Free Personal Financial Plans
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PART 1 THE BASIC FRAMEWORK: ORGANIZING AND MANAGING YOUR FINANCIAL RESOURCES 1 FINANCIAL PLANNING: WHY IT’S IMPORTANT TO YOU CHAPTER FOCUS Personal financial planning involves setting individual priorities and developing specific financial goals. This building block approach provides a sound financial foundation in which both short-term and long-term goals may be achieved. Financial success is determined by many factors including the individual, economic conditions, and adequate financial preparation. The decision to establish a plan should recognize the need to become familiar with the financial planning process. The development of financial goals corresponds closely with the life cycle. Thus, financial planning and decision making directly parallel the different phases of the life cycle. Financial decisions often involve marginal analysis. Marginal analysis is concerned with the comparison of decision alternatives and the need to evaluate marginal costs and marginal benefits. In addition, the examination of opportunity costs and the time value of money are critical in the decision-making process. ______________________________________________________________________________ CHAPTER ORGANIZATION I. Why Study Personal Finance? A. Your Goals in Life 1. Nonfinancial Goals 2. Financial Goals FINANCIAL PLANNING: WHY IT’S IMPORTANT TO YOU 1 2 a. Current Consumption 3 b. Future Consumption 4 c. Savings B. Important Economic Trends 1. Continuing Inflation 2. Persistent Business Cycles 3. Continued Instability in Financial Markets 4. A High and Selectively Rewarding Tax System II. Achieving Financial Goals Through Planning A. Life Cycle Planning B. Major Financial Planning Areas 1. Consumption and Savings Planning 2. Debt Planning 3. Insurance Planning 4. Investment Planning 5. Retirement Planning 6. Estate Planning 7. Income Tax Planning 8. Career Planning C. A Planning Approach III. Making Financial Decisions A. Some Helpful Economic Insights 1. Marginal Analysis 2. Opportunity Costs IV. The Building Blocks of Success ________________________________________________________________________ OBJECTIVES 1. To understand why setting goals is an important first step in financial planning 2 CHAPTER 1 The chapter distinguishes between financial and nonfinancial goals and explains that the former might assist in achieving the latter. The financial goals of consumption and savings force consumers to decide how they will allocate their current incomes. 2. To appreciate that trends in the financial environment--inflation, taxes, and economic conditions-- affect financial success and enhance the need for planning Planning begins with a set of assumptions about the above factors. For example, students should see that a high rate of inflation might influence their planning in terms of selecting investments (stocks over bonds) and in terms of preferring current consumption to future consumption (buy now before prices go up). 3. To see why life-cycle financial planning is important and to understand the nature of a planning approach Planning is a life-long process featuring changing goals over time and changing strategies to achieve goals. A planning approach focuses on major planning areas, such as debt planning, and it includes the critical steps of determining concrete goals and creating action plans to achieve them. 4. To understand what is meant by marginal analysis and opportunity costs and to know how these concepts are used in financial decision making Many students already use these concepts in making decisions such as choosing one course over another or how to spend vacation time. Instructors need to highlight the importance of thinking in terms of opportunity costs associated with each critical financial decision and how to evaluate choices by focusing on marginal changes. 5. To appreciate that financial success builds on a strong foundation and follows a building-block approach through time It is important that students understand the process of accumulating and protecting wealth through time. As an example, you shouldn’t buy a house that is outside your means and then not have sufficient funds to insure it. Nor should you try for a stock market “killing” until you have adequate liquid reserves. ________________________________________________________________________ PERSONAL FINANCE ON THE NET The Internet is uniquely appropriate for financial planning. In this introductory chapter, students should be encouraged to visit some or all of the sites listed in the margin notes. They can experiment at a site by clicking on various icons to see what they offer. The Internet features sites, which provide ample economic and financial data. By visiting the Economic Statistics FINANCIAL PLANNING: WHY IT’S IMPORTANT TO YOU 3 Briefing Room, students can view the same data sets reviewed by key policy makers (including the President) in setting fiscal and monetary policies. Also, encourage students to visit Yahoo’s Stock Quotes to see how the overall market or specific stocks are performing. It’s easy to have students set up a portfolio of stocks that they can monitor throughout the term. ________________________________________________________________________ TEACHING SUGGESTIONS 1. Construct a simplified questionnaire about the personal finance course and “poll” students’ interests in major financial topics. 