Personal Finance Appendix
Review Questions
1. How can a budget help you with your personal finances? What are the major steps
involved in establishing a personal budget?
A budget is a detailed forecast of your expected cash inflows (income) and cash outflows
(expenditures). You can use your budget to develop your financial plan and to monitor
your progress toward achieving your financial goals. Comparing your actual income and
expenses to their budgeted amounts can help you determine whether you are sticking to
your financial plan and, if not, identify problem areas.
The first step in preparing a budget is to determine your sources of income. For most
people, the major source of income is a paycheck. But for entrepreneurs it may be the
profits from their firm. Investors may have interest income from bonds or dividend
income from stocks. And retirees may receive social security and pension income.
The next step is to identify and categorize spending patterns to see where all of your
money goes. How much is spent on rent, how much on gas and car payments, and how
much on eating out? This process can offer some eye-opening revelations about how
much you spend on goods such as video games, fast food, or lattes. Knowledge of your
spending patterns can help you identify areas where you can do a better job of
controlling your costs.
Once your budget is set, you’ll want to compare your actual inflows and outflows of
money to their budgeted amounts to see whether you are sticking to your plans. (If not,
you can identify where the discrepancies are and make adjustments to get back on track.)
You’ll also want to periodically update your budget to reflect changes in income and
expenditures.
BUSPROG: Communication
Bloom’s: Knowledge
Topic: Your Budget
Difficulty Level: Easy
Learning Objective: A-1
2. What is the difference between discretionary costs and non-discretionary costs? Illustrate
the difference by giving examples. Why is this distinction important?
Discretionary costs are those you have the most control over. Examples are the amount
of money you spend on snack food, DVD rentals, clothes and leisure travel. Non-
discretionary costs are those which are harder to adjust—at least in the short run.
Examples are rental payments based on a lease, payments, on a car loan that requires
fixed monthly payments and property or car insurance premiums. The distinction between
discretionary and non-discretionary costs is important because the discretionary costs
, are the ones you have the most ability to adjust in order to achieve your financial goals.
It is important to note that some costs that may appear non-discretionary may actually be
at least partly discretionary. For example, you may think that gasoline and car
maintenance are non-discretionary because you have to use your car to get to work and
school. But many people could significantly cut their auto-related costs by making
arrangements to carpooling, by using mass transit, or by walking or riding a bike when
possible. Similarly, many people could reduce insurance premiums by choosing a higher
deductible or making other adjustments in their coverage.
BUSPROG: Communication
Bloom’s: Knowledge
Topic: How Do I Get Started?
Difficulty Level: Easy
Learning Objective: A-1
3. What is the purpose of a savings account? How much should be invested in this account?
What is the best way to achieve your desired savings balance?
A savings account is an interest-earning account that is intended to provide protection
against an unexpected rise in expenses or decline in income.. Financial experts say that
your goal should be to accumulate enough savings to cover at 6 months of your typical
expenses.
One of the most effective techniques for establishing a sizable savings balance is to “pay
yourself first.” This concept, popularized by David Bach, author of The Automatic
Millionaire, suggests that you have a predetermined amount of each paycheck
automatically deposited into your savings account.
BUSPROG: Communication
Bloom’s: Knowledge
Topic: Your Savings: Building a Safety Net
Difficulty Level: Easy
Learning Objective: A-2
4. What is a credit score and why is it important? What are some key factors that influence
an individual’s score? How would you interpret a credit score of 500? Of 820?
A credit score is a numerical indicator of an individual’s creditworthiness. The most
commonly used scale for credit scores at the present time is the Fair, Isaac and Company
(FICO) scale. The FICO scale runs from 300 to 850. An individual’s FICO score is
based on several factors, including payment history, amount owed, the type of credit
used, and the length of time various credit accounts have been held. Individuals with low
credit scores often find it difficult to obtain credit—and even when they do, they normally
must pay much higher interest rates.
Only about 2% of Americans have FICO scores below 500, and only about 13% have
scores over 800. So, a score of 500 would indicate a very poor credit rating, while a
score of 820 would be considered exceptionally good.
, BUSPROG: Communication
Bloom’s: Knowledge
Topic: Your Credit: Handle With Care
Difficulty Level: Easy
Learning Objective: A-3
5. Why is it important to begin investing early? Why is it important to diversify your
investments? How is the return you expect to earn on various investments related to their
risk?
