Chapter Focus This chapter puts financial planning in perspective - - PDF document

Chapter 1: Financial Planning-- Why It’s Important

Chapter Focus

This chapter puts financial planning in

perspective in relation to your goals in life. The key to financial success is to know your goals and know how to plan for your goals at various stages of your life. To do so, you need to know some basics about your economic environment and important decision making rules.

Chapter Outline

Why study personal finance? Achieving financial goals through planning Making financial decisions

Why Study Family finance? – To Achieve Financial Success

What is financial success

Obtaining maximum benefits from limited

financial resources

How to achieve financial success

Identifying financial goals Understanding important economic trends Planning

Your Goals in Life

Nonfinancial goal

Moral Social Religious Political Family …

Financial goal –

financial independence: self reliance

Current consumption Future consumption Saving

Understanding Important Economic Trends

Continuing inflation

Prices going up over time Inflation in recent years has been less than 5% See a graph of annual inflation rate from 1990 to

2007 on next slide. Note the black line is the actual annual inflation rate.

Visit the following Website to find more

information on inflation http://inflationdata.com/Inflation/Inflation_Rate /Inflation.asp

How does inflation affect you?

Your money can purchase less commodities and

services in the future

Visit the following Website to find more

information on inflation http://inflationdata.com/Inflation/Inflation_Rate /Inflation.asp

How does inflation affect you?

Your money can purchase less commodities and

services in the future

Persistent Business Cycles

The economy goes up and down in cycles called

business cycles

The most recent peak (economic high point) was in

March 2001

The most recent trough (lowest point) was November

2001

Visit the NBER website for information on U.S.

business cycles: http://www.nber.org/cycles.html/

How do business cycles affect you?

Is your job safe? Layoff is common in down times Do you have cash reserves to weather a storm?

Continued instability in financial markets

The graph below shows the S&P 500 (a Stock market

index) from 1950 to 2007.

Visit the following Website for information on

historical data Stock market indexes http://finance.yahoo.com/q?s=^GSPC&d=c&k=c1 &a=v&p=s&t=my&l=off&z=l&q=l

How does this affect you?

Investment return uncertainty Future financial position uncertainty

A Selectively Rewarding Tax System

Encourages

Homeownership Retirement saving Saving for education Business investment …

How does this affect you?

Not taking advantage of these plans is poor financial

practice and can cost you dearly

Achieving Financial Goals Through Planning

Life-cycle planning

Financial goals are different in different stage of

• ne’s life

Life-cycle planning means

All one’s lifelong goals are recognized These goals are attended to at each phase in the cycle

Important Areas of Planning

Career planning (Chapter 1 appendix) Consumption and saving

Financial statements and budgets (Chapter 3) Cash management (Chapter 5)

Income tax planning (Chapter 4) Debt planning

Short term credit (Chapter 6) Consumer durables (Chapter 7) Housing (Chapter 8)

Investment planning

Financial markets and institutions (Chapter 9) Understanding risk and return (Chapter 10) Stocks and bonds (Chapter 11) Mutual funds (Chapter 12)

Insurance planning

Property and liability insurance (Chapter 13) Health and disability insurance (Chapter 14) Life insurance (Chapter 15)

Estate planning (Chapter 15) Retirement planning (Chapter 16)

A Planning Approach

Define a broad goal Break it down to manageable sub-goals Create an action plan to achieve sub-goals Periodically evaluate the action plan

If successful, keep up good work If not, find new action plan or new goal

Making Financial Decisions

Helpful insights

Always employ marginal analysis

Considers whether a decision’s added (marginal) benefits are worth

its added (marginal) costs

Example: whether to move to a $500 apartment that is far away

from school from a $600 apartment near school. The qualities of the apartments are similar.

Marginal benefits: $100 saving in rent per month Marginal costs: added transportation cost and time cost. These costs

can be translated into money values.

If marginal benefits > marginal costs then move to the $500

• apartment. If marginal benefits < marginal cost then don’t.

Always consider opportunity cost

Opportunity cost is benefits you give up when you

choose one alternative over another

Example:

The opportunity cost of buying a fancy dress for $200 is giving

up eating out in nice restaurants for the next two months.

The opportunity cost of taking a family finance class is giving

up the opportunity of taking a different class, such as dancing.

This concept is important because you need to be aware

• f tradeoffs when you make financial decisions. Every

decision has an opportunity cost because of limited resources.

Building Blocks of Success

What is it?

Sequential investing, starting with a low-risk

foundation and then moving to riskier investments

How to achieve it?

Step 1. Build a supporting foundation

Developing your career Acquiring adequate insurance Finding suitable housing Saving to build adequate cash reserves

Step 2. Invest in secured instruments

Long-term savings deposits Government securities Annuities

Step 3. Gradually take greater risks

High-quality stocks and bonds Real estate

Step 4. Avoid these very risky investments until

you are secure at the lower levels

Growth stocks, gold, raw land

Figure1.1: Building Block Approach

Chapter 2. Time Value of Money Chapter Focus

Financial planning must consider the element

• f time. Have a dollar today is worth more

than receiving it ten years from now because

• f inflation and interest rate. This chapter deals

with the basics of time value of money. Because this is a 1000-level class, I will only ask you to learn the basics in this chapter. The textbook goes into much more depth so it’s a good reference if you would like to learn more.

