Finance 1200Fall 2014

Discuss what you will gain from the study of personal finance.

Five Objectives of studying personal finance:

1. Introduction to the subject of personal finance

2. Develop personal financial goals.

3. Define opportunity costs and determine how opportunity costs are associated with personal financial planning.

4. Identify the key components of a financial plan, and

5. Outline the steps involved in developing your personal financial plan.

Step 1 Think back to your formative experiences with money and consider what these memories have taught you about who you were then and how they affect who you are today.

Step 2 Replace your financial fears with new, positive, empowering messages (i.e. "I have more money than I will ever need"; "I am in control of all my affairs"; "I have the power to put my money in good hands").

Step 3 Be honest with yourself about your current financial status and decide how you want to start spending your money.

Step 4 Be responsible to those you love by taking care of these "must-do's"wills, trusts, life insurance, durable power of attorney for health care, long-term-care insurance, and estate planning.

Step 5 Respect yourself and your money by investing wisely in retirement plans, stocks, money market accounts, and mutual funds and by eliminating credit card debt. Your actions will give that respect meaning.

Step 6 You must trust yourself more than you trust others. Pay attention to your inner voice it will tell you if how and in what you are investing is right for you.

Step 7 Give a portion of your money to others. By releasing an anxious grasp on your money, you will open yourself to receive all that is meant to be yours.

Step 8 Understand and accept the cycles of money. The setbacks you may have today or next year will not keep you from financial freedom. If you hold on to your goals and dreams, you will get there.

Step 9 Learn to recognize true wealth. Money itself will not make you financially free. That comes as a result of only that powerful state of mind which tells us that we are worth far more than our money.

“. . . True financial freedom doesn’t depend on how muchmoney you have. Financial freedom is when you havepower over your fears and anxieties instead of the other way around.” -- Suze Orman, The 9 Steps to Financial Freedom, p.2

• Financial literacy -- the vocabulary necessary to manage one’s personal finances

• Personal finance -- the study of personal and family resources considered important in achieving financial success.

• Personal financial planning – the process of planning your spending, financing, and investing to optimize your financial situation.

• Financial success -- the achievement of financial aspirations that are desired, planned, or attempted. It is defined by the individual or family that seeks it.

Discuss what you will gain from the study of personal finance.

Overview of Financial Plan

Financial Planning Decisions

Your Cash Inflow

Your Cash Outflow-

Your Net Cash Flows= Value of Your Assets

Value of Your Liabilities

Your Net Worth

-

=

Use dollars toIncrease assets

Use dollars toIncrease assets

Cash Flow Statement

Balance Sheet

6 Steps of Personal Financial Planning

Step 1: Determine Your Current Financial Situation

Personal Financial StatementsBudgetCash Flow StatementBalance Sheet

Step 2: Develop Your Financial Goals

SMART goals

• Specific

• Measurable

• Action Oriented

• Realistic

• Timely

Dreams/Visions

Step 3: Identify Alternative Courses of Action

•Continue the same course of action.

•Expand the current situation.

•Change the current situation.

•Take a new course of action.

According to the National Endowment for Financial Education, 70 percent of major lottery winners end up with financial difficulties.

Step 4: Evaluate Your Alternatives

•Consequences of Choices•Opportunity Cost

•Evaluating Risk

•Inflation Risk•Interest Rate Risk•Income Risk•Personal Risk•Liquidity Risk

Step 5: Create and Implement Your Financial Action Plan

Saving

Tax withholding

Retirement

Investing

Step 6: Review and Revise Your Plan

Regularly assess your financial decisions1.Specific date each year.2.When significant events occur in your life.

1. Make sure the goal you are working for is something you really want, not just something that sounds good.

2. One goal cannot contradict any of your other goals.

3. Develop goals in the 6 areas of life:1. Family and Home.

2. Financial and Career

3. Spiritual and Ethical

4. Physical and Health

5. Social and Cultural

6. Mental and Educational

4. Write your goal in the positive instead of the negative.

5. Express your goal in time and unit detail.

6. Make sure your goal is high enough.

7. Write your goals down.

8. Share your goals with people that will help you achieve them.

Goal Setting

Financial Goals Should Be: SpecificMeasurableAction OrientedRealisticTimely

Developing Personal Financial Goals

• TYPES OF FINANCIAL GOALS can be:

a) Influenced by the time frame in which you want to achieve your goals

b) Influenced by the financial need that drives your goals

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Developing Financial Goals

SHORT TERM GOALS (LESS THAN 1 YEAR)

INTERMEDIATE GOALS (1TO 5 YEARS)

LONG TERM GOALS (MORE THAN 5 YEARS)

STEP 1Realistic goals for your life situation

STEP 2State goals in

measurable terms

STEP 3Determine time

frame

STEP 4Action to be taken

1 Maximizing Earnings and Wealth– Wealth -- an abundance of money,

property, investments, and other resources.

