Personal Finance, 7e (Madura)

Chapter 3 Applying Time Value Concepts

3.1 The Importance of the Time Value of Money

1) The time period over which you save money has very little impact on its growth.

2) The time value of money concept can help you determine how much money you need to save
over a period of time to achieve a specific savings goal.

3) Time value of money calculations, such as present and future value amounts, can be applied to
many day-to-day decisions.

4) Time value of money is only applied to single dollar amounts.

5) Your utility bill, which varies each month, is an example of an annuity.

6) In general, a dollar can typically buy more today than it can in one year.

7) An annuity is a stream of equal payments that are received or paid at equal intervals in time.

8) An annuity is a stream of equal payments such as a mortgage, social security payments or a

pension.

9) Time value of money computations relate to the future value of lump-sum cash flows only.

10) There are two sets of present and future value tables: one set for lump sums and one set for
annuities.

11) Money received today is worth more than the same amount of money received in the future.
This is true because
A) money received today can grow at a compounded rate.
B) inflation will devalue future dollars.
C) generally, goods and services will cost more in the future.
D) All of these.

12) The time value of money refers to

A) personal opportunity costs such as time lost on an activity.
B) financial decisions that require borrowing funds from a bank.
C) changes in interest rates due to changes in the supply and demand for money in the national
economy.
D) the difference in the value of money depending on when it is received.

13) The time value of money implies that a dollar received today is worth ________ a dollar
received tomorrow.
A) more than
B) less than
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C) the same as
D) Insufficient data to determine the answer.

14) The concept of the time value of money is based on

A) the level of unemployment.
B) taxes.
C) interest earned over time.
D) the Dow Jones Industrial Average.

15) An ordinary annuity can be defined as

A) a series of unequal payments received or paid at equal intervals at the beginning of each
period.
B) a series of equal payments received or paid at equal intervals of time at the end of each
period.
C) a lump sum.
D) intermittent payments for ordinary expenses.

16) Which of the following it not an annuity?

A) Equal monthly payments to your investment account
B) Lottery winnings of $100 per month for life
C) Mortgage payments for a fixed-rate loan
D) Monthly utility bills

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17) The concept of time value of money is important to financial decision making because
A) it emphasizes earning a return of interest on the money you invested.
B) it recognizes that $1 today has more value than $1 received a year from now.
C) it can be applied to future cash flows in order to compare different streams of income.
D) All of these are correct.

3.2 Future Value of a Dollar Amount

1) When money earns interest on interest, it is said to be compounding.

2) When money accumulates interest, it is said to be discounting.

3) In the tables for the future value of a single sum, the future value factors are all less than one.

4) In order to maximize the use of your money, you may want to delay payment of your bills
slightly beyond their due dates.

5) Assuming constant inflation, the length of the period does not matter when computing future
value of an amount today.

8) The process of earning ________ on interest is referred to as compounding.

A) dividends
B) interest
C) an annuity
D) cash outflows

9) The earning of interest on interest over time is called

A) an annuity.
B) an ordinary annuity.
C) compounding.
D) present value.

10) Which of the following is not an example of a future value?

A) The balance in your checking account today
B) A savings account balance in 5 years
C) A mortgage balance in 10 years
D) The value of a retirement account in 20 years

11) To determine how much you must save each year to have enough for your daughter's college
education, you would use the present value of $1 tables.

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12) Which of the following decisions would involve the use of the future value of $1? Select all
that apply.
A) Your brother buys your car and offers to pay you $500 now or $1,500 in two years.
B) You win a lawsuit and are offered a lump-sum payment today of $100,000 or $15,000 a year
for 20 years.
C) Your father and mother wish to deposit enough money on the date of your high school
graduation to enable you to take a cruise that will cost $7000 when you graduate from college in
4 years.
D) You want to have $1,000,000 in order to retire at age 55, but need to know how much you
will need to deposit each year from now until your 55th birthday.

13) Everything else being equal, the ________ the interest rate, the ________ the final
accumulation of money.
A) higher; higher
B) lower; lower
C) higher; lower
D) Both A and B are correct.

