CHAPTER 20 Understanding Personal Finances and Investments 20.7 TEXTBOOK ANSWER KEYS 20.7a Return to Inside Business The Vanguard Group 1. When investing for a long-term goal such as retirement, how are the costs associated with your investments likely to affect your results? Explain your answer in terms of this chapter’s concepts. The chapter mentions looking at a mutual fund’s expense ratio with an eye toward keeping fees down and allowing more of your investments to remain in your account instead of being paid to the mutual-fund company. Another concept is the time factor: If you can keep costs down, you will have more money in your account to work for you in the future. Even a small cost savings in investments will add up over time, because you can invest that amount and receive returns during all the years until you retire. 2. As an investor, what questions would you like to ask a Vanguard representative? How do these questions relate to your financial goals? Students will offer various responses. Some sample questions might be: What investing steps can I take now to start preparing for a comfortable retirement in the future? What kinds of investments are appropriate for an investor at my time of life and in my current financial and family situation? How much should I be saving now to be ready to buy a house (or start a family or go to graduate school) in three to five years? What tools does Vanguard have to help me learn to be a better investor in mutual funds and other investments? 20.7b Review Questions 1. How could developing a personal budget help you obtain the money needed to fund your investment program? By developing a personal budget, you can determine how much money you have available to fund an investment program. Many investment planners suggest that investors should establish an emergency fund equivalent to at least three months of living expenses. Funds in excess of this emergency fund can be invested in an investment program. To develop a personal investment plan, realistic investment objectives must be formulated in accord with prevailing economic conditions and investment opportunities. The potential return and risk must be assessed by obtaining expert advice and careful study. Many planners suggest beginning by establishing an emergency fund equivalent to at least three months’ living expenses. Then additional funds may be invested according to the investment plan. Once investments are made, they must be continually evaluated. 2. What is an “emergency fund,” and why is it recommended? An emergency fund is a certain amount of money that can be obtained quickly. It should be placed in a savings account at the highest available interest. Planners suggest three months’ living expense as reasonable. Financial planners recommend establishing an emergency fund so that money needed to get through an emergency is available. 3. What is the trade-off between safety and risk? How do you calculate rate of return? Safety means minimal risk of loss; risk means a measure of uncertainty about the outcome. Investors choose safe investments to achieve a steady increase in value over an extended period of time. To achieve higher dollar returns on investments, you generally must give up some safety. To calculate rate of return, the total income you receive on an investment over a specific period of time is divided by the amount invested. 4. In general, what kinds of investments provide income? What kinds provide growth? Certificates of deposit, corporate and government bonds, certain stocks and some mutual funds, and real estate provide income. Securities of corporations in the process of growing provide the growth factor. Investors who research carefully will discover mutual funds and real estate that offer growth potential. 5. How do you think that asset allocation, the time your investments have to work for you, and your age affect the choice of investments for someone who is 25 years old? For someone who is 59 years old? A younger person may tend to place his or her money into more growth-oriented investments. If their investments take a nosedive, they have time to recover. Older investors tend to invest more conservatively. 6. Characterize the purchase of corporate and government bonds as an investment in terms of safety, risk, income, growth, and liquidity. Corporate bonds are considered a more conservative investment than either preferred or common stocks or mutual funds, but they are less conservative than bank accounts. They are primarily income producing when interest rates are rising because the market value of existing bonds with a fixed interest rate typically declines. The safety of a bond depends very much on the financial strength of the issuer. Bonds are fairly liquid investments if they are traded on one of the bond exchanges. 7. Describe the three methods by which investors can make money with stock investments. Basically, there are three ways that investors can make money with stock investments: through dividend payments, through an increase in the dollar value of the stock, or through stock splits, which offer a potential for increased profits. 8. An individual may invest in stocks either directly or through a mutual fund. How are the two investment methods different? The direct investment method places money in one particular security. Mutual funds combine and invest the money of many individual investors in a wide variety of securities. This diversification spells safety because an occasional loss incurred with one security is usually offset by gains from other investments. 9. What are the risks and rewards of selling short and purchasing stocks on margin? Investors may borrow up to half the cost of a stock purchase. In doing so, they can purchase twice as many shares of stock by buying on margin. As a result, they will make twice as much profit if things go well. If the price of the stock falls, however, the investors will lose twice as much money. Another risk is the possibility that interest costs will drain the investors’ profits if the market price of the stock does not increase as quickly as expected. 10. How could the Internet help you to research an investment? Today, there is a wealth of information available on most investment and personal finance topics. For example, you can obtain interest rates for certificates of deposit; current price information for stocks, bonds, and mutual funds; and experts’ recommendations to buy, hold, or sell an investment. You can even trade securities online just by pushing the right button on your computer keyboard. Caution: Because the Internet does make so much information available, you need to use the Internet selectively. 11. In addition to the Internet, what other sources of financial information could help you to obtain your investment goals? In addition to the Internet, investors can obtain financial information from local newspapers, business newspapers (e.g., Wall Street Journal and Barron’s), professional advisory services, brokerage firm reports, business periodicals, corporate reports, and securities averages. 