Discussion 1.3
Chapter 1
Personal Finance Basics and the Time Value of Money
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Chapter 1
Learning Objectives
LO1-1 Analyze the process for making personal financial decisions.
LO1-2 Assess personal and economic factors that influence personal financial planning.
LO1-3 Develop personal financial goals.
LO1-4 Calculate time value of money situations associated with personal financial decisions.
LO1-5 Identify strategies for achieving personal financial goals for different life situations.
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The Financial Planning Process
Learning Objective 1-1:
Analyze the process for making personal financial decisions.
What is Personal Financial Planning? …..
The process of managing your money to achieve
personal economic satisfaction
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The Financial Planning Process
Advantages of Personal Financial Planning are:
- Increased effectiveness in obtaining, using,
and protecting financial resources
- Increased control of one’s financial affairs
- Improved personal relationships
- Sense of freedom from financial worries
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Six Steps in the
Financial Planning Process
Continued…
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Six Steps in the
Financial Planning Process
Step 1:
DETERMINE YOUR CURRENT FINANCIAL SITUATION
- Evaluate income, savings, living expenses, and debts
- Prepare a list of current asset and debt balances and amount spent for various items
- Match financial goals to current income and potential earning power
Continued…
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Six Steps in the
Financial Planning Process
Step 2:
DEVELOP YOUR FINANCIAL GOALS
- Identify feelings about money and the reasons for those feelings
- Determine the source of your feelings about money
- Determine the effects of the economy on your goals and priorities
- Make sure that your goals are your own and are specific to your situation
Continued…
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Six Steps in the
Financial Planning Process
Step 3:
IDENTIFY ALTERNATIVE COURSES OF ACTION
- Possible courses of action can be:
- Continue the same course of action
- Expand the current situation
- Change the current situation
- Take a new course of action
Continued…
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Six Steps in the
Financial Planning Process
Step 3:
IDENTIFY ALTERNATIVE COURSES OF ACTION (continued)
- Creativity in decision making is vital to effective choices
- “Do nothing” can be a dangerous alternative
Continued…
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Six Steps in the
Financial Planning Process
Step 4:
EVALUATE YOUR ALTERNATIVES
- CONSEQUENCES OF CHOICES
- Opportunity cost
What you give up when you make a choice
- The cost or trade-off of a decision cannot always be measured in dollars. Sometimes the cost is your time
Continued…
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Six Steps in the
Financial Planning Process
Step 4:
EVALUATE YOUR ALTERNATIVES
- EVALUATING RISK
- Uncertainty is a part of every decision
FINANCIAL PLANNING INFORMATION SOURCES
Best way to analyze and minimize risk is to gather information from financial planning information sources (Exhibit 1-3)
Continued…
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Six Steps in the
Financial Planning Process
Step 5:
CREATE AND IMPLEMENT YOUR FINANCIAL ACTION PLAN
- Develop an action plan that identifies ways to achieve financial goals
- Possible action plans can be increasing savings, reducing spending, or making provisions for taxes
- To implement action plans you may need assistance from others
Continued…
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Six Steps in the
Financial Planning Process
Step 6: REVIEW AND REVISE YOUR PLAN
Financial planning decisions need to be assessed regularly
Complete review should be done at least once a year
More frequent reviews may be required for changing personal, social, and economic factors
Regular reviews of decision-making process can help in making priority adjustments to achieve financial goals
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Influences on Personal Financial Planning
Learning Objective 1-2:
Assess personal and economic factors that influence personal financial planning.
- LIFE SITUATION AND PERSONAL VALUES
Adult life cycle stage
Marital status, household size, and employment
Major events
- Graduation, engagement, career change, children, retirement, etc
Values influence spending and saving decisions
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Influences on Personal Financial Planning
- THE FINANCIAL SYSTEM (how money flows)
Providers of funds (savers and investors)
Financial Intermediaries
Financial Markets
Users of funds (borrowers and spenders)
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Influences on Personal Financial Planning
- ECONOMIC FACTORS
Forces of Supply and Demand on setting prices
Economics is the study of how wealth is created and distributed
The economic environment includes different institutions
Federal Reserve Bank and it’s role in the economy
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Influences on Personal Financial Planning
- GLOBAL INFLUENCES
Global marketplace influences financial activities
American companies compete against foreign companies for US dollars
Balance of exports and imports
Foreign investments and their role in the US Money Supply
The level of Money Supply affects interest rates
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Influences on Personal Financial Planning
CHANGING ECONOMIC CONDITIONS
- Consumer prices
- Consumer spending
- Interest rates
- Money Supply
- Unemployment
- Housing Starts
- Gross domestic product (GDP)
- Trade balance
- Stock market indexes
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Influences on Personal Financial Planning
SELECT A PATH TO FINANCIAL SECURITY
- Save for emergencies and the future
- Maintain a low level of debt
- Have a risk management plan
- Avoid investment scams
- Communicate with others
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Developing Personal Financial Goals
Learning Objective 1-3:
Develop personal financial goals.
