BUS 225 Personal Finance Midterm Study Guide

Comprehensive vocabulary flashcards covering personal finance midterm topics: investing concepts, TVM inputs, financial ratios, retirement accounts, credit scores, and risk parameters.

Stock

An equity security representing ownership and a residual claim on a company's assets and earnings, whose dividends are not guaranteed. Offers uncertain growth.

Bond

A creditor claim with promised interest and principal payments, subject to default risk and interest-rate risk.

treasury

have very low credit risk; prices can fall when rates rise

Diversification

The technique of spreading investments across multiple issuers, industries, countries, and asset classes to reduce company-specific concentration risk, though it cannot eliminate broad market losses.

Dollar-Cost Averaging

A strategy of investing equal dollar amounts at regular intervals, resulting in purchasing more shares at lower prices and fewer at higher prices without guaranteeing a profit.

Asset Allocation

The process of setting target portfolio percentage weights across broad asset classes to establish an investor's desired risk and return profile. Sets the target mix

Rebalancing

The practice of buying and selling portfolio assets to restore the portfolio to its target asset allocation weights after market drift, functioning as risk control rather than a return prediction.

young investor

long horizon can support more stock exposure, but emergency cash, near-term goals, and ability to tolerate losses still matter

Exchange-Traded Fund (ETF)

An investment fund that trades intraday on a stock exchange at market prices, which can differ from its net asset value (NAV) due to spreads, premiums, or discounts.

Open-End Mutual Fund

An investment fund that executes shareholder purchase and redemption orders once per business day at the next calculated net asset value (NAV).

Expense Ratio

The percentage of fund assets deducted annually to cover operating and administrative expenses relative to total assets. Lower cost helps when benchmark and other features are comparable

Beta

A statistical measure of an asset's or portfolio's return sensitivity relative to a chosen market benchmark. It indicates how much an asset's price is expected to move relative to market movements, with a beta of 1 meaning the asset moves in line with the market.

Beta 1.3

indicates higher sensitivity

Beta 0.7

indicates less sensitivity; does not prove low total risk or adequate diversification

Traditional Retirement Account

A retirement tax wrapper (e.g., Traditional 401(k) or IRA) that generally permits pre-tax or deductible contributions and tax-deferred growth, with withdrawals taxed as ordinary income.

Roth Retirement Account

A retirement tax wrapper funded with after-tax contributions that provides tax-free investment growth and tax-free qualified withdrawals.

Vesting Schedule

A statutory timetable determining the percentage of employer-matching retirement contributions that an employee is entitled to keep upon separation from employment.

defined contribution

outcome depends on contributions, returns, fees, and withdrawals

defined benefit

benefit follows a pension formula, subject to plan terms that guarantee retirement income based on salary and years of service.

early distributions

A taxable withdrawal before age 59 1/2 generally faces ordinary income tax plus a 10% additional tax unless an exception applies

Required Minimum Distribution (RMD)

A mandatory annual retirement account withdrawal beginning at age $73$ for individuals born between 1951 and 1959, and age $75$ for individuals born in 1960 or later.

Sequence-of-Returns Risk

The danger that experiencing negative market returns early during retirement withdrawal periods causes accelerated portfolio depletion, even when average returns match long-term expectations.

Rule of 72

A mental math shortcut estimating the years required for an investment to double by dividing $72$ by the annual return percentage ($\text{Doubling time} \approx \frac{72}{\text{annual return in percent}}$).

Dividend Yield

A financial ratio calculated as annual dividend per share divided by current price per share ($\frac{\text{Annual dividend per share}}{\text{Current price per share}}$).

Holding-Period Total Return

The total percentage return generated over a holding period, calculated as $\frac{\text{Ending price} - \text{Beginning price} + \text{Cash dividends}}{\text{Beginning price}}$.

Portfolio Return

sum of (beginning weight x asset return); weights must total 100%

Rebalancing formula

target weight x current total portfolio = target dollar holding

Net Worth

A balance sheet metric representing personal wealth, calculated as total assets minus total liabilities

($\text{Total assets} - \text{Total liabilities}$ ).