12. Would you use a full-service or a discount brokerage firm? Explain your answer. It depends on how much help a person needs when making an investment decision. A full- service broker usually charges higher commissions but gives you personal investment advice and provides detailed research information. A discount broker simply executes buy and sell orders, usually over the phone or online. Most discount brokers offer no or very little investment advice; you must make your own investment decisions. 13. What is the difference between a market order and a limit order? A market order is a request that a security be purchased or sold at the current market price. A limit order is a request that a security be bought or sold at a price equal to or better than (lower for buying, higher for selling) some specified price. 14. Describe how the securities industry is regulated. The securities industry is regulated by congressional legislation such as the Securities Act of 1933, the creation of the Securities Investor Protection Corporation, and the passing of the Sarbanes–Oxley Act to improve corporate accountability and financial reporting. The Securities and Exchange Commission enforces federal security guidelines. Each individual state also requires that security brokers and dealers be licensed and can punish violators. The final level of regulation is within each individual firm, in promoting an ethical trading culture in the office. 20.7c Discussion Questions 1. For the time period between 2007 and 2009 people experienced dramatic declines in the market value of stocks, mutual funds, and other investments. Then, the market began to rebound. Based on the current state of the economy and the investment markets at the time you answer this question, do you think that it is a good time to begin an investment program? Justify your answer. As discussed in the text, experts agree that the best investment program is one that stresses long-term growth over a 20- to 40-year period. Although the dollar value of securities may decrease over the short term, historically, the value of securities has always increased over the long term. However, the answer to this question depends on a variety of factors, such as the time factor, your age, your investment objectives, your ability to tolerate risk, and the economic outlook, among others. What may be the “right” investment for one student may be completely “wrong” for another. 2. What personal circumstances might lead investors to emphasize income rather than growth in their investment planning? What might lead them to emphasize growth rather than income? An investor may decide to emphasize income rather than growth if he or she needs the income from the stock in the near future. Income securities generally provide a steady flow of returns. But if the investor doesn’t need immediate income, he or she may want to invest in growth stocks that offer a greater return. For many young investors, growth is more important than income. 3. In this chapter, it was apparent that stocks have outperformed other investment alternatives over a long period of time. With this fact in mind, why would investors choose to use asset allocation to diversify their investments? Stocks of highly regarded corporations are considered safe, conservative investments that are stable over the long term. Many investors, though, prefer to allocate a portion of their money into investments that offer liquidity, such as money-market accounts, in case of emergencies and into more conservative investments such as bonds to reduce the prospect of selling at a loss because of depressed economic conditions. Seasoned investors know that diversification lessens risk. 4. What type of individual would invest in government bonds? In global mutual funds? In real estate? An investor who invests in government bonds is typically very conservative and wants an investment that is very safe. U.S. government bonds and many municipal bonds fall into this category. (Caution: Investors still need to evaluate municipal bonds—there is more risk with municipals than with U.S. government bonds.) An investor who chooses global mutual funds is choosing an investment with more risk than many investment choices. While many investors believe that global mutual funds provide diversification, in reality, this type of fund is more high risk because of the diversification. These funds often invest in stocks of companies in foreign countries where there is more risk. Another factor that adds to the risk is that it is often more difficult for the fund manager to evaluate companies in foreign countries. An investor in real estate is typically a long-term, conservative investor. Because real estate can increase in value and provides rental income in some cases, people tend to hold on to real estate invest-ments longer than shorter-term investment alternatives. 5. Suppose that you have just inherited 500 shares of IBM common stock. What would you do with it, if anything? There are a number of factors to consider. The first step would be to evaluate IBM’s financial situation. Many of the information sources discussed in this chapter would help. You should also consult an expert. If this is your only investment, you may also want to diversify your holdings. 6. What kinds of information would you like to have before you invest in a particular common stock or mutual fund? From what sources can you get that information? The first piece of information would be the evaluation of the particular firm’s earning potential, since cash dividends are paid out of profits. You would also be interested in dividends paid in past years, the stock’s present market value, and future prospects. Newspapers would provide some of this information. The Internet, brokerage reports, corporate reports, and investors’ services are other sources. 7. Take another look at Figure 20.1 (Mergent’s research report for Dollar Tree, Inc.). Based on the research provided by Mergent’s, would you buy stock in Dollar Tree? Justify your decision by providing specific examples from Figures 20.1. While student answers will vary, you may want to review the material in Figure 20.1. There are many factors to consider. For example, the Business Summary, Recent Developments, Prospects, and Financial Data sections that are part of Figure 20.1 should be discussed as part of the answer to this question. You may also want to discuss other sources of information that are available to investors such as the Internet, Moody’s, Standard & Poor’s, Value Line, and brokerage reports, to mention a few. 20.7d Comments on Video Case 20.1 Suggestions for using this video case are provided in the Pride/Hughes/Kapoor Video Guide. Taming the Debt Monster One Budget at a Time 1. Is all debt bad? When does going into debt make sense? Many money experts suggest that there is “good debt” and “bad debt.” For example, if you take on debt to purchase something that will increase in value and contribute to your overall financial health (such as a student loan), then it’s very possible that debt is a good one. Generally, earning a college degree means you’ll make more money over your life time. Depending on the housing market, a mortgage loan can be a good debt. If the house is expected to appreciate in value, the mortgage on the house will enable you to capitalize on this investment. 