investors?

a. b. c. d.

interest rate risk call risk residual risk default risk

(c, difficult, p. 442)

201

Sources of Information for Bond and Preferred Stock Investors 30.

Which of the following statements regarding bond information is false?

a. b.

It is more difficult to get current pricing information on bonds than on stocks.

The federal government is a less valuable source of information for bonds than for stocks.

There are fewer free sources of information for bonds than for stocks.

All of the above are true.

c. d.

(b, moderate, p. 443)

Essay Questions 1.

Discuss the characteristics and disadvantage of zero-coupon bonds. What type of investor is likely to buy a zero-coupon bond?

Zero-coupon bonds pay no interest and sell at a discount, often a deep discount, below face value. The entire return from a zero-coupon bond comes from capital gains since there is no interest paid. One disadvantage of zero-coupon bonds is their tax treatment by the IRS, which considers the annual appreciation in the value of the bond to be undistributed interest and taxes it even though you receive no return until the end of the term. Zero-coupons also have higher interest-rate risk than other bonds because if the market interest rates rise, the price of zerocoupon bonds will fall more than of interest-bearing bonds. Zero-coupon bonds also have inflation risk. Investors that plan to buy and hold the bonds to maturity and do not need current income are the most likely purchaser of zero-coupon bonds.

2.

What do bond ratings rate? Who are the two most popular bond rating companies? Explain the relationship of bond rating to bond yield. Can a bond have a high rating and still be risky?

Bond ratings rate the level of default risk of a bond issue. Default risk is the risk that the issuer will not be pay the interest and principal as promised. Moody's and Standard and Poor's are the two most popular bond rating companies. There is an inverse relationship between bond rating and bond yield. If a bond is rated highly, it will be lower return than a low-rated bond. This is because a high-rated bond is very safe so it will offer a lower return. Since a low-rated bond has greater default risk, it must offer a higher yield in order to attract investors. A bond can have a high rating and still be very risky as bond ratings only evaluate default risk. There are other types of risk, especially interest-rate risk, that could affect the bond.

202

3.

Would a preferred stock investor prefer the issue pay cumulative or noncumulative dividends? Would a preferred stock investor prefer the issue be participating or non-participating? Explain.

A preferred stock investor would prefer to have an issue that pays cumulative dividends and is a participating issue. A preferred stock issue that pays cumulative dividends will pay any dividends missed in previous years before paying any dividends to the common stockholders. If the issue pays noncumulative dividends, then the missed dividends are not made up. A participating preferred stock is one that allows the preferred stockholders to share in the profits that are left over after the regular preferred dividends and common dividends are paid. A non-participating preferred stock would only pay the regular dividend and the preferred stockholders would not share in any leftover profits.

Mini Case Thomas Wilson is considering investing in some corporate bonds. One choice is a 15year, 8% bond that is currently selling at $890. Another choice is a 5-year, 11% bond that is currently selling at $1,090. Both bonds are AAA rated and both have a $1,000 face value.

If Thomas expects to hold the bonds to maturity, which bond will give him the highest yield? If Thomas expects to sell the bonds in one year and thinks market interest rates will fall to 7 percent, which bond would give him the highest holding-period return?

Answer: Yield to maturity - bond 1 - calculator solution = 1000 FV, 15 N, 80 PMT, 890 PV, solve for I = 9.4% Yield to maturity - bond 2 - calculator solution = 1000 FV, 5 N, 110 PMT, -1090 PV, solve for I = 8.7% The first bond would give Thomas a higher yield to maturity.

If interest rates fall to 7 percent, calculate the new price: Bond 1 = 1000 FV, 14N, 80 PMT, 7 I, solve for PV = $1087 Holding-period return = 80 + (1087 - 890) 80 + 197 890 = 890

= 277/890 = 31%

Bond 2 = 1000 FV, 4 N, 110 PMT, 7 I, solve for PV = 1,135 Holding-period return = 110 + (1135 - 1090) = 110 + 45 1090 1090 = 155/1090 = 14% The first bond, which has the longest term, will give Thomas the highest holding-period return.

203

Chapter 14

Mutual Funds, Investment Real Estate, and Other Investment Alternatives True-False What is a Mutual Fund?

1.

The net asset value of a mutual fund is calculated as the market value of assets less the market value of liabilities divided by the market value of the assets.

(f, moderate, p. 453) 2.

The increase in defined contribution retirement plans has directly contributed to the growth in mutual funds over the last few decades.

(t, moderate, p. 453) 3.

Since mutual funds are investment companies, federal regulations require less disclosure and reporting than is required of regular corporations.

(f, moderate, p. 455) 4.

The effective price of a mutual fund is generally the net asset value.

(t, easy, p. 456) 5.

The issuing company of an open end fund provides the only market for the shares as they are not traded on the secondary market.

(t, moderate, p. 456) 6.

The number of shares in an open-end fund can change every day as can the number of shares in an exchange-traded fund.

(t, moderate, p. 456) 7.

Closed-end funds trade primarily on the over-the-counter market.

(f, moderate, p. 456) 8.

There are more open-end funds than there are closed-end funds.

(t, moderate, p. 456)

205

9.

A unit investment trust is an unmanaged pool of investments that is often composed of common stock

(f, difficult, p. 457) 10.

The standard maturity for a unit investment trust is 20 years.

(f, moderate, p. 457) 11.

By law, a REIT must have a buy-and-hold strategy and have at least 100 stockholders.

(t, moderate, p. 457) 12.

Approximately 90 percent of all REITs are equity REITs.

(t, moderate, p. 457) 13.

One disadvantage of mutual funds is that their transactions cost per trade are likely to be substantially higher than what an individual investor would pay.

(f, moderate, p. 459) 14.

A front-end load is a sales charge that is paid at time of purchase.

(t, moderate, p. 460) 15.

12b-1 fees are charged to pay for operational expenses, such as printing and mailing, of a mutual fund.

(f, moderate, p. 461) 16.

Back-end loads generally decrease over time in order to provide an incentive for shareholders to stay in the fund.

(t, moderate, p. 461) 17.

A no-load fund will always have lower overall expenses than a loaded fund.

(f, difficult, p. 461) 18.

A more actively managed mutual fund will generally have lower expense ratio than a fund that is less active.

(f, moderate, p. 462)

206

19.

Different share classes within a mutual fund differ with regard to load, expenses and dividends paid.

(f, difficult, p. 462) Mutual Fund Investment Classifications 20.

Tax-exempt bond funds are broken down into two subcategories: national municipal bond funds and state municipal bond funds.

(t, moderate, p. 463) 21.

The primary objective of a growth fund is capital appreciation.

(t, easy, p. 463) 22.

Growth and income funds are primarily invested in defensive stocks.

(f, moderate, p. 463) 23.

A mutual fund that is invested in both stocks and bonds is called a value fund.

(f, moderate, p. 464) 24.

A mutual fund entirely invested in companies in the health care industry would be considered a sector fund.

(t, moderate, p. 464) 25.

An international fund invests in securities from countries outside the United States whereas a global fund invests in both U.S. and foreign securities.

(t, moderate, p. 464) 26.

A mutual fund that avoids securities issued by tobacco or alcohol companies or companies that are known polluters is known as a moral fund.

(f, moderate, p. 465) Selecting and Evaluating Mutual Funds 27.

When a single company operates several separately managed mutual funds with difference investment objectives, this is a fund family.

