Solutions Manual
Chapter 1
Understanding Personal Finance
Answers to Chapter concept checks
LO010
1. There are five fundamental steps to the personal financial planning process: (1)
Evaluate your financial condition relative to your education and career choice;
(2) define your financial goals; (3) develop a plan of action to achieve your
goals; (4) periodically develop and implement spending plans to monitor and
control progress toward your goals; and (5) review your financial progress and
make changes as appropriate.
2. Financial success is the achievement of financial aspirations that are desired,
planned, or attempted. Success is defined by the individual or family that seeks
it. Financial success may be defined as being able to actually live according to
one’s standard of living. Financial security is that comfortable feeling that you
financial resources will be adequate to fulfill any needs you have as well as
your wants. Financial happiness is the experience you have when you are
satisfied about money matters. People who are happy about their finances will
see a spillover into positive feelings about life in general.
3. Several things can be accomplished by studying personal finance. Recognize
how to manage the unexpected and unplanned financial events. Pay as little as
possible in income taxes to the Internal Revenue Service (IRS). Understand
how to effectively comparison shop for vehicles and homes. Protect what you
own. Invest wisely. Accumulate and protect wealth that you may choose to
spend during your non-working years or donate.
4. The building blocks for achieving financial success include a foundation of
regular income that provides the means to support your lifestyle and save for
desired goals in the future. The foundation supports a base of various banking
accounts, insurance protection, and employee benefits. Then you can establish
goals, a recordkeeping system, a budget, and an emergency savings fund. You
, will also manage various expenses such as for housing and transportation and
the payment of taxes. You will also need to handle credit, savings, and
educational costs. Finally, you invest in various investment alternatives such as
mutual funds, stocks, and bonds, often for retirement. As a result of all of these
building blocks, you are more apt to have a financially successful life.
LO0200
1. The business cycle entails a wavelike pattern of economic activity as measured
by the gross domestic product with phases including expansion, peak,
contraction, downturn, trough and recovery.1
2. Forecasting the state of the economy involves predicting, estimating, or
calculating what will happen in advance. You need to be able to forecast the
state of the economy, inflation, and interest rates so that you have advance
warning of the directions and strength of changes in economic trends since
they will affect your personal finances. Two statistics you could watch are the
consumer confidence index and the index of leading economic indicators.
3. Inflation reduces the purchasing power of the dollar. This means that your
income will not go as far and, thus, in real terms will be lowered by inflation.
Because items cost more, you will have to consume less and may cut back on
some expenditures in order to be able to afford those with a higher priority.
LO0300
1. The opportunity cost of a decision is measured as the value of the next-best
alternative that must be forgone. If you, for example, put your retirement
savings in a regular savings account instead of in a tax-sheltered retirement
account, you may be forgoing the tax benefits associated with investing in
retirement accounts such as IRAs or 401(k) plans. In another example, if you
decide to borrow the maximum student loan amount for which you qualify in
order to live a bit more comfortably while in college, you will not be able to live
as nicely, save as much for the down payment on a home or save for retirement
once you graduate because of the higher loan payments.
2. Marginal analysis focuses on the next increment of usefulness or cost when
making financial decisions. Marginal utility is the extra satisfaction derived
from having one more incremental unit of a product or service. Marginal cost is
the additional cost of that unit. When marginal utility exceeds marginal cost,
and we compare the two, we can make better financial decisions. As an
example, if you must fly to some destination, is the marginal cost of checking a
bag rather using carry-on worth the marginal utility?2
,3. As your income rises, you will find yourself in higher and higher tax brackets.
One type of decision that is affected by income taxes is how you should invest
for retirement. You might want to invest through a 401(k) plan instead of
keeping your retirement money in a savings account, which is taxable. Since
most types of income are taxable, it is important that you understand the
impact of income taxes on financial decisions. Of particular importance is the
marginal tax rate (the tax rate at which your last dollar earned is taxed). If you
are in the 25 percent marginal tax bracket, you will get to keep 75 percent (100
percent minus 25 percent) of your last taxable dollar earned. If the income is
tax-free income, on the other hand, you would get to keep 100 percent of it.
Therefore, it is important to know your marginal tax rate as well as what types
of income are subject to federal income taxes. It is also important to remember
the impact of state income taxes and Social Security taxes.
LO0400
1. The two common questions about money are its future value and present value.
Future value is what an investment or series of investments will be at a point in
the future. Present value is how much you would need to invest today and/or
in a series of future investments in order to provide some particular amount in
the future.