2. Why is it so important for people to save and invest when they are young? Even small amounts saved early in life will compound and grow over the years. The earlier you start investing, the longer you have to earn a good return on long-term investments. Additionally, younger investors can invest in higher-risk investments that may yield higher returns because they don’t have to access them for a long time and can recuperate from market declines. One tool students might find helpful is the Savings-Investment Calculator found at http://www.mycalculators.com/ca/savecalcm.html. You can enter the number of years you plan to invest, the amount of planned contributions, and the interest rate, and it will show you the future value of your money. For example, a 25-year-old who invests $100 per month and earns 9 percent annually will have saved $421,923.91 by the time he or she is 65 years old. (The 9 percent is based on the fact that, since 1926, stocks have returned just below 10 percent per year.) 3. What steps can you take now to improve your financial outlook? Students’ answers will vary, depending upon their personal circumstances. However, sometimes small changes can enable you to save money. One Web site students may find helpful is www.feedthepig.org. They can get free savings tips by e-mail or on their cell phone. There is also a blog in which people post hints on how they were able to save. 20.7e Comments on Case 20.2 Fidelity Helps Investors Prepare for Their Financial Future 1. Why would Fidelity offer 524 mutual funds? What are the advantages to the company and to investors? By offering so many mutual funds, Fidelity is able to serve the investment needs of a wide range of investors who are looking to meet long-term financial goals such as saving for retirement or shorter-term goals such as investing to have a down payment for a home. Fidelity is also enhancing its reputation as a mutual-fund powerhouse and encouraging investors to bring more of their assets to Fidelity (such as checking accounts). Investors gain the flexibility of finding mutual funds that are suited to their need for liquidity, their attitudes toward risk, and other investment considerations. Ask students how they would begin to sort through so many mutual funds and what criteria are most important to their specific financial situation. 2. What are the pros and cons of having a checking account with Fidelity rather than with a local bank or credit union? One of the pros of having a Fidelity checking account is the ability to quickly and conveniently transfer money into a mutual fund or another investment, making it easy to save. Another pro is that Fidelity has many online tools and resources to help customers manage their money. Also, customers can withdraw money from any bank’s ATM and Fidelity will pay the fee, which saves money and takes the hassle out of withdrawals. One of the downsides, however, is that unless customers live near a Fidelity Investors Center, they can’t communicate face to face as they would with a local bank or credit union. Instead, they would have to communicate with Fidelity on its site, by phone, by e-mail, by social media, or in some other way that is not in person. Another downside is that customers that lack a smartphone or prefer not to do banking via an app will have more difficulty making a checking deposit. Ask students whether they would consider opening a checking account with a company that has no local presence and how they would manage to complete transactions. 3. If you were trying to evaluate a specific mutual fund, where would you obtain the research information needed to choose the right fund? Assuming that you have found the right fund, would you prefer to invest online or talk with a Fidelity broker to complete the transaction? The case states that Fidelity makes analysts’ reports available to customers, as well as other customers’ ratings of investments such as mutual funds. Students will also find ideas in the chapter, including the Internet, business publications, and fund prospectuses. Whether students prefer to invest online or talk with a Fidelity broker, ask them to consider their safety, liquidity, and income requirements and how that would affect their decisions about mutual funds. 20.7f Building Skills for Career Success 1. Social Media Exercise 1. Do you think peer-to-peer investment and personal finance Web sites like these are valuable? Why or why not? Students’ answers may vary. Some students may feel that comparing their investment portfolio’s performance to peers, professional analysts, and financial bloggers may lead to competitiveness, and they may be willing to take more risk to “beat the competition.” Others may look at the details of others’ portfolios that have done well and take tips. Another factor is that students might relate better to peers online, rather than meeting with a “stuffy” investment advisor face to face. 2. Do you trust peer-to-peer collaboration when it comes to investing and personal finance? Why or why not? Students’ answers will vary. It may be helpful to remind them that what they read on these sites may not necessarily be fact. A person can post any returns he or she wants, where or not they are true. 2. Journaling for Success 1. To begin this journal exercise, think about purchases you made over the last month. Describe one product or service that you feel “was worth the money.” Some of the products that students are likely to consider include athletic shoe brands such as Nike, cell phones and/or plans, computer equipment, or other electronics. 2. For the product or service you chose, describe the attributes or features that impressed you. It is likely that students, as most consumers, will focus on attributes of style and design as well as on quality, particularly in terms of reliability and durability. Cost and customer service are other factors that may be considered. 3. Determine if the company that made the product or provided the service is a public company that has issued stock (if not, another product must be chosen). Then use the Internet or go to the library to research the investment potential for this company. Finally, describe why you feel this would be a good or bad investment at this time. Among other factors, students will want to look at dividend income and increases/decreases in market value. Trends in the various social, cultural, economic, technological, political, and demographic environments should also be considered. For example, advances in medical technology will combine technology with the demographics of an aging nation and might make medical stocks attractive. 