Solutions to Critical Thinking Cases
2.1 The Becker’s Version of Financial Planning
Terry and Evelyn Becker are a married couple in their mid-20s. Terry has a good start as an electrical engineer and
Evelyn works as a sales representative. Since their marriage four years ago, Terry and Evelyn have been living
comfortably. Their income has exceeded their expenses, and they have accumulated an enviable net worth. This
includes $10,000 that they have built up in savings and investments. Because their income has always been more
than enough for them to have the lifestyle they desire, the Beckers have done no financial planning.
Evelyn has just learned that she’s two months pregnant. She’s concerned about how they’ll make ends meet if she
quits work after their child is born. Each time she and Terry discuss the matter, he tells her not to worry because
“we’ve always managed to pay our bills on time.” Evelyn can’t understand his attitude because her income will be
completely eliminated. To convince Evelyn that there’s no need for concern, Terry points out that their expenses
last year, but for the common stock purchase, were about equal to his take-home pay. With an anticipated
promotion and an expected 10 percent pay raise, his income next year should exceed this amount. Terry also points
out that they can reduce luxuries (trips, recreation, and entertainment) and can always draw down their savings or
sell some of their stock if they get in a bind. When Evelyn asks about the long-run implications for their finances,
Terry says there will be “no problems” because his boss has assured him that he has a bright future with the
engineering firm. Terry also emphasizes that Evelyn can go back to work in a few years if necessary.
Despite Terry’s arguments, Evelyn feels that they should carefully examine their financial condition in order to do
some serious planning. She has gathered the following financial information for the year ending December 31,
2016:
Salaries Take-home Pay Gross Salary
Terry $52,500 $76,000
Evelyn 29,200 42,000
Item Amount
Food $ 5,902
Telephone 640
Auto loan balance 4,650
Common stock investments 7,500
Cash on hand 85
2012 Nissan Sentra 10,500
Medical expenses (unreimbursed) 600
Homeowner’s insurance premiums paid 1,300
Checking account balance 485
Auto loan payments 2,150
Money market account balance 2,500
Critical Thinking Questions
1. Using this information and Worksheets 2.1 and 2.2, construct the Becker’s balance sheet and income and
expense statement for the year ending December 31, 2016.
2. Comment on the Becker’s financial condition regarding (a) solvency, (b) liquidity, (c) savings, and (d)
ability to pay debts promptly. If the Becker’s continue to manage their finances as described, what do
you expect the long-run consequences to be? Discuss.
a. Solvency Ratio: This ratio shows the degree of exposure to insolvency or how much “cushion” you have as
protection against insolvency. The calculation for her solvency ratio is as follows:
b. Liquidity Ratio:
c. Savings
d. Debt Service ratio = Monthly loan payments = $1,282 = 13.04%
The level of income is substantially covering their loan payments, thus assuming continued income, their debts
are secured.
The Becker’s income is sufficient to build a better Balance Sheet in the future so that their net worth should
3. Critically evaluate the Becker’s approach to financial planning. Point out any fallacies in Terry’s
arguments, and be sure to mention (a) implications for the long term, as well as (b) the potential impact
of inflation in general and specifically on their net worth. What procedures should they use to get their
financial house in order? Be sure to discuss the role that long- and short-term financial plans and
budgets might play.
At this point, the key to their future is maintaining the two income family. Long term if both incomes continue, the
Beckers will build their net worth. While inflation is a constant threat, the impact will be on their real property and large
1.2Brooke Stauer Learns to Budget
Brooke Stauffer recently graduated from college and moved to Atlanta to take a job as a market research analyst.
She was pleased to be financially independent and was sure that, with her $45,000 salary, she could cover her living
expenses and have plenty of money left over to furnish her studio apartment and enjoy the wide variety of social
and recreational activities available in Atlanta. She opened several department-store charge accounts and obtained
a bank credit card. For a while, Brooke managed pretty well on her monthly take-home pay of $2,893, but by the
end of 2016, she was having trouble fully paying all his credit card charges each month. Concerned that her
spending had gotten out of control and that she was barely making it from paycheck to paycheck, she decided to
list her expenses for the past calendar year and develop a budget. She hoped not only to reduce her credit card debt
but also to begin a regular savings program.
Brooke prepared the following summary of expenses for 2016:
Item Annual Expenditure
Rent $12,000
Auto insurance 1,855
Auto loan payments 3,840
Phone 600
Cable TV 440
Gas and electricity 1,080
Medical care 120
After reviewing his 2016 expenses, Brooke made the following assumptions about her expenses for 2017:
1. All expenses will remain at the same levels, with these exceptions:
a. Auto insurance, auto expenses, gas and electricity, and groceries will increase 5 percent.
b. Clothing purchases will decrease to $2,250.
c. Phone and cable TV will increase $5 per month.
d. Furniture purchases will decrease to $660, most of which is for a new television.
e. She will take a one-week vacation to Colorado in July, at a cost of $2,100.
