Chapter 1

Personal Financial Planning:

An Introduction

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Planning and Its Benefits

• Personal financial planning - Process of managing money to achieve personal economic satisfaction.

• Advantages of personal financial planning:

1) Increased effectiveness in obtaining, using, and protecting your financial resources.

2) Increased control of your financial affairs.3) Improved personal relationships.4) A sense of freedom from financial worries

obtained by looking to the future.1-2

The Financial Planning Process

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.

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Consequences of Choices:Opportunity Cost

•Opportunity cost - What you give up when you make a choice •The cost, or trade-off of a decision, cannot always be measured in dollars. Sometimes the cost is your time.

What opportunity costs do you have from being a college student?

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Every Financial DecisionInvolves Evaluating Types of Risk

• Inflation risk. Rising prices cause lost buying power.

• Interest-rate risk. Effect costs of borrowing and rate of return.

• Income risk. The loss of a job.

• Personal risk. Health, safety, or costs.

• Liquidity risk. Higher return may mean less liquidity.

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Financial Planning Information Sources

• Printed materials.• Financial institutions.• School courses and educational seminars.• The internet, online sources, computer software.• Financial specialists.

Financial planners, bankers, accountants, insurance agents, lawyers and tax preparers.

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Developing Personal Financial Goals

• Types of financial goals include those... 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.

• Goals for different financial needs Consumer product goals, etc.

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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

1-8

Influences on Personal Financial Planning

• Adult life cycle stage.• Marital status, household

size, and employment.• Major events.

Graduation, marriage, children, retirement, etc.

• Values. What values are important to you?

• Global influences• Economic conditions

Life situation and personal values

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Changing Economic ConditionsConsumer 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.

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Changing Economic Conditions (continued)

Money Supply The dollars available for spending in our economy.

Unemployment The number of individualswithout employment who arewilling and able to work.

Housing starts Number of new homes beingbuilt.

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Changing Economic Conditions (continued)

GDP: Gross Total value of goods andDomestic Product services produced in a

country.

Trade balance Difference between acountry’s exports andimports.

Market indexes The relative value of stocks as represented bythe index, such as theDow Jones Average or theS&P 500.

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Opportunity Costs and Financial Results Evaluated When Making Decisions

PersonalOpportunity Costs(time, effort, health)

FinancialOpportunity Costs(Interest, liquidity,

safety )

FinancialAcquisitions

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

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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.

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How Simple Interest is Computed

• Simple Interest.Amount in savings x annual interest rate x time period equals the interest.

$100 x 5% x 1 (1 year) 100 x .05 x 1 = $5.00

In one year you have $100 in principle plus $5.00 in interest for a total of $105 at the end of the year.

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Future Value

• 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 can be computed for a single amount or for a series of deposits.

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Present Value

• The current value for 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 can be computed for a single amount or for a series of deposits.

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Components of 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)1-18

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.

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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.

Study personal finance.1-20

Implementing Your Financial Plan(continued)

• Achieving your financial objectives requires two things.A willingness to learn.Appropriate information sources (see

Appendix A).Current periodicals.Financial institutions.Courses and seminars.Personal financial software.The World Wide Web.Financial specialists.

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Lucky You

• Suppose you just won a $100 million lottery and you are given the choice of taking a lump sum or payments over 20 years. Which would you do?

Why?

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