Overview of the Financial Plan


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Overview of the Financial Plan

  1. 1. Overview of the Financial Plan The objectives of this chapter are to: • Introduce the reader to the subject of personal finance. • Identify the key components of a financial plan. • Outline the steps to begin creating a personal financial plan (PFP). Why Study Personal Finance? Personal finance is the process of planning your savings, spending, and investing in order to maximize your optimal financial situation. A personal financial plan specifies your specific financial goals and describes the savings, spending, and investing tools you are going to use to meet your financial goals. Creating and managing your financial plan is a life-long process that involves time and commitments. As anything worth having, a good financial plan requires attention. But the benefits of creating a financial plan include: • Giving you the knowledge you need to make your own financial decisions. Each of us has to determine the opportunity cost of our spending decisions. The opportunity cost represents what you give up as a result of your decisions. By spending money for one item you forgo the opportunity to spend that same money on another option, saving it or investing it. When Jennifer was 20 she became the manager of a retail specialty store. Jennifer was making $30,000 a year and knew that she needed to make some decisions about what she did with her money. Jennifer could spend all the money, spend part of the money and save part of the money, or combine spending, saving, and investing. What Jennifer didn’t realize at the time was that if she invested $100 a month for the next ten year and could make 8% interest on her money she would have more than $17,000 (not bad for a $12,000 investment). But even more importantly, if she quit putting money into her investment and just let it sit there until she reached 60 (30 more years) she would have about $175,000, . . . now that ought to make you rethink spending versus saving!! • Allows you to become financially successful. Although many people believe financial success has to do with how much money a person makes, really it means obtaining the maximum benefits from limited financial resources. Some people who have a lot of money are good at this, some are bad. This means a person can become a financial success (or failure) regardless of their income level. Financial objectives are rarely achieved without restraining current consumption (spending on goods and services). To accomplish this restraint you can 1) put money into savings (income not consumed) to be used on your future goals; 2) invest (using capital to create more money). By saving and investing you are more likely to have funds for future goals. Saving for short- middle- and long-term goals represents a desire for you to achieve a certain standard of living. This standard is what an individual is striving to attain, to maintain once attained, and preserve if threatened. At any 1 Section 1 Financial Planning
  2. 2. given time an individual is at their level of living. In essence, our level of living is where we are right now, our standard of living is where we’d like to be. • Helps you understand your goals and whether you are moving toward or away from those goals. In order to understand how your finances fit into the rest of your life you need to look at both financial and non-financial goals o Financial goals form the basis for financial planning. These goals need to be identified at the beginning of the process of putting your personal financial plan together. There are four steps to creating goals: 1) Evaluate your current financial situation. Create an income statement and a balance sheet to help you. 2) Define your financial goals. These goals need to be concrete goals. Financial goals need to be time and dollar specific. A goal that states “I want to have a nice car.” Does not give enough specifics to save toward. A goal that says “I want a $30,000 car by December 31, 2010.” Gives time and money specificity. Now you can start creating a plan to determine how you’re going to achieve that goal. 3) Develop your plan of action. When making mid- or long-term goals you may need short-term goals to support them. 4) Implement your plan (as some of us country music lovers would say “Just LeDoux it!!”). 5) Evaluate your performance toward your goals. At least annually analyze your performance and determine if you need to revise or adjust your goals. o Non-financial goals are those goals that have to do with your physical, emotional, spiritual, etc. aspirations. Many of these goals may require money to achieve while others do not. However, achieving financial goals may give you more opportunities to enjoy these goals. Figure 1.1 The Planning Process Step 1 Step 2 Step 3 Step 4 Evaluate Your Define Your Develop Your Plan of Implement Your Plan Current Financial Financial Goals Action Condition Just Do It! Decide what you are Make your spending Prepare a Balance saving for and how line up with your Sheet and determine when you want to budget goals. what your net worth is. achieve your goal. Use the goals worksheet to Prepare an Income help you. Statement to determine where you are spending your money. Step 5 Review your progress, Reevaluate your goals and the process to achieve them, and Revise your plan as required to meet your expectations. 2 Chapter 1 Introduction to Personal Finance