The earlier a dollar is invested, the sooner it begins earning a rate of return. And,
because of the power of compounding, the amount earned each year a dollar remains
invested tends to grow. Thus each dollar you invest in your early twenties will grow to
become several dollars by the time you reach retirement age.
In general, investments that offer high potential returns also involve high degrees of risk.
Thus, when making decisions about investments, individuals must balance risk against
reward.
Diversification is important because it helps reduce risk. If you put all of your money into
one particular investment (or even one particular type of investment) you could be wiped
out if that investment goes sour. By spreading your investments over a variety of assets
you become less vulnerable to problems in any specific type of investment. But it is
important to note that diversification it can’t completely eliminate risk.
BUSPROG: Communication
Bloom’s: Comprehension
Topic: Building a Portfolio: A Few Words About Diversification, Risk and Return
Difficulty Level: Moderate
Learning Objective: A-4
6. What is common stock? How does it differ from corporate bonds? What are the two types of
return on that could be earned by stockholders, and how do these returns differ? Why is common
stock considered to be a riskier type of investment than bonds?
Common stock represents shares of ownership in a corporation. Stockholders may earn
either a dividend (distribution of profits) or a capital gain (increase in the market value
of the shares) or both. However, neither dividends nor capital gains are guaranteed.
Bonds are long-term IOUs issued by corporations or government entities. Bonds typically
pay a stated amount of interest per year. The bondholder will also receive the principal
(or face value) of the bond when it matures. Like stocks, bonds are marketable, and the
market price of bonds can change. So it is possible to earn a capital gain (or loss) on
bonds, just as it is with stocks.
Stocks are considered to be riskier than bonds because there is no guarantee that a
stockholder will receive a dividend or capital gain on stock. In contrast, the interest on
bonds is a legally required payment. Also the firm is required to repay the principal when
, the bond matures. But even bonds aren’t completely risk free. If a company gets into
serious financial difficulty it might default on its bonds. (However in the event of
bankruptcy the claims of bondholders come before those of stockholders—a point not
mentioned in the appendix, though it is noted elsewhere in the text.)
BUSPROG: Analytic
Bloom’s: Comprehension
Topic: Building Wealth: The Key Is Consistency – and an Early Start!
Difficulty Level: Moderate
Learning Objective: A-4
7. How are 401(k), 403(b) and 457 employee contribution retirement plans similar and how
do they differ? How do these plans differ from IRAs? How do Roth plans differ from
traditional plans?
401(k), 403(b) and 457 plans are employee contribution retirement plans that are named
for the section of the IRS tax code where they are described. These plans are similar in
many respects; for example, they are all set up by an employer and are implemented
through a payroll deduction system. The main difference is in who qualifies for each type
of plan. 401(k) plans are offered to employees of private sector businesses while 403(b)
plans are for employees of certain types of nonprofit organizations such as schools,
religious organizations and charities. 457 plans are primarily for state and local
government employees and nonprofit organizations (some employees in the nonprofit
sector can qualify for either 403(b) or 457 plans).
There are two different versions of each of these plans: traditional and Roth. In
traditional versions, contributions are tax deductible in the year they are made and
earnings are not taxed. However, withdrawals from traditional plans are taxable. In Roth
versions contributions are not tax deductible, but earnings are not taxed and neither are
withdrawals. Another advantage of these plans is that in many cases employers will
match employee contributions either dollar for dollar or as a percentage of each dollar
the employee contributes.
Another popular way to build wealth for retirement is to set up an individual retirement
account, or IRA. As with employee contribution plans, it is possible to set up either a
Roth IRA or a traditional IRA. Both types of IRAs are individual investments—you make
the decisions about how much to invest (subject to maximum allowable contributions)
and what specific investments to make. But, as with traditional and Roth 401(k), 403(b)
and 457 plans, the nature and timing of the tax advantages are different. With a
traditional IRA the contributions you make reduce your taxable income in the same tax
year. But you must pay taxes on the money distributed from a traditional IRA when you
making withdrawals. On the other hand, the contributions you make to a Roth IRA are
not tax deductible at the time you make them, but the distributions you receive from a
Roth IRA are tax exempt.
401(k), 403(b) and 457 employee contribution plans have two main advantages
compared to IRAs. First they have much higher contribution limits, allowing the investor
to set aside greater amounts of money for retirement. Second, some employers will match
Review Questions
1. How can a budget help you with your personal finances? What are the major steps
involved in establishing a personal budget?
