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

2

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)

5

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)

6

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)

7

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)

8

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)

9

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)

10

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)

12

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

13

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)

14

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

15

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)

16

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)

17

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)

19

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

20

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)

21

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)

22

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)

23

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)

24

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)

25

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)

27

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)

28

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