Chris Leung, Ph.D., CFA, FRM

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1 FNE 215 Financial Planning Chris Leung, Ph.D., CFA, FRM

2 Chapter 2 Planning with Personal Financial Statements

3 Chapter Objectives Explain how to create your personal cash flow statement Identify the factors that affect your cash flows Show how to create a budget based on your forecasted cash flows Describe how to create your personal balance sheet Explain how your net cash flows are related to your personal balance sheet (and therefore affect your wealth)

4 Personal Cash Flow Statement Personal cash flow statement: a financial statement that measures a person s cash inflows and outflows Cash inflows include salaries, interest, dividends Cash outflows include all expenses, both large and small

5 Personal Cash Flow Statement (cont d) Create a statement by recording your revenues and expenses over a period of time Net cash flows: cash inflows minus cash outflows

6

7 Factors That Affect Cash Flow Factors affecting cash inflows: Stage in your career path Closely related to your stage in the life cycle college, career, retirement Type of job Based on skill level and demand for those skills Number of income earners in your household

8 Factors That Affect Cash Flow (cont d) Factors affecting cash outflows: Size of family Age Personal consumption behavior Some people spend all of their income and more while others spend mainly on necessities and concentrate on saving for the future

9 Factors That Affect Cash Flow (cont d)

10 Creating a Budget Budget: a cash flow statement that is based on forecasted cash flows for a future time period Budgets are useful for anticipating either cash surpluses or cash deficiencies

11

12 Creating a Budget (cont d) Anticipating cash shortages Small shortages can usually be made up from your checking account Budgets provide warning of shortages so that you can prepare for them Assessing the accuracy of the budget Compare predicted cash flows to actual cash flows Adjustment may be necessary

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14 Creating a Budget (cont d) Forecast net cash flows over several months Use the information for a typical month and adjust it for unusual expenses such as seasonal shopping Allow for some unexpected expenses like medical care, car and home maintenance Create an annual budget by extending your budget out for longer periods

15 Creating a Budget (cont d)

16 Creating a Budget (cont d) Improving the budget Periodically review the budget to see if you are progressing toward your goals Look for areas that can be changed to improve the budget over time Focus on ethics Don t become overly dependent on others Create a budget and stay within it

17 Personal Balance Sheet Personal balance sheet: a summary of your assets (what you own), your liabilities (what you owe), and your net worth (assets minus liabilities) A balance sheet reflects your financial position at a specific point in time

18 Personal Balance Sheet Assets Liquid assets are financial assets that can be easily sold without a loss in value Household assets are items normally owned by a household, such as a home, a car, and furniture You need to establish market values for these assets the amount you would receive if you sold the asset today Investments Bonds, Stocks, Mutual Funds, Real estate

19 Personal Balance Sheet (cont d) Investments Bonds: certificates issued by borrower, usually firms and government agencies, to raise funds Stocks: certificates representing partial ownership in a firm Mutual funds: investment companies that sell shares and invest the proceeds in investment instruments Real estate: holdings in rental property and land Rental property: housing or commercial property that is rented out to others

20 Personal Balance Sheet (cont d) Liabilities Current liabilities: debts that will be paid within a year Long-term liabilities: debts that will be paid over a period longer than one year Net worth is the difference between what you own and what you owe.

21 Personal Balance Sheet (cont d) Creating a personal balance sheet Allows you to determine your net worth Update it periodically to monitor changes in your net worth over time

22

23 Personal Balance Sheet (cont d) Changes in the personal balance sheet Some changes will affect both your personal balance sheet and your net worth Other changes will affect you personal balance sheet and leave your net worth unchanged Consider the previous personal balance sheet with the purchase of a new car

24

25 Personal Balance Sheet (cont d) Analysis of the personal balance sheet Allows monitoring of liquidity, debt, and ability to save Liquidity is measured by the liquidity ratio Liquidity ratio = Liquid assets/current liabilities From personal balance sheet on previous slide 4,000/2,000 = 2 Higher result = greater liquidity

26 Personal Balance Sheet (cont d) Debt level is measured by debt-toasset ratio Debt-to-Asset Ratio = Total liabilities/total assets From personal balance sheet on previous slide 2,000/9,000 = 22.22% Higher ratio = higher debt relative to assets

27 Personal Balance Sheet (cont d) Savings rate measures savings over the period in comparison to disposable income over the period Savings rate = Savings during the period Disposable income during the period From personal balance sheet on previous slide $400/$2,500 = 16%

28 Relationship Between Cash Flows and Wealth Wealth is built by using net cash flows to invest in assets without increasing liabilities Net cash flows can be used to decrease liabilities which will increase net worth Net worth can change even if net cash flows are zero; for example, the value of an asset or investment increases or decreases

29 Relationship Between Cash Flows and Wealth

30 How Budgeting Fits within Your Financial Plan The key budgeting decisions for building your financial plan are: How can I improve my net cash flows in the near future? How can I improve my net cash flows in the distant future?