  3. 3. Money Matters Would winning the lottery make you happy? Not likely. According to David G. Myers, a happiness researcher, money does not buy happiness. Rich people are no more happy than people with average incomes. In addition, older people are neither less nor more happy than young people. And men have no advantage over women. So who is happy? Only about 10-15 percent Americans identify themselves as truly happy. Certain personality traits, such as extroversion, agreeableness, and conscientiousness, are related to happiness. However, in the right situation, anyone can be happy. Psychologist Mihaly Csikszentmihalyi has observed that people are most satisfied with life when their work and leisure life provide them opportunity to use their skills. Somewhere between the anxiety of being overwhelmed and the apathy of being bored is the ideal mix called "flow." Happy people have more flow. They are appropriately challenged in ways that allow them to personally contribute. Happiness has also been linked to meaningful relationships. Individuals who are happy are supported by close relationships with family members, friends, and fellow employees. Such relationships help fulfill our need to belong to something bigger than ourselves. The network of friends and family also provides us with opportunities to help or be helped. If we are to maintain a healthy balance in life, we will eventually need help from others. Perhaps this partly explains the finding that married individuals, both male and female, are on average happier than single individuals. Finally, happy people are more likely to be involved in a faith community. A Gallup survey found people who responded with the highest scores on spiritual commitment were twice as likely to declare they were very happy. Other research has suggested those with deep religious faith are less vulnerable to depression and more resilient during times of crisis. Meyers notes that religion is usually practiced communally, involving "the fellowship of kindred spirits," and "the bearing of one another’s burdens." So, if happiness is your goal, forget the lottery tickets. Instead, take a friend to lunch. Help a fellow worker. Set your sights on a challenge and enjoy the experience. Look to your network of friends and family. Use your skills to make a difference at home and at work. Applications: To strengthen your personal happiness and add to the joyfulness of you family experience try some of the following: 1. Work on something challenging. 2. Do something for others 3. Smile often 4. Join a group. Participating in a club, a church group, or community group can create many opportunities. 5. Give someone a break. Source: University of Arkansas Cooperative Extension Service 3 Section 1 Financial Planning
  4. 4. Setting Personal Financial Goals Setting goals should be nothing new to you. You have probably done it hundreds of times in your life. You may have a target GPA, a date that you are shooting at to graduate, or places you would like to visit in your life time. Most of us know what we need to do to attain these goals. But when it comes to financial goals, though we may have them – “I want to retire with 2 million dollars” or “I want to save enough money so I don’t have to worry about finances when I retire.” The problem is figuring out how to go about achieving these goals. As with any worthwhile goal, financial goals will require you to reach higher and farther than you ever have before. You will have to spend some time planning your financial journey just as you would have to plan any trip, this process will take some time. Once you reach a location on this journey you will be given the opportunity to look back on what you have accomplished, would you have changed anything? If you would have, make the change, put your financial gear back on, and move forward to your next location along your journey. The difference between this trip and other trip you will take is that this expedition will last a life time. In order to reach your destination you will need to work at it. You will have to get yourself in good financial health to cross some of the financial deserts, mountains, and waters that may get in your way between here and there. But, if you take the time to prepare and use the tools and equipment available to you, you will succeed. Financial goals cover three time horizons: (1) short-term, (2) intermediate-term, and (3) long-term. Short-term goals can be accomplished within the next twelve months. Intermediate-term goals are goals that will take more than one year but less than ten years to accomplish. Long-term goals will take more than ten years for you to complete. 4 Chapter 1 Introduction to Personal Finance
  5. 5. Fi Figure 1.2 Personal Financial Goals Short-Term Goals Dollar Amount Date to Financial Goal to Accomplish Accomplish By 1. Go 2. 3. 4. 5. Intermediate-Term Goals 1. 2. 3. 4. 5. Long-Term Goals 1. 2. 3. 4. 5. This spreadsheet is also located in your PFP under the “Goals” tab. Use the five steps included on that spreadsheet to complete your personal financial goals worksheet. This is a very important part of your financial journey. In fact, your goals should be your Global Positional System (GPS) on this journey. Any time you wonder whether or not you are making the correct financial decision ask yourself “does this help me achieve one of my personal financial goals?” If the answer is no, you should rethink the way you were thinking about using your money. This process of setting and revising goals should be a long-term commitment to your personal finance health. When making long-term goals it is important to understand something about the economy. What is the “traditional” inflation rate, what kind of interest can one expect to make on an investment, etc. This is important because you are trying to determine how much money you need in fifteen, twenty, maybe thirty years from now. We will talk about time value of money and its importance in Chapter 2, but right now let’s just talk about economic trends that may affect your decisions. Understanding Important Economic Trends 5 Section 1 Financial Planning