2. Simple interest is money paid on a principal amount for a given number of
years. The interest is paid only on the principal. For example, you might put
$1000 in a bank savings account at 5 percent interest for one year. You would
have accumulated $50 in that year. Compound interest is interest paid on
interest and principal. For example, if you leave your $1000 on deposit and
don’t withdraw the $50 interest at the end of the year, you will earn interest on
both the deposit and the interest earned during the first year. This difference in
the types of interest paid is important as compound interest is the basic
principle of accumulating wealth. If you invest regularly over time, your money
will grow due to the power of compound interest.1
3.
a. $2000 at 5 percent for four years would equal $2431 ($2000 × 1.2155).
b. $4500 at 9 percent for eight years would equal $8966.70 ($4500 ×
1.9926).
c. $10,000 at 6 percent for 10 years would equal $17,908 ($10,000 ×
1.7908).
LO0500
, 1. A flexible spending account (FSA), also called a flexible spending arrangement,
is a sum of money that the employee sets up at the start of each year that can
then be used during the year to pay for health care- and/or dependent-care
related items. Such an account relates to pretax dollars because the money put
into the account is sheltered from income taxation because it is not included in
one’s taxable income for the year.
2. A high-deductible health plan would lower your health care premiums. To take
advantage of this you would want to also set up and fund a health savings
account (HSA) where you can place pre-tax dollars to await any deductibles or
uncovered health care expenses that might occur later.
3. One example could be depositing $4000 into a 401(k) plan annually. Doing so
would reduce your taxes for the year by $1000 if you were in the 25 percent tax
bracket ($4000 x 0.25). Thus, in effect, you are only contributing $3000 and the
government is providing the other $1000.
4. The first way would be to tax shelter any funds put into the programs. The
second would be a sheltering of the income earned over the years from the
interest or dividends earned by the assets invested in the plan.
LO060 0
1. A professional financial planner differs from a local lawyer or insurance person
in that they are professionally trained and certified in all areas of a client’s
financial life and develops plans and strategies that take all areas into account.
2. Financial planners can be compensated solely from the commissions from the
sale of financial products. They can be compensated by an up-front fee plus
commissions from financial products they might sell. They can be compensated
by an annual or hourly fee that might be offset if the client purchases financial
products from the planner. Finally, they can be compensated solely from the fee
they charge their clients for the services provided.
3. Two professional certification programs for financial planners are the Certified
Financial Planner (CFP) and NAPFA Registered Financial Advisor (NRFA)
programs. Both require passage of an exam or exams, a minimum number of
years of experience, continuing education in the field, and adherence to a code
of ethics.
4. Answers may vary, but three of the most important questions are the
professional experiences of the planner, how the planner is compensated, and
the planner’s qualifications to practice financial planning.
WHAT DO YOU RECOMMEND NOW?
Chapter 1
Understanding Personal Finance
Answers to Chapter concept checks
LO010
1. There are five fundamental steps to the personal financial planning process: (1)
Evaluate your financial condition relative to your education and career choice;
(2) define your financial goals; (3) develop a plan of action to achieve your
goals; (4) periodically develop and implement spending plans to monitor and
control progress toward your goals; and (5) review your financial progress and
make changes as appropriate.
2. Financial success is the achievement of financial aspirations that are desired,
planned, or attempted. Success is defined by the individual or family that seeks
it. Financial success may be defined as being able to actually live according to
one’s standard of living. Financial security is that comfortable feeling that you
financial resources will be adequate to fulfill any needs you have as well as
your wants. Financial happiness is the experience you have when you are
satisfied about money matters. People who are happy about their finances will
see a spillover into positive feelings about life in general.
3. Several things can be accomplished by studying personal finance. Recognize
how to manage the unexpected and unplanned financial events. Pay as little as
possible in income taxes to the Internal Revenue Service (IRS). Understand
how to effectively comparison shop for vehicles and homes. Protect what you
own. Invest wisely. Accumulate and protect wealth that you may choose to
spend during your non-working years or donate.
4. The building blocks for achieving financial success include a foundation of
regular income that provides the means to support your lifestyle and save for
desired goals in the future. The foundation supports a base of various banking
accounts, insurance protection, and employee benefits. Then you can establish
goals, a recordkeeping system, a budget, and an emergency savings fund. You
, will also manage various expenses such as for housing and transportation and
the payment of taxes. You will also need to handle credit, savings, and
educational costs. Finally, you invest in various investment alternatives such as
mutual funds, stocks, and bonds, often for retirement. As a result of all of these
building blocks, you are more apt to have a financially successful life.
LO0200
1. The business cycle entails a wavelike pattern of economic activity as measured
by the gross domestic product with phases including expansion, peak,
contraction, downturn, trough and recovery.1
2. Forecasting the state of the economy involves predicting, estimating, or
calculating what will happen in advance. You need to be able to forecast the
state of the economy, inflation, and interest rates so that you have advance
warning of the directions and strength of changes in economic trends since
they will affect your personal finances. Two statistics you could watch are the
consumer confidence index and the index of leading economic indicators.
3. Inflation reduces the purchasing power of the dollar. This means that your
income will not go as far and, thus, in real terms will be lowered by inflation.
