2006 McGraw-Hill Ryerson Ltd. Kapoor Dlabay Hughes Ahmad Prepared by Cyndi Hornby, Fanshawe College Chapter 1 Personal Financial Planning: An Introduction

2006 McGraw-Hill Ryerson Ltd.

Kapoor Dlabay Hughes Ahmad

Prepared by Cyndi Hornby, Fanshawe College

Chapter 1Personal Financial Planning:

An Introductio

n

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Learning Objectives – Chapter 1

1.Analyze the process for making personal financial decisions

2.Develop personal financial goals3.Assess personal & economic factors that

influence personal financial planning4.Determine personal and financial

opportunity costs associated with personal financial decisions

5.Identify strategies for achieving personal financial goals for different life situations

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Learning Objective # 1

Analyze the process for making personal financial decisions

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Financial Planning and Its Benefits

Personal financial planning is the process of managing your money to achieve personal economic satisfaction

Most people want to handle their finances so that they get full satisfaction from each available dollar

Financial goals include such things as a new car, a larger home, advanced career training, contributions to charity, extended travel, and self-sufficiency during working and retirement years

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Advantages of personal financial planning;

Increased effectiveness in obtaining, using, and protecting your financial resourcesIncreased control of your financial affairsImproved personal relationshipsA sense of freedom from financial worries


The Financial Planning Process


The Financial Planning ProcessDetermine your current financial situationDevelop financial goalsIdentify alternative courses of actionEvaluate alternativesCreate and implement a financial action planReevaluate and revise your plan

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STEP 1DETERMINE YOUR CURRENT FINANCIAL SITUATION

Determine your current financial situation, regarding income, savings, living expenses, and debtsPreparing a list of current asset and debt balances and amounts spent for various items gives you a foundation for financial planning activitiesThe personal financial statements discussed will provide the information needed to match your goals with your current income and potential earning power


Step 1 Example

Within the next 2 months, Kent Mullins will complete his undergraduate studies with a major in international studiesHe has worked part-time in various sales jobsHe has a small savings fund ($1,700) and over $8,500 in student loansWhat additional information should Kent have available when planning his personal finances?


STEP 2DEVELOP YOUR FINANCIAL GOALS

Periodically analyze your financial values and goals

Identifying how you feel about money and why you feel that way• Are your feelings about money based on factual

knowledge or on the influence of others? • Are your financial priorities based on social

pressures, household needs, or desires for luxury items?

• How will economic conditions affect your goals and priorities?

• The purpose of this analysis is to differentiate your needs from your wants


Specific financial goals are vital to financial planningOthers can suggest financial goals for you. However, you must decide which goals to pursueYour financial goals can range from spending all of your current income to developing an extensive savings and investment program for your future financial security


Step 2 Example

Kent Mullins has several goalsPaying off his student loansObtaining an advanced degree in global business managementWorking in Latin America for a multinational companyWhat other goals might be appropriate for John?


STEP 3IDENTIFY ALTERNATIVE COURSES OF ACTION

Developing alternatives (best another way) is crucial when making decisionsMany factors will influence the available alternatives, possible courses of action usually fall into 4 categories:

Continue the same course of actionExpand the current situationChange the current situationTake a new course of action

When you decide not to take action (do nothing) which can be a dangerous alternative


Continue the same course of actionYou may determine that the amount you have saved each month is still appropriate

Expand the current situationYou may choose to save a larger amount each month

Change the current situationYou may decide to use a money market account instead of a regular savings account

Take a new course of actionYou may decide to use your monthly savings budget to pay off credit card debts


Step 3 Example

Kent Mullins has several options available for the near future

Work full time and save for graduate schoolGo to graduate school full time by taking out an additional loanGo to school part time and work part time. What additional alternatives might he consider?


STEP 4EVALUATE YOUR ALTERNATIVES

Evaluate possible courses of action, taking into consideration your life situation, personal values, and current economic conditions

How will the ages of dependents affect your saving goals?How do you like to spend leisure time? How will changes in interest rates affect your financial situation?


CONSEQUENCES OF CHOICES Every decision closes off alternatives•For ex:

–A decision to invest in stock may mean you cannot take a vacation

–A decision to go to school full time may mean you cannot work full time


Every Decision Has An Opportunity Cost (Trade-off)

Opportunity cost is what you give up by

making a choice The cost, referred to as the trade-off of a decision, cannot always be measured in dollars. Sometimes the cost is your timeConsider lost opportunities that will result from your decisions.Evaluate the risks facedRefer to the money you forgo by attending school rather than working. Then the resources you give up (money or time) have a value that is lost

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Decision making will be an ongoing part of your personal and financial situationTherefore, you will need to consider the lost opportunities that will result from your decisionsSince decisions vary based on each person’s situation and values, opportunity costs will differ for each person