17) If you invest $12,000 today at an interest rate of 10%, how much will you have in 10 years?
A) $31,128
B) $25,940
C) $13,860
D) $40,712

18) Mr. Berkey deposits $10,000 in a money market account at his local bank. He receives
annual interest of 8% for 7 years. How much interest will he earn on his investment during this
time period?
A) $17,140
B) $7,140
C) $17,180
D) $7,180

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3.3 Present Value of a Dollar Amount

1) The process of obtaining present values is known as discounting.

2) The process of obtaining present values is known as compounding.

3) The present value interest factor (PVIF) becomes lower as the number of years increases.

4) The same tables can be used to figure future values and present values of $1.

5) The process of obtaining ________ values is referred to as discounting.

A) present
B) future
C) current
D) inflated

6) Susie wants to know how much she needs to save today to have $5,000 in five years. Which
of the following tables should she use?
A) Present value of $1
B) Present value of an ordinary annuity
C) Future value of $1
D) Future value of an ordinary annuity

7) Sandy wants to know how much she needs to save today to have $5,000 in five years at a 7%
interest rate. How much should she invest today?
A) $3500
B) $3946
C) $3565
D) Not enough information is provided.

8) Which of the following decisions would involve the use of the present value of $1?
A) Your brother buys your car and offers to pay you $500 per year for three years or $1,500 in
two years.
B) You win a lawsuit and are offered a lump-sum payment today of $100,000 or $15,000 a year
for 20 years.
C) Your father and mother wish to deposit enough money on the date of your high school
graduation to enable you to take a cruise that will cost $7,000 when you graduate from college in
4 years.
D) You want to have $1,000,000 in order to retire at age 55, but need to know how much you
will need to deposit each year from now until your 55th birthday.

9) Future and present values are dependent upon all of the following, except
A) time.
B) the interest rate.
C) a present or future value interest factor, depending on the problem.
D) annual income.

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12) How much must you invest today at 8% interest in order to see your investment grow to
$15,000 in 10 years?
A) $6,330
B) $6,945
C) $7,620
D) $7,500

13) If Joe has $5,600 today and invests it at a 10% interest rate, how much will he have in 12
years?
A) $17,393.60
B) $17,572.80
C) $15,770.49
D) $12,320.00

14) If Jim wants $25,000 in five years and can earn an 8% interest rate, how much does he need
to invest today?
A) $16,108
B) $17,025
C) $15,158
D) $17,829

3.4 Future Value of an Annuity

1) The cash flows of an annuity due occur at the beginning of each period.

2) An annuity due differs from an ordinary annuity in that the payments occur at the beginning of
the period instead of at the end of the period.

3) If the payment in an ordinary annuity changes over time, you cannot determine the future
value of the payment stream using annuity calculations.

5) Aaron wants to put $200 per month into an individual retirement account at 15% for four
years. What is he solving for using his financial calculator?
A) Present value
B) Future value
C) Interest rate
D) Payment

6) Lisa wants to know how much savings she would accumulate in 15 years if she saves $2,000
per year and her savings earns 4% per year. She needs to determine the
A) present value of an annuity.
B) annuity amount.
C) future value of one specific dollar amount today.
D) future value of an annuity.

7) Jerry wants to know how much he needs to save every year to accumulate $15,000 in five
years at a 10% interest rate. Which of the following tables should he use?
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A) Present value of $1
B) Present value of an ordinary annuity
C) Future value of $1
D) Future value of an ordinary annuity

10) To save for her newborn son's college education, Kelli Peterson will invest $1,500 at the end
of each year for the next 18 years. The interest rate she expects to earn on her investment is 9%.
How much money will she have saved by the time her son turns 18?
A) $55,461
B) $69,027
C) $61,952
D) $68,399

11) The future value of an ordinary annuity assumes that the payments are received
A) at the beginning of the year and the last payment does not compound.
B) at the end of the year and the last payment does not compound.
C) at the beginning of the year and the last payment is compounded.
D) at the end of the year and the last payment is compounded.

3.5 Present Value of an Annuity

1) To determine how much money you would need to save today to withdraw $10,000 a year for
five years, you would use the present value of an annuity tables.

2) Time value concepts can be applied to lottery winnings. The winner can usually choose an
annuity or a lump sum.

3) It is always better to choose a lump sum rather than to choose periodic payments over time.
This is why nearly all lottery winners choose the lump-sum payment.

4) The present value of an annuity can be obtained by discounting the individual cash flows of
the annuity and then summing the resulting present values.

