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Chapter 1 Personal Financial Planning: An Introduction

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Chapter 1 Personal Financial Planning: An Introduction

  1. 1. Chapter 1 Personal Financial Planning: An Introduction 1-1 Kapoor Dlabay Hughes Ahmad Prepared by Cyndi Hornby, Fanshawe College  2009 McGraw-Hill Ryerson Ltd.
  2. 2. Learning Objectives – Chapter 1 <ul><li>Analyze the process for making personal financial decisions. </li></ul><ul><li>Develop personal financial goals. </li></ul><ul><li>Assess economic factors that influence personal financial planning. </li></ul><ul><li>Calculate the time value of money. </li></ul><ul><li>Identify strategies for achieving personal financial goals for different life situations </li></ul>1-2
  3. 3. Learning Objective # 1 Analyze the process for making personal financial decisions. 1-3
  4. 4. Financial Planning and Its Benefits <ul><li>Personal financial planning is the process of managing your money to achieve personal economic satisfaction. </li></ul><ul><li>Advantages of personal financial planning; </li></ul><ul><ul><li>Increased effectiveness in obtaining, using, and protecting your financial resources. </li></ul></ul><ul><ul><li>Increased control of your financial affairs. </li></ul></ul><ul><ul><li>Improved personal relationships. </li></ul></ul><ul><ul><li>A sense of freedom from financial worries. </li></ul></ul>1-4
  5. 5. The Financial Planning Process <ul><li>Step 1 : Determine your current financial situation. </li></ul><ul><ul><li>Prepare a list of current asset and debt balances and amounts spent for various items </li></ul></ul><ul><li>Step 2 : Develop financial goals. </li></ul><ul><ul><li>Analyze your financial values and attitudes towards money. </li></ul></ul><ul><ul><li>What is your financial decision making process? </li></ul></ul><ul><li>Step 3 : Identify alternative courses of action. </li></ul><ul><ul><li>Continue as you are, expand or change the current situation, or take a new course of action. </li></ul></ul>1-5
  6. 6. The Financial Planning Process <ul><li>Step 4 : Evaluate alternatives. </li></ul><ul><ul><li>Take into consideration your life situation, personal values and current economic situation. </li></ul></ul><ul><ul><li>Opportunity cost is what you give up by making a choice. </li></ul></ul><ul><ul><li>The cost, referred to as the trade-off of a decision, can be measured in money or time </li></ul></ul><ul><ul><li>Consider lost opportunities that will result from your decisions. </li></ul></ul><ul><ul><li>Evaluate the risks faced </li></ul></ul>1-6
  7. 7. Evaluate your Economic or Product Risks <ul><li>Interest Rate Risk </li></ul><ul><ul><li>Changing interest rates affect your costs when you borrow and your benefits when you invest </li></ul></ul><ul><li>Inflation Risk </li></ul><ul><ul><li>Rising prices cause lost buying power </li></ul></ul><ul><li>Liquidity risk </li></ul><ul><ul><li>Some investments may be more difficult to convert to cash or sell without significant loss in value </li></ul></ul><ul><li>Product Risk </li></ul><ul><ul><li>Products or services flawed or not meet your expectations </li></ul></ul><ul><ul><li>Retailers may not honour their obligations </li></ul></ul>1-7
  8. 8. Evaluate your Personal Risks <ul><li>Risk of Death </li></ul><ul><ul><li>Premature death can cause financial hardship to family members left behind </li></ul></ul><ul><li>Risk of Income Lost </li></ul><ul><ul><li>Your income could stop as a result of job loss or because you fall ill or are hurt in an accident </li></ul></ul><ul><li>Health Risk </li></ul><ul><ul><li>Poor health may increase your medical costs, may reduce your working capacity or life expectancy </li></ul></ul><ul><li>Asset and Liability Risk </li></ul><ul><ul><li>Assets may be stolen or damaged </li></ul></ul><ul><ul><li>Others may sue you for negligence or for damages caused by your accidents </li></ul></ul>1-8