  6. 6. Understanding personal finances would be so much easier if we lived in an economic environment where nothing changes – but that environment does not exist. So we need to be able to predict what might happen in the future based on past experiences. Certain trends in the economy are pretty good predictors of the future. In the United States the federal government attempts to regulate the economy to maintain stable prices, stable employment, and controlled inflation. By doing this the government hopes to attain economic growth, which is a condition of increased production and consumption in the economy. If this growth occurs there is increased national income. Because it is impossible for this growth to constantly move upward, there are phases that occur throughout time. These phases create a wave-like pattern called the business cycle (or economic cycle). These temporary phases include expression, recession (sometimes moving into depression), and recovery. The preferred stage in the economic cycle is the expansion phase. This is a time when production is high, unemployment is low, retail sales are on the rise, prices are low, and interest rates are falling. When the economy is growing very strongly, the Federal Reserve typically tries to engineer a soft landing by raising interest rates to head off inflation. When this occurs, the economy will move toward a recession, which is generally described as a decline in production. During this phase of the cycle the Federal Reserve will generally lower interest rates to stimulate growth. As rates are lowered and the economy recovers, it heads into the recovery phase of the business cycle, where production, unemployment rates, and retail sales begin to improve. Historically the business cycle takes four to five years to complete. Figure 1.3 Phases of the Business Cycle Expansion Recession Recovery (Prosperity) (or Depression) Average growth rate expected in the economy Let’s look at some of these: The Consumer Price Index (CPI) is a monthly indicator of the changes in the prices paid by urban consumers for a representative basket of goods and services. As figure 1.3 points out, the CPI has drastically changed since the late ‘70’s and early ‘80’s. The CPI is one of the indicators looked at to determine inflation because if the average household is paying 3% more this year for this basket of goods than last year, the inflation rate is about 3%. 6 Chapter 1 Introduction to Personal Finance
  7. 7. Figure 1.4 Consumer Price Index Source: Federal Reserve Bank of St. Louis, National Economic Trends May 2005, p.8 www.stlouisfed.org/ search on National Economic Trends Using the raw data provided in Appendix 1 of this chapter you can determine the average increase in prices from one period to another. Example: The CPI is used to calculate how prices have changes over the years. Let’s say you wanted to buy a $7 item in 2005 . How much would you have needed in 1950 to purchase that same item? The CPI for 1950 = 24.1 The CPI for 2005 = 194.6 Use the following formula to compute the calculation: 1950 Price = 2005 Price x (1950 CPI / 2005 CPI) 1950 Price = $7.00 x (24.1 / 194.6) 1950 Price = .87 Therefore, based on the CPI, an item that cost 87 cents in 1950 would cost $7.00 in 2005. Remember, this does not mean everything increased at this rate. The CPI represents the consumer’s basket of goods. Some prices grow faster and some grow slower. So, if you were planning a long-term goal and trying to anticipate the increased cost of the product in five, ten, even thirty years the CPI would be a place to start estimating the increased cost for that item. At the same time, your investments should grow faster than the inflation rate to grow your wealth in real terms. Real Gross Domestic Product (GDP) measures the value of a nation's output of goods and services for some period of time, usually a year. It is not the only measure of output but the GDP has become a favorite among economists because it is the most comprehensive of output measures. The impacts the GDP can have on the economy are: Interest Rates: Unexpectedly high quarterly GDP growth is perceived to be potentially inflationary if the economy is close to full capacity; this, in turn, causes bond prices to drop and yields and interest rates to rise. Also, higher than expected GDP growth, i..e. good news about the economy, is bad news for the 7 Section 1 Financial Planning
  8. 8. bond market because a strong report causes concern that the Fed might raise the Fed Funds rate to avoid higher inflation. This is bearish for the fixed income market. Stock Prices: Ambiguous. On one side higher than expected growth leads to higher profits and that's good for the stock market. On the other, it may increase expected inflation and lead to higher interest rates that are bad for the stock market. Exchange Rates: Larger than expected GDP growth will tend to appreciate the exchange rate as it is expected to lead to higher interest rates. Figure 1.4 provides a measurement of our economy’s performance since 1979. As you can see there have been four recessions, each has had an impact on American families in terms of savings, investing, and spending. There is no reason to believe this trend will not continue, therefore financial plans need to anticipate possible economic instability. Figure 1.5 Gross Domestic Product Source: Federal Reserve Bank of St. Louis, National Economic Trends May 2005, p.4 www.stlouisfed.org/ search on National Economic Trends These are only a couple of the many economic indicators that exist. In addition to paying attention to these trends, you should stay abreast of what is going on in the financial news and what changes are occurring that could impact your financial plans. How Inflation Affects Income and Consumption When prices are increasing and individual’s income must rise at the same rate in order to maintain purchasing power. If inflation rates are greater than an individual’s