Chapter Outline

Interest rate Finding future value (compounding) Finding present value (discounting) Goal planning

Interest Rate

Definition

The rate at which your saving/investment grows. It’s

usually quoted as an annual rate, such as 5%.

Simple interest

Means the interest you earned from period one does not

earn interest in period two

Compounding

means the interest you earned from period one can earn

interest in period two.

Compounding Illustrated

• You invest $1,000 today, hold the investment for 3 years, and earn 10%

each year. How much will you accumulate at the end of 3 years?

• With simple interest, you earn $100 each year interest. Total will be $1,300

at the end of the 3 years.

• With annual compounding, $1,331:

__________________________________________ Year Beginning-of- Interest End-of-Year Year Amount Earned Amount 1 $1,000 $100 $1,100 2 1,100 110 1,210 3 1,210 121 1,331

Future Value of Money

Future value is the value in the future of a known amount

today with a stated investment interest rate r for a period of n

FV=Today $ * [(1+r)n]

An example

If you invest $1,000 for 20 years at r=5%, how much will you have in

your account?

Answer: FV = $1,000*[(1+5%)20]=$2,653 You can also use Table A.1 on page 446 in the textbook. Note 5% for

20 years has a future value of 2.6533. That means investing $1 for 20 years at 5% interest rate will become $2.65 (called the future value). Then the future value of investing $1,000 for 20 years is 2.6533*1,000=$2,653.

Future Value of an Annuity

Annuity

Definition: A series of equal payments Example: Saving $1,000 a year for 20 years or receiving

$500 a year for 10 years

Future value of an annuity (a saving schedule)

At 6% annual interest rate, saving $1 a year for 20 years

has a future value of 36.785 (Table A.2, page 448). So the future value of saving $1,000 a year for 20 years is 36.785*1,000=$36,785.

That means if you save $1000 a year at 6% annual interest

rate, it will grow into $36,785 in 20 years.

A Saving Schedule Example - The Power of Compounding

If you save $20 a month at 6% annual after tax

interest rate, you will have

$246.70 in 1 year $1,395.40 in 5 years $3,277.58 in 10 years $9,240.82 in 20 years $20,090.30 in 30 years

Present Value of a Single Payment

Present value is the value today of an amount that would exist

in the future with a stated investment interest rate r (called the discount rate) for a period of n.

PV=Future $ / [(1+r)n]

An example:

You are promised to receive $10,000 in 20 years. At an interest rate

r=5%, what’s the value of that $50,000?

Answer: PV=$10,000/[(1+5%)20]=$3,769 You can also use Table A.3 on page 450 in the textbook. Note 5% for

20 years has a present value of 0.3769. That means $1 in 20 years at 5% discount rate has a present value of $0.3769. Then the present value

• f receiving $10,000 in 20 years is 0.3769*10000=$3,769.

Present Value of an Annuity

Annuity

Definition: A series of equal payments Example: Receiving $1,000 a year for 5 years

Present value of an annuity

Because money received at different times have different

values, the present value of this above annuity is less than $5,000.

At 6% annual interest rate, $1 a year for 5 years has a

present value of 4.2124 (Table A.4, page 451). So the present value of receiving $1000 a year for 5 years is 4.2124*1000=$4,212

The formula for this calculation is too complicated for this

• class. However, I do ask you to be able to use Table A.4.

Goal Planning

• Make goals concrete

What and when? House down payment in 5 years How much if undertaken today? $5,000

• Adjust for inflation

3% inflation rate so you need $5,796 (5000*(1+3%)5)

• Determine an interest rate

6% annual after tax

• Determine a savings schedule using future value for an annuity table A.2

6% for 5 years has a table entry of 5.6371 - meaning if you save $1 per year, it will

become $5.64 (rounded in from $5.6371) in 5 years.

To get $5,796 in 5 years, you need $5,796/5.6371=$1,028 You need to save $1,028 per year, or roughly $86 per month.

• Monitoring progress: Are you staying on the saving schedule?

A Useful Financial Calculator For Planning Financial Goals – RBC Centura

Saving goals:

http://partners.financenter.com/rbccentura/calc ulate/us-eng/savings03.fcs

Other goals:

http://www.centura.com/tools/index.html

Assignment for Chapters 1 and 2

• Determining your personal and financial goals may be a difficult task. You

might want to begin by examining your personal value system, using the questionnaire developed by the Values and Lifestyles Program (VALS) at

• SRI. Go to http://www.sric-bi.com/VALS/presurvey.shtml. Answer the

survey questions and identify your primary and secondary types. Click on the types for their explanations, then explain how your types might influence your approach to financial planning.

• Several of the financial calculators can be used for time value problems in
• general. For example, use the financial calculator on RBC Centura at

http://partners.financenter.com/rbccentura/calculate/us-eng/savings03.fcs to answer the following questions:

You hope to receive $5000 in graduation gifts, which you will invest for your

retirement in 30 years. If you can earn 12% each year, how much will you have in retirement fund at the end of 30 years?

You want to buy a $20,000 car in 3 years. If you can invest $6,300 a year and

earn 8% each year, will you have enough funds at the end of three years? Set one concrete financial goal for yourself,

such as saving $2000 in two years for down payment for a car. Use RBC Centura to explore how much you need to save each

• month. Make reasonable assumption about

interest rate and tax rates. Also use the Tables to do the calculation to see if you can get the same answer. For simplicity, you don’t need to adjust for inflation for this question.