EVALUATING RISK

Uncertainty is a part of every decision• Selecting a college major and choosing a

career field involve risk• What if you don’t like working in this field

or cannot obtain employment in it? • Other decisions involve a very low degree

of risk, such as putting money in an insured savings account or purchasing items that cost only a few dollars

• Your chances of losing something of great value are low in these situations


In many financial decisions, identifying and evaluating risk is difficult The best way to consider risk is to gather information based on your experience and the experiences of others and to use financial planning information sources

Information is required at each stage of the decision-making processChanging personal, social, and economic conditions will require that you continually supplement and update your knowledge


Financial Planning Information Sources

Printed materials Financial institutions School courses and educational

seminars Computer software, World Wide

Web, and on-line information sources Financial specialists

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Financial Planning Information Sources


Step 4 Example

As Kent Mullins evaluates his alternative courses of action, he must consider his income needs for both the short term and the long termHe should also assess career opportunities with his current skills and his potential with advanced training What risks and trade-offs should Kent consider?


STEP 5CREATE & IMPLEMENT FINANCIAL ACTION PLANInvolves developing an action plan that identifies

ways to achieve your goalsFor ex, you can increase your savings by reducing your spending or by increasing your income through extra time on the jobAs you achieve your short-term/ immediate goals, the next priority goals will come to focus

To implement your financial action plan, you may need assistance from others

For example, you may use the services of an insurance agent to purchase property insurance or the services of an investment broker to purchase stocks, bonds, or mutual funds


Step 5 Example

Kent Mullins has decided to work full time for a few years while he

(1) pays off his student loans(2) saves money for graduate school(3) takes a couple of courses in the evening and on weekendsWhat are the benefits and drawbacks of this choice?


STEP 6REVIEW AND REVISE YOUR PLAN

Financial planning is a dynamic process that does not end when you take a particular actionYou need to regularly assess your financial decisionsYou should do a complete review of your finances at least once a yearChanging personal, social, and economic factors may require more frequent assessments


When life events affect your financial needs, this financial planning process will provide a vehicle for adapting to those changesRegularly reviewing this decision-making process will help you make priority adjustments that will bring your financial goals and activities in line with your current life situation


Step 6 Example

Over the next 6 to 12 monthsKent Mullins should reassess his financial, career, and personal situationsWhat employment opportunities or family circumstances might affect his need or desire to take a different course of action?


Economic or Product Risk

Interest Rate RiskChanging interest rates affect your costs when you borrow and your benefits when you invest

Inflation RiskRising prices cause lost buying power

Liquidity riskSome investments may be more difficult to convert to cash or sell without significant loss in value

Product RiskProducts or services flawed or not meet your expectationsRetailers may not honour their obligations

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Personal RiskRisk of Death

Premature death causes financial hardship to family members left behind

Risk of Income LossIncome stops because of job loss, illness or accident

Health RiskPoor health increases medical costsMay reduce working capacity or life expectancy

Asset and Liability RiskAssets stolen or damagedSued for negligence or damages caused by your actions

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Develop personal financial goals

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Developing Personal Financial Goals

Financial goals are influenced byPersonal values and attitudes towards money (+ or -)Time frame in which you want to achieve your goals (How long)Type of financial need that

drives your goalsYour life situation

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Timing of goalsShort-term, intermediate and long-term goals.

Goals for different financial needsConsumable products goals

Food, clothingDurable product goals

Appliances, cars, sporting equipment

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Developing Personal Financial Goals – Your Life Situation

Life Situation takes into consideration personal factors

Age, income, marital status, household size, personal beliefsInfluences your spending and savings patterns

Social ChangesMarried at later ageMore households with two incomesSingle parentsLiving longer

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Developing Personal Financial Goals – Your Life Situation

Other events that influence your life situation include

GraduationEngagement and marriageBirth or adoption of a childCareer change or move to a new areaDependant children leaving homeChanges in healthDivorceRetirementDeath of spouse or other family member

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Financial goals should...Be realisticBe stated in specific, measurable termsHave a time frameIndicate the type of action to be taken

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Assess personal and economic factors that influence personal financial planning

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Influences on Personal Financial Planning

Market ForcesSupply and demandProduction costs and competition

Financial institutionsInfluence of the Bank of Canada

Global InfluencesLevel of exports, foreign investors, competition

Economic conditions....Recession, Expansion

Economic factors: the study of how wealth is created and distributed

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Changing Economic Conditions Consumer Prices

Inflation is a rise in the general level of pricesMainly caused by increase in demand without increase in supplyHarmful to people on fixed incomesCan adversely affect people who lend moneyRate of inflation varies

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Changing Economic Conditions