3. Developing Critical-Thinking Skills Students should select funds that meet their personal risk levels. For example, are students risk takers, risk evaders, or indifferent to risk? Their choices of funds are affected by their dispo-sition toward risk. The higher the student’s level of risk tolerance, the more likely he or she will invest in aggressive funds versus income funds. Individuals invest for one or more reasons: a. Meeting liquidity needs c. Retirement b. Saving for a large expenditure d. Speculating By investing in a no-load fund, all the initial investment money begins to work immediately for the investor. Management fees are assessed once a year, and penalties, if they apply, are taken when money is withdrawn from the fund. Prepare a table to reflect the progress of the investments in the project. Investment Project—Initial Investment of $2,000 Name of Mutual Fund __________________________________________________ Week Net Asset Value (NAV) Number of Shares Total Value of Investment 1 2 3 4 5 6 7 8 Add more lines for more weeks Comment on the results of the investments. 4. Building Team Skills Students may find the following table helpful in recording data about their stock investments. Divide $25,000 into three parts or budgets as indicated in Column l below. Stock Purchases Budget Amount Name of Corporation Closing Price No. of Shares Cost of Stock Amt. of Comm. Cost of Investment 1. 2. 3. Name of the corporation: Write in the name of the company from the stock market. Closing price: Record the close price of the stock from the Wall Street Journal. This is the price students will pay per share for the stock. Number of shares: Record the number of shares of stock purchased. Take the budgeted amount and divide it by the close price. Students cannot buy a fraction of a share; therefore, drop all fractions and use only whole numbers. Then subtract four (4) shares from the whole number. This pays the commission. Cost of stock: Multiply the close price by the number of shares. This is the amount of money the shares will cost. Amount of commission: Figure the commission. Multiply the cost of the stock by 1 percent (0.01). This is an approximate amount. Commission rates vary among brokers. Cost of the investment: Add the amount of commission to the cost of the stock to find the cost of the investment. Record Sheet for Recording Weekly Activity Week Date of the Market Close Price *Change from the Previous Week 1 NA for this week 2 3 4 5 6 7 8 9 10 *To find the weekly change, subtract the present week’s close from the previous week’s close; for example, second week’s close from the first week’s close. Stock Sales 1 2 3 4 5 6 7 8 Corp. Name Shares Owned Close Price Gross Amount Received Amount of Comm. Net Amount Received Amount Invested Net Gain (Loss) Column 1: Write in the name of the companies. Column 2: Record the number of shares purchased in each company. Column 3: Record the close price of the stock. Find the close price in the Wall Street Journal. This is the selling price. Column 4: Record the amount of money the investment is worth. Multiply the number of shares bought by the selling price. Column 5: Figure the commission for selling the stock. Multiply the amount in column 4 by 1 percent (0.01). Column 6: Figure the net amount to be received from the investment. Subtract the amount of commission in column 5 from the gross amount in column 4. (When stocks are sold, the commission is subtracted from the gross amount of the sale. When stocks are purchased, the commission is added to the cost of the stock.) Column 7: Record the cost of each investment. Take the amount from the Stock Purchases table. Column 8: Figure the amount of gain or loss on the investment. Determine the difference between columns 6 and 7 by subtracting the smaller number from the larger number. If column 6 is larger than column 7, there is a gain—a return on the investment. If column 7 is larger than column 6, a loss occurred. Comments: Have students comment on the results of the project. Who is the winner? Why? What would they do differently next time? 5. Researching Different Careers You may want to compare the information your students collected in the interview with the information describing account executives in the Occupational Outlook Handbook. What similarities and differences did the students find? Personal financial planners and financial advisors assess the financial needs of individuals and assist them with investments, tax laws, and insurance decisions. Advisors help their clients identify and plan for short- and long-term goals. Advisors help clients plan for retirement, education expenses, and general investment choices. Many also provide tax advice or sell insurance. Although most planners offer advice on a wide range of topics, some specialize in areas such as retirement and estate planning or risk management. A bachelor’s or graduate degree is strongly preferred for personal financial advisors. Employers usually do not require a specific field of study for personal financial advisors, but a bachelor’s degree in accounting, finance, economics, business, mathematics, or law provides good preparation for the occupation. Courses in investments, taxes, estate planning, and risk management are also helpful. Job opportunities are spread throughout the country, although a significant number are located in New York, California, and Florida. About 63 percent worked in finance and insurance industries, including securities and commodity brokers, banks, insurance carriers, and financial investment firms. About 29 percent of personal financial advisors were self-employed, operating small investment advisory firms. Typical annual wages for a personal financial advisor are $69,050. The middle 50 percent earned between $46,390 and $119,290. Additionally, personal financial advisors who work for financial services firms are often paid a salary plus a bonus. Bonuses vary depending on the size and profits of the service firm. 20.8 QUIZZES I AND II Quiz I True-False Questions Select the correct answer. 1. T F Personal investment is the use of your personal funds to earn a financial return. 2. T F Selling short is the process of buying stock with the expectation that it will increase in value and then can be sold at a profit. 3. T F The Securities Investor Protection Act established the Securities and Exchange Commission. 4. T F The basic idea behind asset allocation is to lessen investment risk. 5. T F Over many years, managed funds have outperformed index funds. Multiple-Choice Questions Circle the letter before the most accurate answer. 6. The ease with which an investment can be converted into cash is referred to as a. income. b. cash factor. c. margin transaction. d. liquidity. e. cash mobility factor. 7. Since 1926, stocks have returned just below _____ percent a year. a. 3 b. 5 c. 8 d. 10 e. 20 8. A __________ order is an order to buy or sell a security at the current market price. a. discretionary b. limit c. market d. secured e. speculative 9. Of the following, which would be considered the most speculative investment? a. Commodities b. Municipal bonds c. Corporate bonds d. Preferred stocks e. Common stocks 10. Which of the following would be considered a professional investors’ service? a. Fortune Advisor b. Morningstar c. SEC d. Value Index e. BusinessWeek Online Quiz II True-False Questions Select the correct answer. 1. T F For an investment, the potential return should be directly related to the assumed risk. 2. T F The net asset value of a mutual fund is equal to the current market value of the fund’s portfolio minus the fund’s liabilities, divided by the number of outstanding shares. 