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Chapter 1
Personal Finance Basics and the Time Value of
Money
Chapter 1
Personal Finance Basics and the Time Value of
Money
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 1 Learning Objectives
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1. Analyze the process for making personal financial decisions
2. Develop personal financial goals
3. Assess personal and economic factors that influence personal financial planning
4. Determine the personal and financial opportunity costs associated with personal financial decisions
5. Identify strategies for achieving personal financial goals for different life situations
The Financial Planning Process3
Objective 1: Analyze the process for making personal financial decisions
Personal Financial Planning is the process of managing your money to achieve personal economic satisfaction.
This planning process allows you to control your financial situation. Every person, family, or household has a unique financial position, and any financial activity therefore must also be carefully planned to meet specific needs and goals.
A comprehensive financial plan can enhance the quality of your life and increase satisfaction by reducing uncertainty about your future needs and resources.
The Financial Planning Process4
Advantages of Personal Financial Planning are:1. Increased effectiveness in obtaining,
using and protecting financial resources
2. Increase control of one’s financial affairs
3. Improved personal relationships
4. Sense of freedom from financial worries
The Financial Planning Process (continued)
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Six-step procedure for Financial Planning Determine your current financial situation. Develop your financial goals. Identify alternative courses of action. Evaluate your alternatives. Create and implement your financial action
plan. Review and revise your plan.
The Financial Planning Process (continued)
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Step 1: DETERMINE YOUR CURRENT FINANCIAL SITUATION
Determine current financial situation regarding income, savings, living expenses, and debts
Prepare a list of current asset and debt balances and amount spent for various items
Match financial goals to current income and potential earning power
The Financial Planning Process (continued)
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Step 2: DEVELOP YOUR FINANCIAL GOALS
Identify feelings about money and the reasons for those feelings
Determine the source of your feelings about money
Determine the effects of economy on your goals and priorities
Make sure that your goals are your own and are specific to your situation
The Financial Planning Process (continued)
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Step 3: IDENTIFY ALTERNATIVE COURSES OF ACTION
Possible courses of action can be:
Continue the same course of action
Expand the current situation
Change the current situation
Take a new course of action
The Financial Planning Process (continued)
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Step 3: IDENTIFY ALTERNATIVE COURSES OF ACTION (continued)
Creativity in decision making is vital to effective choices
“Do nothing” can be a dangerous alternative
The Financial Planning Process (continued)
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Step 4: EVALUATE YOUR ALTERNATIVES
CONSEQUENCES OF CHOICES Opportunity cost - What you give up when you make a choice The cost or trade-off of a decision cannot
always be measured in ringgit. Sometimes the cost is your time
EVALUATING RISK Uncertainty is a part of every decision. Best way to analyze and minimize risk is to
gather information from financial planning sources. (Exhibit 1-3)
The Financial Planning Process
(continued)11
Step 5: CREATE AND IMPLEMENT YOUR FINANCIAL ACTION PLAN
Develop an action plan that identifies ways to achieve financial goals
Possible action plans can be increasing savings, reducing spending, or making provisions for taxes
To implement action plans you may need assistance from others
The Financial Planning Process (continued)
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Step 6: REVIEW AND REVISE YOUR PLAN
Financial planning decisions need to be assessed regularly
Complete review should be done at least once a year
Regular reviews of decision-making process can help in making priority adjustments to achieve financial goals
Developing Personal Financial Goals
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Objective 2: Develop personal financial goals
TYPES OF FINANCIAL GOALS can be: Influenced by the time frame in which you want
to achieve your goals Influenced by the financial need that drives your
goals
TIMING OF GOALS Short-term, intermediate and long-term goals
Long term goals should be planned in coordination with short-term and intermediate goals
GOALS FOR DIFFERENT FINANCIAL NEEDS Consumer product goals Durable-produce goals Intangible-purchase goals
Developing Personal Financial Goals (continued)
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GOAL-SETTING GUIDELINES
Goals should be realistic
Goals should be stated in specific terms
Goals should have a time frame
Goals should indicate the action to be taken
Discuss some of your goals
Influences on Personal Financial Planning
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Objective 3: Assess personal and economic factors that influence personal financial planning
LIFE SITUATION AND PERSONAL VALUES Adult life cycle stage Marital status, household size, and employment Major events
Graduation, marriage, career change, children, retirement, etc
Values What values are important to you?
