Finance 123 – Lecture 2 (Chapters 1,2, and overview of 3), January 22, 2007
Trivia: The “Latte Factor” – Assume a person stops off at Starbucks every morning to get a latte that costs $4, instead of drinking the free coffee from the machine at work. He/she does this every work day for 40 years (5 times per week, 4 weeks per month).
If he/she had put this money in savings ($80 per month) and earned 10% annual return, how much money would he/she have (if money earned tax free) at the end of the 40 years?
Answer: $505,926
Chapter 1 – Personal Finance Overview
I.
Financial
Planning Process
1. Personal Balance Sheet (chapter 3 – see below)
2. Personal Cash Flow Statement (chapter 3 – see below)
3. Insurance Policies (Life, Auto, Home or Renters, Health, Disability, Umbrella)
4. Important records – put in safety deposit box. Ex. Birth certificate, passport.
Short Term – within 1 year. – generally cash management goals.
Intermediate Term – 2 to 5 years. – some major purchases (car,home).
Long Term – over 5 years. – major purchases, retirement savings, college savings.
Alternative investment opportunities, banking options, credit card options, insurance options, employment options, lifestyle options, rent or buy house options. Options will be very specific to the individual.
Considerations:
Life situation – thus, your personal financial plan will change when your life situation changes.
Personal Values
Economic Factors
Must take into
account:
Risks – INFLATION, income risk, personal risk, time value of money, liquidity risk
We’ll talk more about inflation below.
Create and implement your Financial Plan. This will include a Personal Cash Flow budget by month. Excel is excellent for this.
Review annually, or
when life situation changes. (ex. Get married, have a child)
II.
Why “one size
doesn’t fit all” with personal financial planning
Stage of Life / Life
situation (p. 14)
Life Priorities
Risk Tolerance – your risk tolerance will determine your investment profile.
III.
INFLATION –
the enemy of savings.
Nominal rate of return – the rate of interest or return on an investment (the stated rate).
Real rate of return – the rate of return after taking into account the effect of inflation.
Inflation – increase in the CPI (Consumer Price Index – a theoretical “basket of goods”)
Formula:
Real Rate of return =
Nominal Rate of Return minus Inflation Rate
Example:
Your savings account yields 5% (this is the nominal rate of return). Inflation is 3%.
Your “real rate of return” is only 2%.
Now, take taxes into
account. Same example, but, suppose you
pay 20% marginal taxes:
Nominal Return: 5%
Pay in taxes: 1%
After Tax Return 4%
Inflation 3%
Real Return 1%
(i.e. you’re only 1% better off one year from now than you are today).
IV.
Time Value
of Money – see separate hand out – second half of class.
Chapter 2 – Education and Employment in
Personal Finance
I.
USA Economy
is a Knowledge or Skilled Based Economy
This is especially true in the 21st century, as
the world develops into a global economy.
Low paying jobs are being outsourced overseas. In the
- Story about consultant charging $10,000 to tighten a bolt.
This is true in every field: (examples)
Medical: Pharmacist, Physician, Nurse, Occupational Therapist, Physical Therapist
Finance and Accounting: CFA, CPA, CFP
Value of a college education is unprecedented – even if you finish last in your class.
What do you call the person who graduates last in their class in med school?
Doctor.
For more jobs in a service economy, see p. 43.
II.
Money is
only part of the equation
Eight to ten hours a day at work can be an ETERNITY if you don’t have a passion for what you are doing.
NY Times – circle the E’s example.
Myers Briggs Personality Test
Free shorter version on internet:
http://www.teamtechnology.co.uk/mmdi-re/mmdi-re.htm
“What Color is My Parachute”
III.
Value of an
Employee Benefit
A tax free employee
benefit is worth more than a taxable employee benefit, and, is worth more than
the same amount in salary.
Example: Suppose your employer offers you free health
insurance (for which you are currently paying $350 per month).
Suppose you are in the 23% marginal tax bracket, how much is this new benefit worth to you?
Hint: more than $350.
Currently, you have to make more than $350 to pay for your health insurance (which costs $350). Why? Your income is taxable.
The value of the benefit (in before tax dollars) is:
Benefit Amount / (1-marginal tax rate)
In this case: $350 / (1-.23) = $454 (that’s how much you had to make to pay your health insurance.
Another way of
looking at it:
Which
is more valuable: An employee benefit
that is tax free such as health insurance that costs $350 per month, or an
employee benefit, such as a company car, that is taxable, that is about $400
per month. You are in the 23% tax bracket.
Answer: The health insurance is tax free, it’s worth $350 in after tax dollars. (It’s worth $350 / (1-.23) = $454 in before tax dollars). (You would have to make $454 to pay for health insurance and the taxes on the income).
The car is taxable income to you. It’s worth $400 in before tax dollars (but less in after tax dollars). Why? You have to pay taxes on the income. How much in after tax dollars?
$400 * (1-.23) = $308
You can work the problem either way: before tax dollars or after tax dollars. But be sure you are comparing apples to apples.
Personally, I use “before tax dollars”. I increase the value of the tax free benefits, and, leave the taxable benefits the same.
Taxes come up so much in personal finance that accountants refer to the Tax Code as the “accountants’ employment security act”. This is a reference to the need for accountants because of the complicated tax laws.
IV.
Cost of
Living in Different Cities
As published in
census statistics, it costs different amounts of money to live in different
cities.
Example: Suppose you have two job offers: one in
You are offered:
Which job offer is really higher?
Answer: Standardize each job offer to an index value of 1.00. Here’s how:
In relative terms, the
Chapter 3 – Personal Financial
Statements
I.
Personal
Balance Sheet and Personal Cash Flow Statement
Excel is good for these statements. You can modify, set goals, figure variances.
II.
Ratios and
Formulas to Compare and Analyze Personal Statements
Debt ratio, Current ratio, Liquidity ratio
III.
Stage of
Life Estimates for Budget Amounts
IV.
Characteristics
of Successful Budgeting
Coming next week:
Finish Chapter 3
Chapter 5 (including Balancing Your Checkbook)
Chapter 6
Review Homework
Review for Test