This Document Contains Chapters 1 to 2 1 FINANCIAL PLANNING: AN INTRODUCTION CHAPTER OVERVIEW This chapter provides the foundation for Personal Finance and the study of financial planning. The chapter starts with a discussion of an overview of the financial planning process. This is followed by coverage of the person’s life situation, personal values, and economic factors that make up the financial planning environment. Next, the opportunity costs, or trade-offs, of decisions are considered in relation to personal and financial resources. Subsequently, the main components of financial planning (obtaining, planning, saving, borrowing, spending, managing risk, investing, and retirement and estate planning) are discussed. Finally, strategies for creating and using a financial plan are introduced. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Analyze the process for making personal financial decisions. Personal financial planning involves the following process: (1) determine your current financial situation; (2) develop financial goals; (3) identify alternative courses of action; (4) evaluate alternatives; (5) create and implement a financial action plan; and (6) re-evaluate and revise the financial plan. Obj. 2 Develop personal financial goals. Financial goals should (1) be realistic; (2) be stated in specific, measurable terms; (3) have a time frame; (4) indicate the type of action to be taken. Obj. 3 Assess personal and economic factors that influence personal financial planning. Financial decisions are affected by a person’s life situation (income, age, household size, health), personal values, and economic factors (prices, interest rates, and employment opportunities). Obj. 4 Determine personal and financial opportunity costs associated with personal financial decisions. Financial opportunity costs are based on the time value of money. Future value and present value calculations enable you to measure the increased value (or lost interest) that results from a saving, investing, borrowing, or purchasing decision. Obj. 5 Identify strategies for achieving personal financial goals for different life situation. Successful financial planning requires specific goals combined with spending, savings, investing, and borrowing strategies based on your personal situation and various social and economic factors. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 2). • Point out the learning objectives (p. 2) in an effort to highlight the key points in the chapter. • Ask students to provide examples of social and economic factors that have increased the importance of personal financial planning today. • Have students answer these three questions as individuals or in small discussion groups: 1. What do you currently know about personal financial planning? 2. What questions do you need answers for about personal finance? 3. How and where might you obtain answers to the questions you have about personal finance? CHAPTER 1 OUTLINE I. The Financial Planning Process Step 1: Determine Your Current Financial Situation Step 2: Develop Financial Goals Step 3: Identify Alternative Courses of Action Step 4: Evaluate Alternatives Step 5: Create and Implement a Financial Action Plan Step 6: Re-evaluate and Revise Your Plan II. Developing Personal Financial Goals A. Factors that Influence Your Financial Goals B. Life Situation C. Goal-Setting Guidelines III. The Influence of Economic Factors A. B. C. D. IV. Market Forces Financial Institutions Global Influences Economic Conditions Time Value of Money A. Interest Calculations B. Future Value C. Present Value V. Achieving Financial Goals A. Components of Personal Financial Planning B. Developing a Flexible Financial Plan C. Implementing Your Financial Plan VI. Appendix 1A: Financial Planners and Other Financial Planning Information Sources VII. Appendix 1B: The Time Value of Money: Future Value and Present Value Computations. CHAPTER 1 LECTURE OUTLINE Instructional Suggestions THE FINANCIAL PLANNING PROCESS (p. 3) • Personal financial planning is the process of managing your money to achieve personal economic satisfaction. • Discussion Question: Why do some decisions require more time and effort than others? • Class Exercise: Select a situation (such as obtaining funds to start a business or getting work-related experience without a job) and have students create a list of alternatives for this problem. • Text Highlight: Exhibit 12 (p. 6) provides information on four types of risks faced in many financial decisions. • Text Reference: The Appendix provides expanded discussion of financial planning information sources and using a financial planner. Step 1. Determine Your Current Financial Situation (p. 4) • Determine your current financial situation with regard to income, savings, living expenses, and debts. Step 2. Develop Financial Goals (p. 4) • Analyze your financial values and goals to set a course for action. Step 3. Identify Alternative Courses of Action (p. 5) • • Various alternatives associated with financial decision making are usually based on deciding to: ∗ Continue the same course of action; for example, you may determine that the amount saved each month is still appropriate. ∗ Expand the current situation; you may choose to save a greater amount each month. ∗ Change the current situation; you may decide to buy Canadian savings bonds instead of using a regular savings account. ∗ Take a new course of action; you conclude to use your monthly saving budget to pay off credit card debts. Creativity in decision making is vital to making effective choices. The more alternatives that are considered, the more likely a person or household will make wise financial choices. Step 4. Evaluate Alternatives (p. 5) • • Every decision closes off alternatives. The opportunity cost is what a person gives up by making a choice. This cost, commonly referred to as the trade-off of a decision, sometimes cannot always be measured in dollars. Decision making will be an ongoing part of your personal and financial