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

Chapter Focus � This chapter puts financial planning in perspective in relation to your goals in life. Chapter 1: Financial Planning-- The key to financial success is to know your Why It’s Important 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. Why Study Family finance? – To Chapter Outline Achieve Financial Success � Why study personal finance? � What is financial success � Obtaining maximum benefits from limited � Achieving financial goals through planning financial resources � Making financial decisions � How to achieve financial success � Identifying financial goals � Understanding important economic trends � Planning Understanding Important Your Goals in Life Economic Trends � Nonfinancial goal � Financial goal – � Continuing inflation financial independence: � Moral � Prices going up over time self reliance � Social � Inflation in recent years has been less than 5% � Current consumption � Religious � See a graph of annual inflation rate from 1990 to � Political � Future consumption 2007 on next slide. Note the black line is the actual � Saving � Family annual inflation rate. � …

� Visit the following Website to find more � Visit the following Website to find more information on inflation information on inflation http://inflationdata.com/Inflation/Inflation_Rate http://inflationdata.com/Inflation/Inflation_Rate /Inflation.asp /Inflation.asp � How does inflation affect you? � How does inflation affect you? � Your money can purchase less commodities and � Your money can purchase less commodities and services in the future services in the future � Continued instability in financial markets � Persistent Business Cycles � The graph below shows the S&P 500 (a Stock market index) from 1950 to 2007. � 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? � A Selectively Rewarding Tax System � Visit the following Website for information on � Encourages historical data Stock market indexes � Homeownership http://finance.yahoo.com/q?s=^GSPC&d=c&k=c1 � Retirement saving &a=v&p=s&t=my&l=off&z=l&q=l � Saving for education � How does this affect you? � Business investment � … � Investment return uncertainty � How does this affect you? � Future financial position uncertainty � Not taking advantage of these plans is poor financial practice and can cost you dearly

Achieving Financial Goals Important Areas of Planning Through Planning � Career planning (Chapter 1 appendix) � Life-cycle planning � Consumption and saving � Financial goals are different in different stage of � Financial statements and budgets (Chapter 3) one’s life � Cash management (Chapter 5) � Life-cycle planning means � Income tax planning (Chapter 4) � All one’s lifelong goals are recognized � Debt planning � These goals are attended to at each phase in the cycle � Short term credit (Chapter 6) � Consumer durables (Chapter 7) � Housing (Chapter 8) A Planning Approach � Investment planning � Financial markets and institutions (Chapter 9) � Understanding risk and return (Chapter 10) � Define a broad goal � Stocks and bonds (Chapter 11) � Break it down to manageable sub-goals � Mutual funds (Chapter 12) � Insurance planning � Create an action plan to achieve sub-goals � Property and liability insurance (Chapter 13) � Periodically evaluate the action plan � Health and disability insurance (Chapter 14) � If successful, keep up good work � Life insurance (Chapter 15) � Estate planning (Chapter 15) � If not, find new action plan or new goal � Retirement planning (Chapter 16) Making Financial Decisions � Always consider opportunity cost � Helpful insights � Opportunity cost is benefits you give up when you choose one alternative over another � Always employ marginal analysis � Considers whether a decision’s added (marginal) benefits are worth � Example: its added (marginal) costs � The opportunity cost of buying a fancy dress for $200 is giving � Example: whether to move to a $500 apartment that is far away up eating out in nice restaurants for the next two months. from school from a $600 apartment near school. The qualities of � The opportunity cost of taking a family finance class is giving the apartments are similar. up the opportunity of taking a different class, such as dancing. � Marginal benefits: $100 saving in rent per month � Marginal costs: added transportation cost and time cost. These costs � This concept is important because you need to be aware can be translated into money values. of tradeoffs when you make financial decisions. Every � If marginal benefits > marginal costs then move to the $500 decision has an opportunity cost because of limited apartment. If marginal benefits < marginal cost then don’t. resources.

Building Blocks of Success � Step 2. Invest in secured instruments � Long-term savings deposits � What is it? � Government securities � Sequential investing, starting with a low-risk � Annuities foundation and then moving to riskier investments � Step 3. Gradually take greater risks � How to achieve it? � High-quality stocks and bonds � Step 1. Build a supporting foundation � Real estate � Developing your career � Step 4. Avoid these very risky investments until � Acquiring adequate insurance you are secure at the lower levels � Finding suitable housing � Growth stocks, gold, raw land � Saving to build adequate cash reserves Figure1.1: Building Block Approach Chapter 2. Time Value of Money Chapter Focus Chapter Outline � Financial planning must consider the element � Interest rate of time. Have a dollar today is worth more � Finding future value (compounding) than receiving it ten years from now because � Finding present value (discounting) of inflation and interest rate. This chapter deals � Goal planning 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.

Interest Rate Compounding Illustrated You invest $1,000 today, hold the investment for 3 years, and earn 10% � � Definition each year. How much will you accumulate at the end of 3 years? � The rate at which your saving/investment grows. It’s With simple interest, you earn $100 each year interest. Total will be $1,300 � usually quoted as an annual rate, such as 5%. at the end of the 3 years. � Simple interest With annual compounding, $1,331: � � Means the interest you earned from period one does not __________________________________________ earn interest in period two Year Beginning-of- Interest End-of-Year Year Amount Earned Amount � Compounding 1 $1,000 $100 $1,100 � means the interest you earned from period one can earn 2 1,100 110 1,210 3 1,210 121 1,331 interest in period two. Future Value of Money Future Value of an Annuity � Future value is the value in the future of a known amount � Annuity today with a stated investment interest rate r for a period of n � Definition: A series of equal payments � FV=Today $ * [(1+r) n ] � Example: Saving $1,000 a year for 20 years or receiving � An example $500 a year for 10 years � If you invest $1,000 for 20 years at r=5%, how much will you have in � Future value of an annuity (a saving schedule) your account? � Answer: FV = $1,000*[(1+5%) 20 ]=$2,653 � At 6% annual interest rate, saving $1 a year for 20 years � You can also use Table A.1 on page 446 in the textbook. Note 5% for has a future value of 36.785 (Table A.2, page 448). So the 20 years has a future value of 2.6533. That means investing $1 for 20 future value of saving $1,000 a year for 20 years is years at 5% interest rate will become $2.65 (called the future value). 36.785*1,000=$36,785. Then the future value of investing $1,000 for 20 years is � That means if you save $1000 a year at 6% annual interest 2.6533*1,000=$2,653. rate, it will grow into $36,785 in 20 years. A Saving Schedule Example - Present Value of a Single Payment The Power of Compounding � Present value is the value today of an amount that would exist � If you save $20 a month at 6% annual after tax in the future with a stated investment interest rate r (called the interest rate, you will have discount rate) for a period of n. � PV=Future $ / [(1+r) n ] � $246.70 in 1 year � An example: � $1,395.40 in 5 years � You are promised to receive $10,000 in 20 years. At an interest rate r=5%, what’s the value of that $50,000? � $3,277.58 in 10 years � Answer: PV=$10,000/[(1+5%) 20 ]=$3,769 � $9,240.82 in 20 years � 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 � $20,090.30 in 30 years 5% discount rate has a present value of $0.3769. Then the present value of receiving $10,000 in 20 years is 0.3769*10000=$3,769.