Influences on Personal Financial Planning (continued)
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ECONOMIC FACTORS
Forces of Supply and Demand and prices
Study of how wealth is created and distributed
Economy includes different institutions
Influences on Personal Financial Planning (continued)
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GLOBAL INFLUENCES
Global marketplace influences financial activities
Economy affected by both financial activities of foreign investors and competition from foreign companies
Balance of exports and imports
Interest rates
Money supply
Influences on Personal Financial Planning (continued)18
ECONOMIC CONDITIONS
Consumer The value of the dollarprices changes in inflation
Consumer The demand for goods and spending services by individuals and households
Interest rates The cost of money; cost ofcredit when you borrow; returnon your money when you saveor invest
Influences on Personal Financial Planning (continued)
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PersonalOpportunity Costs
(time, effort, health)
FinancialOpportunity Costs(Interest, liquidity,
safety )
Financial
Acquisitions
(automobile, home, college education, investments, insurance, retirement fund)
Opportunity Costs and the Time Value of Money
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Every financial decision involves giving up something to obtain something else
PERSONAL OPPORTUNITY COSTS
Time
Other personal opportunity costs can be related to health, leisure etc.
Personal resources like financial resources require careful management
Objective 4: Determine the personal and financial opportunity costs associated with personal financial decisions
Opportunity Costs and the Time Value of Money (continued)
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FINANCIAL OPPORTUNITY COSTS
Time Value of Money Increases in an amount of money
as a result of interest earned. Saving today means more money tomorrow.
Spending means lost interest. Saving and spending decisions involve
considering the trade-offs. Current needs can make spending worthwhile.
Opportunity Costs and the Time Value of Money (continued)
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INTEREST CALCULATIONS
Three amounts are required to calculate the time value of money
Principal
Interest rates
Time
Opportunity Costs and the Time Value of Money (continued)
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COMPUTING SIMPLE INTEREST(Amount in savings) x (annual interest rate) x (time period) = (interest)
For Example:RM100 x 5% x 1 (1 year) 100 x .05 x 1 = RM 5.00
In one year you have RM100 in principle plus RM5.00 in interest for a total of RM105 at the end of the year
Opportunity Costs and the Time Value of Money (continued)
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FUTURE VALUE OF A SINGLE AMOUNT
Future value is the amount to which current savings will increase based on a certain interest rate and a certain time period
Future value is also call compounding - earning interest on previously earned interest
FUTURE VALUE OF A SERIES OF DEPOSITS
Future value can be computed for a single amount or for a series of deposits called annuities
Opportunity Costs and the Time Value of Money (continued)
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PRESENT VALUE OF A SINGLE AMOUNT
Present Value is the current value of a future amount based on a certain interest rate and a certain time period
Present value calculations are also called discounting
The present value of the amount you want in the future will always be less than the future value (See Exhibit 1-8C)
PRESENT VALUE OF A SERIES OF DEPOSITS
Present value can be computed for a single amount or for a series of deposits (See Exhibit 1-8D)
Achieving Financial Goals26
Objective 5: Identify strategies for achieving personal financial goals different life situations
COMPONENTS OF PERSONAL FINANCIAL PLANNING Obtaining (chapter 2) Planning (chapters 3, 4) Saving (chapter 5) Borrowing (chapters 6, 7) Spending (chapters 8, 9) Managing risk (chapters 10-12) Investing (chapters 13-17) Retirement and estate planning (chapters 18, 19)
Achieving Financial Goals (continued)
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DEVELOPING A FLEXIBLE FINANCIAL PLAN
A financial plan is a formalized report that...
Summarizes your current financial situation
Analyzes your financial needs
Recommends future financial activities
Your financial plan can be created by you, with assistance from a financial planner, or made using a money management software package
Achieving Financial Goals (continued)
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IMPLEMENTING YOUR FINANCIAL PLAN
Develop good financial habits
Use a well conceived spending plan to help you stay within your income, while allowing you to save and invest for the future
Have appropriate insurance protection to prevent financial disasters
Become informed about tax and investment alternatives