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Personal Finance, Fourth Canadian Edition Solution Manual

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    NAME DATE Part 1: Brad MacDonald—A Continuing Case CASE QUESTIONS 1. What is Brad’s financial planning life stage? With respect to his current financial position, what are some of the things that Brad should be considering? Brad is in the Early Career life stage. With respect to his current financial position, Brad should consider following the pay-yourself-first principle. In addition, he should try to manage his debt a little better instead of having his debt manage him. Brad should also consider investing in mutual funds. 2. What are Brad’s major goals? Evaluate his goals with respect to how specific, measurable, and realistic they are. Are these short-term or long-term goals? What additional goals could you recommend to Brad for the short and long term? Brad’s major goals are to: (1) gain control of his personal finances, (2) reduce his credit card balance, and (3) start to save $4000 per year toward retirement. With respect to his first goal, Brad needs to be more specific with what it means to him to gain control of his finances. Does he just want to meet his monthly expenses, or would he like to have a certain dollar amount left over at the end of each month toward his other goals? Furthermore, this will allow him to measure his progress toward achieving his first goal. Brad should specify how much he would like to put down on his credit card each month and at what point he would like to have his credit card paid off completely. Based on his cash flow, he will be then able to determine how realistic his second goal is. Finally, although Brad has specified how much he would like to save for retirement he has not indicated at what age he would like to retire, how long he will be retired, and what type of lifestyle expenses he will have in retirement. By specifying these amounts, he will be able to measure whether or not saving $4000 per year toward retirement is enough. For that matter, a budget plan will help him determine if saving $4000 per year is realistic. 3. Prepare personal financial statements for Brad, including a personal cash flow statement and personal balance sheet. Based on these statements, make specific recommendations to Brad about what he needs to do to achieve his goals of paying off his credit card balance and saving for retirement. Brad MacDonald Worksheet: Part 1 1

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    NAME DATE Personal Cash Flow Statement Income This Month Gross monthly pay $4500 Total income $4500 Expenses Taxes, CPP, and EI ($4000 - $3380) $1 120 Rent 1600 Tenant’s insurance ($240/12) 20 Car payment 400 Utilities 100 Credit card payment 250 Smartphone 210 Groceries 200 Clothes 100 Car expenses 250 Entertainment 350 Total Expenses $4600 Net Cash Flows ($100) Personal Balance Sheet Assets Liquid Assets Cash $0 Chequing account 4000 Savings account 200 Other liquid assets 0 Total liquid assets $4200 Brad MacDonald Worksheet: Part 1 2

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    NAME DATE Household Assets Home $0 Car 1 1 000 Furniture 1500 Other household assets 0 Total household assets $12 500 Investment Assets Stocks $1300 Bonds 0 Mutual funds 0 Other investments 0 Total investment assets $1300 Total Assets $18 000 Liabilities and Net Worth Current Liabilities Loans $0 Credit card balance 8000 Other current liabilities 0 Total current liabilities $8000 Long-term Liabilities Mortgage $0 Car loan 10 000 Other long-term liabilities 0 Total long-term liabilities 10 000 Total Liabilities $18 000 Net Worth $0 Brad MacDonald Worksheet: Part 1 3

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    NAME DATE It is obvious that Brad needs to reduce his expenditures to bring them in line with his income; his monthly net cash flow is negative. Although other recommendations are plausible, the most obvious areas where Brad can do this are: (1) Move out of the condo (depending on his lease agreement) and return to an apartment similar to the one that he previously occupied. This would result in savings of approximately $400 per month, which would balance his budget. (2) Reduce the use of his cell phone, which, we’ll assume, will result in an additional $100 per month in savings. (3) Reduce monthly entertainment expenses by one-half, which will result in an additional $175 per month in savings. Implementing these three recommendations will result in a reduction of monthly expenses of $675 and will generate an excess of income over expenses of $575 per month ($675 – $100). I would also recommend to Brad that he develop a monthly cash budget and closely monitor all expenses each month against this budget. These actions would enable Brad to save $575 3 12 months 5 $6900 per year. In turn, this would enable him to save $4000 per year and to pay off his credit card balance in less than three years: $575 3 12 months 5 $6900 per year 2 $4000 savings 5 $2900 to credit cards per year. If Brad does not start saving $4000 per year for another five years, he can pay off his $8000 credit card balance in just over one year. As mentioned above, I would recommend that Brad establish a monthly budget and set a goal of keeping his expenditures within budgetary limits. I would also recommend that Brad begin saving for retirement as soon as he has paid his credit card balance. Brad is probably paying a high interest rate on his credit card debt. Consequently, it would make more sense for Brad to pay his credit card debt before investing for retirement. Brad should not wait five years to begin saving for retirement, as this would result in a loss of compounded interest. Brad MacDonald Worksheet: Part 1 4

