Download Financial Planning

Chapter One
The Importance of
Personal Finance
Learning Objectives
1. List the benefits of studying personal
finance.
2. Summarize the six key steps in
successful personal financial planning.
Learning Objectives (continued)
3. Understand the current economic
environment and forecast the state of
the economy, inflation, and interest
rates over the next few years.
4. Explain fundamental economic
considerations that affect decision
making in personal finance.
Learning Objectives (continued)
5. Make use of time value of money
calculations when making financial
decisions.
6. Recognize how employer-related
money decisions can affect success in
personal finance.
Financial Literacy
• Financial literacy is knowledge of:
– facts
– concepts
– principles
– technological tools
– that are fundamental to being smart about
– money.
Financial Responsibility
• Financial responsibility is being
accountable for:
– your financial decisions and
– your own financial well-being.
Why You Should Study Personal
Finance
• Personal finance–the study of how
people
– spend
– save
– protect
– invest their financial resources.
Personal Financial Planning
• Personal financial planning is the
development and implementation of
long-range plans to achieve financial
success.
Financial Planning
• Financial Planning relates to:
– Consuming–spending on goods and
services.
– Saving–income not spent on current
consumption.
– Investing–assets purchased to provide
income from the asset itself.
Financial Planning (continued)
• Financial planning helps you manage
your level of living
– what you actually experience financially
• In order to attain your standard of living.
– where you would like to be financially
Financial Planning (continued)
• Financial planning helps you achieve
– Financial Success – achievement of
financial aspirations.
– Financial Security – being able to fulfill any
needs and most wants.
– Wealth – an abundance of money and
other financial resources.
– Financial Happiness – the satisfaction you
feel about money matters.
Figure 1.1: Objectives and Steps in
Personal Financial Success
Figure 1.2: The Building Blocks of
Financial Success
How the Economic Environment Will
Affect Your Personal Finances
• Forecasting–predicting, estimating, or
calculating in advance.
Know the State of the Economy
• Economy–a system of managing the
resources of a country, state, or community.
• Economic Growth–increasing production and
consumption in the economy.
• Business/Economic Cycle–Pattern of
economic activity including:
– expansion
– recession
– recovery
Know the State of the Economy
(continued)
• Expansion–
– production high
– unemployment low
• Recession–a recurring period of decline in:
–
–
–
–
total output
income
employment
trade
• Recovery–production, employment, and retail
sales begin to improve.
Figure 1.3: Phases of the Business
Cycle
Predict Future Directions for the
Economy
• Gross Domestic Product (GDP)–Value
of all goods and services produced in
the U.S.
• Index of Leading Economic Indicators
(LEI)–Composite index suggesting the
future direction of the U.S. economy.
Predict Future Directions of Prices and
Inflation
• Inflation–Steady rise in the general level
of prices.
• Deflation–Falling prices.
How Inflation Affects Income and
Consumption
• Purchasing Power–A measure of goods
and services one’s income will buy goes
down during inflation.
• Personal incomes rarely keep up in
times of high inflation.
• Real Income–Income measured in
constant prices relative to some base
time period goes down during inflation.
Percentage Change in Income Formula
Percentage change 
nominal income after raise - nominal income last year
100
nominal income last year
Real Income Formula
nominal income after raise
Real income 
1.0  previous inflation rate
How Inflation is Measured
• Consumer Price Index (CPI)–broad
measure of changes in the prices of all
goods and services purchased for
consumption by urban house holds.
• Personal inflation rate–the rate of
increase in prices of items purchased by
a particular person.
Estimating Future Interest Rates
• Long-term interest rates are generally
higher than short-term interest rates.
• You can forecast interest rates by
paying attention to changes in the
federal funds rate:
– the rate that banks charge one another on
overnight loans.
– provides an early indication of Fed policy
and trends for longer-term interest rates.
Opportunity Costs and Trade-offs in
Decision Making
• Opportunity Cost–Value of the next best
alternative that must be foregone.
• Opportunity cost reflects the best
alternative of what one could have done
instead of choosing to spend, save, or
invest money.
• Trade-offs occur when you give up one
thing for another.
Marginal Analysis in Decision Making
• Utility–The ability of a good or service to
satisfy a human want.
• Marginal Utility–Extra satisfaction from
one more incremental unit of a good or
service.
• Marginal Cost–Additional cost of one
more unit of some item.
– Compare the benefits of the additional
options with the additional costs.
Income Taxes in Decision Making
• Marginal Tax Rate–Tax rate at which
your last dollar earned is taxed.
• Tax-Exempt Income–Income that is
totally and permanently free of taxes.
• Tax-Sheltered Income–Income exempt
from income taxes in the current year.
Figure 1.4.: Tax-Sheltered Returns Are
Greater Than Taxable Returns
The Time Value of Money in Decision
Making
• Time Value of Money compares:
– amounts to be received in the future with
dollar amounts received today
– or dollar amounts received today with
dollar amounts to be received in the future.
• Interest–the price of money.
Compound Interest
• Compound Interest–earning interest on
interest.
• Compounding–earning compound
interest–is the best way to to build value
over time.
Calculating Future Values
• Future Value (FV)–Value of an asset at
the end of a particular time period.
?
Future Value of a Lump Sum
• What the principal will grow to over
time.
• Formula:
– FV = (Present Value) (i +1.0)n where,
– i = the interest rate
– n = the number of time periods.
Figure 1.5: Future
Value of $10,000
with Interest
Compounded
Annually
The Rule of 72
• Rule of 72–Calculates the number of
years it takes for principal to double.
– Years = 72 divided by interest rate.
Figure 1.6: The Rule of 72
Future Value of an Annuity
• What the principal will grow to over time
if a series of deposits are made.
Figure 1.7:
Future Value of
$2000 Annual
Investments
Present Value Calculations
• Present/Discounted Value–Current
value of an asset that will be received in
the future.
Present Value of a Lump Sum
• Present value of an amount to be
received in the future.
Present Value of an Annuity
• Present value of a stream of payments
to be received in the future.
Career-Related Money Decisions
• Employee Benefit–Compensation for
employment other than
– wages
– salaries
– commissions
– other cash payments
Employer-Sponsored Tax-Sheltered
Spending Accounts
• Flexible Spending Arrangement (FSA)
• Health Savings Account (HSA)
Employer-Sponsored Qualified
Retirement Plans
• Plans that give tax advantages, making
it easier to save for retirement; e.g. a
401(k).
First Advantage: Tax-Deductible
Contributions
• The amounts you and your employer
contribute into the account is not
included in your taxable income for the
year contributed.
Second Advantage: Tax-Deferred
Growth
• The investment earning off of the funds
in your account are not subject to
income tax during the year they are
earned.
• Taxes will be paid when the earnings
are withdrawn.
• All employer-based plans will have the
second advantage. Most will also have
the first.
How To Maximize the Benefits from a
Tax-Sheltered Retirement Plan
• Start early to boost your retirement.
• Plan to be a millionaire.
• Saving just 1 percent more of your pay
makes a big difference.
• Never make a hardship withdrawal from
a tax-sheltered retirement plan.
Golden Rules of Personal Finance
1. Pay yourself first by spending less
than you earn.
2. Stay up-to-date about current
economic conditions.
3. Use marginal and opportunity costs
and time value of money calculations
when making financial decisions.
Golden Rules of Personal Finance
(continued)
4. Map your financial future by establishing
goals and realistic plans to achieve them.
5. Take advantage of opportunities to taxshelter some income through your
employer’s benefits program, including fully
funding your 401(k) retirement account.
6. Develop expertise in financial matters and
heed your own advice because you are
responsible for your own financial success.