(t, easy, p. 468)

207

28.

Investing in funds from different fund families reduces market risk.

(f, moderate, p. 469) 29.

Buying mutual funds through a "financial supermarket" has the advantage of being able to purchase funds from different fund families.

(t, moderate, p. 469) 30.

Banks and insurance companies are not allowed to create mutual funds but they are allowed to sell shares in funds of other companies.

(f, moderate, p. 470) Real Estate Investment 31.

Buying a home represents a direct real estate investment.

(t, easy, p. 472) 32.

When you buy a home, you're allowed under tax laws to take a deduction for depreciation.

(f, moderate, p. 472) 33.

It is possible to have rental property that generates positive cash flow but has negative taxable income.

(t, difficult, p. 472) 34.

In general, real estate is not a good hedge against inflation.

(f, moderate, p. 473) 35.

Leverage occurs when you use borrowed funds to make an investment purchase that will earn more than the cost of inflation.

(f, moderate, p. 473) 36.

Relative to other types of investments, real estate investments have very high transaction costs.

(t, moderate, p. 474)

208

37.

Mortgage-backed securities are only indirectly related to real estate and are actually more related to the bond market.

(t, difficult, p. 475) Other Investment Alternatives 38.

Jewelry is considered a highly liquid and potentially high return market for investors.

(f, difficult, p. 476) 39.

The advent of the Internet has greatly increased the resale market for collectibles.

(t, moderate, p. 476) 40.

A put option gives the buyer the right to buy a security at a specified price in the future.

(f, easy, p. 477) 41.

The major advantage of a put or a call is being able to participate in the price movements of the underlying security without buying the security itself.

(t, moderate, p. 477) 42.

Due to their relatively low cost, financial derivatives are considered good choices for novice investors.

(f, moderate, p. 478)

Multiple Choice What is a Mutual Fund?

1.

The net asset value of a mutual fund is calculated as the:

a. b. c. d.

market value of assets - market value of liabilities / shares outstanding. market value of assets + market value of liabilities / shares outstanding. market value of assets - stockholders' equity / shares outstanding market value of assets + stockholders' equity / shares outstanding

(a, moderate, p. 453)

209

2.

ABC Fund has 9 million shares outstanding. The fund's portfolio is now valued at $300 million and the fund owes $18 million to the fund advisors and $5 million for rent and wages. What is the net asset value of the fund?

a. b. c. d.

$30.78 $31.33 $33.00 $34.78

(a, moderate, p. 453; solution: 300 - 23 = 277 million/9 million = $30.78) 3.

Recent mutual fund scandals have focused attention on the frequent buying and selling of mutual fund shares to exploit price discrepancies in securities of the fund. This practice is called:

a. b. c. d.

churning. market timing. fund rotation. switchbacking.

(b, moderate, p. 455) 4.

Mutual funds:

a. b. c. d.

are primarily geared for larger investors. can only be formed as corporations. have a fiduciary responsibility to fund investors. are subject to less stringent securities regulation than other types of securities.

(c, moderate, p. 455) 5.

The issuing company provides the only market for the shares in a (an):

a. b. c. d.

open-end fund. closed-end fund. exchange-traded fund. over-the-counter fund.

(a, moderate, p. 456)

210

6.

Which of the following statements is false regarding closed-end funds?

a. b. c. d.

Closed-end funds have a fixed number of shares.

There are far fewer closed-end funds than there are open-end funds.

Closed-end funds always trade at their net asset value.

Closed-end funds may trade on organized exchanges or in the over-the-counter market.

(c, moderate, p. 456) 7.

Which of the following statements is false regarding exchange-traded funds?

a. b. c. d.

Share prices on an exchange-traded fund are determined by market forces.

Many exchange-traded funds are designed to be index funds.

Exchange-traded funds are technically a closed-end fund. all of the above are true.

(c, moderate, p. 456) 8.

Which of the following statements regarding unit investment trust is false?

a. b. c. d.

Unit investment trust owners are issued redeemable trust certificates.

The major type of asset in these trusts is U.S. Treasury bonds.

Unit investment trusts are essentially unmanaged investments.

The term of a unit investment trust depends on the maturities of the securities held.

(b, difficult, p. 457) 9.

Which of the following statements regard REITs is false?

a. b. c. d.

REITs are a type of closed-end investment company.

Equity REITs make direct investments in rental and commercial property.

REITs, like UITs, have a limited lifespan.

REITs result in higher tax obligations for investors.

(c, difficult, p. 457)

211

10.

Which of the following is not an advantage of investing in a mutual fund?

a. b. c. d.

professional money management diversification reduced transaction costs decreased tax liability

(d, moderate, p. 458-460) 11.

Which of the following is not a fee paid directly by mutual fund shareholders?

a. b. c. d.

an exchange fee a settlement fee a redemption fee an account maintenance fee

(b, moderate, p. 460) 12.

Which of the following is not one of the expenses of a mutual fund?

a. b. c. d.

annual brokerage expenses annual distribution expenses annual management fees operational expenses

(a, moderate, p. 461) 13.

Which of the following statements regarding load mutual funds is true?

a. b. c. d.

The load can be as high as 10 percent of the purchase price of the shares.

The most common type of load is a front-end load.

A back-end load is officially known as a redemption fee.

Load funds make more sense for active investors than buy-and-hold investors.

(b, difficult, p. 4671 14.

A mutual fund fee that is designed to compensate sales professionals for marketing and advertising the fund is a:

a. b. c. c.

load. promotion fee.

11b-1 12b-1

(d, moderate, p. 461)

212

15.

A mutual fund that does not charge either a front-end or back-end load:

a. b. c. d.

is a no-load fund. is a unit fund. does not charge an annual management fee either. always has a higher return than a load fund.

(a, easy, p. 461) 16.

Which of the following statements regarding the expense ratio of mutual funds is false?

a. b. c. d.

All else equal, the lower this ratio, the better.

The expense ratio can be as high as 5 percent.

An index fund would be expected to have a relatively low expense ratio.

Expense ratios should be considered in light of the fund's performance.

(b, moderate, p. 462) 17.

If a mutual fund offers more than one share class, this means:

a. b. c. d.

each share class invests in different securities. the mutual fund is more diversified. share classes differ in load and expenses. this is a fund family.

(c, moderate, p. 462) Mutual Fund Investment Classifications 18.

A mutual fund that invests in a mix of equity and fixed income securities is a:

a. b. c. d.

growth and income fund. value fund. convertible fund. hybrid fund.

(d, moderate, p. 463)

213

19.

Which of the following is not a type of taxable bond fund?

a. b. c. d.

high-yield fund total return fund strategic income fund world bond fund

(b, moderate, p. 463) 20.

Which type of mutual fund tends to be invested in companies with relatively low P/E ratios and good growth potential?

a. b. c. d.

growth fund growth and income fund balanced fund value fund

(d, moderate, p. 464) 21.

A mutual fund whose entire portfolio is invested in stocks of financial service companies would be considered a(an):

a. b. c. d.

undiversified fund. sector fund. income fund. life-cycle fund.

(b, moderate, p. 464) 22.

Which of the following statements concerning index funds is true?

a. b. c. d.

Index funds always buy all the securities in the index they are following.

Index funds generally outperform the index they are imitating.

Index funds' are expected to be very low risk investments.

Index funds generally have minimal trading costs.