2 Practicing Efficient Consumption– We use money for two purposes:

consumption and savings3 Finding Life Satisfaction4 Reaching Financial Security

– Financial Security -- the comfortable feeling that your financial resources will be adequate to fulfill any needs you have as well as most of your wants.

– To reach financial security, first you need to set and prioritize your long-and short-term goals.

5 Accumulating Wealth for Retirement and an Estate

Describe five lifetime financial objectives of most people

Tools in every financial situation

• Reduce debt usage

• Reduce spending

• Review savings investments

• Evaluate insurance coverage

• Avoid financial scams

• Communicate with family

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Influences on Personal Financial Planning (continued)

1-18

20 30 40 50 60 70 80

Initial Goal Setting

Home Purchase

Insurance Planning

Saving for Goals-Pay Yourself First

Family Formation

Age

$

Tax and Estate Planning

Reassessment of Retirement Goals

Stage 1

Early years-A time of

Wealth accumulation

Stage 2

Approaching Retirement-The Golden

Years

Stage 3

The Retirement Years

A Typical Individual’s Financial Life Cycle

Understanding the Economic Environment of Personal Finance

• The State of the Economy

– Economics is the study of how wealth is created and distributed.

– Economy is a system of managing the productive and employment resources of a country, community, or business.

– Economic growth is a condition of increasing production and consumption in the economy.

– Business cycle (or economic growth) is a wavelike pattern of economic activity that includes temporary phases that undulate from boom to bust.

– Expansion occurs when production is at a high capacity, unemployment is low, retail sales are high, and prices and interest rates are low or falling.

– Recession is generally a decline in business “a recurring period of decline in total output, income, employment, trade, usually lasting from six months to a year and marked by widespread contractions in many sectors of the economy.”

– Depression is a severe downward phase of the economic cycle where unemployment is very high, prices are very low, the level of living decreases sharply, and economic activity virtually ceases.

Understanding the Economic Environment of Personal Finance

(cont.)

• Tracking at least two statistics may help understand the direction of the economy:

– Gross Domestic Product (GDP) -- the value of all goods and services produced by workers and capital located in the United States, regardless of ownership.

– Consumer Price Index (CPI) – measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

• Inflation-- a steady rise in the general level of prices.

• Deflation -- falling prices.

• When prices are rising, an individual’s income also must rise to maintain its purchasing power, which is a measure of the goods and services that one’s income will buy.

• Your real income reflects the actual buying power of your nominal income (also called money income.)

Phases of the Business (Economic Cycle)

Expansion(Prosperity)

Recession(or Depression)

Recovery

Average growth rate expected in economy

Bus

ines

s P

rodu

ctio

n an

d R

etai

l Sal

es

Personal Finance Calculations

• Percentage change in personal income -– (nominal income after raise/nominal income before raise -1) x 100

• For example, if Edward received a $1,600 raise to increase his annual salary from $37,000 to $38,600 during a year with annual inflation of 4%, his personal change in income would be calculated as follows:

His nominal increase would be:

$38,600

37,000 = 1.043 -1 x 100 = 4.3%

However, because inflation was 4%, his real increase was only .3% (4.3% nominal increase – 4% inflation = .3% real increase). In real dollars Edward’s increase would be calculated as follows:

• Real income -– nominal income after raise/1 + previous inflation rate

• Edward’s real income =

$38,600

1 + 0.040 = $37,115

Rule of 72

• A handy formula to calculate the number of years it takes to double principal using compound interest is the Rule of 72. You simply divide the interest rate the money will earn into the number 72. For example, if interest is compounded at a rate of 7 % per year, your principle will double every 10.3 years. If the rate is 6 %, it will take 12 years.The rule of 72 also works for determining how long it would take for the price of something to double given a rate of increase in the price. For example, if college tuition costs are rising 8 % per year, the cost of college education doubles in just over nine years.

02468

1012141618

12% 10% 8% 6% 4%

The Rule of 72

Economic Considerations That Affect Decision Making

• Opportunity Costs -- the value of the next best alternative that must forgone.– Opportunity costs are hard to quantify because most involve personal tastes and preferences

“[For many, the] biggest problems in life today . . . Are directly connected with their early, formative experience with money.” (9 Steps to Financial Freedom, p. 7).