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    NAME DATE 4. Calculate Brad’s current ratio, liquidity ratio, debt-to-assets ratio, and savings ratio. What do these ratios tell you about how Brad is managing his financial resources? Current ratio 5 liquid assets/current liabilities 5 $4200/$8000 5 $0.525. Brad has insufficient liquid assets to cover his upcoming payments. For every dollar of liabilities, Hasan has approximately $0.53 in liquid assets. Liquidity ratio 5 liquid assets/monthly living expenses 5 $4200/($4600 – $1 120) 5 1.207 . With his present level of liquid assets, Brad is able to cover a little more than one month’s worth of living expenses. Although Brad has sufficient liquidity for his upcoming payments, he has inadequate liquidity if he were to face an emergency, such as an injury or illness. Debt-to-assets ratio 5 total liabilities/total assets 5 $18 000/$18 000 5 1 or 100%. Although it appears that Brad carries a significant amount of debt, this is not unusual for the Early Career life stage. Over time, his debt-to-assets ratio should decrease from its current level. Savings ratio 5 savings during the period/disposable income during the period 5 2 100/3380 5 2 (.0296) or 2 2.96%. Based on his current spending patterns, Brad is not in a position to save a portion of his disposable income. Brad must reevaluate his spending habits if he is to achieve his goals of paying off his credit card and saving for retirement. 5. Consider Brad’s goal to retire in 20 years by saving $4000 per year starting five years from now. a. Based on your analysis of Brad’s cash flow and your recommendations, is saving $4000 per year a realistic goal? If not, what other goal would you advise? As explained in Question 3, with certain reductions in current expenditures, Brad can realistically achieve his goal of saving $4000 per year in less than a year (assuming he pays his credit card balance first). b. In order for Brad to know what his $4000 per year will accumulate to in 20 years, what additional assumption (or piece of information) must he make (or have)? In order for Brad to determine his total accumulated savings, he will need to make certain assumptions about the rate of return that he can earn annually on his $4000 per year in savings. Brad MacDonald Worksheet: Part 1 5

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    NAME DATE c. Assuming that Brad invests the $4000 per year for 20 years, starting five years from now, and achieves an annual return of 9 percent, compounded monthly, how much will he accumulate in 25 years? P/Y 5 1, C/Y 5 12, N 5 20, I/Y 5 9, PV 5 0, PMT 5 $4000, FV 5 $213 594.17 d. Compare the alternative of investing $4000 every year for 25 years beginning today, with Brad’s plan to invest $4000 every year for 20 years beginning five years from now. How much will Brad have to save each year to accumulate the same amount that he would have had in 25 years if he started saving now instead of five years from now? (Again, assume a 9 percent annual return, compounded monthly.) If Brad starts saving now, he will have to save $2382.92 each year to accumulate the same amount in 25 years, calculated as: P/Y 5 1, C/Y 5 12, N 5 25, I/Y 5 9, PV 5 0, PMT 5 $2382.92 , FV 5 $213 594.17 6. Develop three or four suggestions that could help Brad reduce his income tax exposure. Suggestions to Reduce Taxes Pros Cons In order to reduce his income tax exposure, (a) Brad should review his financial situation to determine if he can take advantage of any deductions that he may not be aware of, such as carrying charges and/or professional dues. (b) If Brad is able to cut back on his expenditures as outlined above, he may be able to make RRSP contributions that would provide him with a dollar-for-dollar deduction against his current income. However, any RRSP contributions made would reduce his ability to quickly pay off his credit card balance and/or his car loan. In order to offset this trade-off, Brad could apply the tax refund generated by the RRSP contribution against one or both of his debt obligations. (c) As a salesperson, Brad may be eligible to deduct employment expenses that he may not be aware. For example, an employee may be able to deduct expenses if they maintain a work space at home. There are strict conditions for this type of employee deduction. Brad should review CRA guide T4044 - Employment Expenses to determine if he would be eligible employee expense deductions. Brad MacDonald Worksheet: Part 1 6