(d, moderate, p. 464-465)

214

Selecting and Evaluating Mutual Funds 23.

Which of the following is not an advantage of buying fund shares through a financial supermarket?

a. b. c. d.

ability to purchase in larger increments ability to switch money from fund to fund easily consolidated financial report ability to purchase from several fund families

(a, difficult, p. 469) 24.

What federal law gave banks and insurance companies the right to create and market mutual funds?

a. b. c. d.

Securities Acts Amendments of 1975 Investment Company Act of 1940 Financial Institutions Reform, Recovery and Enforcement Act of 1989 Financial Services Modernization Act of 1999

(d, moderate, p. 470) Real Estate Investment 25.

Which of the following is not an advantage of investing in real estate?

a. b. c. d.

increased diversification less volatile returns greater liquidity added value to an investment portfolio

(c, moderate, p. 472-473) 26.

A major factor if the housing market that might cause a "housing bubble" in the next decade is:

a. b. c. d.

rising interest rates increased home sales by baby boomers increased home purchases by Generation Xers. deflation

(b, difficult, p. 472)

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27.

When you invest in real estate through a trustee, this is known as:

a. b. c. d.

a unit investment trust. a real estate derivative. an indirect real estate investment. a blind transaction.

(c, easy, p. 475) 28.

Which of the following is not a disadvantage of a direct real estate investment?

a. b. c. d.

lack of liquidity reduced diversification increased taxes high transactions costs

(c, moderate, p. 474) 29.

A real estate business arrangement in which several investors put up funds to buy a commercial property with someone else managing the property is known as:

a. b. c. d.

a blind transaction. a limited partnership. a unit investment trust. a mortgage-backed security.

(b, moderate, p. 474) 30.

A government agency that is very involved in the mortgage-backed security market is the:

a. b. c. d.

Federal Land Bank Bank for Cooperatives Government National Mortgage Association Federal Association of Home Mortgages

(c, easy, p. 475)

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Other Investment Alternatives 31.

Investing in previous metals

a. b. c.

generally increases the return of a diversified portfolio. can only be achieved by a direct investment. usually requires the payment of commissions on all transactions of at least 2 percent. must be done through the Treasury Department.

d.

(c, difficult, p. 476) 32.

Which of the following statements concerning financial derivatives is true?

a.

Investments in financial derivatives are considered high-return, low-risk investments.

Their value is based on the price movements of an underlying security or commodity.

These investments are a good way to add diversification to a stock and bond portfolio. all of the above are true.

b. c. d.

(b, moderate, p. 477-478) 33.

A transaction involving financial derivatives that attempts to offset losses in value of other securities held is known as:

a. b. c. d.

speculating. arbitrage. hedging. short selling.

(c, easy, p. 478)

217

Essay Questions 1.

What are the major differences between an open-end and closed-end fund?

Open-end funds, known as mutual funds, are the most common type of investment company. Unlike other companies, they are constantly selling share of stock and also redeem their own shares. The market price of a share of an open-end fund is a calculated price, known as the net asset value. There is no secondary market for mutual fund shares as the issuer is the only buyer for investors who wish to sell their shares. Unlike open-end funds, closed-end funds have a set number of shares just as other corporations. The shares of a closed-end fund can trade on a stock exchange or in the over-the-counter market just like the shares of regular corporations. The closed-end fund does not buy back its own shares as a mutual fund does. In addition, the price of a closed-end fund share is not a calculated price but is determined by market forces, again just as are the prices of other stocks. There are considerably fewer closed-end funds than there are open-end funds.

2.

Discuss the characteristics of load and no-load funds. What kind of investor would be best served by a load fund? What kind of investor would be better off with a no-load fund?

Load funds charge a sales charge to mutual fund investors to provide investors access to professional advice from brokers and financial planners. Most load funds are charge a front-end load, which is a sales charge charged at the time of purchase. Some load funds charge a back-end load, which is charged on shares sold back to the fund within a certain period of time. A back-end load is also known as a contingent deferred sales charge. The load can be as high as 8.5 percent of the purchase price but most load funds charge a lower percent. Noload funds, as the name implies, charges no commission at the time of purchase.

Since you are gaining professional advice, load funds make sense for investors who need more advice and also plan on a buy-and-hold strategy. If you stay in the fund a long time, the loading fee usually becomes insignificant. But if you are an active investor and trade your funds frequently, you would be better off in a no-load fund as your loading fee would reduce the amount of your investment and would lower your return. In the short run, you may not have sufficient return to offset the loading fee.

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3.

What is a value fund? How does it compare to a growth fund?

A value fund is one that invests in stocks of companies that are undervalued, which means the stock price is currently less than the company's potential. If the market starts to value the company's stock as expected, the stock price will rise and the fund will have a capital gain. The companies invested in are companies with sound financial positions and good fundadmentals. Often these companies are selling at lower price/earning ratios than growth companies. A value fund would thus generally be considered less risky than growth fund.

Mini-Case Sam is considering investing in a mutual fund. He is looking at Friendly Fund, which is a no-load and has a NAV of $21, and Funny Fund, which is a load fund with a NAV of $24. The loading fee on Funny Fund is 4 percent. If Sam thinks Friendly Fund will average a 10 percent increase in NAV over the next 5 years and Funny Fund will average a 11 percent increase in NAV, what will be the expected NAVs of each fund at the end of 5 years? If Sam decides to sell his shares at that time, what would be his expected holding-period return on each fund, assuming no dividends paid. Which fund should Sam buy, based on your calculations? If Sam has to sell out in only 8 months and the beginning NAVs had not changed but each fund paid a $.50 dividend per share, would this change your recommendation? Why? Answer: Friendly Fund = using financial calculator = 21 PV, 5 N, 10 I, 0 PMT, FV = $33.82. expected NAV = $33.82 Funny Fund = 24 PV, 5 N, 11 I, 0 PMT, FV = $40.44 = expected NAV Expected HPR = Friendly Fund = 33.82 - $21 $21 Expected HPR = Funny Fund = 40.44 - 24.96* 24.96 * purchase price = 24 (1.04) = 24.96

=

12.82/21 = 61%

= 15.48/24.96 = 62%

Based on the expected HPR, Funny Fund is the better choice If Sam only receives a $.50 dividend as his return, he would be better off in Friendly Fund. Since Funny Fund's loading fee of $.96 is greater than the $.50 dividend, Sam would not have a positive return if he invested in Funny Fund.

219

Chapter 15

Saving for Distant Goals: Retirement and Education Funding True-False Estimating Retirement Income Needs 1.

The most common retirement age has decreased in recent years to 59.

(f, moderate, p. 487) 2.

Inflation is a major reason why many people underestimate the amount of money needed for retirement.

(t, moderate, p. 488) 3.

A majority of studies have shown that expenses in retirement are approximately 70 percent of preretirement expenses.

(f, moderate, p. 489) 4.

The replacement ratio method is considered a more accurate method than the adjusted expense method when estimating retirement income needs.

(f, moderate, p. 490) 5.

Since most retirement income is tax exempt, there is no need to consider the effect of taxes when estimating retirement needs.

(f, easy, p. 490) 6.

More than two-thirds of all retirees get at least 90 percent of their retirement income from Social Security.

(f, moderate, p. 491) 7.

Since women, on average, earn less than men and have shorter working careers than men, they tend to have lower Social Security benefits than men.