• Utility -- the ability of a good or service to satisfy a human want.

• Marginal Utility -- the extra satisfaction derived from having one more incremental unit of a product or service.

• Marginal Costs -- the additional cost of one more incremental unit of some item.

Effect of Compound InterestSimple Interest Compound Interest

Year Principal Rate TimeInterestEarned

NewBalance Principal Rate Time

InterestEarned

NewBalance

1 100.00 10% 1 10.00 110.00 100.00 10% 1 10.00 110.00 2 100.00 10% 1 10.00 120.00 110.00 10% 1 11.00 121.00 3 100.00 10% 1 10.00 130.00 121.00 10% 1 12.10 133.10 4 100.00 10% 1 10.00 140.00 133.10 10% 1 13.31 146.41 5 100.00 10% 1 10.00 150.00 146.41 10% 1 14.64 161.05 6 100.00 10% 1 10.00 160.00 161.05 10% 1 16.11 177.16 7 100.00 10% 1 10.00 170.00 177.16 10% 1 17.72 194.87 8 100.00 10% 1 10.00 180.00 194.87 10% 1 19.49 214.36 9 100.00 10% 1 10.00 190.00 214.36 10% 1 21.44 235.79

10 100.00 10% 1 10.00 200.00 235.79 10% 1 23.58 259.37 11 100.00 10% 1 10.00 210.00 259.37 10% 1 25.94 285.31 12 100.00 10% 1 10.00 220.00 285.31 10% 1 28.53 313.84 13 100.00 10% 1 10.00 230.00 313.84 10% 1 31.38 345.23 14 100.00 10% 1 10.00 240.00 345.23 10% 1 34.52 379.75 15 100.00 10% 1 10.00 250.00 379.75 10% 1 37.97 417.72 16 100.00 10% 1 10.00 260.00 417.72 10% 1 41.77 459.50 17 100.00 10% 1 10.00 270.00 459.50 10% 1 45.95 505.45 18 100.00 10% 1 10.00 280.00 505.45 10% 1 50.54 555.99

180.00 455.99

Chapter01 - Personal Finance Basics and Time Value of Money

TM 1-7

Contributions Contributions

Age Made Early Age Made Later

22 $ 2,000 22 $ 0 23 2,000 23 0 24 2,000 24 0 25 2,000 25 0 26 2,000 26 0 27 2,000 27 0 28 2,000 28 0 29 2,000 29 0 30 2,000 30 0 31 0 31 2,000 32 0 32 2,000 33 0 33 2,000 34 0 34 2,000 35 0 35 2,000 36 0 36 2,000 37 0 37 2,000 38 0 38 2,000 39 0 39 2,000 40 0 40 2,000 41 0 41 2,000 42 0 42 2,000 43 0 43 2,000 44 0 44 2,000 45 0 45 2,000 46 0 46 2,000 47 0 47 2,000 48 0 48 2,000 49 0 49 2,000 50 0 50 2,000 51 0 51 2,000 52 0 52 2,000 53 0 53 2,000 54 0 54 2,000 55 0 55 2,000 56 0 56 2,000 57 0 57 2,000 58 0 58 2,000 59 0 59 2,000 60 0 60 2,000 61 0 61 2,000 62 0 62 2,000 63 0 63 2,000 64 0 64 2,000 65 0 65 2,000

Amount available at age 65:

THE IMPACT OF TIME VALUE OF MONEY AT 9% INTEREST

Total of

$70,000 Invested

Total of

$18,000 Invested

$470,249 $579,471

Income Taxes in Decision Making

• Marginal Tax Rate -- is the tax rate at which your last dollar earned is taxed.

Assume Juanita has taxable income of $32,000 and receives a $1,000 bonus from her employer. Juanita’s federal tax rate is 28% and her state tax rate is 6%. What is Juanita’s effective marginal tax rate?

1,000 x .28 = $280.00 Federal taxes

1,000 x .06 = $ 60.00 State taxes

1,000 x .0765 = $ 76.50 Social Security Taxes

Total Taxes .4165 $416.40

Tax Sheltered Returns Are Greater Than Taxable Returns

$0

$50,000

$100,000

$150,000

$200,000

$250,000

10Years

15Years

20Years

25Years

30Years

Taxable ReturnsTax Sheltered Returns

Methods for computing Time Value of Money

• Formulas

• Time value of money tables

• Financial calculators

• Spreadsheet software

• Time value of money web sites1-32

The Time Value of Money in Decision Making

• Time value of money is the idea that paying or receiving money over time is affected by the fact that money can earn a positive rate of return over time.