existence. Thus, you will need to consider the lost opportunities that result from your decisions. • • Uncertainty is a par of every decision. In many financial decisions, identifying and evaluating risk is a difficult task. The best way to consider risk in such decisions is to gather information based on your experiences and those of others and refer to the research of financial planning sources. Relevant information is required at each stage of the financial planning process. Step 5. Create and Implement A Financial Action Plan (p. 7) • Develop a plan of action to achieve your goals. Step 6. Re-evaluate and Revise Your Plan (p. 8) • Decision making is a circular, ongoing process in which current decisions influence future choices. DEVELOPING PERSONAL FINANCIAL GOALS (p. 9) • ∗ ∗ ∗ Many Canadians have money problems due to: poor planning weak financial habits extensive numbers of marketplace influences in the form of advertising, selling efforts, and product availability. Types of Financial Goals (p. 9) • • • • • • Short-term goals are those to be achieved within the next year or so, such as saving for an annual vacation or paying off small debts. Intermediate goals have a time frame of two to five years. Long-term goals involve financial plans that may be more than five years off, such as retirement and college savings. Consumable-product goals usually occur on a periodic basis involving items used up relatively quickly, such as food, clothing, or entertainment spending. Durable-product goals usually involve infrequent, expensive items, such as appliances, motor vehicles, and sporting equipment. Most durable goals consist of tangible items. In contrast, however, many people overlook intangible goals. These goals may relate to personal relationships, health, education, and leisure. Goal setting for these life circumstances is also necessary for a person’s overall well-being. • Concept Check 1-1 (p. 9) CHAPTER 1 LECTURE OUTLINE Life Situation (p. 10) • • The personal factors include your age, income, size of household, and your attitudes and beliefs. Your life situation is affected by various personal events (see list on p. 11). Values are personal beliefs and ideas that a person considers correct, desirable, and important. Instructional Suggestions • Text Highlight: Exhibit 14 (p. 9) provides an overview of common financial goals and activities for different life situations. • Concept Check 1-2 (p. 11) • Discussion Question: How would various personal events (see list on p. 10) affect personal financial decisions? • Text Highlight: Use Exhibit 1-6 (p. 12) to point out how various economic factors affect financial decisions. • Assignment: Have students use old newspapers and information from friends and relatives to compare current prices with those of five or ten years ago. • Discussion Question: What types of attitudes in our society contribute to higher inflation? Goal-Setting Guidelines (p. 12) • Goal setting is at the center of financial decision making. Financial goals should: 1. be realistic 2. be stated in specific, measurable terms 3. have a time frame 4. indicate the type of action to be taken Economic Factors (p. 12) • • • • • • • • • Economic conditions (supply and demand, prices, and interest rates) and economic institutions (business, labor, and government) also affect personal finance. Economics is the study of how wealth is created and distributed. The price of a specific good or service is determined by supply and demand. Just as high demand for a consumer product forces its price up, a high demand for money forces interest rates up. This price of money reflects both the limited supply of money and the demand for it. Banks, trust companies, credit unions, insurance companies, and investment companies facilitate financial activities in our society. The Bank of Canada is our central banking system. It influences the money supply by borrowing funds, changing interest rates, and buying or selling government securities. The level of exports and imports, and the investment in our country by foreign companies affect the interest rates and prices in our society. Consumer prices, consumer spending, and interest rates affect the financial planning environment. Inflation is a rise in the general level of prices. In times of inflation, the buying power of the dollar decreases. The main cause of inflation is an increase in demand without a comparable increase in supply. Inflation is most harmful to people who live on fixed incomes. • • Consumer spending is the total demand for goods and services in the economy; this influences employment opportunities and potential for income. Interest rates represent the cost of money. Like everything else, money has a price. The forces of supply and demand influence interest rates. As the amount saved and invested by consumers increases the supply of money, interests rates tend to decrease. But as consumer, business, government, and foreign borrowing increases the demand for money, interest rates also tend to increase. • Discussion Question: Interest rates influence most aspects of our economic existence. Why are changing interest rates a significant component of personal financial planning? • Concept Check 1-3 (p. 16) • Concept Check 1-4 (p. 22) OPPORTUNITY COSTS & THE TIME VALUE OF MONEY (p. 16) • • • • • • Distinguish between personal and financial opportunity costs. Personal opportunity cost involves time that, when used for one activity, cannot be used for other activities. Other personal opportunity costs relate to health. The time value of money refers to the increase of an amount of money as a result of interest earned. Computation of interest is based on: ∗ the amount of the savings ∗ the annual interest rate ∗ the length of time the money remains deposited. Future value, also referred to as compounding, is the amount to which current savings will increase based on a certain interest rate and a certain time period. Future value calculations may be used for both a single