(t, moderate, p. 492)

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8.

If your company retirement plan considers how long you have worked for the company and your final salary in determining your retirement income, you are in a defined contribution plan.

(f, moderate, p. 493) 9.

A 401(k) is a type of defined contribution retirement plan.

(t, easy, p. 493) 10.

Social Security is a type of defined contribution plan.

(f, easy, p. 494) 11.

After reaching a set maximum of income, which is increased annually with inflation, Social Security and Medicare taxes are not deducted from workers' paychecks.

(f, moderate, p. 494) 12.

Under the Social Security system, payroll taxes from previous workers go toward paying benefits of current beneficiaries.

(f, moderate, p. 494) 13.

Social Security benefits are adjusted for inflation which ensures that a retiree's purchasing power will not decline over time.

(t, moderate, p. 495) Establishing a Monthly Savings Target 14.

If you are over 50, you are allowed to make larger annual contributions to your retirement accounts in order to catch up with younger workers.

(t, moderate, 500) 15.

Double-income couples without children, due to their larger combined income, typically have more wealth than comparable households with children.

(f, moderate, difficult, p. 500)

222

Personal Retirement Savings Options 16.

The contribution limit for a Roth IRA is less than for a traditional IRA but the IRA has higher income limits.

(f, difficult, p. 502) 17.

Unlike traditional IRAs, Roth IRAs do not have a tax deduction for contributions even if you are not participating in an employer retirement plan.

(t, moderate, p. 502) Preparing for Retirement Payouts 18.

If you purchase an annuity that will pay you $10,000 per year for 10 years, you have purchased a single life annuity.

(f, moderate, p. 503) Funding Your Children's Education 19.

In recent years, the rise in college tuition has greatly outpaced the rate of inflation.

(t, moderate, p. 507) 19.

Coverdell Education Savings Accounts allow pre-tax contributions of $2,000 per year and tax-free withdrawals.

(f, moderate, p. 507) 20.

A Section 529 plan, which may be offered by both the states and federal government, can be either a prepaid tuition plan or a savings plan.

(f, difficult, p. 507) 21.

The Hope Scholarship allows a tax deduction of up to $5,000 of qualified college expenses in the first two years of college.

(f, moderate, p. 509)

223

Multiple Choice Estimating Your Retirement Income Needs 1.

Many people are not very well prepared for retirement because they:

a. b. c. d.

overestimate inflation. are myopic. focus too much on long-term goals. fail to focus on the averages.

(b, moderate, p. 488) 2.

Which of the following methods for estimating retirement income needs assumes retirement expenses will be some fixed proportion of your preretirement needs?

a. b. c. d.

replacement ratio method fixed ratio method adjusted expense method percentage adjustment method

(a, easy, p. 489) 3.

If you expect to retire in 25 years and have estimated that you will need $45,000 in today's dollar, how much will you need in the first year of retirement assuming a 5 percent average inflation rate?

a. b. c. d.

$152,386 $154,670 $155,853 $156,658

(a, moderate, p. 490; calculator solution, 45000 pv, 25 n, 5 interest rate, 0 pmt, solve for FV = $152,386) 4.

Which of the following methods for estimating retirement income is considered the most accurate?

a. b. c. d.

replacement ratio method adjusted expense method fixed ratio method percentage adjustment method

(b, moderate, p. 491)

224

5.

Which of the following is not a major source of retirement income?

a. b. c. d.

Social Security employer-sponsored retirement plans inheritance employment income

(c, easy, p. 491) 6.

Which of the following is an example of occupational segregation?

a. b. c. d.

Younger workers are more likely to hold high-tech jobs.

College-educated workers are more likely to hold professional jobs.

Immigrants are more likely to hold low-paying jobs.

Women are more likely to work for employers that do not provide retirement benefits.

(d, difficult, p. 492) 7.

If your retirement benefit is based upon years of service and a percentage of your highest salary, you are enrolled in a:

a. b. c. d.

defined benefit plan. defined contribution plan. fixed salary plan. variable salary plan.

(a, easy, p. 493) 8.

If your retirement benefits will be greatly affected by the rate of return earned on assets invested, this is a:

a. b. c. d.

defined benefits plan. defined contribution plan. fixed salary plan. variable salary plan.

(b, easy, p. 494)

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9.

To reach fully insured status under Social Security, you must have participated in the system for at least:

a. b. c. d.

20 quarters.

30 quarters.

40 quarters.

50 quarters.

(c, easy, p. 494) 10.

Which of the following statements is false regarding divorcee benefits under Social Security?

a. b. c.

Divorcees can receive 50 percent of their ex-husband benefits if they qualify.

In order to qualify for benefits, the marriage must have lasted at least 10 years.

If a man has more than one ex-wife, only his most recent ex-wife can receive benefits.

If you remarry, you will not be eligible for a divorcee benefit.

d.

(c, moderate, p. 495) 11.

Which of the following is the average of a person's 35 highest years of monthly earnings that is used in determining Social Security benefits?

a. b. c. d.

MIA PIA IMA AIME

(d, moderate, p. 495) 12.

Which of the following is not one the causes of the projected insolvency of Social Security?

a. b. c. d.

Higher incomes leading to higher benefits People living longer The baby boom generation is larger than generation following it all of the above are true

(a, difficult, p. 496)

226

Establishing a Monthly Savings Target 13.

Which of the following is not one of the reasons it is somewhat difficult to determine the total wealth needed at retirement?

a. b. c. d.

needs change the number of years in retirement is uncertain rates of return vary inflation changes

(c, moderate, p. 498) 14.

You plan to retire in 15 years. If your projected annual retirement income shortfall is $30,000 and you estimate you can earn 7 percent on your investments, how much do you need to have at retirement if you plan to live on investment income alone?

a. b. c. d.

$82,770 $210,000 $428.571 $753,870

(c, moderate, p. 499; solution: 30000/.07 = 428,571) 15.

Which of the following is not one of the recommended tips for retirement saving?

a. b. c. d.

Borrow in order to invest young Maximize your pretax contributions Maximize your employer match Don't borrow against your retirement plan assets

(a, moderate, p. 500) 16.

Which of the following demographic groups tends to be the best prepared for retirement?

a. b. c. d.

DINKs DIPPIEs YUPPIEs TWINKIEs

(b, difficult, p. 500)

227

17.

Tom starts investing $250 per month at age 20. Bob starts investing $250 per month at age 30. Both Tom and Bob are the same age and can each earn 8 percent on their invested funds. If both retire at age 60, how much more will Tom have in his retirement account compared to Bob?

a. b. c. d.

$45,737 $372,590 $500,162 $872,752

(c, difficult, p. 500; calculator solution: 250 pmt, 0 pv, 8/12 interest rate, 480 n, FV for Tom = 872,752; 250 pmt, 0 pv, 8/12 interest rate, 360 n, FV for Tom = $372,590.

Difference = $872,752-$372,590 = 500,162) Personal Retirement Savings Options 18.

As compared to a traditional IRA, a Roth IRA:

a. b. c. d.

is easier to set up. has a lower minimum age for tax-free withdrawals. allows investments to accumulate tax-free; a traditional IRA does not. allows deductible contributions: a traditional IRA does not.

(c, moderate, p. 502) Preparing for Retirement Payouts 19.

An annuity that pays an equal annual amount until death is a (an):

a. b. c. d.

annuity for a specific term. single life annuity. fixed annuity. variable annuity.