Because items cost more, you will have to consume less and may cut back on
some expenditures in order to be able to afford those with a higher priority.
LO0300
1. The opportunity cost of a decision is measured as the value of the next-best
alternative that must be forgone. If you, for example, put your retirement
savings in a regular savings account instead of in a tax-sheltered retirement
account, you may be forgoing the tax benefits associated with investing in
retirement accounts such as IRAs or 401(k) plans. In another example, if you
decide to borrow the maximum student loan amount for which you qualify in
order to live a bit more comfortably while in college, you will not be able to live
as nicely, save as much for the down payment on a home or save for retirement
once you graduate because of the higher loan payments.
2. Marginal analysis focuses on the next increment of usefulness or cost when
making financial decisions. Marginal utility is the extra satisfaction derived
from having one more incremental unit of a product or service. Marginal cost is
the additional cost of that unit. When marginal utility exceeds marginal cost,
and we compare the two, we can make better financial decisions. As an
example, if you must fly to some destination, is the marginal cost of checking a
bag rather using carry-on worth the marginal utility?2
,3. As your income rises, you will find yourself in higher and higher tax brackets.
One type of decision that is affected by income taxes is how you should invest
for retirement. You might want to invest through a 401(k) plan instead of
keeping your retirement money in a savings account, which is taxable. Since
most types of income are taxable, it is important that you understand the
impact of income taxes on financial decisions. Of particular importance is the
marginal tax rate (the tax rate at which your last dollar earned is taxed). If you
are in the 25 percent marginal tax bracket, you will get to keep 75 percent (100
percent minus 25 percent) of your last taxable dollar earned. If the income is
tax-free income, on the other hand, you would get to keep 100 percent of it.
Therefore, it is important to know your marginal tax rate as well as what types
of income are subject to federal income taxes. It is also important to remember
the impact of state income taxes and Social Security taxes.
LO0400
1. The two common questions about money are its future value and present value.
Future value is what an investment or series of investments will be at a point in
the future. Present value is how much you would need to invest today and/or
in a series of future investments in order to provide some particular amount in
the future.
2. Simple interest is money paid on a principal amount for a given number of
years. The interest is paid only on the principal. For example, you might put
$1000 in a bank savings account at 5 percent interest for one year. You would
have accumulated $50 in that year. Compound interest is interest paid on
interest and principal. For example, if you leave your $1000 on deposit and
don’t withdraw the $50 interest at the end of the year, you will earn interest on
both the deposit and the interest earned during the first year. This difference in
the types of interest paid is important as compound interest is the basic
principle of accumulating wealth. If you invest regularly over time, your money
will grow due to the power of compound interest.1
3.
a. $2000 at 5 percent for four years would equal $2431 ($2000 × 1.2155).
b. $4500 at 9 percent for eight years would equal $8966.70 ($4500 ×
1.9926).
c. $10,000 at 6 percent for 10 years would equal $17,908 ($10,000 ×
1.7908).
LO0500
, 1. A flexible spending account (FSA), also called a flexible spending arrangement,
is a sum of money that the employee sets up at the start of each year that can
then be used during the year to pay for health care- and/or dependent-care
related items. Such an account relates to pretax dollars because the money put
into the account is sheltered from income taxation because it is not included in
one’s taxable income for the year.
2. A high-deductible health plan would lower your health care premiums. To take
advantage of this you would want to also set up and fund a health savings
account (HSA) where you can place pre-tax dollars to await any deductibles or
uncovered health care expenses that might occur later.
3. One example could be depositing $4000 into a 401(k) plan annually. Doing so
would reduce your taxes for the year by $1000 if you were in the 25 percent tax
bracket ($4000 x 0.25). Thus, in effect, you are only contributing $3000 and the
government is providing the other $1000.
4. The first way would be to tax shelter any funds put into the programs. The
second would be a sheltering of the income earned over the years from the
interest or dividends earned by the assets invested in the plan.
LO060 0
1. A professional financial planner differs from a local lawyer or insurance person
in that they are professionally trained and certified in all areas of a client’s
financial life and develops plans and strategies that take all areas into account.
2. Financial planners can be compensated solely from the commissions from the
sale of financial products. They can be compensated by an up-front fee plus
commissions from financial products they might sell. They can be compensated
by an annual or hourly fee that might be offset if the client purchases financial
products from the planner. Finally, they can be compensated solely from the fee
they charge their clients for the services provided.
3. Two professional certification programs for financial planners are the Certified
Financial Planner (CFP) and NAPFA Registered Financial Advisor (NRFA)
programs. Both require passage of an exam or exams, a minimum number of
years of experience, continuing education in the field, and adherence to a code
of ethics.
4. Answers may vary, but three of the most important questions are the
professional experiences of the planner, how the planner is compensated, and
the planner’s qualifications to practice financial planning.
WHAT DO YOU RECOMMEND NOW?
