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Lecture 2

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  • 1. Introduction to Economics Elements of Personal Finance
  • 2. Econ 109 Class Page
    • Econ Home Page: http://www. econ . ucsb . edu
  • 3. Economics 109 Llad Phillips Fall 2002 Introduction to Economics Hour, Location: 2:00-3:15, Engineering 1104 Instructor: Llad Phillips, Llad@econ.ucsb.edu Office Hours: NH 3032, 9:30-10:15 TuTh and 10:30-11:15 W, and by appointment Arthur O’Sullivan and Steven Sheffrin, Economics, Principles and Tools, Third Edition(2003,2001)
  • 4.  
  • 5. Concepts in Economics
    • This Time: How to think like an economist, the economic paradigm
    • This Time: You pay for the service of the car: one year, two years, three years
    • Last Time: scarcity
    • Last Time: opportunity cost
  • 6. Personal Finance Examples
    • Buying a Car
    • The most important thing about the example is process :
  • 7. Economists have a name for this process: The Economic Paradigm
    • Step One: List your options for choice
      • for example pay cash or keep the cash
  • 8. Economists have a name for this process: The Economic Paradigm
    • Step One:
    • Step Three: pick the best option for you
      • for example: keep the cash
  • 9. What Happened to Step Two?
    • Step Two: value the options
  • 10. Economics: Two Types of Issues
    • Efficiency
      • step 3 of the paradigm: pick the best option
      • optimize
    • Equity
  • 11.  
  • 12.  
  • 13. What is the next most important thing to remember from the car example?
    • Two Main Costs
      • depreciation
      • foregone interest
  • 14. Depreciation: Taurus, GL Sedan
  • 15.  
  • 16. Walnut Creek Ford Dealer
    • 1996 Taurus
    • Advertised Price: $16,488
  • 17. Choice: cash
    • purchase price: $16,488
    • tax at 7.5 %: $1,237
    • documents: $35
    • total: $17,760
  • 18. Keep Your Money This Year  Next Year Year After $17,760 $17,760 $17,760 $1,225* $1,225 $1,225 * @ 6.9 % interest $17,760 $18,985 $20,210 Buy The Car, Cash Car’s Services For 1 Yr. Car’s Services For 2 Yrs. Resale value: $14,947** $13,538# ** MSRP - Depreciation = MSRP - MSRP * 0.194 = $18,545 * 0.806 # MSRP - Depreciation = MSRP - MSRP * 0.27 = $18,545 * 0.73 Cost of Car’s Services: $4,038(1 Yr.) & $6,672(2 Yrs.)
  • 19. Another Decision: How to Pay?
  • 20. Choice of Payment Method
    • cash
    • lease
    • loan
  • 21. http://www.fordcredit.com/
  • 22. Advertised 2-Year Lease Deal for a 1996 Taurus
    • drive-off costs(payments due at lease signing): $2,136.77
    • monthly Payment: $249 + tax
    • remember: tax + documents = $1237 + $35 = $1272, spread over 24 months, or $53 per month
    • total monthly payment: $249 + $53= $302
    • total payments: 24*$302=$7248
    • drive-off + payments= $9384.77
  • 23. Example Walnut Creek Dealer: 1996 , Ford Taurus, $16,488   5,976 + tax 249 + tax
  • 24. Example 249 + tax 24 months 5,976 + tax
  • 25. This Year  Next Year Year After $2,450 $1,225* $4,222 $6,672 * @ 6.9 % interest $4,038 Buy The Car, Cash foregone interest on $17,760: depreciation: # price+tax-blue book = $17,760 - 0.806*$18,545 $2,813# Lease, 24 months total drive-off: $2,137 $2,137 total monthly payments @$302/m.: $3,624 $7,248 foregone interest on $2,137**: $147 $294 $5908 $9679 ** Assumes no opportunity cost of monthly payments
  • 26. What is the advantage of leasing?
    • Low drive-off compared to paying $17,760 cash
  • 27. http://www.fordcredit.com/calculator/calcbuffer.html
  • 28.  
  • 29. Cost of Using a ‘96 Taurus for 2 Yrs. * foregone interest on the drive-off of $2,137
  • 30. Elements of Personal Finance
    • Economics in every day life
      • loans
        • car loans
  • 31. Example: Buying a New ‘96 Taurus
    • Knowns
      • advertised price + tax + documents: $17,760
      • down payment: $2,137
      • loan amount: $15,623
        • loan amount = $17,760 - $2,137
      • annual interest rate: 6.9%
      • loan term in months: 24 months
    • Unknowns
      • monthly payment
  • 32. Monthly Payment?
    • Could use Ford calculator, but that was for a 48 month loan
    • could use the program Excel
  • 33. Using Excel 5.0 for a Solution Monthly Payment?