(b, moderate, p. 504)

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20.

If you don’t have enough money to retire, you may need to:

a. b. c. d.

increase savings rely on family rely on public assistance all of the above

(d, moderate, p. 504) Funding Your Children's Education 21.

John and Mary have a 4 year-old son. Public college tuition is $12,000 today and inflation is rising at 4 percent per year. How much will college tuition be when John and Mary's son enters college in 14 years?

a. b. c. d.

$13,170 $20,267 $20,780 $24,188

(c, moderate, p. 506; calculator solution: 12000 pv, 4 I, 14 n, 0 pmt, FV = 20,780) 22.

Which of the following education savings plan allows a maximum contribution of $2,000 per year per child?

a. b. c. d.

Coverdell Education Savings Account Section 529 tuition plan Section 529 savings plan all have the same maximum contribution

(a, moderate, p. 507) 23.

Which of the following education savings plans may reduce eligibility for financial aid?

a. b. c. d.

Coverdell Education Savings Account Section 529 tuition plan Section 529 savings plan all may reduce eligibility for financial aid

(d, moderate, p. 509)

229

24.

Which of the education savings plan has a maximum age by which to use the funds?

a. b. c. d.

Coverdell Education Savings Account Section 529 tuition plan Section 529 savings plan none have a maximum age

(a, moderate, p. 509) 25.

A tax credit for eligible college expenses incurred during the first two years of college is the:

a. b. c. d.

Coverdell Education credit Hope Scholarship tax credit Lifetime Learning tax credit Post-secondary tax credit

(b, moderate, p. 509)

Essay Questions 1.

What are some of the reasons women, in general, have lower retirement income than men?

Much of the differences between the retirement income of men and women is the result of different labor market experiences. Women earn less, on average, than men and have shorter careers. This leads to lower Social Security benefits. In addition, there may some occupational segregation that occurs. Occupational segregation occurs when women are more likely to work in firms and industries that have employer-sponsored retirement plans. All these factors cause women to have lower retirement income, on average, than men.

230

2.

Who is eligible for spousal benefits under Social Security? Discuss the size of the spousal benefit and any requirements.

A spouse of a fully insured worker is eligible for spousal benefits. Spousal benefits give the spouse 50 percent of their insured spouse's benefit. If a person has qualified for Social Security benefits for their own earnings, they can still choose to get 50 percent of their spouse's benefit if that would be greater than the benefit they would receive based on their own earnings. In addition, if the insured spouse dies, the surviving spouse then receives 100 percent of the deceased spouse's benefit. In the case of divorce, divorcees are eligible to receive 50 percent of their divorced spouse's benefit as long as the marriage lasted at least 10 years and the non-insured spouse did not remarry after the divorce.

3.

What are the major differences between a traditional IRA and a Roth IRA? Contributions to traditional IRAs are tax deductible for those not in an employersponsored retirement plan while contributions to a Roth IRA are never tax deductible. Roth IRAs are funded by after-tax dollars. The earnings on a traditional IRA are tax deferred regardless of the tax-deductibility of contributions but there are penalties for early withdrawal. The earnings on a Roth IRA are tax free if the taxpayer has reached 59 1/2 years or is using the proceeds for qualified education, medical expenses or for first-time home expenses. The income level for qualified contributions to a Roth IRA is higher than with a traditional IRA.

Mini Case Pam Potter, 22, recent college graduate and has accepted a job with a large bank holding company as a financial analyst. Her starting salary is $29,000. Pam has been told that average raises in the firm are 4 percent per year. The bank has a defined contribution retirement plan that employees contribute 6 percent of their salary into and the company matches the employee contribution.

If Pam stays with the bank till she retires at age 62, what will be her ending salary? Assuming her average salary over the 40-year period is $85,000, what would be the average amount contributed into Pam's retirement account by both Pam and the bank annually?

If Pam earns an average annual return of 11 percent on her retirement funds, how much would Pam have in her retirement account at age 62 based on the average annual contribution calculated above? Recalculate if the average contribution is only $7,000, she only earns 6 percent on her retirement funds and retires after 30 years? What do these two amounts tell us about retirement planning assumptions?

231

Answer: Pam's ending salary (calculator solution) = 29000 PV, 40 N, 4 I, 0 PMT, solve for FV = $139,230.

If Pam's average salary is $85, 000, annual contributions to her retirement account are: .12 x 85,000 = $10,200.

Based on average annual contributions of $10,200, Pam will have $5,934,626 in 40 years when she retires. (calculator solution: 10200 PMT, 40 N, 0 PV, 11 I, solve for FV) If her contributions are $7,000 and she retires after 30 years and only earns 6 percent, she will have $553,407. (7000 PMT, 30 N, 6 I, 0 PV, solve for FV) The wide difference between the two retirement amounts is due to the different assumptions. Therefore, making the right assumption is key to getting an accurate picture of future retirement income. It is generally better to be more conservative in assumptions than too optimistic.

232

Chapter 16

Life Insurance and Long-Term Care Planning True-False Life Insurance and Your Financial Plan 1.

Life insurance is designed to replace the income lost by premature death.

(t, easy, p. 521) 2.

Compared to property insurance policies, life insurance policies generally have a longer term.

(t, moderate, p. 521) 3.

As you survive each successive year, your life expectancy, measured as expected age at death, decreases.

(f, moderate, p. 524) 4.

A disadvantage of the income-multiple method to determining how much life insurance is needed is its complexity.

(f, moderate, p. 526) 5.

The most important category of needs addressed in a needs analysis is the deathrelated cost.

(f, moderate, p. 527) 6.

In estimating life insurance needs, the rise in household expenses due to inflation is generally cancelled out by the rate of return earned on investments.

(t, difficult, p. 529) 7.

Young single persons should buy larger amounts of insurance as premiums are lower than for older persons.

(f, moderate, p. 529)

233

Selecting a Life Insurer and Type of Policy 8.

Term life insurance allows you to buy a large amount of insurance with a smaller premium than whole life insurance.

(t, moderate, p. 531) 9.

The right to renew a term life insurance policy without additional proof of insurability is known as permanent life protection.

(f, moderate, p. 532) 10.

If a term policy is convertible, the insured has the right to convert to permanent life insurance for the same premiums.

(f, moderate, p. 532) 11.

The rate of return on most permanent life policies is comparable with rates earned on other investments.

(f, moderate, p. 532) 12.

If a whole life insurance policy has premiums paid over the insured's whole life, this is an ordinary life insurance policy.

(t, moderate, p. 532) 13.

Both universal life and variable life insurance allow policyholders to direct the investment component of their policies.

(t, easy, p. 534) 14.

Stock life insurance companies pay a dividend to policyholders at the end of the year.

(f, moderate, p. 535-536) Reading Your Policy 15.

Nonforfeiture laws require that insurers must refund a fair amount of the cash value of permanent life insurance policies if held a minimum number of years.

(t, moderate, p. 539)

234

16.

Most life insurance policies do not pay out on policies if the insured commits suicide.

(f, moderate, p. 539) 17.

Many life insurance policies double the amount of the death benefit if the insured dies as result of an accident.

(t, moderate, p. 540 Planning for Long-Term Care Costs 18.

Since only about one-tenth of all people require nursing home care, long-term care insurance is not generally recommended.

(f, moderate, p. 542) 19.