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    NAME DATE (d) Brad should review how effectively he is using his tax credits. In particular, charitable contributions are effective at reducing tax for individuals because the tax credit earned is calculated based on the highest federal marginal income tax bracket of 29 percent. Since Brad’s income falls below this marginal tax threshold, every dollar that he contributes to a qualifying charity will reduce his tax payable by more than what he had paid in tax on that dollar. Brad MacDonald Worksheet: Part 1 7

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    How to achieve the goal Assess alternative plans available and choose the most appropriate plan given the financial situation. How to implement the plan Sharon decided saving $500 a month is the best plan; deposit the money in a liquid investment, such as a savings account. How to evaluate the plan Sharon should monitor the progress to ensure that saving $500 each month is not too ambitious and is realistic. NAME DATE Chapter 1: The Sampsons—A Continuing Case CASE QUESTION Help the Sampsons summarize their current financial position, their goals, and their plans for achieving their goals by filling out the following worksheets. Current Financial Position Major Assets Amount Savings (high, medium, or low) Low Money owed $150 000 mortgage, $2000 credit card balance Salary The Sampson’s income was $54 000, but will now be about $66 000 since Sharon just started a part-time job Financial Goals Goal 1. Purchase a New Car for Sharon This Year Goal 2. Pay for the Children’s Post-Secondary Education in 12–17 Years from Now How to achieve the goal Assess alternative plans available and choose the most appropriate plan given the financial situation and the savings necessary for Sharon’s new car. How to implement the plan The Sampsons decided saving $300 a month is the best plan. Long-term investments, such as a tax-deferred education account (RESP), should be considered as investments. How to evaluate the plan The Sampsons should monitor the progress to ensure they are saving $300 each month, especially given the additional savings for Sharon’s new car. The Sampsons Worksheet: Chapter 1 1

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    NAME DATE Goal 3. Set Aside Money for Retirement How to achieve the goal Set aside a manageable and realistic amount each month toward retirement. This amount is currently contingent on meeting their other, shorter-term plans of buying a new car and saving for their children’s post- secondary education. How to implement the plan Seek the advice of a financial adviser to assess different investment options, such as stocks or bonds. The Sampsons should be aware that advisers may exaggerate the potential of investments and may recommend investments that give the adviser high commissions. How to evaluate the plan The Sampsons should monitor their progress to ensure they are saving at least some money for retirement. Since this is a very long-term goal, an annual assessment of their retirement savings is appropriate. The Sampsons Worksheet: Chapter 1 2

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    NAME DATE Part 2: Brad MacDonald—A Continuing Case CASE QUESTIONS 1. What factors should Brad consider in selecting a financial institution? Brad should consider the convenience of making deposits and withdrawals, including ABM locations and the availability of Web-based access. He should also consider interest rates paid to depositors and minimum balance requirements. Finally, Brad should consider fees such as service charges, per cheque charges, and ABM-use charges. 2. If Brad’s shares double in value over the next five years, what annual return, compounded monthly, would he realize? Based on his projected annualized return, would it be advisable to sell the shares to pay off his credit card? Should Brad consider shopping for a new credit card? If so, how should he go about doing this? If Brad is projecting that his stocks will double in the next five years, then the annual return, compounded monthly, that he will realize is 13.94%, computed as follows: P/Y 5 12, C/Y 5 12, N 5 60, I/Y 5 13.94 , PV 5 2 1300, PMT 5 0, FV 5 2600 Since there is no PMT being made, you may, assume any P/Y and adjust N to find the same: P/Y 5 1, C/Y 5 12, N 5 60, I/Y 5 13.94 , PV 5 2 1300, PMT 5 0, FV 5 2600 Comparing this to the 21 percent interest rate, compounded daily, that he is paying on his credit card, the best decision is, therefore, to liquidate the stock and use the proceeds to pay down his credit card balances. This is true even if the stock Brad owns do double in value over the next five years. Brad should also be advised to shop for a new credit card, considering the number of “fee-less” credit cards on the market today whose interest rates may be as low as 9 or 10 percent. A few internet searches will allow Brad to compare at least two or three credit cards with no fee and low interest rates. 3. Address Brad’s reluctance to pay off his credit card balance. Show him what he could earn in five years if he paid off the credit card balance and invested the required minimum monthly payment saved at 6 percent, compounded monthly. NOTE: The required minimum monthly payment is 3 percent of the outstanding balance of $8000. To convince Brad to pay off his credit card balance, point out to him that it is unlikely that he would realize a 21 percent annual return on his stocks over five years. If Brad were to sell his stocks and use the proceeds to pay off his credit card balance, he would not pay the monthly minimum payments of $245 (3% 3 $8000). Instead, he could invest the $240 minimum payment per month at an annual rate of 6 percent, compounded monthly, accumulating over $16 744.81 in five years, calculated as: P/Y 5 12, C/Y 5 12, N 5 60, I/Y 5 6, PV 5 0, PMT 5 2 240, FV 5 16 744.81 Brad MacDonald Worksheet: Part 2 1