A budget is a detailed forecast of your expected cash inflows (income) and cash outflows
(expenditures). You can use your budget to develop your financial plan and to monitor
your progress toward achieving your financial goals. Comparing your actual income and
expenses to their budgeted amounts can help you determine whether you are sticking to
your financial plan and, if not, identify problem areas.
The first step in preparing a budget is to determine your sources of income. For most
people, the major source of income is a paycheck. But for entrepreneurs it may be the
profits from their firm. Investors may have interest income from bonds or dividend
income from stocks. And retirees may receive social security and pension income.
The next step is to identify and categorize spending patterns to see where all of your
money goes. How much is spent on rent, how much on gas and car payments, and how
much on eating out? This process can offer some eye-opening revelations about how
much you spend on goods such as video games, fast food, or lattes. Knowledge of your
spending patterns can help you identify areas where you can do a better job of
controlling your costs.
Once your budget is set, you’ll want to compare your actual inflows and outflows of
money to their budgeted amounts to see whether you are sticking to your plans. (If not,
you can identify where the discrepancies are and make adjustments to get back on track.)
You’ll also want to periodically update your budget to reflect changes in income and
expenditures.
BUSPROG: Communication
Bloom’s: Knowledge
Topic: Your Budget
Difficulty Level: Easy
Learning Objective: A-1
2. What is the difference between discretionary costs and non-discretionary costs? Illustrate
the difference by giving examples. Why is this distinction important?
Discretionary costs are those you have the most control over. Examples are the amount
of money you spend on snack food, DVD rentals, clothes and leisure travel. Non-
discretionary costs are those which are harder to adjust—at least in the short run.
Examples are rental payments based on a lease, payments, on a car loan that requires
fixed monthly payments and property or car insurance premiums. The distinction between
discretionary and non-discretionary costs is important because the discretionary costs
, are the ones you have the most ability to adjust in order to achieve your financial goals.
It is important to note that some costs that may appear non-discretionary may actually be
at least partly discretionary. For example, you may think that gasoline and car
maintenance are non-discretionary because you have to use your car to get to work and
school. But many people could significantly cut their auto-related costs by making
arrangements to carpooling, by using mass transit, or by walking or riding a bike when
possible. Similarly, many people could reduce insurance premiums by choosing a higher
deductible or making other adjustments in their coverage.
BUSPROG: Communication
Bloom’s: Knowledge
Topic: How Do I Get Started?
Difficulty Level: Easy
Learning Objective: A-1
3. What is the purpose of a savings account? How much should be invested in this account?
What is the best way to achieve your desired savings balance?
A savings account is an interest-earning account that is intended to provide protection
against an unexpected rise in expenses or decline in income.. Financial experts say that
your goal should be to accumulate enough savings to cover at 6 months of your typical
expenses.
One of the most effective techniques for establishing a sizable savings balance is to “pay
yourself first.” This concept, popularized by David Bach, author of The Automatic
Millionaire, suggests that you have a predetermined amount of each paycheck
automatically deposited into your savings account.
BUSPROG: Communication
Bloom’s: Knowledge
Topic: Your Savings: Building a Safety Net
Difficulty Level: Easy
Learning Objective: A-2
4. What is a credit score and why is it important? What are some key factors that influence
an individual’s score? How would you interpret a credit score of 500? Of 820?
A credit score is a numerical indicator of an individual’s creditworthiness. The most
commonly used scale for credit scores at the present time is the Fair, Isaac and Company
(FICO) scale. The FICO scale runs from 300 to 850. An individual’s FICO score is
based on several factors, including payment history, amount owed, the type of credit
used, and the length of time various credit accounts have been held. Individuals with low
credit scores often find it difficult to obtain credit—and even when they do, they normally
must pay much higher interest rates.
Only about 2% of Americans have FICO scores below 500, and only about 13% have
scores over 800. So, a score of 500 would indicate a very poor credit rating, while a
score of 820 would be considered exceptionally good.
, BUSPROG: Communication
Bloom’s: Knowledge
Topic: Your Credit: Handle With Care
Difficulty Level: Easy
Learning Objective: A-3
5. Why is it important to begin investing early? Why is it important to diversify your
investments? How is the return you expect to earn on various investments related to their
risk?