Meals on Wheels is a Medicare service that delivers regular meals to elderly people.

(f, moderate, p. 544) 20.

As more insurance companies enter the long-term care insurance market, many experts believe rates will fall.

(t, moderate, p. 545) 21.

Long-term care insurance typically reimburses you for specific expenses.

(f, moderate, p. 545) 22.

Most long-term care insurance includes a waiting period which is the number of days you receive and pay for care before the insurance begins to pay for care.

(t, moderate, p. 546)

235

Multiple Choice Life Insurance and Your Financial Plan 1.

Life insurance is based on the concept of:

a. b. c. d.

diversification. actuarial science. risk pooling. mortality intermediation.

(c, easy, p. 521) 2.

In order to account for the chance that their estimate of your mortality risk is inaccurate, insurers add a:

a. b. c. d.

risk charge. actuarial premium. mortality fee. underwriting fee.

(a, moderate, p. 521) 3.

Which of the following is not a benefit of life insurance?

a. b. c. d.

tax savings protection from inflation large amount of coverage protection from creditors

(b, moderate, p. 522) 4.

A standardized mortality table shows:

a. b. c. d.

life expectancy of those who live to each age yearly probabilities of dying deaths per 1,000 all of the above are shown

(d, moderate, p. 523)

236

5.

Which of the following is not a good reason to buy life insurance?

a. b. c. d.

hedge against inflation preserve household wealth cover business losses in the event of owner’s death replace income for surviving dependents

(a, moderate, p. 525) 6.

Which of the following statements is generally true regarding life insurance coverage?

a. b. c. d.

The lower your wealth, the less life insurance you need.

The more dependents you have, the lower amount of life insurance you need.

You will need more life insurance during the child-rearing years than later on.

If your spouse doesn't work, you need less life insurance.

(c, moderate, p. 525) 7.

The simplest method for determining how much life insurance is needed is the:

a. b. c. d.

financial needs method. mortality multiplier method. percent of debt method. income-multiple method.

(d, moderate, p. 526) 8.

A weakness of the income-multiple method used to determine life insurance needs is its assumption that:

a. b. c. d.

"no two people are alike." "one size fits all." "a bird in the hand is better than two in the bush." "biggest is best."

(b, moderate, p. 526) 9.

Under the financial needs method, the most important category of needs are:

a. b. c. d.

costs at death. lump sum needs. household maintenance. attorney fees.

(c, moderate, p. 527)

237

10.

Which of the following would not be eligible for survivor benefits under Social Security?

a. b. c. d.

A 17-year old son A 40-year old wife with a 10-year old daughter A 59-year old wife all would receive survivor benefits

(c, difficult, p. 527) Selecting a Life Insurer and Type of Policy 11.

If you own a ______________policy, you are never allowed to choose how your premiums will be invested. a. b. c. d.

whole life insurance universal life insurance variable life insurance term life insurance

(a, moderate, p. 533) 12.

The major advantage of term life insurance over whole life insurance is that:

a. b. c. d.

term life is available without proof of insurability; whole life is not. term life always has a constant premium; whole life does not. term life tends to have lower premiums than whole life. term life has a choice of investments; whole life does not.

(c, easy, p. 531) 13.

A term life insurance policy that can be extended for another term without the insured taking a medical exam has:

a. b. c. d.

convertibility. decreasing protection. permanent life protection. guaranteed renewability.

(d, moderate, p. 532)

238

14.

If your children are growing up and leaving home, it might make sense to have:

a. b. c. d.

whole life insurance. decreasing term insurance. universal life insurance. variable life insurance.

(b, difficult, p. 532) 15.

The value of the investment component of a permanent life insurance policy is known as the:

a. b. c. d.

book value. market value. cash value. liquidation value.

(c, easy, p. 532) 16.

If a whole life insurance policy requires premiums be paid only for a specified period of time and then the policy is paid up, this is known as:

a. b. c. d.

paid-up whole life. limited payment life insurance. decreasing term insurance. universal life insurance.

(b, moderate, p. 532) 17.

Which of the following is not one of the criticisms of whole life insurance?

a. b. c. d.

the higher tax rate than on comparable investments. relatively inflexible premium payments. generally low investment returns. all of the above are criticisms of whole life insurance

(a, difficult, p. 533)

239

18.

Which of the following has a variable premium that adjusts for the mortality, expense and investment experience of the insurer?

a. b. c. d.

whole life insurance universal life insurance current assumption whole life insurance variable life insurance

(c, moderate, p. 534) 19.

Which of the following types of life insurance is the riskiest for the insured?

a. b. c. d.

term life insurance whole life insurance universal life insurance variable life insurance

(d, difficult, p. 534) 20.

Life insurance policies issued by a mutual company are called:

a. b. c. d.

convertible policies. participating policies. shareholder policies. partner policies.

(b, moderate, p. 536) 21.

Which of the following is not one of the characteristics you should consider when choosing a life insurance agent?

a. b. c. d.

reputation education fees responsiveness

(c, moderate, p. 537)

240

22.

Which of the following is an ethical life insurance practice?

a. b. c. d.

suggesting you convert a term policy into a whole life policy using unrealistic rates of return in determining expected cash value encouraging replacement of an existing cash-value policy with a new one. suggesting borrowing from a whole life policy to buy a variable annuity.

(a, difficult, p. 537) Reading Your Policy 23.

For flexible-premium policies, the usual grace period for missed payments is:

a. b. c. d.

one month. two months. three months. four months.

(b, moderate, p. 538) 24.

A policy loan on a cash value life insurance policy

a. b. c. d.

automatically terminates the policy. usually has an interest rate similar to other market interest rates. includes a set schedule for repayment.

In the event of death, the death benefit is reduced by the outstanding loan balance.

(d, difficult, p. 538) 25.

Items such as the name of the insurance company, the name of the insured, the policy issue date and face amount of the policy are normally listed:

a. b. c. d.

in a cover letter accompanying the policy. on a policy declaration page. in a writ of certiorari. on a policy prospectus.

(b, moderate, p. 538)

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26.

Without __________ insurers might be tempted to do very limited investigations before issuing a policy.

a. b. c. d.

a convertibility clause guaranteed renewability an incontestable clause a nonforfeiture clause

(c, moderate, p. 538) 27.

Which of the following require that if your contract lapses before maturity but after some stated time, the insurer must refund an amount of the cash reserve?

a. b. c. d.

incontestable clause nonforfeiture laws reinstatement provisions convertibility clause

(b, moderate, p. 539) 28.

An option that allows terminally ill policyholders to receive a portion of their life insurance proceeds before their death is known as:

a. b. c. d.

a right to life provision. death waiver. accelerated benefits. viatical settlement

(c, moderate, p. 540) 29.

Which of the following is not one of the common settlement options for beneficiaries of life insurance policies?

a. b. c. d.

lump sum periodic interest only income for life lump sum plus interest

(d, moderate, p. 541)

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Planning for Long-Term Care Costs 30.

Medical and personal care for persons with an extended illness or disability not provided in a hospital is known as:

a. b. c. d.

viatical care. residual care. long-term care. hospice care.

(c, easy, p. 542) 31.

Under Medicare, nursing home coverage is limited to:

a. b. c. d.

30 days.

60 days.

100 days.

180 days.

(c, moderate, p. 544) 32.