salary increase the individual is said to have lost purchasing power. When the increase in salary is larger than inflation the individual has increased his/her purchasing power. When looking at one’s income, we need to clarify whether we are looking at nominal income, the salary you and your employer agree upon. For example, when you take a job for $35,000, that is your nominal income. It is unadjusted for change in the purchasing power of the dollar. The other, and more important income, is real income. This is the income an individual receives after adjusting for changes in purchasing power caused by inflation. A price index is used to determine the difference between the purchasing power of a dollar in a base year and the purchasing power now. For instance, if cost of a market basket increases from $100 to $120 in ten years, reflecting a 20% decline in purchasing power, salaries must rise 20% if real income is to be maintained. 8 Chapter 1 Introduction to Personal Finance
  9. 9. To equate this to one’s annual wage, let’s assume that Jenny, our retail manager that was making $30,000 was to get increases of $500, $600, and $700 over the following three years after her initial hire. Let’s also assume that inflation has been 3% for these same years. Although Jenny’s nominal income has increased from $30,000 to $31,800 ($30,000 + $500 +$600 + $700), her purchasing power has decreased. In order for her purchasing power to have stayed the same, she would need to be making $32,782 ($30,000 x 1.03 = $30,900 x 1.03 = $31,827 x 1.03 = $32,782). In other words, Jenny has lost $982 of purchasing power. Another way to compare annual wage increases with the rate of inflation is to convert the raise into a percentage and compare that percentage to the inflation rate: Percentage change = (Nominal income after raise – nominal income in previous year) x 100 in personal income Nominal income in previous year Using the example above for the first year after Jenny started: Percentage change in personal income = ($30,500 – $30,000) x 100 $30,000 Percentage change in personal income = $500 x 100 $30,000 Percentage change in personal income = .0167 x 100 Percentage change in personal income = 1.67 Jenny had a real increase of 1.67% while inflation was at 3%. The Importance of Planning Planning is the key to your personal finance success. As stated earlier, your plan is your GPS in your financial journey. Waiting until you reach your mid 40’s and realizing you need to do something about your retirement is a scary approach. Rather, why not start early, work hard, and end up where you want to be? That’s the alternative planning gives you. This type of planning, making your financial objectives part of your life early and working on them throughout your life, is called life cycle planning. We go through different stages in our life. As we leave one stage and enter another stage we tend to concentrate on different aspects of our finances. That doesn’t mean our plan changes, just that a different part of that plan becomes more important. Figure 1.6 9 Section 1 Financial Planning
  10. 10. A Typical Individual’s Financial Life Cycle Stage 1 Stage 2 Stage 3 $ Early years-A time of Approaching The Retirement Years Wealth accumulation Retirement- The Golden (Ages 65 and over) (through age 54) Years (Ages 55-64) Reassessment of Retirement Goals Tax and Estate Planning Consumption and Saving Retirement Family Formation Saving for Goals-Pay Yourself First Insurance Planning Family Development Home Purchase Initial Goal Setting Family Maturity 20 30 40 50 60 70 80 Age Based on Arthur Keown’s Typical Life Cycle from Personal Finance, Third Edition, p. 8. The first twenty-or-so years of a person’s life is spent paying for things. During this stage you may have to pay for your education, you might live at home and depend on parents to pay for housing, utilities, etc., but by the time you graduate from college, you need to take your financial life cycle process seriously. Although there are three distinct stages of financial progress in a typical person’s life, there are eight separate financial planning areas that will influence your financial journey. Each of these areas will be discussed in more detail throughout this book: Consumption and savings, debt planning, insurance planning, investment planning, retirement planning, estate planning, income planning, and career planning. Consumption and savings planning is an important part of your strategy to achieve financial goals. When you make money you have two choices: 1) will you spend it (consumption) or 2) will I save (or invest) it. The answer to this question will guide you throughout your financial life. Debt planning is an aspect that most of us face throughout our lives. Debt is not a bad thing if it’s controlled. The use of debt can help us hedge against inflation, save funds while taking advantage of cost savings, allow us the convenience of not carrying cash, 10 Chapter 1 Introduction to Personal Finance