  • 34. Cost of Using a ‘96 Taurus for 2 Yrs. * residual value: $11,480 vs. Kelly Blue Book resale value of $13,538 ** blue book: $13,538
  • 35. Catch 22
    • The 2-year loan looks best
    • But, …. Ford was not offering a 2-year loan, but a 4-year loan
  • 36. Some General Facts About Loans
    • From our car loan example
  • 37. Using Excel 5.0 for a Solution
  • 38. Increasing the Length of the Loan Tradeoffs
    • monthly payment amount decreases
    • amount of total payments increases
    • amount of total interest payments increases
    • total interest as % of total payments increases
  • 39. Using Excel 5.0 for a Solution
  • 40. Interest as a Fraction of Cost
  • 41.  
  • 42.  
  • 43. Summary: Loans
    • interest is front-loaded in payment plan
    • interest cost increases with the loan term
    • total cost increases with the loan term
    • equity is low at the beginning of the loan
  • 44. Personal Financial Planning Financing Life Events
  • 45. Life Event* Approach
    • Marriage/commitment to significant other
    • children
      • financial security: insurance
      • housing
      • education
    • retirement
    • long term care
    • estate
    *reference: Ernst & Young’s Personal Financial Planning Guide, 2nd Ed. John Wiley
  • 46. Life Cycle Approach: Learning & Earning Age Infancy Nurturing Adolescence High School Education Young Adult College Adult Work Senescence Retirement Activity/ Phase:
  • 47. Life Cycle Approach: The Planners Age Infancy Adolescence Young Adult Adult Senescence 100% 50% 0 % You Parents
  • 48. Life Cycle Approach: Planning Age Nurturing High School Education College Work Retirement Education: Investment in Human Capital or Earning Power Accumulating Assets cars appliances furnishings --------------------- house financial assets Spending
  • 49.  
  • 50.  
  • 51. Planning Tools
    • Assets-Liabilities Statement
      • Assets Minus Liabilities = Net Worth
        • measure of wealth
    • Income-Expenditure Statement
      • Income Minus Expenditures = Saving
        • measure of change in wealth
  • 52. http://www.fordcredi.com/fplanner.cgi
  • 53. Income-Expense Statement
  • 54. Income-Expense Statement: US Population 1988 other: health, 5%; pensions & Soc. Sec., 7%; other, 15% Source: Guide to Understanding Personal Finance, p. 87
  • 55. Assets-Liabilities Statement
  • 56. Strategies for Meeting Future Expenses
    • Buy a House
    • Tax-Sheltered Savings Plans
    • Stocks and Bonds
  • 57.  
  • 58. Buying a House
    • Positives
      • provides space
      • builds equity
      • interest is deductible
    • Negatives?
      • down payment requires saving for this goal
      • interest payments are front-loaded, equity growth delayed
      • opportunity cost of not investing in stocks
  • 59. Summary - Vocabulary - Concepts
    • economic paradigm
    • down payment
    • loan term
    • monthly payment
    • annual percentage rate or APR
    • equity
    • personal financial planning
    • life event ananysis
    • human capital
    • assets
    • liabilities
    • net worth, wealth
    • income
    • expenditures
    • savings
  • 60. Excel : select cell for monthly payment, click on Function Wizard select Financial and PMT
  • 61. Excel : click on the help button in the previous window for examples
  • 62. The Economic Approach to Problem Solving The Economic Paradigm
  • 63. The Economic Paradigm
    • describing the alternatives to choose among
    • pricing the alternatives
    • choosing the best alternative
  • 64. The Economic Paradigm example: buying a car
    • describing the alternatives to choose among
      • cash: the opportunity cost of losing interest
      • lease: depreciation included in payments
      • loan: sell the car to account for depreciation
    • pricing the alternatives: valuation
      • Oscar Wilde- economists know the price of everything and the value of nothing
    • choosing the best alternative
      • best: lowest cost
      • possibly subject to a constraint: having the $
  • 65. The Principle of Opportunity Cost
    • No matter what we do, there are always tradeoffs.
    • Scarcity -- limited resources -- is the reason.
    • The opportunity cost of something is what you sacrifice to get it.
  • 66. Opportunity Costs and Production Possibilities
    • The production possibility curve illustrates the principle of opportunity cost for an entire economy.
    • -- shows all possible combinations of goods and services available to entire economy.
    • --- principle of opportunity cost explains why production possibility curve is negatively sloped.
  • 67. THE MARGINAL PRINCIPLE
    • Marginal Benefit
    • The extra benefit resulting from a small increase in the activity.
    • Marginal Cost
    • The additional cost resulting from a small increase in the activity.