Long-term care insurance

a. b.

should always be bought when one is young in order to get the lowest premium. has been around a long time but is receiving more attention now due to an increase in the number of elderly. is overpriced. is a growing product area and it is expected that more insurers will be entering the long-term care insurance market in the future.

c. d.

(d, difficult, p. 544-545) 33.

Which of the following is not one of the features you should consider before buying long-term care insurance?

a. b. c. d.

convertible option services covered inflation protection benefit period

(a, moderate, p. 545-546)

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34.

Which of the following is not a typical waiting period for long-term care insurance?

a. b. c. d.

30 60 100 120

(d, difficult, p. 546)

Essay Questions 1.

How do factors such as the age and number of dependents, your age and life-cycle stage, spouse's earning capacity and financial wealth and obligations affect how much life insurance you need? Be specific.

The more children you have and the younger they are, the more life you need to take care of them until they reach maturity. Generally, you need more life insurance if you are a young married person in the child-rearing stage of your life.

If your spouse has a low earnings capacity, you will need more insurance to take care of your spouse's needs. The lower your financial wealth, the more insurance you need to offset the lack of assets and wealth. Conversely, the more the obligations you have, the more insurance you need to cover these financial obligations in case of your death.

2.

What is term life insurance and its major advantage? What is guaranteed renewability and what are the limits of guaranteed renewability?

Term life insurance provides death protection for a set number of years and does not provide any cash or surrender value. The major advantage of term life is its lower premiums compared to whole life or permanent life policies. You can buy a relatively large amount of insurance for a relatively small premium. A relatively common provision of term policies are guaranteed renewability clauses which allow the policyholder to renew the policy when the term is over for another term of the same length without additional proof of insurability. With each renewal, the premium is raised to reflect the additional mortality risk. The major limit of guaranteed renewability is age. Most policies only allow for renewal until age 65 or 70.

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3.

What are nonforfeiture laws? What types of life insurance policies would be covered under nonforfeiture laws? What options do you have with regard to how you receive your cash reserve amount?

Nonforfeiture laws require the payment of a portion of a cash reserve account if the policyholder has been in the policy some minimum amount of time but has let the policy lapse. Permanent life policies build up a cash reserve in the early years and would be subject to these laws. Policyholders have several options as to receiving the cash amount. They can just take the cash or accept a paid-up policy with the face value that the cash amount would purchase. They can also accept a term life policy with the same face value as the lapsed policy but for a term that the cash amount would purchase. And finally, the policyholder can accept an annuity for retirement income based on the cash amount.

Mini Case Larry Lawson has gotten a quote for term insurance with a 5-year term and face value of $100,000 of $150 per year premiums. He has also gotten a quote on a permanent life policy with the same face value with annual premiums of $910. If Larry buys the term policy and invests the difference between the term policy premium and the permanent life policy, how much will he have at the end of five years if he can earn 9 percent on his invested funds? Would he continue to earn this much every five years? Why or why not? What other factors beside cost should Larry consider before making his decision?

Answer: 910 - 150 = 760 annual difference. Solution: 760 PMT, 9 I, 5 N, 0 PV, FV = $4,548.

Larry would not continue to earn this much every 5 years as his premiums on the term policy would increase with each renewal so the difference would be less.

Before deciding which policy to purchase, Larry should look at the term policy to make sure it has guaranteed renewability in case he wants to renew the policy at the end of the 5 year term without proof of insurability. If his health is in question, he may be better off with a permanent policy that he does not have to renew. He should also consider his stage in the life cyle an d if he really needs insurance his entire life. He should also consider his ability to actually invest the difference. He may need the forced savings of a permanent life policy.

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Chapter 17

Estate Planning True-False What is Estate Planning?

1.

The process of developing a plan for what will happen to your wealth and dependents when you die is known as probate planning.

(f, easy, p. 555) 2.

State inheritance taxes are generally a higher cost than federal estate taxes.

(f, moderate, p. 556) 3.

Births, deaths and even change of state of residence will often cause a revision in estate plans.

(t, easy, p. 557) Key Components of an Estate Plan 4.

A person designated to receive something from an estate after a person's death is a testator.

(f, moderate, p. 557) 5.

If you die without a valid will and have no living relatives, all your assets become the property of the state government through a legal process known as probate.

(f, moderate, p. 558) 6.

A living will is designed to state a person's medical preferences if that person is unable to make medical decisions due to illness or disability.

(t, moderate, p. 558) 7.

Both wills and letters of last instruction should be prepared by an attorney since they are legal documents.

(f, moderate, p. 559)

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Wills and Other Important Documents 8.

A person designated to carry out the provisions of a will is known as an executor.

(t, easy, p. 561) 9.

Once children reach the age of majority, they legally become adults and are entitled to receive any inheritance left to them.

(f, moderate, p. 562) 10.

In general, witnesses to a will should not be people who are named in the will as beneficiaries.

(t, moderate, p. 563) 11.

A legal amendment to a will is known as a rider.

(f, moderate, p. 563) 12.

In community property states, any property owned by one spouse is assumed to be owned by both spouses, regardless of who acquired it or when it was acquired.

(f, moderate, p. 564) 13.

Leaving a Roth IRA to your youngest beneficiary will maximize its tax benefits.

(t, moderate, p. 564) 14.

The best place to keep wills and powers of attorney is in a safe-deposit box.

(f, moderate, p. 565) Estate and Gift Taxes 15.

Under 2004 tax law, you and your spouse can give up to $11,000 per person per year tax-free with no limits on the number of people you gift.

(t, moderate, p. 566) 16.

There is no federal estate tax due in 2005 for estates of less than $1.5 million.

(t, moderate, p. 567)

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17.

Your gross estate is reduced by funeral costs, settlement expenses, and charitable bequest to arrive at your adjusted gross estate.

(f, difficult, p. 568) Reducing Taxes Through Trusts and Gifts 18.

A testamentary trust is established through the provisions of a will.

(t, moderate, p. 570) 19.

A revocable trust is subject to both probate and estate taxes.

(f, difficult, p. 570) 20.

A life insurance trust, which removes the proceeds of a life insurance policy from an estate, is most recommended if the primary beneficiary is not the spouse of the deceased.

(t, moderate, p. 571) 21.

A standard family trust, also known as a qualified terminable interest property trust, is designed for married couples in order to avoid estate taxes on the estate of the surviving spouse.

(f, moderate, p. 571) 22.

Taxes payable can be reduced by giving tax-deferred retirement plan assets to a charity.

(t, moderate, p. 572)

Multiple Choice What is Estate Planning?

1.

A person's net worth at the time of their death is known as:

a. b. c. d.

an inheritance. an estate. probate. a trust.

(b, easy, p. 555)

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2.

Which of the following is not a reason to have an estate plan?

a. b. c. d.

to reduce the chance of family discord to minimize the costs of settling the estate to make sure funeral arrangements are handled properly to make sure assets are distributed as intended

(c, moderate, p. 555) 3.

The legal process of settling an estate is known as:

a. b. c. d.

liquidation. trust management. a will. probate

(d, easy, p. 555) 4.

If you die without a valid will, this is known as:

a. b. c. d.

contested. intestate. escheat. interred.

(b, easy, p. 557) 5.

A legal document that designates another to make decisions on your behalf in the event of incapacity is a:

a. b. c. d.

living will. trust. durable power of attorney. escheating.

(c, moderate, p. 558)

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Wills and Other Important Documents 6.