2. All expenses will be budgeted in equal monthly installments except for the vacation and these items:
a. Auto insurance is paid in two installments due in June and December.
b. She plans to replace the brakes on her car in February, at a cost of $220.
c. Visits to the dentist will be made in March and September.
3. She will eliminate her bank credit card balance by making extra monthly payments of $75 during each of the
first six months.
4. Regarding her income, Brooke has just received a small raise, so her take-home pay will be $3,200 per month.
Critical Thinking Question
1. a. Prepare a preliminary cash budget for Brooke for the year ending December 31, 2016, using
the format shown in Worksheet 2.3.
b. Compare Brooke’s estimated expenses with his expected income and make recommendations that
will help him balance her budget.
2. Make any necessary adjustments to Brooke’s estimated monthly expenses, and revise her annual cash
budget for the year ending December 31, 2016, using Worksheet 2.3.
3. Analyze the budget and advise Brooke on her financial situation. Suggest some long-term, intermediate,
and short-term financial goals for Brooke, and discuss some steps she can take to reach them.
Case 2.2, Problem 1a
Income and Expense Statement
Name: Brooke Stauer
For the Year Ending December 31, 2016
Income 2016 2017
Salary Alex’s take-home pay of $2,893/mo in
2016 and $3,200/mo in 2017 . $ 34,716 $ 38,400
Other income
Phone 600 660
Cable TV and other 440 500
Food Groceries 2,500 2,625
Other transportation expenses
Medical Health-related insurance
Doctor, dentist, hospital, medicines 190 190
Clothing Clothes, shoes, accessories 3,200 2,250
Insurance Homeowner’s
Life
Personal care Laundry, cosmetics, hair care 424 424
Recreation &
entertainment
Vacations 2,100
Other recreation and entertainment 2,900 2,900
Case 2.2, Problem 2—Worksheet
2.3 ANNUAL CASH BUDGET BY MONTH
Name(
s) Brooke Stau!er
For the
Yea
rending December 31, 2017
INCOME Jan
.
Fe
b.
Mar
.
Apr. May Jun
e
July Au
g.
Se
pt.
Oct. No
v.
Dec. Total
Take-home
pay
3,2
00
3,2
00
3,20
0
3,20
0
3,20
0
3,20
0
3,200 3,2
00
3,2
00
3,20
0
3,2
00
3,20
0
38,4
00
Phone 55 55 55 55 55 55 55 55 55 55 55 55 660
Cable TV 41 41 41 41 42 42 42 42 42 42 42 42 500
Groceries 218 218 218 219 219 219 219 219 219 219 219 219 2,62
5
Dining out 216 216 216 216 217 217 217 217 217 217 217 217 2600
Auto
insurance
0 0 0 0 0 974 0 0 0 0 0 974 1,94
8
Installment
loan for
stereo
45 45 45 45 45 45 45 45 45 45 45 45 540
Personal
care
35 35 35 35 35 35 35 35 36 36 36 36 424
us expenses
Credit card
payments
75 75 75 75 75 75 0 0 0 0 0 0 450
Roth IRA
contribution
s
[2] Total
Expenditur
es
2,7
71
2,8
62
2,80
5
2,77
2
2,77
5
3,74
9
4,802 2,7
02
2,7
38
2,70
3
2,7
03
3,67
7
37,0
59
MONTHLY
(DEFICIT)
3. Analyze the budget and advise Brooke on her financial situation. Suggest some long-term, intermediate,
and short-term financial goals for Brooke, and discuss some steps she can take to reach them.
Hanging by a thread summarize Brooke’s current position. The income statement for the two years provide sufficient
information to assess her current position. It would be a good exercise for the class to discuss what could be reduced.