3. T F The time your investment has to work for you and your age should not be considered when choosing a conservative investment. 4. T F With the exception of savings bonds, the minimum purchase for each type of U.S. government security is $1,000, with additional increments of $1,000. 5. T F Most investment information available on the Internet is too expensive for small investors. Multiple-Choice Questions Circle the letter before the most accurate answer. 6. A 24-year-old single individual would most likely choose investments that offer a. safety. b. income. c. growth. d. dividend yields. e. liquidity. 7. A(n) __________ is a request that a security be bought or sold at a price equal to or better than (lower for buying, higher for selling) some specified price. a. margin call b. limit order c. option d. margin order e. prospectus 8. The SEC was created by the a. Securities Act of 1933. b. Securities Exchange Act of 1934. c. Investment Company Act of 1940. d. Investment Advisors Act of 1940. e. Sarbanes–Oxley Act of 2002. 9. Which of the following statements is true? a. Load funds outperform no-load funds. b. Management fees range from 4 to 7 percent a year. c. 12b-1 fees are approximately 1 percent of the fund’s assets. d. Generally, managed funds outperform index funds. e. Small-cap funds invest in companies that issue corporate bonds that have little risk. 10. Which of the following would most likely be considered a high-risk investment technique? a. Unsecured bank transactions b. Corporate bonds c. Real estate d. Common stocks e. Margin transactions 20.9 ANSWER KEY FOR QUIZZES I AND II Quiz I True-False Multiple-Choice 1. T 6. d 2. F 7. d 3. F 8. c 4. T 9. a 5. F 10. b Quiz II True-False Multiple-Choice 1. T 6. c 2. T 7. b 3. F 8. b 4. F 9. c 5. F 10. e 20.10 CLASSROOM EXERCISES 20.10a Homework Activities • Have students bring in an article that shows an example of a traditional investment alternative. • Researching and Following a Company Throughout the Course (continuing assignment). Have students explain whether they would invest in their company and why. • Have students track interest rates on various money market accounts and certificates of deposit using the Wall Street Journal or the local newspaper. If you want students to track this information over time but do not want to turn this into a long-term assignment, they can use the library or Internet to research the rates historically. Similarly, you might ask students to track stock prices. • Have students interview one or two older people about their investment experience. Students could ask the interviewees to identify techniques that have helped them in saving and investing. They could also ask about the types of problems the interviewees encountered in their investment efforts. • My Personal Plan Activity. See description under classroom activities below. This activity lends itself well to a homework paper. • Play a Virtual Market Activity. Students learn about online trading and Wall Street terms and play a “virtual market” at this Web site from PBS’s science series, NOVA: http://www.pbs.org/ wgbh/nova/stockmarket/virtual.html. Students are given $100,000 to invest in four fictional companies, watch press releases, price trends of the stock to determine how the companies are faring, and decide when to buy or sell. After they have played the game, have them write a brief (one- to two-page) summary of their experience. How did the economy fare under their leadership? What did they learn from playing the game? (Alternatively, you can use this in the classroom as a team competition. See instructions below under Classroom Activities.) 20.10b Classroom Activities • What to Do with My Bond Exercise. Place students into groups of three to five and pass out copies of the handout. The students are to decide what actions they will take under two differing scenarios. It will take approximately 20 minutes, and they should use their texts if they need them. Follow up with discussion. Answers are provided. • My Personal Plan Individual Activity. The purpose of this exercise is to determine the ability of students to invest, their interest in investing at this point in their lives, and where they would invest. Each student should be given a copy of the handout, which includes a discussion of compound interest and then given a minimum of 30 minutes to complete the exercise. They should be encouraged to bring their textbooks to class that day and use the information available in Chapter 20. At the end of the activity, you can choose to collect the papers or just use them for class discussion. If the latter, be sure to indicate to students that they should not reveal their personal financial situations but rather discuss in a general way what students can save and invest. A handout is provided. • Personal Financial Management Spreadsheet Exercise. This is a team-based alternative to the “My Personal Plan” individual activity. It requires that teams of two or three students examine the provided spreadsheet and answer questions. This will take less time than the individual activity. • We Won the Lottery! Team Exercise. This is a team-based (three to four students) investment strategy exercise. After passing out the assignment handout, students should be told they have approximately 20 to 30 minutes for the activity. They should also use the information provided in the text as a basis for their investment choices. At the end of the allotted time, each team should be prepared to discuss and defend their investment choices. Since the stated objective of the plan is growth over ten years, students should have a portfolio that is not overly conservative. • Play a Virtual Market Activity. Students learn about online trading and Wall Street terms and play a “virtual market” at this Web site from PBS’s science series, NOVA: http://www.pbs.org/wgbh/nova/stockmarket/virtual.html. Students are given $100,000 to invest in four fictional companies, watch press releases, price trends of the stock to determine how the companies are faring, and decide when to buy or sell. After they have played the game, have them report orally on how the portfolio fared and what they learned from playing the game. You might also consider awarding a small prize (or bonus points) to the team that achieves the best results. (Note: You can also use this exercise as a homework assignment for individual students. See Homework Activities above.) 