The person writing a will is known as the:

a. b. c. d.

testator. grantor. heir. grantee.

(a, easy, p. 560) 7.

Which of the following is not one of the common elements of a will?

a. b. c. d.

inventory of assets power of executor distribution of assets payment of taxes

(a, moderate, p. 560-561)

8.

A person designated to carry out the provisions of a will is called:

a. b. c. d.

a guardian. an executor. a trustee. a beneficiary.

(b, easy, p. 561) 9.

The major purpose of having witnesses sign the will is:

a. b. c. d.

to make sure there is no case of forgery. to make sure the testator is actually who he says he is. to make sure the testator had the capacity to make the will. to make sure the distribution of assets is done fairly.

(c, difficult, p. 562)

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10.

A form of property ownership in which each person owns his or her share independently and retains the right to transfer that share by sale or will is a:

a. b. c. d.

joint tenancy with right of survivorship. tenancy in common. community property ownership. tenancy with reservation.

(b, moderate, p. 564) Estate and Gift Taxes 11.

Which of the following statements is false regarding federal gift taxes?

a.

There is no gift tax on payments for medical or educational costs if made directly to the provider of the service.

Both and estate and gift taxes have decreasing marginal tax rates.

You can give your spouse an unlimited amount and not pay gift taxes.

If you and your wife have one son, he can be given $22,000 a year and there will be no gift taxes.

b. c. d.

(b, difficult, p. 566) 12.

In 2005, the federal estate tax rate on estates over $1.5 million is:

a. b. c. d.

35 percent.

39 percent 45 percent 47 percent

(d, moderate, p. 567) 13.

Which of the following statements regarding federal estate taxes is true?

a.

You can leave up to $2 million per child to your children without them paying any tax.

Under current law, the federal estate tax will be permanently repealed in 2010.

You can leave your entire estate to your spouse and no federal estate taxes will be due. all of the above are true

b. c. d.

(c, moderate, p. 567)

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14.

In order to exclude your pension plan benefits from your gross estate, you must:

a. b. c. d.

have an estate under $1.5 million. have designated a beneficiary to receive the benefits. be fully vested in the plan. be covered under a defined benefits plan.

(b, moderate, p. 568) 15.

Which of the following is the formula for adjusted gross estate?

a. b. c. d.

gross estate - marital and charitable bequests + taxable gifts. gross estate - funeral costs and marital and charitable bequests. gross estate - funeral costs and settlement expenses. gross estate - marital and charitable bequests.

(c, difficult, p. 568) 16.

Which of the following statements regarding state death taxes is true?

a.

State death taxes are all calculated by applying a flat percentage of the value of the property.

All but 2 states impose some type of tax on property received from someone who has died.

State death taxes rarely give any exemption for marital and charitable transfers.

Current federal estate tax law gives a credit for state death taxes paid.

b. c. d.

(d, moderate, p. 569) Reducing Taxes Through Trusts and Gifts 17.

A person or entity who sets up a trust and transfers assets to the trust is the:

a. b. c. d.

grantor. trustee. testator. grantee.

(a, easy, p. 569)

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18.

If your primary purpose in setting up a trust is to reduce estate taxes, then you should set up:

a. b. c. d.

a revocable trust. an irrevocable trust. a living trust. a testamentary trust.

(b, moderate, p. 570) 19.

A trust that is established by a will is called:

a. b. c. d.

a revocable trust. an irrevocable trust. an inter vivos trust. a testamentary trust.

(d, moderate, p. 570) 20.

Which of the following is not a type of standard family trust?

a. b. c. d.

credit shelter trust qualified remainder trust exemption equivalent trust A-B trust

(b, difficult, p. 571) 21.

If you are worried that your spouse will remarry and assets will not reach your children when your spouse dies, you should set up:

a. b. c. d.

a residuary trust. a unified credit trust. an income trust. a qualified terminable interest property trust.

(d, moderate, p. 571)

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22.

Which of the following allows you to give away an asset but retain the cash flow generated by the asset during your lifetime?

a. b. c. d.

a residuary trust. a charitable remainder trust. a charitable lead trust. a qualified terminable interest property trust.

(b, moderate, p. 571)

Essay Questions 1.

What is the difference between a living will and a durable power of attorney?

What are problems often encountered in drafting a living will?

A living will specifies what kind of medical care you want to receive if you are unable to make those decisions for yourself. Typically, in a terminal illness, a person may be physically incapacitated and unable to communicate. A living will provides your family with guidance as to your wishes. A durable power of attorney is used in conjunction with a living will in order to designate someone to make decisions on your behalf if you are temporarily or permanently unable to do so. The person designated can be given very explicit instructions or can be given broad powers. A durable power of attorney can be granted for legal and financial decisions as well as medical decisions. The major problem in drafting a living will is deciding what limits you want. If you make the wording very vague, you give your family greater latitude but more decisions to make. If you make the wording very specific, you may not cover every situation which can arise.

2.

What is the difference between a joint tenancy with right of survivorship and a tenancy in common. Which type of arrangement would be best suited to two business partners who each own half of an apartment complex?

A joint tenancy with right of survivorship is when two people own property together and the ownership of the property automatically passes to the survivor if one party should die. It does not have to go through probate. The entire property is owned jointly and if you are one of the owners, you do not have the right to leave any of the property to your heirs. Tenancy in common is when two people own property together but each party retains the right to transfer their ownership interest independently. If one party dies, his share of the property will go to his heirs as stated in his will. A tenancy in common would be best suited for the two business partners so that, if one partner dies, his half of the complex would go his wife or children. He would probably not want his business partner to get the entire property but would want to leave his share to his family.

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3.

Under current law, how much can you give annually without paying federal gift taxes? What are the two major exceptions to the limits on gifts? If you are married, what is the most you and your spouse can give to your daughter and her husband per year without paying gift taxes?

Currently, you can give up to $11,000 per person per year without paying gift taxes. The two major exceptions to this limit are gifts to your spouse and gifts for payment of medical or educational costs. There is no limit on gifts to your spouse for tax purposes. The gifts for medical or educational costs are also not limited as long as you pay the medical or educational provider directly. If you are married, you and your spouse can give $44,000 per year to your daughter and her husband per year without paying gift taxes.

Mini-Case Robbie Roberts died in 2005 and left an estate valued at $3.5 million after the payment of his debts. In his will, he directed his executor to pay $25,000 to the Red Cross, $150,000 to Habitat for Humanity and the rest of his estate to his brother, Milton. His funeral cost $12,000 and his executor charged a fee of $7,000. $62,000 went to his lawyers.

Calculate the gross estate, adjusted gross estate and taxable estate. What is the applicable exemption for 2005? What is the amount that is subject to taxes?

Answer: Gross estate = 3.5 million Adjusted gross estate = Gross estate - funeral expense - executor's fee - legal fees 3.5 million - 12,000 - 7,000 - 62,000 = $3,419,000 Taxable estate = Adjusted gross estate - unlimited deductions 3,419,000 - 25,000 - 150,000 = $3,244,000 The exemption for 2005 is $1.5 million. The amount that would be subject to taxes is $3,244,000 - 1,500,000 = $1, 744,000

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TEST BANK TO ACCOMPANY

PERSONAL FINANCE Skills for Life

Vickie L. Bajtelsmit Colorado State University

Prepared by Cheryl McGaughey Angelo State University