© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Fifth Edition Personal Finance An Integrated Planning Approach Bernard J. Winger Ralph R. Frasca

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Chapter 1: Financial Planning-- Why It’s Important l Increased Emphasis on Self Reliance –Less From Government; e.g. Social Security –Less From Employer; e.g. Reduced Role of Traditional Retirement Plans l Achieving Financial Independence l Coping with Economic Uncertainties and Shocks

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Financial Success and Financial Independence l Financial Success: Obtaining Maximum Benefits from Limited Financial Resources l Financial Independence: Having Sufficient Income or Financial Resources To Be Self Reliant

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. What Are Your Goals in Life? l Nonfinancial Goals l Financial Goals –Current Consumption –Future Consumption –Savings

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. The Principle of Diminishing Marginal Satisfaction l Current consumption is limited by diminishing marginal satisfaction. l Example: Would you rather drink 7 soft drinks right now, or have 1 a day for the next 7 days? Most people prefer the latter choice because each additional bottle after the first one (or two) provides much less satisfaction. Indeed, the 7th bottle right now might make you sick!

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Important Economic Trends l Continuing Inflation--How High? 3-4%? l Persistent Business Cycles –Is Your Job Safe? –Do You Have Cash Reserves to Weather a Storm? l A Perplexing Tax System –High Tax Rates –Selectively Rewarding

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. A Planning Approach l Define a Broad Goal l Break it Down To Manageable Sub-goals l Create an Action Plan to Achieve Sub-goals l Periodically Evaluate the Action Plan –If Successful, Keep Up Good Work –If Not, Find New Action Plan or New Goal

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Planning Areas l Consumption and savings planning l Debt Planning l Insurance Planning l Investment Planning l Retirement Planning l Estate Planning l Income Tax Planning

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Marginal Analysis l Looks at changes in important variables l Considers whether a decision’s added benefits are worth its added costs l Example: you choose not be buy whole life insurance because the cash build-up in the policy is less than what you could earn by buying term insurance and investing the saved premiums.

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Opportunity Costs l Opportunity costs are benefits that you give up when you choose one alternative over another l Example: the opportunity cost of taking a course in personal finance is the knowledge you could have gained by taking another course in its place

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. What Is Meant by the “Time Value of Money?” l Having a dollar today is worth more than receiving a dollar sometime in the future. l Conversely, paying a dollar at a later date is more desirable than paying it now. l The above statements make sense because any sum of money today can be invested to earn interest and thereby grow to a larger amount.

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Time Value of Money: Compounding l Must Know: –Interest Rate –Number of Periods Investment is Held l Assumes Interest Earned Is Reinvested l Can Find the Future Value of: –A Single Payment –An Ordinary Annuity –An Annuity Due

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Coumpounding Illustrated You invest $1,000 today, hold the investment for 3 years, and earn 10% each year. How much will you accumulate at the end of 3 years? __________________________________________ Year Beginning-of- Interest End-of-Year Year Amount Earned Amount 1 $1,000 $100 $1, , , , ,331 Answer

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Portion of a Future-Value-of- $1- Table Number of Interest Rate ( i ) Periods (n) 6% 8% 10%

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Easy Way to Find An FV l Use FV of $1 Table to find the FV value for your problem l Multiply by the number of $s invested l Example: How much will you accumulate over 10 years by investing $4,000 today and earning 8% a year? Answer: Find FVof $1 for n = 10, i = 8: it is Then x $4,000 = $8,635.60

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. What Is an Annuity? l An annuity is a series of equal payments l An ordinary annuity (OA) assumes the payments occur at the end of periods. Most future-value-of-$1-annuity tables show ordinary annuities l An annuity due assumes the payments occur at the beginning of periods l Annuities are found in many investments, such as bonds

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. FV of an Ordinary Annuity An investment of $1,000 is made at the end of each of the next 3 years and earns 10%. How much is accumulated at the end of 3 years? –First payment earns interest for 2 years; so, $1,000 x 1.1 x 1.1 = $1,210 –Second payment earns interest for one year; so, $1,000 x 1.1 = $1,100 –Third payment earns no interest; so, $1,000 X 1.0 = $1,000 –Add: $1,210 + $1,100 + $1,000 = $3,310

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Portion of a Future-Value-of- $1- Annuity Table Number of Interest Rate ( i ) Periods (n) 6% 8% 10%

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Converting an Ordinary Annuity (OA) Into An Annuity Due (AD) l The conversion formula is: FVAD = (1 + i ) x FVOA where i = the interest rate earned l Previous example calculated an OA of $73,570. If payments were made at the beginning of periods, then FVAD = (1.06) x $73,570 = $77,984

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Time Value of Money: Discounting l Must Know: –Interest Rate –When Money is Received in the Future l Assumes Interest Earned Is Reinvested l Can Find the Present Value of: –A Single Payment –An Ordinary Annuity –An Annuity Due

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Portion of a Present -Value-of- $1-Table Number of Interest Rate ( i ) Periods (n) 6% 8% 10%

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Portion of a Present -Value-of-a- $1 Annuity-Table Number of Interest Rate ( i ) Periods (n) 6% 8% 10%

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Finding Present Values l Easiest method is to use the tables l Problem 1: What is the present value of $1,331 to be received at the end of 3 years, assuming a 10% discount rate? (1) Find the PV of $1 for n = 3 and i = 10%; it is (2) Multiply by $1,331 to find answer: x $1,331 = $1,000

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Finding Present Values l Problem 2: What is the present value of $800 to be received at the end of each of the next 20 years, assuming a 6% interest rate? (1) Find the PV of $1 annuity for n = 20 and i = 6%; it is (2) Multiply $800 by = $9, l If payments were at beginning of periods: PVAD = (1 + i) x PVOA = 1.06 x $9, = $9,726.48

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Meet the Steele Family l Typical suburban family consisting of Arnold (h) and Sharon (w) and two kids-- Nancy and John l Enjoying the “good life” associated with an above-average income l Doing virtually no financial planning –to educate the children –to enjoy retirement

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Building Blocks of Success--The Foundation l Developing Your Career l Acquiring Adequate Insurance l Finding Suitable Housing l Saving to Build Adequate Cash Reserves

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Building Blocks of Success-- Going Up the Ladder l First Floor: Invest in Very Secure Instruments; e.g. Bank CDs l Second Floor: Gradually Increase Risks to Earn Higher Returns; e.g. High Quality Stocks l Top Floor: Invest in All Types of Assets to Maximize Wealth; e.g. Risky Growth Stocks

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc. Next Chapter 2 Financial Statements and Budgets