  9. 9. The Financial Planning Process <ul><li>Step 5 : Create and implement a financial action plan. </li></ul><ul><ul><li>Choose ways to achieve your goals </li></ul></ul><ul><ul><li>May require assistance from others </li></ul></ul><ul><li>Step 6 : Reevaluate and revise your plan. </li></ul><ul><ul><li>Your plan should be reviewed regularly based on your life circumstances </li></ul></ul>1-9
  10. 10. Financial Planning Information Sources <ul><li>Printed materials. </li></ul><ul><li>Financial institutions. </li></ul><ul><li>School courses and educational seminars. </li></ul><ul><li>Computer software, World Wide Web, and on-line information sources. </li></ul><ul><li>Financial specialists. </li></ul>1-10
  11. 11. Learning Objective # 2 Develop personal financial goals. 1-11
  12. 12. Developing Personal Financial Goals <ul><li>Financial goals are influenced by ; </li></ul><ul><ul><li>Personal values and attitudes towards money </li></ul></ul><ul><ul><li>Time frame in which you want to achieve your goals. </li></ul></ul><ul><ul><li>Type of financial need that drives your goals. </li></ul></ul><ul><ul><li>Your life situation </li></ul></ul>1-12
  13. 13. Developing Personal Financial Goals <ul><li>Factors that influence your financial goals: </li></ul><ul><li>Timing of goals. </li></ul><ul><ul><li>Short-term, intermediate and long-term goals. </li></ul></ul><ul><li>Goals for different financial needs. </li></ul><ul><ul><li>Consumable products goals </li></ul></ul><ul><ul><ul><li>Food, clothing </li></ul></ul></ul><ul><ul><li>Durable product goals </li></ul></ul><ul><ul><ul><li>Appliances, cars, sporting equipment </li></ul></ul></ul>1-13
  14. 14. Developing Personal Financial Goals – Your Life Situation <ul><li>Life Situation takes into consideration personal factors </li></ul><ul><ul><li>Age, income, marital status, household size, personal beliefs and employment situation </li></ul></ul><ul><ul><li>Influences your spending and savings patterns </li></ul></ul><ul><li>Social Changes </li></ul><ul><ul><li>Married at later age </li></ul></ul><ul><ul><li>More households with two incomes </li></ul></ul><ul><ul><li>Single parents </li></ul></ul><ul><ul><li>Living longer </li></ul></ul>1-14
  15. 15. Developing Personal Financial Goals – Your Life Situation <ul><li>Average person goes through four basic stages in personal financial management </li></ul><ul><li>Referred to as the life cycle approach to financial planning </li></ul><ul><li>Early years (until the mid-30’s) </li></ul><ul><ul><li>Focus on creating an emergency fund, saving for down payment on house or condo, purchasing life insurance, start thinking about retirement </li></ul></ul><ul><li>Middle years (mid-30’s to mid-50’s) </li></ul><ul><ul><li>Focus on building wealth by paying down mortgage and increasing savings and investments </li></ul></ul>1-15
  16. 16. Developing Personal Financial Goals – Your Life Situation <ul><li>Middle Years (50’s+) </li></ul><ul><ul><li>Focus is on providing an adequate retirement fund </li></ul></ul><ul><li>Retirement Years </li></ul><ul><ul><li>Focus is on the efficient management of previously acquired wealth </li></ul></ul>1-16
  17. 17. Developing Personal Financial Goals – Your Life Situation <ul><li>Other events that influence your life situation include; </li></ul><ul><ul><li>Graduation </li></ul></ul><ul><ul><li>Engagement and marriage </li></ul></ul><ul><ul><li>Birth or adoption of a child </li></ul></ul><ul><ul><li>Career change or move to a new area </li></ul></ul><ul><ul><li>Dependant children leaving home </li></ul></ul><ul><ul><li>Changes in health </li></ul></ul><ul><ul><li>Divorce </li></ul></ul><ul><ul><li>Retirement </li></ul></ul><ul><ul><li>Death of spouse or other family member </li></ul></ul>1-17