2. Have students discuss those factors giving them happiness now and those factors that are likely to bring happiness in the future. Tell them to be specific and somewhat personal, if necessary. Then, ask them how finances might bear upon achieving their happiness goals, both now and in the future. For a more general discussion, pose the issue that money does not provide happiness. 3. Discuss the importance of personal financial management, and explain how each individual can benefit from establishing goals and developing financial plans. 4. Emphasize the usefulness of life-cycle planning and explain how each phase of the life- cycle will affect the decision-making process. Use examples and illustrate the difference in financial decisions with each phase of the life cycle. 5. Have students compare their financial planning concerns with those of their parents and grandparents. Have them discuss similarities and differences. Use this exercise to highlight the nature of life-cycle financial planning. 6. Identify each phase of the life cycle and identify the major goals and planning areas of each phase. Allow students to determine how their own financial decisions will become more complex as they progress through the life cycle. 7. List several factors that influence the economic environment, and discuss how personal financial management is affected by economic conditions. Discuss specific economic conditions, such as inflation and unemployment, and determine what effect these conditions have on financial planning. 8. Introduce the concept of opportunity cost to show how they may need to balance financial and non-financial goals. For example, the opportunity cost of buying an expensive new car may be the hours of family activity forgone because of the need to work longer hours away from home. 9. Ask students if they know the current level of interest rates and whether the economy is growing or declining. Consider giving an Internet assignment for quick answers to these 4 CHAPTER 1 questions. Then, ask them if a growing economy is a boon for the job market when they graduate. 10. Tell students that a rich aunt has died and left them a legacy of $50,000. Ask them what they would do with it. Use the discussion to highlight a building block approach to wealth accumulation. ________________________________________________________________________ FOLLOW-UP ON THE STEELE FAMILY 1. It appears that the Steeles have not really planned for the future in terms of setting realistic and achievable goals. Nevertheless, thinking (or dreaming) about the future is not a bad place to start the planning process. However, it must not end there. 2. Nancy’s music lessons and perhaps the vacation to Hawaii are short range goals. The vacation condo, the European vacation, the children’s education, and retirement are long- range goals. 3. The Steeles need to convert their dreams into clearly defined goals. Exactly what do they hope to achieve, how much will it cost, and how will they provide necessary funds to meet the costs are questions requiring specific answers. Instructors might wish to use this question as a prelude to the next chapter, which deals with goal planning in detail. 4. The economic processes discussed in this chapter offer potential pitfalls and boons to the planning process. Rising inflation rates will make all future goals more expensive; contrarily, rising investment returns make them less expensive. A deep recession could lead to unemployment, making a liquid reserve fund very important. Instructors can use this question to highlight the importance of planning as an on-going process, rather than a single event. _______________________________________________________________________ ANSWERS TO PROBLEMS AND REVIEW QUESTIONS 1. Financial success is defined as obtaining the maximum benefits from limited resources. It is difficult to measure financial success, since benefits are difficult to measure. 2. Both financial and nonfinancial goals are important in the financial planning process. Financial goals can be easily defined for financial planning purposes since they involve measurable amounts for consuming--now and in the future--and saving. However, nonfinancial goals represent those items that are often difficult to define in monetary terms. Thus, personal financial planning should attempt to achieve a level of satisfaction that is consistent with both types of goals. FINANCIAL PLANNING: WHY IT’S IMPORTANT TO YOU 5 3. Financial independence is often thought of as having sufficient income or resources to be self-reliant. Of course, it can have different meanings; some people might think of it as having enough money to do whatever they want. 4. Future consumption is simply that—consumption at a future point in time. Current consumption is consumption within the current period of time, which usually refers to a planning period, such as a year. One form of consumption is not necessarily better than the other—it’s simply a matter of priorities. Would you rather have an elegant life style now and be destitute in retirement; or, would you rather consume somewhat uniformly throughout your life? You are free to choose either alternative. 