5) You utilize present and future value concepts in investment, purchase, and retirement
decisions.

6) You can afford to make monthly payments of $400 for 60 months to buy a new car. Assuming
you can borrow at 6% per year interest, how would you figure out how much money you can
borrow?
A) Ask your dad
B) Use present value of an annuity calculation
C) Use future value of annuity calculation
D) Not enough information given to determine answer

7) Which of the following decisions would involve the use of the present value of a $1 ordinary
annuity table?
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A) Your brother buys your car and offers to pay you $500 now or $1,500 in two years.
B) You win a lawsuit and are offered a lump-sum payment today of $100,000 or $15,000 a year
for 20 years.
C) Your father and mother wish to deposit enough money on the date of your high school
graduation to enable you to take a cruise that will cost $7,000 when you graduate from college 4
years hence.
D) You want to have $1,000,000 in order to retire at age 55, but need to know how much you
will need to deposit each year from now until your 55th birthday.

8) To compute how much you would need to save each year for the next 25 years to allow you to
withdraw $20,000 for the following 30 years, you would need to use
A) the future value of an annuity.
B) the present value of an annuity.
C) both future and present value of an annuity.
D) both present and future value of $1.

9) To determine how much you would need to save each year to reach a specific goal, you would
use
A) present value of $1.
B) future value of $1.
C) present value of an annuity.
D) future value of an annuity.

10) Yogi Berra Jr. has agreed to play for the New York Mets for $4 million per year for the next
10 years. What table would you use to calculate the value of this contract in today's dollars?
A) Present value of a single amount
B) Future value of an annuity
C) Future value of a single amount
D) Present value of an annuity

11) The state lottery has just informed you that you have won $1 million to be paid out in the
amount of $50,000 per year for the next 20 years. With a discount rate of 12%, what is the
present value of your winnings?
A) $221,950
B) $398,150
C) $373,450
D) $392,150

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17) Lucky Louie just won the lottery! He has a choice of taking $1,000,000 in cash or receiving
$50,000 per year for 30 years beginning at the end of this year. The best way to make this choice
is to
A) consult an economic advisor.
B) consult an oracle.
C) calculate the future value of the annuity payments.
D) calculate the present value of the annuity payments.

3.6 Using Time Value to Estimate Savings

1) Present and future values concepts are applied in all of the following decisions, except
A) purchase of a home.
B) calculation of withdrawals needed during retirement.
C) calculation of savings for a large purchase.
D) annual cash inflows.

2) Present and future values concepts are not applied to which of the following?
A) Payments on a home
B) Calculation of withdrawals needed during retirement
C) Calculation of savings for a large purchase
D) The balance of your checking account today

3) The time value of money can be applied to all of the following, except
A) bond valuation.
B) stock valuation.
C) determining the current market value of your home.
D) determining the amount of taxes owed on income this year.

Use the data in table 3.1 to answer the following question(s):

Future value of $1 7% Year 5 Factor 1.403

Present value of $1 7% Year 5 Factor 0.713
Future value of a $1 ordinary annuity 7% Year 5 Factor 5.751
Present value of a $1 ordinary
annuity 7% Year 5 Factor 4.100

Table 3.1

4) Refer to Table 3.1 above. How much will you need to deposit today to enable you to withdraw
$1,000 each year for the next 5 years if the money is invested at 7%?
A) $1,403
B) $713
C) $5,751
D) $4,100

5) Refer to Table 3.1 above. How much will you have if you deposit $1,000 today in an account
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paying 7% and you leave it on deposit for 5 years?
A) $1,403
B) $713
C) $5,751
D) $4,100

6) Refer to Table 3.1 above. How much will you have if you deposit $1,000 each year for the
next 5 years in an account paying 7%?
A) $1,403
B) $713
C) $5,751
D) $4,100

7) Refer to Table 3.1 above. How much will you need to deposit today in an account paying 7%
if you wish to have $1,000 in 5 years?
A) $1,403
B) $713
C) $5,751
D) $4,100

9) If Art wants $35,000 in 10 years and can earn a 12% interest rate, how much does he need to
invest today?
A) $10,538
B) $10,310
C) $11,270
D) $14,375

10) At what annual rate would $200.00 grow to $497.60 in five years?
A) 19%
B) 18%
C) 20%
D) 22%

11) How many years will it take for $35 to grow to $53.87 if it is invested at 9% compounded
annually?
A) 6.0
B) 5.5
C) 5.0
D) 4.0

12) How many years will it take for $500 to grow to $1,039.50 if it is invested at 5%
compounded annually?
A) 15
B) 14
C) 13
D) 12

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3.7 How Time Value Fits Within Your Financial Plan

1) The future value of your savings and debt affect all of the following, except
A) financial planning tools.
B) protecting your wealth.
C) liquidity management.
D) marketing management.