  18. 18. Developing Personal Financial Goals – Your Life Situation <ul><li>Common financial goals and activities include; </li></ul><ul><ul><li>Obtain appropriate career training </li></ul></ul><ul><ul><li>Create an effective financial record keeping system </li></ul></ul><ul><ul><li>Develop a regular savings and investment program </li></ul></ul><ul><ul><li>Accumulate an appropriate emergency fund </li></ul></ul><ul><ul><li>Purchase appropriate types and amounts of insurance coverage </li></ul></ul><ul><ul><li>Create and implement a flexible budget </li></ul></ul><ul><ul><li>Evaluate and select appropriate investments </li></ul></ul><ul><ul><li>Establish and implement a plan for retirement goals </li></ul></ul><ul><ul><li>Make a will and develop an estate plan </li></ul></ul>1-18
  19. 19. Developing Personal Financial Goals <ul><li>Financial goals should... </li></ul><ul><ul><li>Be realistic </li></ul></ul><ul><ul><li>Be stated in specific, measurable terms </li></ul></ul><ul><ul><li>Have a time frame </li></ul></ul><ul><ul><li>Indicate the type of action to be taken. </li></ul></ul>1-19
  20. 20. Learning Objective # 3 Assess economic factors that influence personal financial planning . 1-20
  21. 21. Influences on Personal Financial Planning <ul><li>Market Forces. </li></ul><ul><ul><li>Supply and demand. </li></ul></ul><ul><ul><li>Production costs and competition. </li></ul></ul><ul><li>Financial institutions. </li></ul><ul><ul><li>Influence of the Bank of Canada </li></ul></ul><ul><li>Global Influences. </li></ul><ul><ul><li>Level of exports, foreign investors, competition. </li></ul></ul><ul><li>Economic conditions.... </li></ul>Economics: The study of how wealth is created and distributed 1-21
  22. 22. Changing Economic Conditions <ul><li>Consumer Prices </li></ul><ul><ul><li>The value of the dollar </li></ul></ul><ul><ul><li>Changes in inflation (a rise in the general level of prices) </li></ul></ul><ul><ul><li>Mainly caused by increase in demand without increase in supply </li></ul></ul><ul><ul><li>Harmful to people on fixed incomes </li></ul></ul><ul><ul><li>Can adversely affect people who lend money </li></ul></ul><ul><li>Consumer Spending </li></ul><ul><ul><li>The demand for goods and services by individuals and households influences employment opportunities </li></ul></ul><ul><ul><li>Reduced spending causes unemployment </li></ul></ul>1-22
  23. 23. Changing Economic Conditions <ul><li>Interest Rates </li></ul><ul><ul><li>Represents the cost of money </li></ul></ul><ul><ul><li>The cost of credit when you borrow </li></ul></ul><ul><ul><ul><li>Borrowing increases demand and interest rates rise </li></ul></ul></ul><ul><ul><li>The return on your money when you save or invest </li></ul></ul><ul><ul><ul><li>Saving and investing increase the supply of money and interest rates decrease </li></ul></ul></ul>1-23
  24. 24. Changing Economic Conditions <ul><li>Money Supply </li></ul><ul><ul><li>Dollars available for spending in our economy </li></ul></ul><ul><li>Unemployment Rate </li></ul><ul><ul><li>The number of people without employment who are willing and able to work </li></ul></ul><ul><li>Housing Starts </li></ul><ul><ul><li>The number of new homes being built </li></ul></ul><ul><li>Gross Domestic Product (GDP) </li></ul><ul><ul><li>The value of goods and services produced within a country’s borders including items produced with foreign resources </li></ul></ul>1-24