  11. 11. and help out in times of emergency. But debt must be managed carefully. It doesn’t make any sense to charge at 18 percent interest rate when there are funds available making 8 percent interest. Insurance planning may be one of the most commonly overlooked aspects of financial health. Although the need for insurance grows as assets and responsibilities increase, it doesn’t mean younger individuals don’t need insurance. When you are young your primary asset is your ability to work and make money, therefore you probably need to have disability insurance. If you’re renting an apartment, do you know your neighbor to the left and right of you, upstairs and downstairs well enough to trust that they won’t have a fire that could destroy your possessions? As you take on additional responsibilities by buying assets or starting a family you will need to increase the insurance you have to protect what you have. Investment Planning should begin as you start saving. An important part of your investment plan should be how liquid you want to stay. What type of investments are you interested in and when should you sell or buy investments. The difference between a good and bad investment plan can be the difference between succeeding and failing at your financial goals. Retirement Planning should be part of your initial plan. Each of us must accumulate the majority of our retirement nest egg during our working years. Although you may be relying on Social Security and employer-sponsored retirement programs for the majority of your retirement income, we must realize supplemental resources may be required to allow us to live the way we desire. Estate Planning is important for all of us since the chances of living forever are very slim! This portion of the cycle includes keeping your financial house in order, creating sound tax strategies early, and having a proper will created. Income Tax Planning is a part of each of our financial lives. As the old saying goes “Nothing is sure but death and taxes.” Since we know it’s going to be part of our lives we might as well embrace it and make the most of it by using tax laws to our benefit. Career Planning affects our financial, mental, and emotional health. Many of us relate who we are to what we do. When someone asks “What do you do?” We rarely say, “I save appropriately, invest adequately, and have enough money in my retirement fund to feel financially secure.” Instead we often answer “I’m an administrator” or “I’m a teacher.” As you go through this life cycle your career will probably change a number of times. So it’s important to your financial well being to prepare yourself for these changes. Making Sound Financial Decisions 11 Section 1 Financial Planning
  12. 12. Making decisions is often difficult. In order to make the decision easier it is best if we use the tools available to us. Two of the most common tools used to help make financial decisions are marginal analysis and opportunity costs. Marginal analysis is defined as evaluating the changes in important variables that are related to changes in decision inputs you can control. For instance, if you need a new pair of shoes for the job you were recently offered. You only need one pair, but it would be nice to have both a black and brown pair of dress shoes, you must determine the benefit of buying the second pair of shoes. If the benefit outweighs the cost you would buy them. If the benefit does not outweigh the cost you wouldn’t buy them. Opportunity costs are the benefits you give up by making one choice over another. If you are taking this class, which is an elective and does not count toward your major, when you could be taking a class that counts toward your degree, what is your opportunity cost? Utility is the ability of a good or service to satisfy a human want. A key task for any individual is to determine how much utility is gain from a particular decision. An example would be, if you had the chance to go to a concert and you could buy front row seats for $85 or seats in the 35th row for $60 what is the marginal utility, or added satisfaction gained by buying the front row tickets. At the same time you must remember the marginal cost, or additional cost for these tickets. Though these examples may seem trivial, the concept is important. You could ask what the opportunity cost is of choosing one degree over another? What are the opportunity costs associated with continuing your education and getting a graduate degree rather than stopping at an undergraduate degree? What are the opportunity costs of going to college instead of stopping at a high school diploma? To understand this concept better ask yourself, “What do I give up when I make this decision?” The answer will give you the opportunity cost of making your decision. Economic Impact of Income Taxes on Decision Making Throughout this book you will find that the important aspect of making money is not how much you make but how much you keep, so one area that we have to consider is the economic impact of paying income taxes. Of particular importance is the marginal tax rate you pay. This is the tax rate at which the last dollar you earned is taxed at. As income increases, the taxpayer pays a progressively higher marginal tax rate. Because we pay Social Security tax, State tax, Federal tax there is also what is called the effective marginal tax rate which is the total tax rate you pay. We will discuss these rates in more detail in chapter 4, but I want you to start thinking of the importance of reducing your tax through tax exempt income, income that is totally and permanently free of tax, or tax sheltered income, income that is exempt from taxes in the current year. Affect of Time on the Value of Money in Decision Making In looking at middle- and long-term goals, you need to be able to answer two questions: 1. How much do I need to invest today in order to have a certain amount in the future? 2. What will the amount I’m putting away today be worth in 5, 10 . . . . years? 12 Chapter 1 Introduction to Personal Finance