5. The principle of diminishing marginal satisfaction provides help here. Without the ability to borrow, our consumption could never be greater than our income. However, since our incomes are not uniform through time (usually we have much higher incomes as we grow older) this means that in a sense we over-consume with high incomes (very low marginal satisfaction) and under-consume with low incomes (very high marginal satisfaction). Borrowing allows us to smooth the marginal satisfactions through time. 6. Saving is simply income not consumed. People save for a variety of reasons—some save simply because they enjoy seeing their wealth grow—but the most basic reason for saving is that they wish to consume in the future. So, future goals are set and savings are planned to achieve them. 7. Inflation has come down considerably over the past 25 years, from double-digit rates to rates below five percent. Estimating an inflation rate for the next 25 years is almost impossible. Most planners simply extrapolate current rates forward. In the present environment, a three percent rate seems appropriate for long-range goals. 8. The economy is most often in an expansionary phase, however, recessions have occurred with some degree of regularity, the most recent being in 1990--1991. While no one knows for sure, it seems a very safe bet to guess that recessions will occur in the future. 9. The stock market is a very poor place to put money that might be needed on short notice. The term safety usually implies that an investment will not decline in value. In this sense, the stock market fails to meet the test of safety since it frequently declines in value. 10. Planners often use the stock market’s long-run average historical rate of return, which is around ten percent. 11. Our tax law is not neutral and financial plans must consider potential tax impacts. A good example is the generous treatment of home ownership insofar as mortgage interest and property taxes are allowable deductions against income. All other things the same, owning a home is typically far cheaper than renting one. 12. The life cycle is characterized by many different phases. These phases include young adult, family formation, family development, family maturity, and retirement. Planning for each phase is extremely beneficial to individual, as a specific area of interest may be 6 CHAPTER 1 analyzed and thoroughly examined. In general, this approach provides the opportunity to establish specific plans for each phase of the life cycle. 13. Financial planning involves a systematic decision-making process. A planning approach can be developed by analyzing four basic steps. The initial step is to state the goal in precise terms so that it is easily defined. The second step consists of creating an action plan that will assist in determining how this goal is to be achieved. The third step is the evaluation of the performance that is characterized by the action plan. The final step involves a reassessment of current goals and the development of new goals. The eight major planning areas are: career planning, consumption and savings plan, debt planning, insurance planning, retirement planning, estate planning, and income tax planning. 14. Marginal analysis is concerned with the study of variables that affect the decision-making process. Marginal analysis focuses on changes that affect the final decision and the ultimate course of action. Opportunity cost is measured by determining the expected satisfaction to be received from a specific alternative. The expected satisfaction is often influenced by each decision alternative as the opportunity costs are used extensively in financial planning to evaluate the effectiveness of financial decisions. In addition, a thorough analysis of all feasible financial alternatives should assist the individual during the financial planning process. 15. One should recognize the satisfaction to be received from making a specific decision and measure this satisfaction against the expected satisfaction of additional alternatives. Thus, the cost of spending a night at home is the pleasure you might enjoy by going out, or the income you give up by not working at a night job. 16. (a) The extra 200 miles would require additional gas (let’s say, $15). Oil, lube, wear on the car would be minimal (let’s say $3). So, total marginal costs equal $18, while marginal revenue equals $40; it seems like a decent offer, and Martin should take it. (b) The main opportunity cost is the use of Martin’s time. A 200-mile side trip could take 3 to 4 hours. Martin must decide what the alternative use of his time is worth and then weigh this amount against the $22 ($40 minus $18) net marginal revenue. 17. A building-block approach refers to the process of securing basic financial safety before undertaking risky investments. Basic investments in housing, insurance, and liquidity come before speculative investments. 