Liquidity Ratio

A financial indicator of short-term expense coverage, calculated as liquid assets divided by monthly expenses ($\frac{\text{Liquid assets}}{\text{Monthly expenses}}$), expressed in months covered.

Course No-Debt Current Ratio

A project-specific ratio measuring expense reserves, calculated as liquid assets divided by annual expenses ($\frac{\text{Liquid assets}}{\text{Annual expenses}}$), expressed in years covered with a target of at least $1.0$.

consumer debt ratio

monthly nonmortgage debt payments / monthly take-home pay

debt payment

monthly debt payments / gross monthly income

Debt-to-Asset Ratio

A solvency metric measuring balance sheet leverage, calculated as total liabilities divided by total assets ($\frac{\text{Total liabilities}}{\text{Total assets}}$).

Savings Ratio

A cash-flow ratio measuring savings effort, calculated as annual savings divided by annual gross income ($\frac{\text{Annual savings}}{\text{Annual gross income}}$).

Housing (Front-End) Ratio

A financial ratio comparing monthly housing costs (such as PITI) to gross monthly income ($\frac{\text{Monthly housing costs}}{\text{Gross monthly income}}$).

Fixed-to-Variable Expense Ratio

A budget flexibility measure calculated as monthly fixed expenses divided by monthly variable expenses ($\frac{\text{Monthly fixed expenses}}{\text{Monthly variable expenses}}$), with a project target of $1:1$ or less.

Net worth to income ratio

net worth / annual income; use stated income definition

investment allocation ratio

asset-class value / total investment portfolio value

Real Return

An inflation-adjusted rate of return calculated by the formula $\frac{1 + \text{nominal return}}{1 + \text{inflation}} - 1$.

Preferred shares vs common shares

preferred shares have a fixed dividend and priority over common shares in asset liquidations, while common shares usually have voting rights and dividends that can fluctuate.

2 bond risks

interest rate risk & credit/default risk

Interest-Rate Risk

The risk that existing fixed-rate bond prices will fall when market yields rise, with longer maturities and higher duration exhibiting greater sensitivity.

Credit/Default Risk

The risk that a bond issuer will fail to make promised interest or principal payments, requiring lower credit quality issuers to pay higher yields to compensate investors.

Risk Tolerance

An investor's psychological willingness to accept investment volatility and potential financial losses.

Risk Capacity

An investor's actual financial ability to absorb financial losses without jeopardizing immediate goals or financial solvency.

Inflation risk

purchasing power declines

Liquidity risk

selling quickly at a fair price is difficult

market risk

broad prices fall

business risk

an individual firm performs poorly

interest rate risk (scenario language)

changing rates affect values

balance sheet

A financial statement that summarizes a company's assets, liabilities, and shareholders' equity at a specific point in time, providing a snapshot of its financial position.

cash flow statement

A financial statement that provides a summary of the cash inflows and outflows of a company over a specific period, showing how cash is generated and used in operating, investing, and financing activities.

budget

A financial plan that outlines expected income and expenditures over a defined period, helping individuals or organizations manage their finances effectively.

50/30/20 Rule

A budgeting framework allocating take-home income into $50\%$ needs, $30\%$ wants, and $20\%$ savings and debt repayment.

SMART goal

A specific, measurable, achievable, relevant, and time-bound objective that helps individuals set and reach personal or financial targets effectively.

Opportunity Cost

The potential benefit or return forfeited from the best alternative option when choosing one financial action over another.

General FICO categories

are the main components used to calculate a FICO score, including payment history, amounts owed, length of credit history, new credit, and types of credit used.

FICO category weights

payment history 35%, amounts owed 30%, history length 15%, new credit 10%, credit mix 10%

Credit Utilization

The proportion of available revolving credit being borrowed, calculated as revolving credit balances divided by revolving credit limits ($\frac{\text{Revolving balances}}{\text{Revolving credit limits}}$).

Lifestyle Inflation

The tendency for spending to expand concurrently with income increases, preventing higher earnings from translating into an improved savings rate.

Time Value of Money (TMV)

The concept that a sum of money has greater value now than the same sum in the future due to its potential earning capacity. This principle is fundamental in finance for evaluating investments and cash flows.

PV

Value today / at the start of the timeline. An existing nest egg is not a payment

FV

Value at the end. Often zero when a loan is fully repaid or retirement funds are exhausted.