  13. 13. Both of these questions relate to the time value of money calculation, which allows you to consider the worth of a dollar today compared to previous or future years. This calculation creates a base for calculating. Because we earn compound interest, interest on both the principal (the original amount you invested) and interest, you can’t just use the simple interest (interest on the principal only) calculation of Interest = Principal x Rate x Time to calculate how much money you will have given a specific interest rate for a given amount of time. Instead you need to use a compounding equation. Here’s an example of the difference between simple interest and compound interest: Table 1.1 Simple Interest Compared to Compound Interest Simple Interest Compound Interest Interest New Interest New Year Principal Rate Time Earned Balance Principal Rate Time Earned Balance 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 In this example a person invested $100 at 10% interest for 18 years. On the left is the calculation if we used the simple interest formula (Interest = Principal x Rate x Time or, in this example: Interest = $100 x .10 x 18 = $180). On the right is the compound interest calculation. You can see what a drastic affect occurs for a small amount of money over time. This becomes even greater if an annuity is set up, where money is put in consistently over time rather than a one time investment. Time value is calculated in two areas, future value and present value. Each of these areas are valued as a lump sum amount (one payment) or an annuity (multiple payments). The future value (FV) is the valuation of an asset projected to the end of a particular time period in the future. 13 Section 1 Financial Planning
  14. 14. Future Value of a Lump Sum The future value of a lump sum is calculated as follows, where i represents the interest rate and n represents the number of time periods: FV = (Present value of sum of money)(I +1.0)ⁿ Applying this formula to the table above: = ($100)(.10 + 1.0)18; FV = ($100)(1.1)18; FV = ($100)(5.5599); FV = $555.99 While this calculation is correct, it gets very difficult as the number of years increases. You can use a financial calculator to do the math, or you can use a table to do the calculation for you like the one in Figure 1.2: Figure 1.2 Future Value of $1 After a Given Number of Periods Periods 1% 2% 3% 4% 8% 9% 10% 1 1.010 1.020 1.030 1.040 1.0800 1.090 1.1000 0 0 0 0 0 2 1.020 1.040 1.060 1.081 1.1664 1.188 1.2100 1 4 9 6 1 3 1.030 1.061 1.092 1.124 1.2597 1.295 1.3310 3 2 7 9 0 4 1.040 1.082 1.125 1.169 1.3605 1.411 1.4641 6 4 5 9 6 5 1.051 1.104 1.159 1.216 1.4693 1.538 1.6105 0 1 3 7 6 6 1.061 1.126 1.194 1.265 1.5869 1.677 1.7716 5 2 1 3 1 7 1.072 1.148 1.229 1.315 1.7138 1.828 1.9487 1 7 9 9 0 8 1.082 1.171 1.266 1.368 1.8509 1.992 2.1436 9 7 8 6 6 9 1.093 1.195 1.304 1.423 1.9990 2.171 2.3579 7 1 8 3 9 10 1.014 1.219 1.343 1.480 2.1589 2.367 2.5937 6 0 9 2 4 11 1.115 1.243 1.384 1.539 2.3316 2.580 2.8531 7 4 2 5 4 12 1.126 1.268 1.425 1.601 2.5182 2.812 3.1384 8 2 8 0 7 13 1.138 1.293 1.468 1.665 2.7196 3.065 3.4523 1 6 5 1 8 14 1.149 1.319 1.512 1.731 2.9372 3.341 3.7975 5 5 6 7 7 15 1.161 1.345 1.558 1.800 3.1722 3.642 4.1772 14 Chapter 1 Introduction to Personal Finance
  15. 15. 0 9 0 9 5 16 1.172 1.372 1.604 1.873 3.4259 3.970 4.5950 6 8 7 0 3 17 1.184 1.400 1.652 1.947 3.7000 4.327 5.0545 3 2 8 9 6 18 1.196 1.428 1.702 2.025 3.9960 4.717 5.5599 1 2 4 8 1 To use this table all you do is go across the top row to the rate used to calculate your return (10% in this case). Now go down that column until you come to the row reflecting the number of periods (18 in this case). The factor in the cell where these two meet (5.5599 in this example) is the value of money factor (∫). Multiply the future value factor by the amount invested ($100 in our sample) to get the future value of your investment ($100 x 5.5599 = 559.90). Notice how close this answer is to the one we calculated earlier. Now, imagine investing a larger amount of money for the same 18 years. Let’s say we invested $10,000 at 6%, 8%, 10%, 12%, and 14%. The amount we would have after each of these years respectively would be: 6% (∫=2.8543) 8% (∫=3.9960) 10% (∫=5.5599) 12% (∫=7.6900) 14% (∫=10.5752) $28,543 $39,960 $55,599 $76,900 $105,752 Not bad for a $10,000 one-time investment!! Graphically, the growth of that investment would look like this: Future Value of $10,000 With Interest Compounded Annually $110,000 $105,752 $90,000 $76,900 $70,000 6% Future Value 8% $55,599 $50,000 10% $39,960 12% $30,000 $28,543 14% $10,000 -$10,000 1 6 12 18 Years 15 Section 1 Financial Planning
  16. 16. As you can see from this graph, the longer the time frame the more space exists between the lines. This difference is due to a phenomena explained by the rule of 72, which tells how long it takes for you original investment to double using compound interest. To calculate how long it will take your investment to double, simple divide 72 by your interest rate. For instance, if you’re earning 8% interest it will take 9 years for your investment to double (72 ÷ 8 = 9). You can also determine how long it will take the price of an item to double assuming it continues to increase at the same rate for a given number of years. For instance, if college tuition is increasing at 9% and you want to know how long it will take to double divide 72 by 9 (72 ÷ 9 = 8) to find out that in eight years your tuition will double. So quit messing around and graduate!!!! Future Value of an Annuity When most people save to meet long-term goals they invest by putting a series of payments away. The calculation of an annuity can be completed by using a future value of an annuity table, similar to the table used for the lump sum. Since your are placing more money into your account though, as you would expect, the numbers are larger. Below is the same table we discussed in the lump sum section but for an annuity: Periods 1% 2% 3% 4% 8% 9% 10% 1 1.000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 2 2.0100 2.0200 2.0300 2.0400 2.0800 2.0900 2.1000 3 3.0301 3.0604 3.0909 3.1216 3.2464 3.2781 3.3100 4 4.0604 4.1216 4.1836 4.2465 4.5061 4.5731 4.6410 5 5.1010 5.2040 5.3091 5.4163 5.8666 5.9847 6.1051 6 6.1520 6.3081 6.4684 6.6330 7.3359 7.5233 7.7156 7 7.2135 7.4343 7.6625 7.8983 8.9228 9.2004 9.4872 8 8.2857 8.5830 8.8923 9.2142 10.636 11.028 11.4359 6 5 9 9.3685 9.7546 10.159 10.582 12.487 13.021 13.5795 1 8 6 0 10 10.462 10.949 11.463 12.006 14.486 15.192 15.9374 2 7 9 1 6 9 11 11.566 12.168 12.807 13.486 16.645 17.560 18.5312 8 7 8 4 5 3 12 12.682 13.412 14.192 15.025 18.977 20.140 21.3843 5 1 0 8 1 7 13 13.809 14.680 15.617 16.626 21.495 22.953 24.5227 3 3 8 8 3 4 14 14.947 15.973 17.086 18.291 24.214 26.019 27.9750 4 9 3 9 9 2 15 16.096 17.293 18.598 20.023 27.152 29.360 31.7725 9 4 9 6 1 9 16 17.257 18.639 20.156 21.824 30.324 33.003 35.9497 9 3 9 5 3 4 17 18.430 20.012 21.761 23.697 33.750 36.973 40.5447 4 1 6 5 2 7 18 19.614 21.412 23.414 25.645 37.450 41.301 45.5992 16 Chapter 1 Introduction to Personal Finance