  25. 25. Changing Economic Conditions <ul><li>Trade Balance </li></ul><ul><ul><li>The difference between a country’s exports and its imports </li></ul></ul><ul><li>S&P / TSX composite index and other stock market indexes </li></ul><ul><ul><li>The relative value of stocks represented by the index </li></ul></ul>1-25
  26. 26. Learning Objective # 4 Calculate the time value of money. 1-26
  27. 27. Financial Opportunity Costs (discounting) 1-27 <ul><li>Time Value of Money </li></ul><ul><li>Is the increases in an amount of money as a result of interest earned </li></ul><ul><li>Every time you spend, save, invest or borrow money you should consider the time value of money as an opportunity cost </li></ul>Present Amount Now Future Value (compounding) Value Amount Later
  28. 28. How Simple Interest is Computed <ul><li>Simple Interest : interest compounded on the principal, excluding previously earned interest </li></ul><ul><li>$100 x 6% x 1 (1 year) 100 x .06 x 1 = $6.00 </li></ul><ul><li>In one year you have $106. </li></ul>1-28 (P) (r) (T) (I) Amount x Annual x Time = Interest in Savings Interest Rate Period
  29. 29. How Compound Interest is Computed <ul><li>Compound Interest : Interest that is earned on previously earned interest </li></ul><ul><ul><li>Each time interest is added to the principal, the next interest is computed on the new balance </li></ul></ul>1-29 1 st year: $100 x 6% x 1(year) = $106.00 2 nd year: ($100 + $6) x 6% x 1(year) = $112.36 3 rd year: ($106 + $6.36) x 6% x 1(year) =$119.10
  30. 30. Future Value of Money <ul><li>Is the amount to which current savings will increase based on certain interest rate and certain time period </li></ul><ul><li>Calculations involve compounding since interest is earned on previously earned interest </li></ul><ul><li>Can be computed for a single amount or a series of deposits </li></ul><ul><ul><li>Annuity - series of equal deposits or payments </li></ul></ul><ul><li>Start investing now to take advantage of the future value of money. </li></ul>1-30
  31. 31. Present Value of Money <ul><li>The current value of a future amount based on a certain interest rate and a certain time period. </li></ul><ul><li>Present value calculations are also called discounting. </li></ul><ul><li>Allows you to determine how much to deposit now to obtain desired future amount </li></ul><ul><li>Can be computed for a single amount or a series of deposits </li></ul>1-31
  32. 32. Learning Objective # 5 Identify strategies for achieving personal financial goals for different life situations. 1-32
  33. 33. Components of Financial Planning <ul><li>Obtaining (chapter 1) </li></ul><ul><li>Planning (chapters 2,3) </li></ul><ul><li>Saving (chapter 4) </li></ul><ul><li>Borrowing (chapters 5,6) </li></ul><ul><li>Spending (chapter 7) </li></ul><ul><li>Managing Risk (chapters 8,9) </li></ul><ul><li>Investing (chapters 10-13) </li></ul><ul><li>Retirement and Estate Planning (chapters 14,15) </li></ul>1-33
  34. 34. Developing a Flexible Financial Plan <ul><li>A financial plan is formalized report that... </li></ul><ul><ul><li>Summarizes your current financial situation. </li></ul></ul><ul><ul><li>Analyzes your financial needs. </li></ul></ul><ul><ul><li>Recommends future financial activities. </li></ul></ul><ul><li>Your financial plan can be created by you, done with assistance from a financial planner, or made using a money management software package. </li></ul>1-34
  35. 35. Implementing Your Financial Plan <ul><li>Develop good financial habits. </li></ul><ul><ul><li>Use a spending plan to stay within your income, allowing you to save and invest for the future. </li></ul></ul><ul><ul><li>Have appropriate insurance protection to prevent financial disasters. </li></ul></ul><ul><ul><li>Become informed about tax and investment alternatives. </li></ul></ul><ul><li>Achieving your financial objectives requires.. </li></ul><ul><ul><li>A willingness to learn. </li></ul></ul><ul><ul><li>Appropriate information sources. </li></ul></ul>1-35