Personal Finance, 7e (Madura)

Chapter 4 Using Tax Concepts for Planning

4.1 Background on The Tax System

1) Knowledge of tax laws can help you conserve your income.

2) Knowledge of individual income taxes is crucial to sound financial planning.

3) Taxpayers can have more than the minimum amount of required income tax withheld from
their pay.

4) Your gross wages are subject to FICA (Federal Insurance Contributions Act) taxes that fund
the Social Security system and Medicare.

5) There is no Social Security tax on income beyond a certain level.

11) The knowledge of tax laws can help you

A) conserve your income.
B) enhance your investments.
C) protect the transfer of your wealth at your death.
D) All of the above.

12) A branch of the U.S. Treasury Department, called the ________, administers the federal tax
system.
A) U.S. Department of Tax
B) Internal Revenue Service
C) U.S. Tax Authority
D) U.S. Department of Collection

15) If you have a salary of $30,000, an IRA deduction of $2,000, a standard deduction of
$12,000, and a FICA rate of 7.65 percent, how much did you pay in FICA taxes this year?
A) $1,805
B) $1,958
C) $2,142
D) $2,295
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4.2 Calculating Your Taxable Income

1) Different tax brackets are associated with each filing status such as single, married filing
jointly, and head of household.

2) All taxpayers have a large degree of freedom in choosing their filing status.

3) Which of the following is not a tax filing status option?

A) Single
B) Divorced
C) Married filing jointly
D) Head of household

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6) Gross income includes which of the following?
A) Salaries
B) Dividends
C) Capital gains
D) All of these

13) Capital gains occur when

A) you sell your home for more than you paid.
B) you sell your family car for more than you paid.
C) you sell investment assets for more than you paid.
D) Both A and C are correct.

14) Adjusted gross income is calculated by subtracting

A) your IRA contribution.
B) interest paid on student loans up to $2500.
C) unlimited interest paid on student loans.
D) Both A and B are correct.

15) Gross income consists of all reportable income from any source.

16) Interest and dividends received by an individual taxpayer are generally taxable.

17) The timing on the sale of an investment asset generating a capital gain makes little or no
difference in the amount of taxes that are owed.

18) A long-term capital gain results from profit on the sale of capital assets that were held 12
months or more.

19) Employee contributions to qualified Individual Retirement Accounts (IRAs) and interest paid
on student loans are deducted from gross income to calculate a taxpayer's adjusted gross income.

20) All reportable income from any source is called

A) wages and salaries.
B) gross income.
C) interest income.
D) dividend income.

4.3 Your Taxes If You Take the Standard Deduction

1) When calculating taxable income, you are allowed to reduce income by a standard deduction
or itemized list of deductions.

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4) Each year, taxpayers can choose whether to take the standard deduction or itemize their
deductions.

6) Taxable income equals

A) gross income less standard deduction.
B) gross income plus interest less standard deduction.
C) gross income less capital gains less itemized deductions.
D) None of these are correct.

8) Tax brackets are income levels that have different tax rates.

10) Marginal tax rate is the

A) average rate for your total income.
B) lowest rate applied to your taxable income.
C) rate applied to your last dollar of taxable income.
D) None of these is correct.

16) Lucky Louie earned a salary of $100,000 this year and interest income of $3,000. Louie, was
not so lucky in the stock market however and had capital losses of $3,000. What was Lucky
Louie's taxable income, assuming Louie takes the standard $12,000 deduction?
A) $88,000
B) $81,000
C) $89,000
D) $90,000
Answer: A
Diff: 3
Question Status: Major Revision
AACSB: Analytical Thinking

4.4 Calculating Your Taxes If You Itemize Deductions

1) All taxpayers have a choice of whether to take the standard deduction or itemize deductions.

