Fina Fi nanci ncial Pl Planni nning ng vs vs. Fi Fina nanci - - PDF document

1

Aa Aaron Stevens EC1 EC171 71, 8 8 September 2011

The Lifecycle Model

• f Saving and Consumption

Fi Fina nanci ncial Pl Planni nning ng vs vs. Fi Fina nanci ncial Economi Economics cs

Fi Finan anci cial al pl plan anning g star arts with h go goal als:

Ho How w much much will will that hat co cost st? ? When hen? Wh What rate do you expect to earn on investments? …ar arrive at how much to save now

Fi Finan anci cial al eco economics cs star arts with h res esour urces ces:

Wh What do you have? Wh What are your obligations? Ho How w sho should uld yo you u allo allocat cate e yo your ur reso resources? urces? Mi Minimize risks to guarantee success

Li Life- e-Cycle e Ec Economi

• nomics

Resources

Life-Cycle Theory of Saving and Consumption

Obligations Sustainable Standard of Living Household Composition Annual financial plan

The conceptual framework to answer life’s financial questions:

(simple arithmetic)

Wh What’s o

• n Your

Balance Balance She Sheet? t?

What assets did you list? What liabilities did you list? Is your net worth positive or negative? List your assets on the left-hand side List your liabilities on the right-hand side (Don’t worry about exact amounts) Does this balance sheet fairly represent your economic condition?

Wh What is Value?

What is the e value e of f my my old 1985 F150 Truck? (I paid $1 $100 fo for it in Dec ecemb ember er, 20 2004)

Wh What is Value?

Source: ht http:// //usedcars.kb kbb.c .com/cars/cars-for-sale-Ford.F150-Regular-Cab/year-1985.1989

Wh What is Value?

• Book value
• Market value

Accounting practices describe different tools for valuing assets and liabilities: Economic value measures the income that will be generated by an asset

• ver it’s remaining useful life.

Fut Futur ure e Income ncome

Ho How does future inc ncome show up on n your bal balanc ance e sheet? eet? Why? y? Ho How much is your HC HC worth today? In In 10 10 year years? In s? In 30 30 years? In 50 years? Hu Human n Capital is the asset which enabl enables es you you to to gener generate ate labor abor incom ncome. e.

A A Mi Milliona

• naire At

At Age Age 22! 22!

Jo Joe e Bl Blow, age age 22 Jo Joe e ea earns rns $42,000 pe per r year Jo Joe e will work rk un until age age 66 (n (no t taxes, i interest r rate = = 0 0%)

Yo Your ur Eco Economic Ne Net Worth

+ Huma man Capital

As Assets + Cash + Securities + Property = = Tota

• tal Conve
• nventi

ntiona

• nal As

Assets Li Liabi abilities es

• Short term debts
• Long term debts

= = Tota

• tal Conve
• nventi

ntiona

• nal Li

Liabiliti ties

Conven entional NW = Co

• Conv. Asset

ets - Co

• Conv. Liabilities

es

Econ Econom

• mic N

c Net et Wo Worth = CNW + HC

Fut Futur ure e Consumpt

• nsumption
• n

Wh What about future consumption?

Yo You’re e go gonna have e to consume me (ea eat, buy shel elter er, clothes es, en enter ertainmen ment) fo for the e res est of f your life. fe.

Ho How w much h ca can y you consume, over your li life feti time?

Li Lifetime me Budge udget Const

• nstraint

nt

Your lifetime consumption is bounded by the value of your lifetime resources:

(recall, conventional net worth = assets - liabilities)

= + Human Capital Conv. Net Worth Lifetime Consumption

Fut Futur ure e Consumpt

• nsumption
• n is

s a De Declining Liability

Jo Joe e Bl Blow, age age 22 Ther There’s ev every chance Jo Joe wo would live to age 100.

Ri Risk sk: Ou Outliving Your Mo Money

Jo Joe e Bl Blow, age age 22 Si Since Joe will stop working at age age 66, 66, but but he he needs eeds to eat eat un until age age 100...

Co Convert Hu Human Ca Capital to to Fi Financial Wealth

Du During working years, accum accumul ulat ate e fi finan anci cial al capi capital al to offset et the decl declining g val alue ue of hu human an cap apital al.

Wh What’s s the Secret to Ac Accum umulate ulate Fi Financ nancial al Wealth? alth? Sav Savings = Income - Co Consumption (th (the s secret is t is th that th t there is is n no s secret! t!)

Du During working years, accum accumul ulat ate e fi finan anci cial al capi capital al to offset et the decl declining g val alue ue of hu human an cap apital al.

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You are young You are young and you work. k. Yo You are old and you die. you die. Ea Each period of time , , in real time, , is roughly 30 roughly 30 years of years of adulthood. adulthood.

Tw Two

• Per

Period

• d Model
• del

Bu Budget Co Constraint: Yo Yout uth

= Cy Cy + + S S = W

What you earn What you earn (labor income) (labor income) What you save What you save What you consume What you consume in your youth in your youth

Wh When you’re re young, you work and recei receive e labo abor r inco come. e.

+

Bu Budget Co Constraint: Ol Old Age Age

Wh When you’re re old, you live by consuming (s (spend nding ing d dow

• wn) y

n) you

• ur s

saving vings.

Co = = S

Consumption Consumption when old when old Amount saved Amount saved when young when young

Li Lifet etime me Budget udget Co Constraint*

Cy + S = W Co = S By algebraic magic: Co = W - Cy

• r

Cy + Co = W

*N *No Investment Return *N *No Taxes and/or Benefits

It was for this work (in 1954) that Franco Modigliani won the Nobel Prize in Economics in 1985

Wh What You Learned Today

• Fi

Financial Planning vs vs. . Fina nanc ncial Econo nomics

• Ec

Economic Value

• Hu

Human Capital

• Th

The Lifecycle Model explains the need to con conver vert hu t human an cap capital tal to fin to finan anci cial al cap capital tal (a (a pro rocess calle lled sa savings).

• T

The he 2 2 p peri riod m d mode del a and t d the he L Life fetime Bud Budget get Cons Constr trai aint nt

Announc Announceme ment nts and nd To

• Do

Do

Readings:

• ME,

E, ch2.1 .1, pp37-39 (today) Homew mework 1: Estima mate e your huma man capital (due e Tues esday)