20.10c Exercise Handouts Follow on Next Pages What to Do with My Bond You and your teammates have purchased a bond that cost your group $1,000. You are faced with two possible scenarios. In the time allotted to you, decide what action you would take under each of those scenarios. Be prepared to defend your answer. Scenario 1 Six months after you purchased the bond, the business community turns suddenly pessimistic because of fear that the economy will weaken. As a result, the supply of debt securities declines. Based on this scenario, what would you expect to happen to the price of the bond that you purchased? What action, if any, would you take? Why? Scenario 2 After six months, the stock market reaches a five-year high due to favorable economic forecasts and high corporate profit expectations. Under this scenario, what would you expect to happen to the price of your bond? What action would you take, if any, and why? What to Do with My Bond Answers Scenario 1 Six months after you purchased the bond, the business community turns suddenly pessimistic because of fear that the economy will weaken. As a result, the supply of debt securities declines. Based on this scenario, what would you expect to happen to the price of the bond that you purchased? What action, if any, would you take? Why? The reasonable expectation is that the value of the bond will increase for several reasons. In a declining economy, stock prices will generally fall, and therefore bonds will offer a more attractive option for investors. This will increase the market value and prices of bonds. As well, if the supply of debt securities declines, the price of bonds will increase because demand will drive the price of bonds up. In this scenario, the bondholder can either sell their bond immediately for a higher price than they paid for it and make a quick profit or wait for a longer period of time if they believe the market price will increase. Scenario 2 After six months, the stock market reaches a five-year high due to favorable economic forecasts and high corporate profit expectations. Under this scenario, what would you expect to happen to the price of your bond? What action would you take, if any, and why? Generally, when the stock market is strong, the bond market suffers because investors can realize better returns on their investments from stocks. Under these circumstances (and in this case), the market price of bonds generally would be expected to decline. The bondholder has several options under this scenario. They can either sell their bond at a price lower than they purchased it and purchase stocks for higher appreciation or wait for the bond’s price to increase and then sell the bond and move their money into stocks. Their decision is dependent on how long they believe the economy (and the stock market) will remain strong. My Personal Plan The purpose of this exercise is to help you assess whether or not you are interested in and able to invest at this point in time, as well as to have you start considering where and how you would invest. Step 1: Starting an investment fund as a student may seem daunting. But read the background section on compound interest below—it may be more realistic than it seems. Compound Interest—A Primer Like many students, you may find it difficult to save. But a little saved when you are young can result in a bigger nest egg when you are older than if you wait. It’s all about the compound interest you earn over time. For example, if you manage to save $100 a year or less than $2.00 a week and it earns 5 percent interest each year, you’ll have $105.00 at the end of the first year. But at the end of the second year, you’ll have $110.25. Not only did you earn $5.00 on the $100.00 you initially deposited—your original “principal”—but you also earned an extra $0.25 on the $5.00 in interest. Twenty-five cents may not sound like much at first, but it adds up over time. Even if you never add another dime to that account, in 10 years you’ll have over $162.00 through the power of compound interest, and in 25 years you’ll have almost $340.00. Take a look at the Rule of 72 below for another example and way to look at the subject. Rule of 72 The Rule of 72—really just a “rule of thumb”—is a great way to estimate how your investment will grow over time. If you know your investment’s expected rate of return, the Rule of 72 can tell you approximately how long it will take for your investment to double in value. Simply divide the number 72 by your investment’s expected rate of return (ignoring the percent sign). Assuming an expected rate of return of 9 percent, your investment will double in value about every 8 years (72 divided by 9 equals 8). Knowing how quickly your investment will double in value can help you determine a “ballpark” estimate of your investment’s future value over a long period of time. Let’s say that you invest $10,000 in a retirement plan. What will your investment be worth after 40 years, if you don’t make any additional contributions? Assuming an expected rate of return of 9 percent, the total approximate value of your investment would double to $20,000 in 8 years, $40,000 in 16 years, $80,000 in 24 years, $160,000 in 32 years, and $320,000 in 40 years. (Source: “Tips for Teaching Students About Saving and Investing,” Securities and Exchange Commission, www.sec.gov/investor/students/tips.htm, accessed November 5, 2006.) Step 2: Assess your current situation. Are there any areas of expense you could realistically cut back or any additional income opportunities? Remember, investing the equivalent of just $2.00 a week is a good start. And you may be able to save more. Write down your personal options for savings, being as specific as possible. Here are some suggestions to get you started. • Reduce credit card use or pay off a credit card balance to reduce/eliminate interest expense • Shift to a less costly cell phone plan • Cut back on personal entertainment expenses • Reduce clothing expenses • Work more hours • Look for a higher paying job • Other Step 3: Estimate annual savings from those items identified in step 2. Step 4: Indicate where you would invest the funds generated in step 3 over the next three years. Explain your choices. PERSONAL FINANCIAL MANAGEMENT You and your teammates need to develop a personal budget based on the details presented in the spreadsheet on the next page. Think about your personal goals for the following year and use details in the spreadsheet to answer the following questions: 1. What are your personal financial goals for the upcoming year? 2. How will you address those financial goals? What are your sources of funds? 3. Do you have periods of the year with negative cash flow? If so, how will you financially manage those time periods? What strategies and tactics will you use? 4. What if your car needed a new transmission in July ($1,800 expenditure)? How would you handle this financial crisis? 