McGraw-Hill/IrwinFocus on Personal Finance, 2e Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

1 Personal Financial Planning in Action

1-1-22 Objective 1: Identify Social and Economic Influences on Personal Financial Goals

Financial Planning: process of managing your money to achieve personal economic satisfaction.

Financial Plan: formalized report that summarizes your current financial situation, analyzes your financial needs, and recommends future financial activities.

What types of decisions are part of financial planning?

What happens to people without a financial plan?

1-1-33 Objective 1: Identify Social and Economic Influences on Personal Financial Goals

Advantages of Financial Planning • Increased effectiveness in obtaining, using, and

protecting financial resources.• Increased control of financial affairs.• Improved personal relationships.• A sense of freedom from financial worries obtained

by looking to the future.

• Other? (e.g., reaching future goals)

1-1-44Objective 1: Identify Social and Economic Influences on Personal Financial Goals

Adult life cycle stage. Marital status, household

size, and employment. Major events.

– Graduation, marriage, divorce.– Birth or adoption of child.– Career or health changes.

Values.– What are the ideas and principles you consider correct,

desirable and important?

Life Situation and Personal Values

1-1-55 Financial Planning in Our Economy Economy’s influence on financial planning

– Phases of the business cycle: expansion, peak, contraction, trough (takes 4-5 years on average)

Economics: the study of how wealth is created and distributed; strongly influences financial planning

Role of the Federal Reserve (e.g., interest rates, money supply)

1-1-66 Financial Planning in our Economy Inflation is a rise in the general level of prices

– Inflation reduces the buying power of the dollar

– Is most harmful to people living on fixed incomes

– Inflation rates have varied over time (10-12% in early 1980s)

– The CPI (Consumer Price Index) is a measure of inflation

– Many people face hidden inflation (not spending like CPI)

1-1-77 Financial Planning in our Economy

Interest Rates represent the cost of money

– Affected by supply and demand of money

– Have a major affect on financial planning

– Risk is also a factor in determining interest rates

• Reason why longer-term loans cost more and longer term CDs pay more: increased uncertainty over time

– Interest rates influence many financial decisions

1-1-88 The Rule of 72

Rule of 72–Calculates the number of years it takes for principal to double.– Years = 72 divided by interest rate.– Example: 72 divided by 8% = 9 years

Calculates the interest rate it takes for principal to double.– Interest rate = 72 divided by number of years– Example: 72 divided by 10 years = 7.2%

1-1-99 The Rule of 72 in Pictures

1-1-1010 Financial Planning Activities

Obtaining- Get resources from employment, investments

Planning- Plan spending and saving through budgeting process

Saving- Money for emergencies and short-term goals

Borrowing- Wise borrowing habits; not misusing credit

Spending- Considering consequences; spending < earnings

Managing Risk- Adequate insurance coverage for risks

Investing- Select securities for income and LT growth

Retirement and Estate Planning- Financial security in later life

1-1-1111 Objective 2: Develop Personal Financial Goals

There are 3 different time frames for achieving financial goals– Short-Term Goals- Achieved within next year– Intermediate Goals- Achieved within next 2 to 5 years– Long-Term Goals- Achieved > 5 years in the future

There are 3 different financial needs goals– Consumable-Product Goals (food, clothing, entertainment)– Durable-Product Goals (“big ticket” items like appliances and cars)– Intangible-Product Goals (health, education, relationships, service)

Goal setting guidelines suggests goals should...SMART– Be realistic, be stated in specific, measurable terms, have a time

frame, and indicate the type of action to be taken.

1-1-1212 Objective 3: Assess Personal and Financial Opportunity Costs of Financial Decisions

Opportunity cost is what you give up by making a choice.

– The cost, referred to as the trade-off of a decision, cannot always be measured in dollars. Sometimes the cost is your time.

– Consider lost opportunities that will result from your decisions (health, knowledge, abilities)

Write down an example of a recent opportunity cost in your life.

1-1-1313 The Time Value of Money

Increases in an amount of money as a result of interest earned.– Saving today means more money tomorrow. Spending

means lost interest. 4 types of time value calculations

– Future value of a single amount (1-A)– Future value of a series of deposits (annuity) (1-B)– Present value of a single amount (1-C)– Present value of a series of deposits (1-D)

1-1-1414 How Simple Interest is Computed

Simple Interest:Amount in savings (principal) x annual interest rate x time period equals the interest.

$100 x 5% x 1 (1 year) 100 x .05 x 1 = $5

In one year, you have $100 in principal plus $5 in interest for a total of $105 at the end of the year

1-1-1515 Future Value Future value is the amount to which current savings will

increase based on a certain interest rate and a certain time period.

Future value is also call compounding - earning interest on previously earned interest (compound interest)

Future value can be computed for a single amount or for a series of deposits (examples?)

Compound Interest Analogy: Who Wants to Be a Millionaire? game show (greatest rewards at end)

1-1-1616 Present Value

The current value for a future amount based on a certain interest rate and a certain time period.

Present value calculations are also called discounting.

The present value of the amount you want in the future will always be less than the future value.

Present value can be computed for a single amount or for a series of deposits.

1-1-1717 Future Value of a Lump Sum ExampleFuture Value (FV)–Value of an asset at the end of a particular time period.

? Example: Value of $1,000 in 4 years at 8% interest

Exhibit 1-A

FVF (8%, 4 years) = 1.360

1,000 x 1.3605 = $1,360

1-1-1818 Future Value of an Annuity Example

FV of an Annuity (FVOA)- What principal will grow to over time if a series of regular deposits are made.

Example: $2,000 annual deposits to Roth IRA at 8% interest for 40 years from age 22 to 62 = $518,120

Exhibit 1-B

FVOA (8%, 40 years) = 259.060

$2,000 x 259.060

?

1-1-1919 Present Value of a Lump Sum ExamplePresent/Discounted Value (PV)–Current value of an asset that will be received in the future.

Example: Today’s value of a $25,000 inheritance to be received in 10 years, assuming the principal earns an 8% average annual return.

Exhibit 1-C

PV (8%, 10 years) = 0.463

$25,000 x 0.463 = $11,575

1-1-2020 Present Value of an Annuity Example PV of an Annuity (PVOA)- Present value of a stream

of payments to be received in the future.

Example: The amount to have invested at retirement to provide $30,000 of income per year for 20 years with a 7% return = $317,820

Exhibit 1-D

PVOA (7%, 20 years) = 10.594

$30,000 x 10.594

1-1-2121 Objective 4: Implement a Personal Plan

1. Determine your current financial situation.2. Develop your financial goals.3. Identify alternative courses of action.

• Continue the same course of action (e.g. same savings rate)• Expand the current situation (e.g., higher savings rate)• Change the current situation (e.g., switch to online bank or credit union)• Take a new course of action (e.g., pay off credit card debt instead of saving)

4. Evaluate your alternatives.• Consequences of choices (e.g., opportunity costs)• Evaluating different types of risks (e.g., inflation risk)• Financial planning information sources (e.g., advisors, media, Web sites)

5. Create and implement your financial action plan.6. Review and revise your plan.

1-1-2222 Wrap Up Chapter Quiz

Concept Check 1-1- Who Suffers or Benefits From Inflation?

– Person with money in savings?, person borrowing money?, person lending money?, person receiving a fixed income?

Concept Check 1-2- Match Goals and 4 Life Situations

Concept Check 1-3- Solve the three time value of money problems