7) The government usually adjusts itemized deduction amounts annually to account for inflation.
Answer: FALSE
Diff: 1
Question Status: Major Revision
AACSB: Application of Knowledge

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12) Purchasing which of the following items on credit may help reduce your tax bill?
A) Automobile
B) Home
C) Stereo
D) Boat

17) Legal methods of reducing your taxes include all of the following, except
A) organizing your records to track appropriate expenses and contributions.
B) preparing your return early in the tax preparation season so you are not rushed.
C) seeking the advice of an accountant.
D) overstating cash contributions to Salvation Army Christmas kettles.

20) Sally's adjusted gross income is $38,000. She owns a home and has mortgage interest
expense of $9500, charitable contributions of $1500, property tax of $7,000 and interest on her
car loan of $2,100. This year she also had medical expenses of $2,000. She is allowed a standard
deduction of $12,000. What is Sally's taxable income?
A) $38,000
B) $31,300
C) $20,000
D) $29,200

4.5 Conditions That Can Provide Tax Benefits

1) If you were to receive $100,000 from a corporation, the most tax-efficient way to receive it
would be as
A) dividends.
B) interest.
C) capital gains.
D) salary.

2) If a stock was purchased in January 2014 for $1,000 and sold in December 2015 for $3,000, a
________ of $2,000 results.
A) long-term capital gain
B) short-term capital gain
C) long-term capital loss
D) short-term capital loss

3) If a stock was purchased for $5,000 in January 2015 and is sold in December 2015 for $3,000,
a ________ of $2,000 results.
A) long-term capital gain
B) short-term capital gain
C) long-term capital loss
D) short-term capital loss
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4) Jane purchased General Motors stock for $20,000. Seven years later, in 2015, she sold the
stock for $35,000. What is Jane's gain or loss?
A) $15,000 long-term gain
B) $15,000 short-term gain
C) $15,000 extraordinary gain
D) No gain or loss is recognized.

5) If you own stock that has increased in price, it would be best to sell it after you have owned it
for at least
A) 6 months and one day.
B) 12 months and one day.
C) 18 months and one day.
D) 24 months and one day.

4.6 How Tax Planning Fits Within Your Financial Plan

1) The key tax planning decisions in building your financial plan are knowing what tax savings
are currently available to you and how you can increase your tax savings in the future.

2) Describe how taxes affect your personal budget, income statement, and balance sheet.

6) Prudent tax planning considers ways to

A) reduce your taxes by not recognizing some of your income.
B) reduce income by deferring recognition via 401k and IRA accounts.
C) maximize long-term capital gains.
D) Both B and C are correct.

Personal Finance, 7e (Madura)

Chapter 5 Banking and Interest Rates

5.1 Types of Financial Institutions

1) Bank fees for use of an automated teller machine (ATM) do not need to be considered when
choosing a bank since fees are set by the federal government and are the same for all banks.

2) Bank ATM charges may be substantial if you make many transactions monthly and use out-
of-network machines.

3) Depository institutions are financial institutions that accept deposits (that are insured up to a
maximum level) from individuals or firms and provide loans.

4) An example of a depository financial institution is an insurance company.

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7) Credit unions are nonprofit depository institutions that serve members who have a common
affiliation (such as the same employer or same community).

10) Finance companies are more selective in choosing the borrowers they serve, and therefore
they usually charge lower interest rates than banks or credit unions.

12) A mutual fund is a means by which investors with relatively small amount of money can
invest in a portfolio of securities.

13) Financial institutions loan funds at ________ they pay depositors.

A) a lower interest rate than
B) a higher interest rate than
C) a rate equal to the rate
D) a cost plus 3% of what

15) Financial institutions that accept deposits (that are insured up to a maximum level) from
individuals and provide loans are called
A) finance companies.
B) depository institutions.
C) investment companies.
D) nondepository institutions.

16) Which of the following is not a depository institution?

A) Commercial bank
B) Securities firm
C) Savings institution
D) Credit union

19) Which of the following financial institutions would be used the most by business customers
wishing to borrow money?
A) Commercial banks
B) Savings institutions
C) Credit unions
D) All are used equally by business customers.

20) To join a credit union, you need to

A) have a steady job.
B) be a member of a group with a common bond.
C) have established good credit.
D) be sponsored by an existing member of that credit union.

