CHAPTER 1
UNDERSTANDING PERSONAL FINANCE
ANSWERS TO CHAPTER CONCEPT CHECKS
1.1
1. 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.
2. 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. Financial building blocks include a foundation of a regular income for providing 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 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.
1.2
1. The business cycle entails a wavelike pattern of economic activity as measured by the gross
domestic product with phases including expansion, peak, contraction and trough.
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 can 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.
4. The federal government measures inflation using two commonly watched statistics. Inflation in
prices for items that consumers purchase is measured by the consumer price index, which tracks
the price changes for a specific market basket of purchases from month to month. A producer
price index also exists for prices paid by businesses for the items they buy .
1.3
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
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
, Chapter 1: Understanding Personal Finance 2
downpayment 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?
3. As your income rises, you will find yourself in higher and higher tax brackets. You can shelter part
of your income from taxes by investing in, for example, a tax-exempt security instead of a taxable
financial asset. An example of a tax-exempt security is a municipal bond. Also, 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 27 percent marginal tax bracket, you
will get to keep 73 percent (100 percent minus 27 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 (currently 7.65 percent of earned income).
1.4
1. 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 it
is the basic principle of accumulating wealth. If you invest regularly over time, your money will
grow due to the power of compound interest.
2. The two components when figuring time value of money are what an investment will be worth
after a period of time and how much must be put away today to provide some dollar amount at a
specific point in the future.
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. $10000 at 6 percent for 10 years would equal $17,908 ($10,000 × 1.7908).
1.5
1. 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.
2. Depositing $4000 into a 401(k) plan would reduce your taxes for the year by $1000 if you were in
the 25 percent tax bracket.
3. The first way would be to shelter any funds put into the programs. The second would be a
sheltering of the income from interest or dividends earned by the assets invested in the plan.
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
UNDERSTANDING PERSONAL FINANCE
ANSWERS TO CHAPTER CONCEPT CHECKS
1.1
1. 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.
2. 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. Financial building blocks include a foundation of a regular income for providing 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 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.
1.2
1. The business cycle entails a wavelike pattern of economic activity as measured by the gross
domestic product with phases including expansion, peak, contraction and trough.
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 can 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.
4. The federal government measures inflation using two commonly watched statistics. Inflation in
prices for items that consumers purchase is measured by the consumer price index, which tracks
the price changes for a specific market basket of purchases from month to month. A producer
price index also exists for prices paid by businesses for the items they buy .
1.3
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
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
, Chapter 1: Understanding Personal Finance 2
downpayment 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?
3. As your income rises, you will find yourself in higher and higher tax brackets. You can shelter part
of your income from taxes by investing in, for example, a tax-exempt security instead of a taxable
financial asset. An example of a tax-exempt security is a municipal bond. Also, 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 27 percent marginal tax bracket, you
will get to keep 73 percent (100 percent minus 27 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 (currently 7.65 percent of earned income).
1.4
1. 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 it
is the basic principle of accumulating wealth. If you invest regularly over time, your money will
grow due to the power of compound interest.
2. The two components when figuring time value of money are what an investment will be worth
after a period of time and how much must be put away today to provide some dollar amount at a
specific point in the future.
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. $10000 at 6 percent for 10 years would equal $17,908 ($10,000 × 1.7908).
1.5
1. 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.
2. Depositing $4000 into a 401(k) plan would reduce your taxes for the year by $1000 if you were in
the 25 percent tax bracket.
3. The first way would be to shelter any funds put into the programs. The second would be a
sheltering of the income from interest or dividends earned by the assets invested in the plan.
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