– For example, if you were to win the lottery and be offered the choice to receive a lump sum of $1,000,000 now or payments of $60,000 per year for 20 years for a total of $1,200,000. The more favorable answer for you depends upon the interest rate you could earn on your investment.

• Present value (or discounted value) is the current value of an asset that will be received in the future.

• Future value is the valuation of an asset projected to the end of a particular time period in the future.

Basic calculations:

FV = (Present value of sum of money)( I + 1.0)(I + 1.0)(I + 1.0) . . .

Or FV = (PV)(1 + r) n

PV = (FV)

(1 + r)n

(Calculation assumes compound interest)

The Time Value of Money in Decision Making

• Assume you have the option of two different investment options. First, a friend wanted to borrow $5,000 for three years and pay you back $6,000 in a lump sum. Second, you could invest the same $5,000 for three years in a government bond paying 7 percent annual interest. Which investment would be the best financial decision?

FV = (PV)(1 + r) n

= (5,000)(1+.07)3

= 5,000 x 1.225043

= $6,125.22

You would earn $125.22 more by investing in the government bonds.

Future Value of a Dollar (Single Payment)

Future Value of a Series of Annual Deposits (Annuity)

Present Value of a Dollar (Single Payment)

Present Value of a Series of Annual Deposits (Annuity)

Do I have the money now?

Yes No

Is it a lump sum?

Is it a lump sum?

Yes Yes No No

Use FV

Use Future Value Table

Use PV Use PVA

Keeping the Time Value of Money Formulas Straight

Use FVA

Use Present Value Table

The Difference Between Simple Interest and Compound Interest

• Simple Interest is the interest computed on principal only Interest = Principle x Rate x Time or I = P x R x T.

• Compound Interest is the calculation of interest on interest as well as interest on the original investment.

Future Value of $10,000 with Interest Compounded Annually

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

0 10 20 30

14%

12%

10%

8%

6%

How Work Decisions Affect Success in Personal Finance

• Fringe Benefit is compensation for employment that does not take form of wages, salaries, commissions, or other cash payments. Examples include paid holidays, health insurance, and a retirement plan. Some fringe benefits are tax-sheltered, such as a flexible spending accounts and retirement accounts.

The Positive Effects of a Flexible Spending Account

Without With Flexible Spending the Plan The Plan AccountMonthly salary $2,500 $2,500 --

To FSA account -- (410) $410

Taxable salary $2,500 $2,090

Income tax* (248) (186)

Social Security tax (191) (160)

Salary after taxes $2,061 $1,744

Medical and/or

Dependent care expenses (410) (410)

Take home pay $1,651 $1,344

FSA reimbursement -- 410 (410)

Effective take home pay $1,651 $1,744

How Work Decisions Affect Success in Personal Finance

• Fringe Benefit is compensation for employment that does not take form of wages, salaries, commissions, or other cash payments. Examples include paid holidays, health insurance, and a retirement plan. Some fringe benefits are tax-sheltered, such as a flexible spending accounts and retirement accounts.

Steps in Successful Management of Personal Finance

Retirement and estate planning

Investment planning

Income and asset protection

Managing expenditures

Cash and credit management

Financial planning

Lifetime Financial ObjectivesAccumulate wealth for retirement

Reach financial security

Find life satisfaction

Practice efficient consumption

Maximize earnings and wealth

Wea

lth

The Building Blocks of Financial Success

Stocks andBonds

MutualFunds

Real Estate

InstallmentLoans

EducationCosts

CreditCards

PensionPlans

TransportationExpenses

OrganizedFinancial Records

HousingExpenses

InsuranceExpenses

SavingsAccounts

RealisticBudget

Short-TermGoals

Long-TermGoals

ContingenciesIncomeTaxes

EmergencySavings Fund

InsuranceProtection

EmployeeFringe Benefits

CheckingAccount

SavingsAccount

Money MarketAccount

Use of regular income to provide basic lifestyle and savings to meet emergencies

FinanciallySuccessful Life

Achieve

Invest

Handle

Manage

Establish

Base

Foundation

Good Debt vs. Bad Debt

• Debt incurred for consumption is bad debt.

Bad Debt

= Debt Danger Ratio

Annual Income

Debt Danger Ratio beyond 25% can spell trouble.