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24) Which of the following financial institutions specializes in making personal loans to people
who are perceived to have a higher risk of default?
A) Finance companies
B) Commercial banks
C) Savings institutions
D) Credit unions

25) If you were taking out a personal loan, the highest rate would probably be charged by a
A) commercial bank.
B) finance company.
C) member of your family.
D) credit union.

29) A financial conglomerate offers a diverse set of services that include which of the following?
A) Credit cards
B) Personal loans
C) Brokerage subsidiary
D) All of the above

31) If you have $10,000 that you do not currently need for expenses and you wish to put it
somewhere so that it will earn a return, which of the following financial institutions would you
not choose?
A) Savings institution
B) Finance company
C) Securities firm
D) Investment company

32) You have $3,000 that you may need any day to replace the furnace in your house. Which of
the following would be the best place to put the $3,000?
A) A one-year CD earning 4%
B) A common stock mutual fund earning 9%
C) A savings account earning 2%
D) Shares of stock in a high-tech company that could double in 6 months

33) Your great aunt Mary passed away and left you an inheritance of $5,000. Since you don't
have a need for the money in the near future, which of the following would be the best place to
put the $5,000?
A) A savings account earning 1% interest
B) A checking account
C) A five-year CD paying 4.38% annually
D) High-risk stock in a producer of natural gas that is predicted to triple in the next year

39) Lucky Louie has $10,000 that he wants to invest for 3 years but wants to take no risk on the
investment. His best course of action would be to
A) invest in a 3-year Treasury note.
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B) invest in a blue-chip stock portfolio.
C) put his money in a 3-year CD at his bank.
D) Both A and C are correct.

5.2 Banking Services Offered

1) To prevent an overdraft or "bounced check," it is always a good idea to record each check
written in your check register and reconcile your account balance when you receive your
monthly bank statement.

2) You can be assured that if your ATM query shows you have a certain balance in your
checking account, that figure is more accurate than the amount in your check register.

3) Debit cards allow you to pay for a purchase later when the bill arrives.

4) A debit card differs from a credit card in that it does not provide credit; instead, it deducts the
purchase from your checking account immediately.

5) Banks do not charge fees for safety deposit boxes.

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8) A(n) ________ card allows you to pay for a purchase at a later time when the bill arrives.
A) credit
B) debit
C) expense
D) ATM

9) A(n) ________ card allows you to pay for a purchase directly from your checking account
without writing a check.
A) credit
B) debit
C) expense
D) travel

13) Your checkbook balance at the end of May is $1,041.52. When you receive May's bank
statement, you discover the following additional items: Bank fees, $27.00; Interest earned,
$16.35. Your adjusted checkbook balance after considering these items is
A) $1030.87.
B) $1052.17.
C) $950.04.
D) $997.65.

5.3 Selecting a Financial Institution

1) Convenience, deposit rates and insurance, and fees are primary considerations in choosing a
financial institution for your needs.

2) Since rates and fees differ only slightly between all national banks, there is little need to
consider these when choosing your financial institution.

3) Because of potential security concerns, it is unlikely that you will find a financial institution
that offers mobile applications.

4) Because they have lower expenses, Web-based financial institutions tend to pay higher
interest rates on deposits than institutions with physical branches.

8) Lorenzo is considering two banks for his checking account. Suny Bank requires a minimum
deposit of $100 and charges a monthly fee of $8, plus 5 cents a check. Merchants Bank also
requires a minimum deposit of $100, it charges a per check fee of 15 cents but no monthly fee.
How many checks would Lorenzo need to write each month to make Suny Bank cheaper to use
than Merchants?
A) over 50
B) over 60
C) over 70
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D) over 80

10) Lucky Louie's bank requires a minimum balance at all times of $1500 in order to provide
free checking services. The bank pays .5% per annum interest on the minimum balance. If you
do not maintain the balance, account service fees are $4 per month. Assuming Lucky can earn
2.5% on his money not sitting at the bank, what is his net benefit to maintaining the minimum
balance?
A) Not a benefit; he should invest his money elsewhere at 2.5%
B) $18 per year benefit
C) $48 per year benefit
D) Breakeven

5.4 Interest Rates on Deposits and Loans

1) Certificates of deposit (CDs) with shorter maturity dates tend to pay higher interest rates than
those with longer maturity dates.

