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
• 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
• 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
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.
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
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
To strengthen your personal happiness and add to the joyfulness of you family experience try some of the
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
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
Fi Figure 1.2
Personal Financial Goals
Short-Term Goals Dollar Amount Date to
Financial Goal to Accomplish Accomplish By
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
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)
expected in the
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
6 Chapter 1 Introduction to Personal Finance
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.
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
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
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
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
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
Percentage change in personal income = $500 x 100
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.
9 Section 1 Financial Planning
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)
Reassessment of Retirement Goals
Tax and Estate Planning
Consumption and Saving Retirement
Saving for Goals-Pay Yourself First
Initial Goal Setting Family Maturity
20 30 40 50 60 70 80
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
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
Making Sound Financial Decisions
11 Section 1 Financial Planning
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
2. What will the amount I’m putting away today be worth in 5, 10 . . . . years?
12 Chapter 1 Introduction to Personal Finance
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
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
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
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
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
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
$30,000 $28,543 14%
-$10,000 1 6 12 18
15 Section 1 Financial Planning
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
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
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
2 .9803 .9612 .9426 .9246 .8573 . .8264
3 .9706 .9423 .9151 .8890 .7938 . .7513
4 .9610 .9238 .8885 .8548 .7350 . .6830
5 .9515 .9057 .8626 .8219 .6806 . .6209
6 .9420 .8880 .8375 .7903 .6302 . .5645
7 .9327 .8706 .8131 .7599 .5835 . .5132
8 .9235 .8536 .7894 .7307 .5403 . .4665
9 .9143 .8368 .7664 .7026 .5002 . .4241
17 Section 1 Financial Planning
10 .9053 .8206 .7441 .6756 .4632 . .3855
11 .8963 .8043 .7224 .6496 .4289 . .3505
12 .8874 .7885 .7014 .6246 .3971 . .3186
13 .8787 .7730 .6810 .6006 .3677 . .2897
14 .8700 .7579 .6611 .5775 .3405 . .2633
15 .8613 .7430 .6419 .5553 .3152 . .2394
16 .8528 .7284 .6232 .5339 .2919 . .2176
17 .8444 .7142 .6050 .5134 .2703 . .1978
18 .8360 .7002 .5874 .4936 .2502 . .1799
$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:
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
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
Mutual Stocks and Real Pension Invest
Funds Bonds Estate Plans
Credit Installment Savings Education Handle
Cards Loans Accounts Costs
Housing Transportation Insurance Income
Expenses Expenses Expenses Taxes
Long-Term Short-Term Organized Realistic Emergency
Goals Goals Financial Budget Savings Fund
Checking Savings Money Insurance Employee Base
Account Account Market Protection Fringe Benefits
Use of regular income to provide basic lifestyle and savings to meet emergencies Foundation
19 Section 1 Financial Planning
Suze Orman gives nine steps to achieve financial freedom in her book The 9 Steps to
“. . . 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
-- 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
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
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
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
Financial success means obtaining the maximum benefits from limited financial
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
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)
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
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
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
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
Consumer Price Index, 1913-2005
Base year is chained;
1982-1984 = 100
25 Section 1 Financial Planning