PMT

Equal recurring cash flow each period. Enter zero for a lump-sum-only problem

rate

Return or interest per payment period. Nominal 6% compounded monthly -> 6%/12

nper

Number of periods: 40 years of monthly saving -> 480

type

0 = payments at period-end; 1 = period-beginning. Default is 0

signs

Cash paid out and cash received must have opposite signs. A negative PMT commonly means a contribution/payment, not an error.

future balance excel function

=FV(rate,nper,pmt,pv,type)

amount needed now excel function

=PV(rate,nper,pmt,fv,type)

recurring payment excel function

=PMT(rate,nper,pv,fv,type)

number of periods excel function

=NPER(rate,pmt,pv,fv,type)

monthly compounding in excel

divide rate by 12 and multiply number of periods by 12 to compute monthly interest payments.

Invest $5,000 for 10 years at 6%, annual compounding.

=FV(6%,10,0,-5000,0)

Answer: $8,954.24

Need $20,000 in 5 years; earn 5% annually.

=PV(5%,5,0,-20000,0)

Answer: $15,670.52

Deposit $300 at each month-end for 30 years; nominal 6% compounded monthly.

=FV(6%/12,30*12,-300,0,0)

Answer: $301,354.51

Borrow $20,000 for 5 years at nominal 6%, repaid monthly.

=PMT(6%/12,5*12,20000,0,0)

Answer: $386.66

Today's annual spending is $40,000. Inflation is 3% for 30 years.

=FV(3%,30,0,-40000,0)

Answer: $97,090.50

retirement plan

first finds the balance needed at retirement, then finds the contributions needed before retirement

The retirement deck assumes Sam starts at age 25, retires at 65, plans for 25 retirement years, spends $100,000 per year, and earns 6%. To reproduce the slide, treat spending as level dollar payments and ignore inflation. Assume withdrawals at year-end and saving at month-end.

(nest egg and monthly saving)

Stage A - nest egg:

=PV(6%,25,-100000,0,0)

Required retirement balance = $1,278,335.62.

Stage B - monthly saving:

=PMT(6%/12,40*12,0,1278335.62,0)

Excel returns approximately -$641.90; save $641.90 per month.

A company issues both common stock and bonds.

I. Common shareholders are owners.

II. Bondholders generally have priority over common shareholders in liquidation.

III. Common dividends must be paid every year.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

A I and II are true; III is false. Dividends are not mandatory.

A stock costs $80 and pays $4 in annual dividends.

I. Its current dividend yield is 5%.

II. Its total return is guaranteed to be 5%.

III. If its price falls to $50 and the dividend stays $4, its current yield becomes 8%.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

B I and III are true. Total return also includes price change; dividends can change.

You invest $300 at $30/share and $300 at $15/share.

I. You buy 10 shares and 20 shares.

II. Average cost per share is $22.50.

III. This strategy guarantees a profit.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

E Only I is true. Cost is $600/30 = $20 per share. DCA cannot guarantee gains.

Market interest rates rise after you buy a long-term Treasury.

I. The bond has no risk because it is a Treasury.

II. Its market price generally falls.

III. Its interest-rate risk is different from corporate default risk

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

C II and III are true. Low credit risk does not remove market-price risk.

An investor holds funds across many industries and countries.

I. Company-specific concentration risk can fall.

II. Broad market risk can remain.

III. Holding three funds with nearly identical holdings may add little diversification.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

D All three are true. Count distinct underlying exposures, not just fund names.

A portfolio starts 70% stocks and 30% bonds. Stocks earn 8%; bonds earn 3%.

I. Portfolio return is 6.5%.

II. The simple average, 5.5%, is the correct portfolio return.

III. The weights should total 100%.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

B I and III are true: .70 x 8% + .30 x 3% = 6.5%.

A $50,000 portfolio targets 60/40 stocks/bonds but holds $35,000/$15,000.

I. Target stocks are $30,000.

II. Selling $5,000 stocks and buying $5,000 bonds restores the target, ignoring costs.

III. Rebalancing guarantees a higher return next year

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

A I and II are true. Rebalancing restores intended risk; it does not ensure better returns.