- TYPES OF FINANCIAL GOALS
a) Can be influenced by the time frame in which you want to achieve your goals
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Developing Personal Financial Goals
- TYPES OF FINANCIAL GOALS
b) Can be influenced by the financial need that drives your goals
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Developing Personal Financial Goals
- TYPES OF FINANCIAL GOALS
TIMING OF GOALS
- Short-term, intermediate, and long-term goals
- Long-term goals should be planned in coordination with short-term and intermediate goals
GOALS FOR DIFFERENT FINANCIAL NEEDS
- Consumable-product goals
- Durable-product goals
- Intangible-purchase goals
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Developing Personal Financial Goals
- GOAL-SETTING GUIDELINES
Goals should be SMART:
- Specific: know what your goals are to create a plan
- Measurable: with a specific amount
- Action-oriented: identify the personal financial activities
- Realistic: utilizing your income and life situation
- Time-based: identify the time frame to achieve the goal
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Opportunity Costs and the Time Value of Money
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Learning Objective 1-4:
Calculate time value of money situations associated with personal financial decisions.
Opportunity Costs and the Time Value of Money
- Every financial decision involves giving up something to obtain something else
- PERSONAL OPPORTUNITY COSTS
Time
Other personal opportunity costs can be related to health, leisure etc.
Personal resources like financial resources require careful management
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Opportunity Costs and the Time Value of Money
- FINANCIAL OPPORTUNITY COSTS
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
Saving and spending decisions involve considering the trade-offs. Current needs can make spending worthwhile
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Opportunity Costs and the Time Value of Money
Time Value of Money (continued)
INTEREST CALCULATIONS
Three amounts are required to calculate the time value of money
- Principal (the amount of savings)
- Interest rate (annual)
- Time
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Opportunity Costs and the Time Value of Money
Time Value of Money (continued)
COMPUTING SIMPLE INTEREST
=Amount in savings x annual interest rate x time period
=interest amount
For Example:
=$100 x 5% x 1 (1 year)
=$100 x .05 x 1
=$5.00
In one year, you have $100 in principal plus $5.00 in interest for a total of $105 at the end of the year.
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Opportunity Costs and the Time Value of Money
1) FUTURE VALUE OF A SINGLE AMOUNT
- 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
- See Exhibit 1-8A
2) FUTURE VALUE OF A SERIES OF DEPOSITS
- Future value can be computed for a single amount or for a series of deposits called an annuity
- See Exhibit 1-8B
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Opportunity Costs and the Time Value of Money
3) PRESENT VALUE OF A SINGLE AMOUNT
- Present Value is the current value of 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
- See Exhibit 1-8C
4) PRESENT VALUE OF A SERIES OF DEPOSITS
- Present value can be computed for a single amount or for a series of deposits
- See Exhibit 1-8D
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Opportunity Costs and the Time Value of Money
METHODS FOR COMPUTING TIME VALUE OF MONEY
- Formulas
- Time value of money tables
- Financial calculators
- Spreadsheet software
- Time value of money web sites
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Achieving Financial Goals
Learning Objective 1-5:
Identify strategies for achieving personal financial goals for different life situations.
COMPONENTS OF PERSONAL FINANCIAL PLANNING
Obtaining (chapter 2)
Planning (chapters 3, 4)
Saving (chapter 5)
Borrowing (chapters 6, 7)
Spending (chapters 8, 9)
Managing risk (chapters 10-12)
Investing (chapters 13-17)
Retirement and estate planning (chapters 18, 19)
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Achieving Financial Goals
- DEVELOPING A FLEXIBLE FINANCIAL PLAN
A financial plan is a formalized report that...
- Summarizes your current financial situation
Analyzes your financial needs
Recommends future financial activities
Your financial plan can be created by you, with assistance from a financial planner, or made using a money management software package
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Achieving Financial Goals
- IMPLEMENTING YOUR FINANCIAL PLAN
Develop good financial habits
Use a well conceived spending plan to help you stay within your income, while allowing you to save and invest for the future
Have appropriate insurance protection to prevent financial disasters
Become informed about tax and investment alternatives
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Achieving Financial Goals
- STUDYING PERSONAL FINANCE
Resources
Personal Financial Planner sheets
Website www.mhhe.com/kdh
Practice Quizzes and end-of-chapter activities
Online sources for current finance information
Talk to others
Achieving your financial objectives requires a willingness to learn and appropriate information sources
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