31 Chapter 3 Applying Time Value Concepts

32 Chapter Objectives Calculate the future value of a dollar amount that you save today Calculate the present value of a dollar amount that will be received in the future Calculate the future value of an annuity Calculate the present value of an annuity

33 The Importance of the Time Value of Money Can be applied to a single dollar amount also called a lump sum Can also be applied to an annuity Annuity: a series of equal cash flow payments that occur at the end of each period An example would be a monthly deposit of $50 into your savings account

34 Future Value of a Single Dollar Amount Compounding: the process by which money accumulates interest To determine the future value of an amount of money you deposit today, you must know: The amount of your deposit today The interest rate to be earned on the deposit The number of years the money will be invested

35 Future Value of a Single Dollar Amount (cont d) Future value interest factor (FVIF): a factor multiplied by today s savings to determine how the savings will accumulate over time Can be calculated using the future value table or a financial calculator Future value table shows various interest rates (i) and time periods (n)

36 Future Value of a Single Dollar Amount (cont d) Suppose you want to know how much money you will have in five years if you invest $5,000 now and earn an annual return of 9 percent The present value of money (PV) is the amount invested, or $5,000 Find the interest rate of 9 percent and a time period of five years on the table

37 Exhibit 3.1 Future Value of $1 (FVIF)

38 Exhibit 3.1 Future Value of $1 (FVIF) (cont d)

39 Future Value of a Single Dollar Amount (cont d) Using the information in the example and the table, we can determine that, in five years, your money will be worth: $5, = $7,695 This can also be determined using a financial calculator

40 Future Value of a Single Dollar Amount (cont d) Focus on ethics: delaying payments Investing money while delaying payment obligations allows you to earn interest on your funds However, delaying payments may result in late fees and penalties that may damage your credit rating Make use of your money while you can, but always make obligatory payments

41 Present Value of a Dollar Amount Discounting: the process of obtaining present values Present values tell you the amount you must invest today to accumulate a certain amount at some future time This amount is based on some interest rate you could earn over that period

42 Present Value of a Dollar Amount (cont d) To determine present values, you need to know: The amount of money to be received in the future The interest rate to be earned on the deposit The number of years the money will be invested

43 Present Value of a Dollar Amount (cont d) Using the Present Value Table Present value interest factor (PVIF): a factor multiplied by a future value to determine the present value of that amount Notice that PVIF is lower as the number of years increases and as the interest rate increases Can also be calculated using a financial calculator

44 Present Value of a Dollar Amount (cont d) You would like to accumulate $50,000 in five years by making a single investment today. You believe you can achieve a return from your investment of 8 percent annually. What is the dollar amount that you need to invest today to achieve your goal?

45 Exhibit 3.2 Present Value of $1 (PVIF)

46 Exhibit 3.2 Present Value of $1 (PVIF) (cont d)

47 Present Value of a Dollar Amount (cont d) Using the information in the example and the table we can determine that in order to have $50,000 today: $50, = $34,050 This can also be determined using a financial calculator

48 Future Value of an Annuity Annuity due: a series of equal cash flow payments that occur at the beginning of each period Timelines: diagrams that show payments received or paid over time These values can also be calculated using a table or a financial calculator

49 Future Value of an Annuity (cont d) Future value interest factor for an annuity (FVIFA): a factor multiplied by the periodic savings level (annuity) to determine how the savings will accumulate over time i is the periodic interest rate n is the number of payments in the annuity

50 Future Value of an Annuity (cont d) Suppose that you have won the lottery and will receive $150,000 at the end of every year for the next 20 years. As soon as you receive the payments, you will invest them at your bank at an interest rate of 7 percent annually. How much will be in your account at the end of 20 years, assuming you do not make any withdrawals?

51 Exhibit 3.3 Future Value of a $1 Ordinary Annuity (FVIFA)

52 Exhibit 3.3 Future Value of a $1 Ordinary Annuity (FVIFA) (cont d)

53 Future Value of an Annuity (cont d) Using our example and the table, we can determine that, at the end of twenty years, you would have: $150, = $6,149,250 This can also be determined using a financial calculator

54 Present Value of an Annuity The present value of an annuity is determined by discounting the individual cash flows of the annuity and adding them up This value also can be obtained by either using a present value of an annuity table or a financial calculator

55 Present Value of an Annuity (cont d) Present value interest factor for an annuity (PVIFA): a factor multiplied by a periodic savings level (annuity) to determine the present value of the annuity i represents various rates of interest n represents the time periods in the annuity

56 Present Value of an Annuity (cont d) Suppose you have just won the lottery. As a result of your luck, you will receive $82,000 at the end of every year for the next 25 years. Now, a financial firm offers you a lump sum of $700,000 in return for these payments. If you can invest your money at an annual interest rate of 9 percent, should you accept the offer?

57 Exhibit 3.4 Present Value of a $1 Ordinary Annuity (PVIFA)

58 Exhibit 3.4 Present Value of a $1 Ordinary Annuity (PVIFA) (cont d)

59 Present Value of an Annuity (cont d) Using our example and the previous table we can determine that the present value of the stream of $82,000 payments is: $82, = $805,486 Since this amount is more than the $700,000 offered, you would reject the offer

60 Using Time Value to Estimate Savings Estimating the future value from savings Provides motivation for regular saving Estimating the annual savings that will achieve a future amount Helps set specific goals when saving for a large purchase

61 How a Savings Plan Fits Within Your Financial Plan Key savings decisions for building your financial plan are: How much should I attempt to accumulate in savings for a future point in time? How much should I attempt to save every month or every year?

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