Consumer SpendingDemand for goods and services influences employment opportunitiesReduced spending causes unemployment

Interest RatesRepresent the cost of moneySaving and investing increase the supply of money and interest rates decreaseBorrowing increases demand and interest rates rise

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Determine personal and financial opportunity costs associated with personal financial decisions

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Opportunity Costs and Financial Results Evaluated When Making Decisions

PersonalOpportunity Costs

(time, effort, health)

FinancialOpportunity Costs(Interest, liquidity,

safety )

Financial

Acquisitions

(automobile, home, college education, investments, insurance, retirement fund)

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Financial Opportunity Costs

(discounting)Present

AmountNow

FutureValue(compounding)

ValueAmount

Later

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Time Value of Money• Increases in an amount of money as a result of interest earned•Every time you spend, save, invest or borrow money you should consider the time value of money as an opportunity cost


How Simple Interest is ComputedSimple Interest: interest compounded on the principal, excluding previously earned interest

$100 x 6% x 1 (1 year) 100 x .06 x 1 = $6.00

In one year you have $106

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(P) (r) (T) (I)

Amount x Annual x Time = Interest

in Savings Interest Rate Period


How Compound Interest is Computed

Compound Interest: Interest that is earned on previously earned interest

Each time interest is added to the principal, the next interest is computed on the new balance

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1st year: $100 x 6% x 1(year) = $106.00

2nd year: ($100 + $6) x 6% x 1(year) = $112.36

3rd year: ($106 + $6.36) x 6% x 1(year) =$119.10


Future Value of Money

Is the amount to which current savings will increase based on certain interest rate and certain time periodCalculations involve compounding since interest is earned on previously earned interestCan be computed for a single amount or a series of depositsStart investing now to take advantage of the future value of money

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Present ValueThe current value of a future amount

based on a certain interest rate and a certain time period Present value calculations are also called discountingAllows you to determine how much to deposit now to obtain desired future amountCan be computed for a single amount or a series of deposits

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Identify strategies for achieving personal financial goals for different life situations

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Components of Financial Planning Obtaining (chapter 1)

Planning (chapters 2,3)Saving (chapter 4)Borrowing (chapters 5,6)Spending (chapter 7)Managing Risk (chapters 8,9)Investing (chapters 10-13)Retirement and Estate Planning (chapters 14,15)

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Developing a Flexible Financial Plan

A financial plan is formalized report thatSummarizes your current financial situationAnalyzes your financial needsRecommends future financial activities

You financial plan can be created by you, done with assistance from a financial planner, or made using a money management software package

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Implementing Your Financial PlanDevelop good financial habits

Use a spending plan to stay within your income, allowing you to save and invest for the futureHave appropriate insurance protection to prevent financial disastersBecome informed about tax and investment alternatives

Achieving your financial objectives requires

A willingness to learnAppropriate information sources

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Chapter 1 - Appendix

Financial Planners and Other Financial Planning Information SourcesCurrent PeriodicalsFinancial InstitutionsCourses & SeminarsPersonal Finance Software

SpreadsheetsMoney Management & Financial Planning ProgramsTax SoftwareInvestment Analysis Programs

The Internet

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Financial Planning SpecialistsAccountantsBankersCredit counselorsCertified Financial PlannersInsurance agents/brokersInvestment BrokersLawyersReal Estate AgentsTax Preparers

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Financial planners are categorized based on the method of compensation

1. Fee-only planners2. Fee-and-commission planners3. Commission-only planners

Do you need a financial planner?Your incomeYour willingness to make independent decisions

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Summary of Learning Objectives

Analyze the process for making personal financial decisions

Determine current financial situationDevelop financial goalsIdentify alternative courses of actionEvaluate alternativesCreate and implement a financial planRe-evaluate and revise the financial plan

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Develop personal financial goalsGoals should be realisticBe stated in specific, measurable

termsHave a time frameIndicate the type of action to be takenAffected by person’s values, attitudes towards money and life situation

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Assess economic factors that influence personal financial planning

Consumer pricesInterest ratesEmployment opportunities

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Summary of Learning ObjectivesDetermine personal and financial opportunity costs associated with personal financial decisions

Every decision involves a trade off• Personal opportunity costs include time,

effort and health• Financial opportunity costs based on time

value of money

Future and present value calculations measure increased value or lost interest from saving, investing, borrowing or purchasing decisions

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Summary of Learning ObjectivesIdentify strategies for achieving personal financial goals for different life situations

Requires specific goals combined with spending, saving, investing and borrowing strategiesBased on your personal life situation and various social and economic factors

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Documents

2006 McGraw-Hill Ryerson Ltd. Kapoor Dlabay Hughes Ahmad Prepared by Cyndi Hornby, Fanshawe College Chapter 1 Personal Financial Planning: An Introduction