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    NAME DATE 4. Assume that Brad has managed to pay off his credit card and no longer has a required minimum monthly payment of $250. All other expenses remain the same. Refer to Brad’s personal cash flow statement that you developed in Part 1 and recompute his personal cash flow statement: Given no credit card payment, with all other expenses staying the same, Brad’s Personal Cash Flow Statement shows a Positive Net Cash Flow of $150: Personal Cash Flow Statement Income This Month Gross monthly pay $4500 Total Income $4500 Expenses Taxes, CPP, and EI ($4000 2 $3380) $1 120 Rent 1600 Tenant’s insurance ($240/12) 20 Car payment 400 Utilities 100 Credit Card Payment 250 Smartphone 210 Groceries 200 Clothes 100 Car expenses 250 Entertainment 350 Total Expenses $4600 $150 Net Cash Flows Since Brad made the decision to closely monitor his expenses and reduce his smartphone and entertainment expenses, Brad’s revised cash flow statement is shown below. Note that he now has a positive net cash flow of $350 because he has managed to cut his monthly expenses by a total of $450. In this scenario, he saved $250 monthly due to having no credit card payment, $50 on smartphone expenses, and $150 on entertainment expenses. This results in an overall Positive Net Cash Flow of $350. Brad MacDonald Worksheet: Part 2 2

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    NAME DATE Personal Cash Flow Statement Income This Month Gross monthly pay $4500 Total Income $4500 Expenses Taxes, CPP, and EI ($4000 2 $3380) $1 120 Rent 1600 Tenant’s insurance ($240/12) 20 Car payment 400 Utilities 100 Smartphone 160 Groceries 200 Clothes 100 Car expenses 250 Entertainment 200 Total Expenses $4150 Net Cash Flows $350 Determine if Brad can afford to: a. Purchase the new car. If Brad purchases the car that he discussed and finances it at 8 percent for four years, a financial calculator or website shows that his monthly car payments will amount to $488: P/Y 5 12, C/Y 5 12, N 5 48, I/Y 5 8, PV 5 20 000, PMT 5 2 488.26, FV 5 0 Monthly car payment calculators can be found by searching for “calculators for car payments.” This exceeds his current car payment of $400 by more than $88. You should also mention to Brad that not only will his car payment increase with the purchase of his new vehicle, but very likely his car insurance will increase as well. (SUVs are one of the highest insurance cost categories for car insurance.) Purchasing the new car would result in Brad’s current monthly cash surplus being reduced. You need to mention to Brad that this will greatly restrict his ability to save for other goals such as his desired retirement. Brad MacDonald Worksheet: Part 2 3