  36. 36. Summary of Learning Objectives <ul><li>Analyze the process for making personal financial decisions </li></ul><ul><ul><li>Determine current financial situation </li></ul></ul><ul><ul><li>Develop financial goals </li></ul></ul><ul><ul><li>Identify alternative courses of action </li></ul></ul><ul><ul><li>Evaluate alternatives </li></ul></ul><ul><ul><li>Create and implement a financial plan </li></ul></ul><ul><ul><li>Re-evaluate and revise the financial plan </li></ul></ul>1-36
  37. 37. Summary of Learning Objectives <ul><li>Develop personal financial goals </li></ul><ul><ul><li>Goals should be realistic </li></ul></ul><ul><ul><li>Be stated in specific, measurable </li></ul></ul><ul><ul><li>terms </li></ul></ul><ul><ul><li>Have a time frame </li></ul></ul><ul><ul><li>Indicate the type of action to be taken </li></ul></ul><ul><ul><li>Affected by person’s values, attitudes towards money and life situation </li></ul></ul>1-37
  38. 38. Summary of Learning Objectives <ul><li>Assess economic factors that influence personal financial planning </li></ul><ul><ul><li>Consumer prices </li></ul></ul><ul><ul><li>Interest rates </li></ul></ul><ul><ul><li>Employment opportunities </li></ul></ul>1-38
  39. 39. Summary of Learning Objectives <ul><li>Calculate the time value of money. </li></ul><ul><ul><li>Every decision involves a trade off </li></ul></ul><ul><ul><ul><li>Personal opportunity costs include time, effort and health </li></ul></ul></ul><ul><ul><ul><li>Financial opportunity costs based on time value of money </li></ul></ul></ul><ul><ul><li>Future and present value calculations enable you to measure increased value (or lost interest) from saving, investing, borrowing or purchasing decisions </li></ul></ul>1-39
  40. 40. Summary of Learning Objectives <ul><li>Identify strategies for achieving personal financial goals for different life situations </li></ul><ul><ul><li>Requires specific goals combined with spending, saving, investing and borrowing strategies </li></ul></ul><ul><ul><li>Based on your personal life situation and various social and economic factors </li></ul></ul>1-40
  41. 41. Chapter 1A - Appendix <ul><li>Financial Planners and Other Financial Planning Information Sources </li></ul><ul><li>Current Periodicals </li></ul><ul><li>Financial Institutions </li></ul><ul><li>Courses & Seminars </li></ul><ul><li>Personal Finance Software </li></ul><ul><ul><li>Spreadsheets </li></ul></ul><ul><ul><li>Money Management & Financial Planning Programs </li></ul></ul><ul><ul><li>Tax Software </li></ul></ul><ul><ul><li>Investment Analysis Programs </li></ul></ul><ul><li>The Internet </li></ul>1-41
  42. 42. Chapter 1A - Appendix <ul><li>Financial Planning Specialists </li></ul><ul><ul><li>Accountants </li></ul></ul><ul><ul><li>Bankers </li></ul></ul><ul><ul><li>Credit counselors </li></ul></ul><ul><ul><li>Certified Financial Planners </li></ul></ul><ul><ul><li>Insurance agents/brokers </li></ul></ul><ul><ul><li>Investment Brokers </li></ul></ul><ul><ul><li>Lawyers </li></ul></ul><ul><ul><li>Real Estate Agents </li></ul></ul><ul><ul><li>Tax Preparers </li></ul></ul>1-42
  43. 43. Chapter 1A - Appendix <ul><li>Financial planners are categorized based on the method of compensation </li></ul><ul><ul><li>Fee-only planners </li></ul></ul><ul><ul><li>Fee-and-commission planners </li></ul></ul><ul><ul><li>Commission-only planners </li></ul></ul><ul><li>Do you need a financial planner? </li></ul><ul><ul><li>Your income </li></ul></ul><ul><ul><li>Your willingness to make independent decisions </li></ul></ul>1-43

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