2) A certificate of deposit guarantees or locks in an interest rate for a specified time and rate.

3) A risk-free rate is a return on an investment that is guaranteed for a specified period.

4) A risk premium is the amount of interest you might receive over and above the risk-free return
insured by the federal government.

5) Investments with a higher risk of default pay higher rates of interest than those that are less
risky.

12) The ________ is an additional return beyond the risk-free rate that can be earned from a
deposit guaranteed by the government.
A) risk-free rate
B) risk premium
C) specific return
D) nominal return
Answer: B
Diff: 1
Question Status: Carryover
AACSB: Application of Knowledge

13) Your commercial bank is offering a one-year CD with an interest rate of 7%. A financial
company offers an interest rate of 10% on its one-year certificate (not a CD). The risk premium
offered by the financial company is
A) 7%.
B) 3%.
C) 4%.
D) 1.5%.

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14) The interest rate is composed of the ________ and the ________.
A) risk-free rate; risk discount
B) risk-free rate; risk premium
C) risk-free rate; default risk premium
D) None of the above

15) In saving or investing, the ________ the risk, the ________ the potential return.
A) higher; higher
B) lower; lower
C) higher; lower
D) Both A and B are correct.

16) The relationship between risk and return

A) is positive.
B) is negative.
C) is inverse.
D) has no correlation.

17) Juan has $1,000 that he would like to invest in a CD. His bank offers two alternatives, a one-
year CD paying 6% or a two-year CD paying 9% per annum. Juan has been reading that interest
rates are rising, and, based on his research, he estimates that by year-end the rate on one-year
CDs will increase to 10%. What alternative would give Juan the most interest and what would
the total interest be?
A) Two one-year CDs returning $120 interest
B) Two one-year CDs returning $160 interest
C) One two-year CD returning $180 interest
D) One two-year CD returning $1,900 interest

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18) Jack has $1,000 that he wishes to invest for the next two years. One-year CDs are currently
paying 8% while two-year CDs are paying 12% per annum. Economists are predicting that
interest rates will rise by the end of the year. What is the minimum interest rates would have to
increase to in order for the one-year CD to be better than the two-year CD?
A) 16%
B) 14%
C) 12%
D) 10 %

5.5 Why Interest Rates Change

1) Interest rate changes are affected by the relationship of the total supply of funds provided by
all investors and the total demand for funds by all borrowers.

2) The monetary policy of the Federal Reserve System (the Fed) has very little to do with the
changes in interest rates a consumer will experience.

3) The risk-free rate on borrowed funds is determined by

A) the Federal Reserve.
B) Congress.
C) supply and demand.
D) the banking system.

4) Information such as ________ can be easily found on a variety of Web sites.

A) loan rates
B) stock quotes and company information
C) yields of Treasury securities
D) All of the above

5) When interest rates rise, individuals who make deposits will earn a ________ rate of interest,
while individuals who need to borrow funds will have to pay a ________ rate.
A) higher; lower
B) lower; higher
C) higher; higher
D) lower; lower

9) If the government borrows funds to finance a military build-up, this will cause a
A) shift in the demand for funds.
B) shift in the supply of funds.
C) shift in monetary policy.
D) shift in open-market operations.

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11) Which of the following is true with regard to rising interest rates?
A) Use short-term loans to take advantage of low interest rates.
B) Select long-term savings options to lock in current interest rates.
C) Use long-term loans to take advantage of current low rates.
D) The term of the loan option is not affected by rising interest rates.

14) When the Fed loosens monetary policy, interest rates will ________ and money supply will
________.
A) go up; stay the same
B) go down; stay the same
C) go down; go up
D) go up; go down`

5.6 How Banking Services Fit Within Your Financial Plan

1) Describe how interest rates affect your personal budget, income statement, and balance sheet.
What account groups do they affect? Give two specific examples.

2) If you are anticipating a rising interest rate environment, your planning and analysis of your
loan and investment portfolio should focus on
A) minimizing fixed rate investments and moving variable rate debt to fixed rate.
B) investing in more fixed rate securities and moving variable rate debt to fixed rate.
C) investing in preferred stock since the dividend rate is above the CD and bond interest rates.
D) investing in CDs since they are insured by FDIC and minimizing borrowing.

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