18. Bryan should realize the potential losses with biotech stocks, which could easily decline 50% in value over a short period of time. Suppose Bryan has a $1,500 car repair bill arise unexpectedly. What does he do if his nest egg has fallen to $1,000? ________________________________________________________________________ ANSWERS TO CASE PROBLEMS Case 1.1 The Haggertys’ Financial Planning FINANCIAL PLANNING: WHY IT’S IMPORTANT TO YOU 7 1. Yes, the Haggertys can certainly benefit from financial planning, as it provides a means that may assist them in achieving their financial goals. A definite plan for buying a house would indicate important details such as the date of purchase, the down payment, and the expected purchase price. In addition, a financial plan would enable them to make specific decisions concerning the purchase and financing of a new house. A financial plan might also resolve some apparent conflict about the importance of buying a house. 2. The suggestion to invest in growth stocks should be analyzed carefully, as many common stocks investments are extremely risky. The anticipation of earning 20% is too optimistic. Jan and Mickey should develop a specific plan for the purchase of a new house and evaluate their risk preferences associated with alternative investments. In addition, they should also consult with a financial planner or a stockbroker to determine an appropriate investing strategy. If they wish to purchase a house within the next several years, stock investment may be too risky. A longer horizon could allow for greater short-term variability and would support a larger equity allocation of their funds. 3. The idea to wait and invest in common stocks when their prices fall is sound investment strategy; however, it is not certain that a recession will occur and prices will decline. Therefore, Mickey should question the recommendation of a friend and the reliability of this forecast. Forecasting, at best, is an educated guess that may or may not yield favorable results. Both Jan and Mickey should acknowledge that a successful financial plan must be specific, but also flexible as to specific economic environments. Case 1.2 Lou Pirella and Vicki Wright: Two College Students 1. The major opportunity cost of her MBA degree is the income she could earn during the period she is in school. Additional opportunity costs include the higher compensation level she would have by working, plus any budgeted savings. Another opportunity cost is the tuition and related expenses, in the sense these funds could be used for the other purposes. 2. The decision Vicki faces can be analyzed as follows: Total tuition costs taking 15 credit hours Each semester (4 semesters @ $3,000 each) $12,000 Total tuition costs taking 20 credit hours Each semester (60 @ $250 each) $15,000 Marginal cost of accelerated program $ 3,000 The benefit of the accelerated program is graduating one semester earlier. Thus, the opportunity cost of the slower program is the additional income Vicki could earn during the “saved” semester. 8 CHAPTER 1 3. Since Lou is entering the work force, his days of cavalier living as a student are over. He needs to get his act together, and he can start by at least determining the interest rate on his credit card. Lou seems content with not paying off the card’s balance, while at the same time he intends to make aggressive stock market selections. It’s highly unlikely that the rate of return on Lou’s investments will equal the interest rate on his credit card. For openers, then, he should consider paying off the card’s balance. Then, he ought to consider suitable disability, life, and property and auto insurance. He doesn’t seem to be at the point where he might realistically consider aggressive investing. Marie Wilson Goal-Planning Exercise This exercise is meant to be somewhat open-ended, so instructors can expect a wide variety of responses. The primary purpose of the exercise overall is to encourage students to think of their own personal financial situations as they help Marie with her financial planning. Actually, encouraging students to set goals may be the single most important lesson we provide during the course. A business firm seldom runs efficiently if it lacks financial targets that it attempts to achieve. At a more abstract level, business managers are encouraged to have a “vision” for the firm, in the sense of where it should be in five or ten years. So, too, students need visions, which lead to dreams, and ultimately to concrete goals. The table below indicates some possible goals and when Marie anticipates achieving them. Instructors might ask students if they believe that Marie has a broad vision of what she would like her life to be. While the case does not probe the issue to that extent, it can certainly be added to a classroom discussion. FINANCIAL PLANNING: WHY IT’S IMPORTANT TO YOU 9 Form 1.1 Identifying Financial Goals Date to Number of Current Date________________ Achieve Goal Years in the Future A. Short-Range Goals (1-2 Years) 1. Enroll in law school 1,2 2. Buy a new car 1 3. Pay off all credit card debt 1,2 4. Pay off school loans 1,2 B. Intermediate-Range Goals (2-10 Years) 1. Continue law school 3,4 2. Sending Jake to college 5 3. Continue paying off school loans 3,4,5,6,7,8 C. Long-Range Goals (Over 10 Years) 1. Down payment on a condo 10 2. Sending Jake to college 14,15,16, 17 3. Having a retirement nest egg 40 D. Discussion of goals 1 CHAPTER 1 0