5. What longer-range strategies can you use to improve your financial situation next year? Personal Financial Management Instructor Notes The objective of the exercise is to develop a forecasted (pro-forma) personal budget and to anticipate periods of negative personal cash flow. It will also be possible to derive a financial “game plan” based on future monthly cash flow needs. Instructions: • Pair students in the class as teams of two or three. • Make copies of the spreadsheet (or e-mail to the students ahead of class). • Give the teams 15 minutes to answer the five questions at the bottom of the spreadsheet. The questions will compel the teams to develop a plan to get them out of an unfavorable financial scenario. • Encourage creativity and instruct teams to develop as many ways to improve the financial situation as possible. • Review the answers with the class by having a few of the teams report their answers. A healthy discussion will ensue (especially for Questions 3, 4, 5). • Always draw parallels to what businesses do in managing cash and expenses through tough times. Key Learning Objectives: • Developing a forecasted budget and pro-forma statements for personal or business use is a critical activity. • One must have a solid financial plan for managing through periods of negative cash flow. • The elements of a personal financial plan are very similar to business financial plans (e.g., cut expenses, borrow, sell assets, increase sales, raise capital, etc.). Questions and Suggested Answers: 1. What are your personal financial goals for the upcoming year? Answers will vary; but bottom line, have a positive cash position at the end of the year. 2. How will you address those financial goals? What are your sources of funds? Personal income, borrowing money, using assets, etc. 3. Do you have periods of the year with negative cash flow? If so, how will you financially manage those time periods? What strategies and tactics will you use? Negative cash flow throughout the year. Answers will vary from there. Most will cite reducing various expenses, taking a second job, using credit card (discouraged!), using assets, etc. 4. What if your car needed a new transmission in July ($1,800 expenditure)? How would you handle this financial crisis? Answers will vary. Most will cite using credit card (revolving line), or just selling the car outright. If the latter, impress upon the students that the lack of reliable transportation could impact their job and their income (unintended consequence!). 5. What longer-range strategies can you use to improve your financial situation next year? Answers will vary. Students will discuss finding a permanent second job, moving to a new apartment, negotiating new contracts for services, using assets, etc. We Won the Lottery! Congratulations! You and your team members have won $1 million in the lottery! After taxes, you have approximately $670,000 left. Rather than split up the money, your team has decided to set up an investment fund, with each of you eventually sharing equally in the proceeds. You have all agreed not to touch the fund for at least ten years. Your objective is to generate maximum growth over the ten-year period. Based on those parameters, you now have to decide exactly how you will invest that money. You have many choices, from common stock and mutual funds to bonds, insurance annuities, real estate, and precious metals. One of the things you may wish to do is make a list of the investment choices and rank them according to both risk level and growth potential. You can then balance your portfolio accordingly, remembering that most experts recommend a diversified plan. Be prepared to defend your plan. RUNNING A BUSINESS—PART 7 Suggestions for using this video case are provided in the Pride/Hughes/Kapoor Video Guide. Plans for Financing Growth 1. What kinds of questions do you think Cincinnati officials asked Graeter’s owners before agreeing to loan the company $10 million? Why would Graeter’s go with this financing arrangement rather than borrowing from a bank to pay for the Bond Hill factory? Cincinnati officials probably asked questions related to Graeter’s “character”—its history of repaying debts when due, as well as the commitment its owners have to remaining actively involved in the community and its economic life. Officials probably looked at the company’s financial statements and asked about its past and future income and cash flow, plus its other financial obligations. They might have considered the possibility of requesting collateral for the loan and they probably considered questions related to how quickly or slowly Graeter’s would be willing and able to repay the loan. Graeter’s benefited from low interest rates and a long repayment period, plus other financial incentives received in exchange for making this investment in the community, which probably explains why the company chose this financing arrangement with Cincinnati rather than borrowing from a bank. 2. One of the financing strategies Graeter’s has not used is to sell common stock to the general public. Why would Graeter’s hesitate to go public? Do you agree with its decision to use debt rather than equity financing? If Graeter’s goes public, it would have to make certain concessions to stockholders, including holding an annual meeting, which can affect its corporate policies. A public company also operates under stricter financial reporting requirements than a privately held firm. One of the biggest advantages is that issuing shares does not create a debt obligation; the company is under no obligation to buy the shares back from its shareholders. Nor is it required to pay them dividends; it can retain all its earnings to fund business operations and expansion. Some students may say that because debt financing must be repaid with interest, it is a less attractive option than raising money by selling common stock to the public. On the other hand, students will also recognize that going public entails some costs, initially and over time. 3. As an investor, would you be willing to buy shares in Graeter’s if it decided to go public through an IPO? Explain why the company’s stock would or would not be a good investment for you. Students should recognize that their willingness to invest is based on their individual assessment of safety, risk, income, growth, and liquidity. Buying Graeter’s stock means that, like all stocks, some risk is involved, and there is no guarantee of return. If Graeter’s offers dividends, stockholders would benefit, and if the value of its stock increases, stockholders would benefit from that, as well—but dividends aren’t required, and stock prices fluctuate over time. BUILDING A BUSINESS PLAN—PART 7 The Exit Strategy Component Students should provide some information about their exit strategy and discuss any potential major trends, problems, or risks that they may encounter. In the exit strategy component, students should at least address the following issues: • How will they get themselves (and their money) out of the business? • Will their children take over the business, or will the business be sold later? • Will the business offer an initial public offering (IPO)? • Will investors get their money back? The Critical Risks and Assumptions Component In this section, students should address the following issues: • What if the market does not develop as predicted? What if the market develops too rapidly? • What if their competitors underprice or make their product obsolete? • What if there is an unfavorable industry-wide trend? • What if trained workers are not available as predicted? The Appendix Component Students can provide supplemental information and documents that are pertinent to their businesses in one or more appendices. Some documents that they can include are as follows: • Résumés of owners and principal managers • Advertising, samples, and brochures • An organization chart • Floor plans Review of Business Plan Activities By now, your students have discovered that writing a business plan involves a long series of interrelated steps. Emphasize that like any project involving a number of complex steps and calculations, a business plan should be reviewed carefully and revised before it