The earlier a dollar is invested, the sooner it begins earning a rate of return. And,
because of the power of compounding, the amount earned each year a dollar remains
invested tends to grow. Thus each dollar you invest in your early twenties will grow to
become several dollars by the time you reach retirement age.
In general, investments that offer high potential returns also involve high degrees of risk.
Thus, when making decisions about investments, individuals must balance risk against
reward.
Diversification is important because it helps reduce risk. If you put all of your money into
one particular investment (or even one particular type of investment) you could be wiped
out if that investment goes sour. By spreading your investments over a variety of assets
you become less vulnerable to problems in any specific type of investment. But it is
important to note that diversification it can’t completely eliminate risk.
BUSPROG: Communication
Bloom’s: Comprehension
Topic: Building a Portfolio: A Few Words About Diversification, Risk and Return
Difficulty Level: Moderate
Learning Objective: A-4
6. What is common stock? How does it differ from corporate bonds? What are the two types of
return on that could be earned by stockholders, and how do these returns differ? Why is common
stock considered to be a riskier type of investment than bonds?
Common stock represents shares of ownership in a corporation. Stockholders may earn
either a dividend (distribution of profits) or a capital gain (increase in the market value
of the shares) or both. However, neither dividends nor capital gains are guaranteed.
Bonds are long-term IOUs issued by corporations or government entities. Bonds typically
pay a stated amount of interest per year. The bondholder will also receive the principal
(or face value) of the bond when it matures. Like stocks, bonds are marketable, and the
market price of bonds can change. So it is possible to earn a capital gain (or loss) on
bonds, just as it is with stocks.
Stocks are considered to be riskier than bonds because there is no guarantee that a
stockholder will receive a dividend or capital gain on stock. In contrast, the interest on
bonds is a legally required payment. Also the firm is required to repay the principal when
, the bond matures. But even bonds aren’t completely risk free. If a company gets into
serious financial difficulty it might default on its bonds. (However in the event of
bankruptcy the claims of bondholders come before those of stockholders—a point not
mentioned in the appendix, though it is noted elsewhere in the text.)
BUSPROG: Analytic
Bloom’s: Comprehension
Topic: Building Wealth: The Key Is Consistency – and an Early Start!
Difficulty Level: Moderate
Learning Objective: A-4
7. How are 401(k), 403(b) and 457 employee contribution retirement plans similar and how
do they differ? How do these plans differ from IRAs? How do Roth plans differ from
traditional plans?
401(k), 403(b) and 457 plans are employee contribution retirement plans that are named
for the section of the IRS tax code where they are described. These plans are similar in
many respects; for example, they are all set up by an employer and are implemented
through a payroll deduction system. The main difference is in who qualifies for each type
of plan. 401(k) plans are offered to employees of private sector businesses while 403(b)
plans are for employees of certain types of nonprofit organizations such as schools,
religious organizations and charities. 457 plans are primarily for state and local
government employees and nonprofit organizations (some employees in the nonprofit
sector can qualify for either 403(b) or 457 plans).
There are two different versions of each of these plans: traditional and Roth. In
traditional versions, contributions are tax deductible in the year they are made and
earnings are not taxed. However, withdrawals from traditional plans are taxable. In Roth
versions contributions are not tax deductible, but earnings are not taxed and neither are
withdrawals. Another advantage of these plans is that in many cases employers will
match employee contributions either dollar for dollar or as a percentage of each dollar
the employee contributes.
Another popular way to build wealth for retirement is to set up an individual retirement
account, or IRA. As with employee contribution plans, it is possible to set up either a
Roth IRA or a traditional IRA. Both types of IRAs are individual investments—you make
the decisions about how much to invest (subject to maximum allowable contributions)
and what specific investments to make. But, as with traditional and Roth 401(k), 403(b)
and 457 plans, the nature and timing of the tax advantages are different. With a
traditional IRA the contributions you make reduce your taxable income in the same tax
year. But you must pay taxes on the money distributed from a traditional IRA when you
making withdrawals. On the other hand, the contributions you make to a Roth IRA are
not tax deductible at the time you make them, but the distributions you receive from a
Roth IRA are tax exempt.
401(k), 403(b) and 457 employee contribution plans have two main advantages
compared to IRAs. First they have much higher contribution limits, allowing the investor
to set aside greater amounts of money for retirement. Second, some employers will match