  17. 17. 7 3 4 4 2 3 Use this table the same way you did the lump sum table. Let’s take our same $10,000, but let’s assume we put $555.56 away every year ($555.56 x 18 years = $10,000). We still earn 10% interest. Now, our value after 18 years would be (45.5992 x 555.56 = $25,333) $25,333. Notice how much difference time makes. One of the important concepts to understand about the future value of money is that time is more important (when you begin saving) than the initial amount you invest. In order to make the same $55,599 that I made by putting $10,000 into an account which made 10% interest for 18 years, I would have to put $1,219 away annually, or a total of $21,947 over 18 years. More than double the $10,000 I put away and let sit for 18 years!! Present Value of a Lump Sum Just as you can determine how much a lump sum of money invested today will be worth in the future, you can also determine how much a lump sum received in the future is worth today by using a present value calculation. Present value (or discounted value) is the current value of an asset (or stream of assets) that will be received in the future. You would use this calculation to determine how much money you need to set aside today to have a certain amount of money in the future. For instance, let’s say you want to set aside enough money beginning today to pay for your child’s education in 18 years. Assume your child’s education will cost $100,000 and you believe you can receive 8% on your money over that time period. You would go to a present value table, just like you did the future value table to determine how much you need to invest today: Periods 1% 2% 3% 4% 8% 9% 10% 1 .9901 .9804 .9709 .9615 .9259 . .9091 9174 2 .9803 .9612 .9426 .9246 .8573 . .8264 8417 3 .9706 .9423 .9151 .8890 .7938 . .7513 7722 4 .9610 .9238 .8885 .8548 .7350 . .6830 7084 5 .9515 .9057 .8626 .8219 .6806 . .6209 6499 6 .9420 .8880 .8375 .7903 .6302 . .5645 5963 7 .9327 .8706 .8131 .7599 .5835 . .5132 5470 8 .9235 .8536 .7894 .7307 .5403 . .4665 5019 9 .9143 .8368 .7664 .7026 .5002 . .4241 17 Section 1 Financial Planning
  18. 18. 4604 10 .9053 .8206 .7441 .6756 .4632 . .3855 4224 11 .8963 .8043 .7224 .6496 .4289 . .3505 3875 12 .8874 .7885 .7014 .6246 .3971 . .3186 3555 13 .8787 .7730 .6810 .6006 .3677 . .2897 3262 14 .8700 .7579 .6611 .5775 .3405 . .2633 2992 15 .8613 .7430 .6419 .5553 .3152 . .2394 2745 16 .8528 .7284 .6232 .5339 .2919 . .2176 2519 17 .8444 .7142 .6050 .5134 .2703 . .1978 2311 18 .8360 .7002 .5874 .4936 .2502 . .1799 2120 $100,000 x PV∫ = amount needed to invest $100,000 x .2502 = $25,020 Present Value of an Annuity The present value of an annuity is the current worth of a stream of payments to be received in the future. Again, you use the present value of an annuity to make this calculation. The complete tables for both present value and future values are included at the end of the book in Appendix A. Career Planning Related to Personal Finance Once you are at the point of making career decisions, there are a few items that are critically important: 1) what are the employee benefits associated with your job. The employee benefits is the compensation you receive in a form other than cash. This can be health, dental, flexible spending arrangement, or life insurance. It may include a retirement account, vacation, sick leave, and paid vacation days; 2) what is the location of the job. Before digging up stakes and moving to another city it is important to compare the cost of living at the two cities. You can compare two (or more) cities by using the index provided by each city on a number of internet sites. Three such sites are: www.homefair.com/homefair/calc/salcalc.html www.cityrating.com/cotsofliving.asp cgi.money.cnn.com/tools/costofliving/costofliving.html In each of the three indexes listed above all you need to do is choose the salary, city moving from and city moving to, and the index will calculate the comparable salary needed in the city you’re moving to compared with the salary in your current location. 18 Chapter 1 Introduction to Personal Finance
  19. 19. We will discuss the employee benefits portion of the choice later in the book. Building Your Financial Success One Block at a Time Financial success doesn’t just happen. It is a long, planned process. To begin with you need to create a foundation, this is the purpose of this class. You are not going to leave here with your plan visualized, planned, and carried out. Hopefully, when you complete this course you will have a strong foundation to build on. From there you will be able to build on your person goals to eventually achieve the success you desire. Below is a sample of the building blocks required in order to achieve financial success: Building Blocks of Financial Success Financially Successful Life Achieve Mutual Stocks and Real Pension Invest Funds Bonds Estate Plans Credit Installment Savings Education Handle Cards Loans Accounts Costs Housing Transportation Insurance Income Contingencies Manage Expenses Expenses Expenses Taxes Long-Term Short-Term Organized Realistic Emergency Goals Goals Financial Budget Savings Fund Establish Records Checking Savings Money Insurance Employee Base Account Account Market Protection Fringe Benefits Account Use of regular income to provide basic lifestyle and savings to meet emergencies Foundation 19 Section 1 Financial Planning
