Personal Financial Management

Personal Financial Management Sample Exam 2004 – 2005 Prof. Gareth Myles g.d.myles@ex.ac.uk

Question 1 Why is financial planning worthwhile? Showhow financial planning can be used by constructing a financial plan for the next 10 years for a graduate aged 22 who is about to undertake a Master’s degree before entering full-time employment. Be clear about the assumptions you adopt.

Points • The discussion of the value of financial planning should describe what financial planning is, and then its value. Need to emphasise objectives, constraints and attitudes. • Points: a. current position (debt?) b. expected employment (degree?) c. personal situation (marital status?) d. interests. Make assumptions, then construct the plan. Set objectives, and be realistic. • Any assumption will be allowed but a degree of realism will be rewarded.

Degree of Detail • The categories of expenditure do not need to be excessively precise • Marks will be gained by focus on the financial aspects - use of financial instruments - understanding of appropriate interest rates - comprehension of risks

Question 2 (i) What does it mean to say one asset is more risky than another? (ii) The table gives the returns on 3 assets in the 2 potential states of the world next year. If state 1 occurs 2/3 of the time, calculate the expected return on each asset and the variance of return. Which asset is the riskiest?

Points • An answer should talk about return and risk in general terms, then should provide formal definitions. More risk described, then defined. Must say what we mean by risk and how we measure it. • This is a very straightforward calculation. The riskiest will have the largest variance.

Calculations • Asset A return = (2/3)7 + (1/3)2 = 16/3 variance = (2/3)(7 – 16/3)2 + (1/3)(2 – 16/3)2 = (2/3)(25/9)+(1/3)(100/9) = 150/27

Question 3 You are arrested by the police for falling asleep at a football match. When the arresting officer discovers you know about personal finance, he requests your advice and you do not feel in a position to refuse. What questions would you ask and how would the answers affect your advice?

Points This is about the basic information you need to plan. Aside from determining the current financial position and objectives, it is also necessary to determine attitudes to risk and potential promotion opportunities. For any long-term plan would also need to know pension situation. Then relate possible answers to the choices made in constructing a financial plan.

Answers • Attitude to risk determines assets choice • Pension rights affect long-term plan • Age of retirement can be significant • Plan for period after retirement • Promotion prospects can be relevant

Question 4 How do you calculate an APR? Present an example to show how an APR can be used to contrast two different financial flows over the same period. Is it a worthwhile concept?

Points This answer must define what an APR is, what it is trying to do, and why this is worthwhile. The formula must be stated and the interpretation of this given. You must present your own example and the quality of this will matter – the APR must add something to the comparison. The evaluation of whether it is worthwhile should be related to your example, and to general conclusion.

Calculating APRs • The APR formula involves a series of cash flows at different times • Receive £100 at t = 0, receive £50 at t = 1.5, pay £90 at t = 1, pay £80 at t = 2 • How do you solve? By trial and error in the examination

Question 5 You have accumulated a debt of £2000 on a credit card. If the card charges a rate of interest of 2% per month and allows a minimum payment of 5% of outstanding balance to be made each month, what would be the debt on card after 3 years of making the minimum payment? Is accumulating credit card debt a good financial strategy? Can you suggest a better alternative?

Points The calculation is the same as in the class exercise. This should be set out in detail for each month: balance, interest, repayment. Whether it is a good strategy should be related to the typical rate of interest on the credit card compared to alternative forms of borrowing. This then links into the final part concerning either alternative ways of borrowing or changes to consumption plan to avoid borrowing.

Points • You should not underestimate the importance of the discussion • Each question should take 40 minutes – use this time • The better alternatives should reveal financial knowledge

Question 6 Evaluate the statement “The more informed we become, the less we will be able to insure.” Can insurance markets work perfectly in practice?

Points The evaluation of the first statement must relate back to the theory of insurance; the basic feature of which is the sharing of risks. Any question of this form is an invitation to describe the theory. Do this carefully. The second part must define what is meant by “perfectly”. Again this is about the theory of insurance – in this case inviting you to describe moral hazard and adverse selection. Examples always make for a better answer.

Good Essays • Besides describing the theory of insurance you must also answer the questions • To do this requires understanding the theory • It also requires an interpretation of the question • Make sure this interpretation is stated

Question 7 Should an informed person ever pay inheritance tax? Does the same answer apply to income tax?

Points The answer must describe the basic features of inheritance tax (rate of tax, what it applies to, exemptions, spouses). Then it should proceed to review options for reducing the tax liability. This should then be repeated for income tax. The answer must distinguish what it different between income tax and inheritance tax.

Question 8 Why are the developed countries expected to suffer from a “pensions crisis”? What financial decisions can you take to minimise your exposure to this?

Points The essay must say what the pensions crisis is, what is causing it, provide some evidence, and relate it to pensions and taxation. Then you consider how to plan to avoid these problems – the answer to this part must distinguish between the various alternative forms of pension (including their important features) and then a realistic plan.

Additional Points • Inclusion of statistical information (dependency ratio, value of state pension etc.) will improve essay • The role of government policy is central • This answer can be linked to current news reporting

Personal Financial Management