is presented to potential investors. Students should review their answers to all the questions in the preceding parts to make sure that they are all consistent throughout the entire business plan. Although many would-be entrepreneurs are excited about the prospect of opening their own business, caution students that it takes a lot of hard work, time, and, in most cases, a substantial amount of money. While the business plan provides an enormous amount of information about their business, it is only the first step. Once it is completed, it is now their responsibility to implement the plan. Wish them good luck in their business venture. The Executive Summary Component Finally, students must prepare the executive summary. Although it is written last, it should be placed after the introduction. The executive summary component should include a one- to two-page overview of the entire business plan. Remind students that this is the most important part of the business plan and is of special interest to busy bankers, investors, and other interested parties. Students must capture the reader’s attention instantly in the first sentence by using key selling points or benefits of the business. The executive summary should include basic company information and a description of the market opportunity. Chapter 20 Video Case: Taming the Debt Monster One Budget at a Time RUNNING TIME: 2:42 Chapter 20 provides insight into understanding personal finances and investments. Many personal finance experts recommend that individuals should begin the process of managing money by determining their financial condition. Depending on investment goals, investors seek varying degrees of safety, risk, income, growth, and liquidity from their investments. Securities may be purchased in either the primary or the secondary market. Asset allocation is the process of spreading money among several different types of investments to lessen risk. Traditional investments include bank accounts, corporate bonds, government bonds, common stock, preferred stock, mutual funds, and real estate. High-risk investment techniques can provide greater returns, but they also entail greater risk of loss. Today, there is a wealth of information on stocks, bonds, and other securities and the firms that issue them. Concepts Illustrated in the Video • Budgets • Credit Card Debt • Investment Goals • Portfolio Management VIDEO CASE SUMMARY Danny Kofke is a special needs teacher in Jefferson, Georgia—the kind of job he says “gives back” every day. He says, “I have a job that I enjoy … even though I don’t get paid that large of a salary.” His salary is a little over $40,000 per year, which is approximately $10,000 less than the average American household. Yet, Kofke has been able to keep his family out of debt, and for the past seven years, his wife Tracy has been able to stay at home to raise their children. Kofke says, “Anything we have except the house is ours.” Their two cars, new refrigerator, washer and dryer, and even a 50-inch flat-screen TV have all been paid for. That’s a rarity in an economy that has left many Americans mired in debt, carrying an average debt of $14,500. The Kofkes don’t worry about “keeping up with the Joneses.” Tracy Kofke says, “We don’t want for much. If we do want for something, we end up saving for it.” Kofke believes that the biggest mistake people make with their money is that they don’t keep track of it and they don’t know how they’re spending it. This is one of the keys to the Kofkes’ financial success. Another key is spending as little as possible on the “must haves” and skipping impulse buys. Tracy plans a grocery list and sticks to it and makes use of grocery store coupons. This fall, the Kofkes’ youngest daughter started school, and Tracy returned to work part time. They acknowledge that her paycheck (about $600 per month) will give them some flexibility and set them up to tackle their next goal—a debt-free retirement. Critical-Thinking Questions Using information from the case and the video, answer the following questions: 1. In what ways do the Kofkes exhibit effective money management that will help them prepare for their goal of a debt-free retirement? First, the Kofkes have likely developed a personal income statement that lists their income and expenses for a specific period of time. They have a clear understanding of how much income they have each month and what their fixed expenses (i.e., mortgage, insurance, etc.) are. Surplus funds are used for savings to buy things they want. Second, the Kofkes have a budget—a plan for spending their income. They keep to that budget when shopping for groceries, use coupons whenever possible, and avoid impulse purchases. Third, they manage credit card debt—they don’t have any. What they have purchased, they have paid for; this means they avoid paying finance charges of 10 to 20 percent or more. 2. One of the questions to be answered when developing investment goals is: “Are you willing to make the necessary sacrifices to ensure that your investment goals are met?” In what ways have the Kofkes made sacrifices to achieve their investment goals? Tracy Kofke asserts that, “We don’t want for much. If we do want something, we end up saving for it.” Danny Kofke emphasizes the importance of not buying things you don’t really want or need because other people have them. The Kofkes don’t worry about what their neighbors think. They also keep to a strict budget and avoid impulse purchases when shopping. Tracy will also delay purchases to wait for money-saving coupons. 3. The Kofkes are now planning to tackle their next goal: a debt-free retirement. What type of asset allocation would you recommend for their portfolio at this time? Twenty years from now? The Kofkes are young right now and will likely not need to tap into their investments for ten years or more. Depending on how risk-tolerant they are and how much they can save and invest each year, they should consider investing in growth-oriented stocks or mutual funds. As they begin to near retirement, they may want to consider changing the allocation of their portfolio so that a bigger portion of their investments is in conservative bonds (such as short-term government bonds), highly rated corporate bonds, or certificates of deposit. Chapter 20 Lecture Launcher: Retirement? Please! VIDEO SUMMARY In this scene, Dan talks to Aron, one of Urban Farmz’s employees, about a new baby he has on the way and his plans to try to attend college. “If you want, I can take a look at your finances, get you into a good college savings plan, and maybe convert some of your retirement to a 529 [plan],” Dan tells him. “Retirement? Please,” replies Aron. “All I’ve got is a few thousand in the bank for emergencies.” Dan wonders if Urban Farmz has the means to create a 401(k) plan for its employees. He agrees to talk to Caleb and Jake about it. Aron says he will talk to his co-workers to see if they would use such a plan if it were available. Solution Manual for Business William M. Pride, Robert J. Hughes, Jack R. Kapoor 9781133595854, 9780538478083, 9781285095158, 9781285555485, 9781133936671, 9781305037083
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