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    NAME DATE b. Lease the new car. Brad’s idea to lease a car will result in lease payments of approximately $400 per month. Considering that Brad’s current three-year-old car has 87 000 kilometres on it (an average of 29 000 kilometres per year), he should also expect to incur additional kilometre charges over and above the $400 per month lease payment. At a rate of $0.35 per kilometre, Brad will incur an extra monthly charge of $145.83, calculated as ((29 000 2 240 000) * 0.35) 4 12. You should also remind Brad that in three years he will have no vehicle to show for his $400 per month lease payment. At the end of the three-year lease term, the cumulative value of his $400 per month lease payment and extra kilometres charges will exceed the cumulative value of his current $400 payment. Although there is no immediate reduction of his monthly cash surplus, Brad will have to pay an extra $5250 ($145.83/month * 36 months) at the end of the lease for the extra kilometres he will have driven based on his past driving history. This will impact his future ability to save for his other financial goals. Furthermore, Brad must pay a security deposit of $800 when signing the lease, which can be paid from the $5000 cash surplus he will have after selling his car for $15 000 and paying off the $10 000 mortgage. This leaves him $4200 to put toward his credit card debt. c. Purchase the condo. Purchasing the condo would lower Brad’s overall housing costs by approximately $223 per month. Using RBC Royal Bank to calculate mortgage payments ( https://www.rbcroyalbank.com/cgi- bin/ mortgage/mortcalc.pl), we find that Brad’s mortgage payment would be approximately $712.22 assuming the 6% is compounded semi-annually (as per the bank act) and paid per month (assuming a mortgage of $126 000 at 6 percent for 30 years). Adding to this the $150 per month in taxes ($1800/12), the $70 per month condo fee, a $20 per month ($240/12) increase in household insurance, and $125 per month in heating costs, you will come up with a total of $1077.22. This is $222.78 less than Brad’s current rent of $1300. The problem would be for Brad to secure the $19 620 needed for the down payment of $14 000, closing costs of $3100, and CMHC fees of $2520 (126 000 * 2%). Unless he could secure this from family members, the increased debt payment would more than offset the $222.78 per month savings from the purchase of the condo. Brad MacDonald Worksheet: Part 2 4

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    NAME DATE d. Purchase the car and the condo. In reviewing the calculations in (a) and (c) above, Brad cannot afford to purchase both the SUV and the condo without significantly reducing his monthly cash surplus which is needed to reach other goals. The only way for Brad to afford both the SUV and the condo is to increase his debt level. Given Brad’s goal to reduce his credit card debt, this is currently not the best course of action. e. Lease the car and purchase the condo. Again referring to the computations above in (b) and (c), it is apparent that Brad’s cash flow will not allow him to both lease the car and purchase the condo without significantly reducing his monthly cash surplus needed to reach other goals. 5. Based on the information you provided, Brad decides not to buy the condo at this time. How can he save the necessary funds to purchase a condo or house in the future? Be specific in your recommendations. By selling his stock and making changes to his financial situation, he can earmark a significant portion of the resulting $350 cash surplus for down payment accumulation. Investing the funds in an aggressive investment that could potentially yield 10 percent, Brad could accumulate the necessary funding for a down payment in a relatively short period of time. For example, assuming Brad saves $250 per month at an annual interest rate of 10 percent compounded monthly, he could accumulate $19 359 in just five years. This amount would be sufficient to cover the down payment and closing costs required on his targeted home. If Brad feels like investments earning 10% are too risky, he can instead choose to invest in a less aggressive investment and take more time to save the same amount. If Brad can one day pay for the down payment and closing costs, owning the home will save Brad money on a monthly basis, since he will not have to pay the rent of $1300 per month anymore. 6. In talking to Brad, you mention the increasing threat of identity theft. Brad seems concerned, and after asking him several questions, you determine the following: a. Brad has several credit cards in his wallet but uses only one regularly. He also carries his social insurance card, as he can never remember the number. b. Brad recycles, including old invoices, credit card statements, and bank statements after retaining them for the appropriate legal time period. Brad MacDonald Worksheet: Part 2 5

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    NAME DATE c. Brad uses his smartphone for virtually all his telephone calls, including ordering merchandise and paying by credit card. Comment on each of these points in terms of the risk of identity theft, and make recommendations to Brad for appropriate changes that will reduce his risk of exposure to identity theft. a. Brad has several credit cards in his wallet but uses only one regularly. He also carries his social insurance card, as he can never remember the number. Brad should keep the amount of identification in his wallet, including credit cards, to a minimum. In addition, Brad does not need to regularly carry his social insurance card in his wallet. If needed, he should use other forms of identification when possible. b. Brad recycles, including old invoices, credit card statements, and bank statements after retaining them for the appropriate legal time period. Brad should protect his personal information by ensuring that the items he is recycling, including old invoices, credit card statements, and bank statements, are shredded. c. Brad uses his smartphone for virtually all his phone calls, including ordering merchandise and paying by credit card. Brad should avoid ordering merchandise and paying by credit card unless he has initiated the contact or knows with whom he is dealing with. Brad MacDonald Worksheet: Part 2 6

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