Terms Found in the Chapter
annuity A fixed sum of money that occurs annually.
assets Items that one owns.
balance sheet A financial statement that describes a person’s financial position at a given point in
time.
budget A detailed financial report that looks forward, based on expected income and
expenses.
budget control
schedule
A summary that shows how actual income and expenses compare with the various
budget categories and where variances (surpluses or deficits) exist.
budget variance The difference between the budgeted and actual amount paid out or received.
cash basis A method of preparing financial statements in which only transactions involving
actual cash receipts or actual cash outlays are recorded.
cash deficit An excess amount of expenses over income, resulting in insufficient funds as well
as in decreased net worth.
cash surplus An excess amount of income over expenses that results in increased net worth.
compounding When interest earned each year is left in an account and becomes part of the balance
(or principal) on which interest is earned in subsequent years.
current (short-term)
liability
Any debt due within 1 year of the date of the balance sheet.
debt service ratio Total monthly loan payments divided by monthly gross (before-tax) income;
provides a measure of the ability to pay debts promptly.
discounting The process of finding present value; the inverse of compounding to find future
value.
equity The actual ownership interest in a specific asset or group of assets.
expenses Money spent on living costs and to pay taxes, purchase assets, or repay debt.
fair market value The actual value of an asset, or the price for which it can reasonably be expected to
sell in the open market.
future value The value to which an amount today will grow if it earns a specific rate of interest
over a given period.
fixed expenses Contractual, predetermined expenses involving equal payments each period.
income and
expense statement
A financial statement that measures financial performance over time.
income Earnings received as wages, salaries, bonuses, commissions, interest and dividends,
or proceeds from the sale of assets.
insolvency The financial state in which net worth is less than zero.
investments Assets such as stocks, bonds, mutual funds, and real estate that are acquired in order
to earn a return rather than provide a service.
liabilities Debts such as credit card charges, loans, and mortgages.
liquid assets Assets that are held in the form of cash or that can readily be converted to cash with
little or no loss in value.
liquidity ratio Total liquid assets divided by total current debts; measures the ability to pay current
debts.
long-term liability Any debt due 1 year or more from the date of the balance sheet.
net worth An individual’s or family’s actual wealth; determined by subtracting total liabilities
from total assets.
open account credit
obligations
Current liabilities that represent the balances outstanding against established credit
lines.
personal financial
statement
Balance sheets and income and expense statements that serve as essential planning
tools for developing and monitoring personal financial plans
present value The value today of an amount to be received in the future; it’s the amount that
would have to be invested today at a given interest rate over a specified time period
to accumulate the future amount.
personal property Tangible assets that are movable and used in everyday life.
real property Tangible assets that are immovable: land and anything fixed to it, such as a house.
rule of 72 A useful formula for estimating about how long it will take to double a sum at a
given interest rate.
savings ratio Cash surplus divided by net income (after tax);indicates relative amount of cash
surplus achieved during a given period.
solvency ratio Total net worth divided by total assets; measures the degree of exposure to
insolvency.
timeline A graphical presentation of cash flows.
time value of money The concept that a dollar today is worth more than a dollar received in the future.
variable expenses Expenses involving payment amounts that change from one time period to the next.
.
Chapter Outline
Learning Goals
I. Mapping Out Your Financial Future
A. The Role of Financial Statements in Financial Planning
B. Assessing Your Financial Situation, Plans, and Goals
*Test Yourself*
II. The Balance Sheet: How Much Are You Worth Today?
A. Assets: The Things You Own
B. Liabilities: The Money You Owe
C. Net Worth: A Measure of Your Financial Worth
D. Balance Sheet Format and Preparation
E. A Balance Sheet for Simon and Meghan Kane
*Test Yourself*
III. The Income and Expense Statement: What We Earn and Where It Goes
A. Income: Cash In
B. Expenses: Cash Out
C. Cash Surplus (or Deficit)
D. Preparing the Income and Expense Statement
E. An Income and Expense Statement for Simon and Meghan Kane
*Test Yourself*
IV. Using Your Personal Financial Statements
A. Keeping Good Records
B. Managing Your Financial Records
C. Tracking Financial Progress: Ratio Analysis
D. Balance Sheet Ratios
E. Income and Expense Statement Ratios
*Test Yourself*
V. Cash In and Cash Out: Preparing and Using Budgets
A. The Budgeting Process
B. Forecasting Income
C. Forecasting Expenses
D. Finalizing the Cash Budget
E. Dealing with Deficits
F. A Cash Budget for Simon and Meghan Kane
E. Using Your Budgets
*Test Yourself*
VI. The Time Value of Money: Putting a Dollar Value on Financial Goals
A. Future Value
B. Future Value of a Single Amount
C. Future Value of an Annuity
D. The Rule of 72
E. Present Value
1. Present Value of a Single Amount
2. Present Value of an Annuity
3. Other Applications of Present Value
*Test Yourself*
Summary
Financial Planning Exercises
Applying Personal Finance
What’s Your Condition?
Critical Thinking Cases
2.1 The Beckers’ Version of Financial Planning
2.2 Brooke stauffer Learns to Budget
Money Online!