  20. 20. Suze Orman gives nine steps to achieve financial freedom in her book The 9 Steps to Financial Freedom: “. . . True financial freedom doesn’t depend on how much money you have. Financial freedom is when you have power over your fears and anxieties instead of the other way around.” -- Suze Orman, The 9 Steps to Financial Freedom, p.2 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. 20 Chapter 1 Introduction to Personal Finance
  21. 21. Key Terms Annuity - putting a series of payments away (15) Business (economic) cycle— . A wave-like pattern created by graphing the economic growth. These temporary phases include expression, recession (sometimes moving into depression), and recovery. (6) Compound interest - Interest on both the principal and interest (13) Consumer Price Index (CPI) is a monthly indicator of the changes in the prices paid by urban consumers for a representative basket of goods and services. (6) Consumption - spending on goods and services. (1) Economic growth, which is a condition of increased production and consumption in the economy. (6) Effective marginal tax rate - The total tax rate you pay (12) Employee benefits - The compensation you receive in a form other than cash (17) Expansion phase. A phase of the business cycle when production is high, unemployment is low, retail sales are on the rise, prices are low, and interest rates are falling. (6) Financial success means obtaining the maximum benefits from limited financial resources. (1) Future value (FV) is the valuation of an asset projected to the end of a particular time period in the future (13) Gross Domestic Product (GDP) measures the value of a nation's output of goods and services for some period of time, usually a year. (7) Intermediate-term goals are goals that will take more than one year but less than ten years to accomplish. (4) Invest - using capital to create more money. (1) Level of living -- where we are right now (2) Life cycle planning - making your financial objectives part of your life early and working on them throughout your life (9) Long-term goals will take more than ten years for you to complete. (4) 21 Section 1 Financial Planning
  22. 22. Marginal analysis - evaluating the changes in important variables that are related to changes in decision inputs you can control (12) Marginal cost - The additional cost for one item over another (12) Marginal tax rate - The tax rate at which the last dollar you earned is taxed at (12) Marginal utility - The added satisfaction gained by choosing one item over another (12) tickets Nominal income - the salary you and your employer agree upon (8) Opportunity cost represents what you give up as a result of your decisions. (1) Personal financial plan specifies your specific financial goals and describes the savings, spending, and investing tools you are going to use to meet your financial goals. (1) Principal - The original amount you invested (13) Present value (or discounted value) is the current value of an asset (or stream of assets) that will be received in the future (16) Real income - the income an individual receives after adjusting for changes in purchasing power caused by inflation (8) Recession – A phase of the business cycle generally described as a decline in production. During this phase of the cycle the Federal Reserve will generally lower interest rates to stimulate growth (6) Recovery phase—A phase of the business cycle where production, unemployment rates, and retail sales begin to improve. (6) Rule of 72 tells how long it takes for you original investment to double using compound interest (15) Savings = income not consumed. (1) Simple interest - Interest on the principal only (13) Short-term goals can be accomplished within the next twelve months (5) Soft landing--When the economy is growing very strongly, the Federal Reserve typically tries to engineer a soft landing by raising interest rates to head off inflation. Standard of living - what an individual is striving to attain, to maintain once attained, and preserve if threatened. (1) 22 Chapter 1 Introduction to Personal Finance
  23. 23. Tax exempt income - Income that is totally and permanently free of tax (12) Tax sheltered income - Income that is exempt from taxes in the current year (12) Utility - ability of a good or service to satisfy a human want (12) 23 Section 1 Financial Planning
  24. 24. Questions for Discussion 1. Describe the difference between standard of living and level of living. 2. List the six steps in personal financial planning. 3. Describe the phases in the economic cycle. 4. Compare the difference between nominal and real income. 5. Why is it important to estimate future interest rates? 6. Define “opportunity cost” and give an example of how opportunity cost might affect your financial decision making. 7. Describe the difference between simple and compound interest. 8. Compare the difference in the cost of living in Grand Junction, Colorado and Salt Lake City, Utah. 24 Chapter 1 Introduction to Personal Finance
  25. 25. Appendix 1 Consumer Price Index, 1913-2005 CPI-U Base year is chained; 1982-1984 = 100 25 Section 1 Financial Planning
  26. 26. Annual Percent Change Year Annual Average (Rate of Inflation) 1913 9.9 -- 1914 10.0 1.0 1915 10.1 1.0 1916 10.9 7.9 1917 12.8 17.4 1918 15.1 18.0 1919 17.3 14.6 1920 20.0 15.6 1921 17.9 -10.5 1922 16.8 -6.1 1923 17.1 1.8 1924 17.1 0.0 1925 17.5 2.3 1926 17.7 1.1 1927 17.4 -1.7 1928 17.1 -1.7 1929 17.1 0.0 1930 16.7 -2.3 1931 15.2 -9.0 1932 13.7 -9.9 1933 13.0 -5.1 1934 13.4 3.1 1935 13.7 2.2 1936 13.9 1.5 1937 14.4 3.6 1938 14.1 -2.1 1939 13.9 -1.4 1940 14.0 0.7 1941 14.7 5.0 1942 16.3 10.9 1943 17.3 6.1 1944 17.6 1.7 1945 18.0 2.3 26 Chapter 1 Introduction to Personal Finance
  27. 27. 27 Section 1 Financial Planning