A 22-year-old has retirement savings and tuition due in three months.

I. Every dollar should be in stocks because the investor is young.

II. The retirement portion may reasonably use more stocks than near-term tuition funds.

III. Risk tolerance and the ability to absorb losses both matter.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

C II and III are true. Evaluate each goal's horizon, not age alone.

Compare a conventional ETF with an open-end mutual fund.

I. ETFs trade intraday at market prices.

II. Mutual funds are usually purchased/redeemed at the next calculated NAV.

III. Both structures can use an index strategy.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

D All three are true. ETF does not mean index, and mutual fund does not mean active.

Two comparable funds track the same benchmark. A costs 0.10%; B costs 0.60%.

I. B costs $50 more per year on a constant $10,000 balance.

II. A beta of 1.2 guarantees a 12% return whenever you invest.

III. The higher-expense fund must earn a higher net return

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

E Only I is true: $10,000 x .005 = $50. Beta and fees do not guarantee returns.

Assume deductible/pre-tax Traditional contributions and qualified Roth withdrawals.

I. Traditional generally provides a current income-tax benefit.

II. Qualified Roth withdrawals are income-tax-free.

III. Roth is always superior regardless of tax rates or contribution circumstances

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

A I and II are true. Compare present and future tax rates on a fair resource basis.

Salary is $80,000; match is 50% on the first 6% of pay contributed.

I. Contributing 6% means $4,800 of employee contributions.

II. The maximum employer match is $2,400.

III. A 10% employee contribution earns an $8,000 employer match.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

A I and II are true. Maximum match = $80,000 x 6% x 50% = $2,400.

Evaluate these statements under current rules.

I. Every withdrawal before age 59 1/2 necessarily has a 10% additional tax.

II. People born in 1960 or later generally reach applicable RMD age at 75.

III. Original owners of Roth IRAs have no lifetime RMD.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

C II and III are true. Exceptions make I too absolute; tax and additional-tax rules are distinct.

Two retirees experience identical returns in reverse order and make withdrawals.

I. They must finish with the same balance.

II. Early losses can be especially damaging.

III. Without contributions or withdrawals, reordering the same percentage returns leaves the compounded ending balance unchanged

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

C II and III are true. Cash flows make the timing of returns matter.

Liquid assets are $18,000; expenses are $3,000 monthly and $36,000 annually.

I. Liquidity ratio is 6 months.

II. The course no-debt current ratio is 0.5.

III. The two ratios express coverage using different time units

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

D All three are true: 18,000/3,000 = 6; 18,000/36,000 = .5 years.

Assets $120,000; liabilities $30,000; gross annual income $60,000; savings $9,000.

I. Debt-to-asset ratio is 25%.

II. Net worth is $90,000.

III. Savings/gross-income ratio is 20%.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

A I and II are true. Savings ratio = $9,000/$60,000 = 15%.

Take-home pay is $4,000 per month.

I. The 50/30/20 guideline assigns $800 to saving/debt repayment.

II. Saving $100 monthly for 12 months toward $1,200 is measurable and time-bound.

III. Payment history is a major FICO score factor.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

D All three are true. Achievability and relevance still need consideration for a fully SMART goal.

You save monthly for 20 years at nominal 6%, compounded monthly.

I. Use rate = 6%/12 and nper = 240.

II. Use rate = 6% and nper = 240.

III. End-of-month deposits use type = 1.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

E Only I is true. End-of-period deposits use type 0; type 1 means beginning.

A worksheet models a level annual spending gap for 25 retirement years.

I. Its PV at retirement is the nest egg needed to fund the gap under the assumptions.

II. Existing savings can lower required future contributions.

III. Increasing assumed returns guarantees that the plan will succeed.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

A I and II are true. An assumption cannot ensure the realized outcome.

A goal costs $10,000 today; inflation is 3% annually for 10 years.

I. The future cost is $10,000/(1.03)^10.

II. The future cost is about $13,439.16.

III. A nominal return should not be mixed carelessly with spending held in today's dollars.

A = I and II only B = I and III only C = II and III only D = I, II, and III E = I only

C II and III are true. Inflate forward: $10,000 x 1.03^10. Division would discount.