amount and equal deposits. (See Exhibit 1-8.) Present value, also referred to as discounting, is the current value for a future sum based on a certain interest rate and a certain time period. Present value calculations may also be used for both a single amount and a series of amounts. (See Exhibit 1-8.) ACHIEVING FINANCIAL GOALS (p. 22) • Throughout life, each individual has needs that the intelligent use of available financial resources can satisfy. Financial planning involves deciding how to obtain, protect, and use those resources. Components of Personal Financial Planning (p. 22) • The eight major components of personal financial • Text Highlight: Exhibit 1-9 (p. 22) offers an overview of the course. planning are: 1. obtaining financial resources 2. planning for current living expenses and future financial security 3. saving for emergencies, unexpected bills, replacement of major items, and special purchases 4. borrowing in a responsible manner 5. spending to meet daily living needs 6. managing risk through insurance decisions 7. investing for long-term financial security 8. retirement and estate planning Developing a Flexible Financial Plan (p. 26) • • • A financial plan is a formalized report that summarizes your current financial situation, analyzes your financial needs, and recommends a direction for your financial activities. Financial activities may be organized on the basis of spending, saving, investing, and borrowing decisions. Text Highlight: Exhibit 110 (p. 26) presents an overview of a financial plan which includes examples of goals, short-term strategies, and long-term strategies. Implementing Your Financial Plan (p. 26) • • The most important strategy for success is the development of financial habits that will contribute to both short-term satisfaction and long-term financial security. Using a set spending plan will help you stay within your income while you save and invest for the future. • Concept Check 1-5 (p. 27) CONCLUDING ACTIVITIES • Point out the chapter summary (p. 27) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. • Have students start a journal of personal finance information and readings that they encounter in the daily newspaper, news magazines, personal business periodicals, and on the World Wide Web. • Have students create a case problem for class use based on a personal financial experience they have experienced or observed. CHAPTER 1 QUIZ ANSWERS True-False 1. T 2. F 3. T 4. T 5. T 6. F 7. F Multiple Choice 8. B 9. D 10. C 11. A 12. D 13. A 14. B Name ________________________________________ Date____________________________ CHAPTER 1 QUIZ TRUE-FALSE _____1. A major purpose of personal financial planning is future economic security. _____2. Personal financial planning starts by creating a plan of action. _____3. Interest rate risk and inflation risk can affect any financial decision. _____4. Inflation reduces the buying power of a dollar. _____5. Changes in interest rates affect your cost of borrowing and your return on investments, thus it is one of the risks you face when making financial decisions. Intermediate goals have a time frame of two to seven years. _____6. _____7. The life cycle approach is the idea that an average person goes through three basic stages in personal financial management. MULTIPLE CHOICE _____8. Opportunity cost refers to a. your personal values. b. trade-offs when a decision is made. c. current economic conditions. d. commonly accepted financial goals. _____9. The first step in the financial planning process is to a. create a financial plan of action. b. develop financial goals. c. evaluate and revise your actions. d. determine your current financial situation. _____10. You need a place to live. You have determined that you can continue to rent an apartment, move in with your parents, look at buying a condominium or look at buying a house. This is an example of which step in the financial planning process? a. Determining your current financial position b. Developing financial goals c. Identifying alternative courses of action d. Evaluating alternatives _____11. You want to budget your money so that you can see a movie once a month. This is an example of: a. A consumable products financial goal b. A durable goods financial goal c. An intangible goal d. A long term financial goal _____12. Economics refers to a. setting personal financial goals. b. planning future financial security. c. changes in prices due to supply and demand. d. the study of wealth. _____13. Career planning is the part of the __________ component of financial planning. a. obtaining b. sharing c. saving d. planning _____14. Financial strategies refer to a. the process of predicting your future financial situation. b. courses of action to achieve financial goals. c. resources an individual has available for investing. d. ideas or principles that are considered correct, desirable, or important. SUPPLEMENTARY LECTURE Financial Planning Through the Ages People in their 20s-30s should… • start saving regularly and invest for the long haul for retirement, children’s education, or a down payment on a house. • make contributions to tax-deductible retirement plans. • create a diversified portfolio of common stock. • have adequate health and property insurance, however, consider going without life insurance if they have no dependents. People in their 40s-50s should… • maximize contributions to tax-advantaged retirement plans. • plan for adequate funds for children’s college education. • use stocks and stock funds for the largest share of long-term investments. • review life, health, and home insurance for adequate coverage. People 50-plus should… • not feel they have to preserve all their wealth for others. • • • • be careful about retiring too young and not have adequate funds for what may be 30 more years. maintain earnings potential with a part-time job after retirement. not put all funds in fixed-income securities such as bank accounts and bonds. consider a long-term care insurance policy. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 1-1 (p. 9) 1. What steps should we take in developing our financial plan? Every decision involves identification of the basic problem, generation of alternative courses of action, consideration of personal, social, and economic factors that influence the decision, evaluation of alternative courses of action, selection of the most appropriate one, and implementation of the course of action selected. 2. What are some risks are associated with financial decisions? Common risks associated with financial decisions include inflation risk, interest-rate risk, economic risk, and personal risk (Exhibit 1-2, p. 6). 3. What are some common sources of financial planning information? The common sources of personal financial planning information are financial specialists, printed materials, school courses and seminars, financial institutions, and computer software. Refer students to Appendix 1 of the textbook for additional information. The most helpful information sources will depend on a person’s need and situation. Magazine articles may be helpful to some, while others may require a computerized information system to gather investment data. 4. Why should you re-evaluate your actions after making personal financial decisions? Too often people think that once a plan is implemented, the work is over. However, we must continually re-evaluate our decisions since many factors (our life situation, the economy, AND personal goals) can change. In addition, we reassess the situation since the alternative selected may not turn out exactly as planned.) 5. What Web site feature of www.cafp.org or www.canadianfinance.com would provide assistance with your financial decisions? Answers will vary. Students might refer to investment advice, money management tips, or buying on credit warnings. Concept Check 1-2 (p. 12) 1. What are examples of long-term goals? Long-term goals are financial objectives more than just a few years off (usually more than five years), such as retirement savings, money for children’s college education, or other long-term savings goals. 2. What are the four main characteristics of useful financial goals? Useful financial goals should (1) be realistic; (2) be stated in specific, measurable terms; (3) have a time orientation; and (4) imply the type of action to be taken. (p. 12) 3. How does your life situation affect your financial goals? The financial goals we set for ourselves, ultimately the way we spend and save our money vary greatly depending on our life situation. For example, an unmarried 25 year old with no children may be willing to take a few more risks and spend a larger amount of money since he/she only has him/herself to support. The opposite is true for a married, 45 year old with two children. He/she will likely spend money more wisely and take great consideration when presented with a risky situation. Concept Check 1-3 (p. 16) 1. How might the uncertainty of inflation make personal financial planning difficult? Inflation can affect financial planning with unexpected higher prices for which a budget was not planned. Or, expected inflation will mean higher interest rates as a lender is concerned about being paid back in dollars with less buying power. 2. What factors influence the level of interest rates? Interest rates are affected by the supply and demand for money, along with the risk of lending and borrowing money. Concept Check 1-4 (p. 22) 1. How can you use future value and present value computations to measure the opportunity cost of a financial decision? Time value of money calculations (future value and present value) are used to compute interest earned and the value of a sum of money at a later date. (See text pages 16-20; Appendix 1B and the “Financial Planning Calculations” feature on page 21). 2. Use the time value of money tables in Exhibit 1-8 to calculate the following: a. The future value of $100 at 7 percent in 10 years. $100 × 1.967 = $196.70 b. The future value of $100 a year for 6 years earning 6 percent. $100 × 6.975 = $697.50 c. The present value of $500 received in 8 years with an interest rate of 8 percent. $500 × 0.54 = $270 Concept Check 1-5 (p. 27) 1. What are the main components of personal financial planning? The main components of financial planning are obtaining, planning, saving, borrowing, spending, managing risk, investing, and retirement and estate planning. (p. 22) 2. What is the purpose of a financial plan? A financial plan provides a person with an overall summary of current and desired financial situations along with planned actions to reach those goals. 3. Identify some common actions taken to achieve financial goals. Common financial planning strategies include developing a savings plan, investing in stocks and bonds, purchasing real estate for investment purposes, planning investment and other financial decisions with taxes in mind, limit the use of credit, and investing in a variety of investment vehicles. OPENING CASE QUESTIONS (p. 2) 1. How did Karen benefit from her parents’ advice and her own financial planning? Following advice from her parents, Karen consulted a financial planner to help her invest her money. By doing this, Karen is taking her first steps in personal financial planning which will help her get full satisfaction from each available dollar. 2. What decisions does Karen need to make regarding her future? Karen has already determined her current financial situation and financial goals. Her next step is to identify alternative courses of action and evaluate these alternatives so that she is able to create and implement a financial action plan. 3. How could various personal and economic factors influence Karen’s financial planning? Many factors can influence Karen’s financial planning, for example, graduation, engagement or a change in health can influence her spending and saving patterns and financial needs. In addition, economic factors such as inflation and interest rates can have a large effect on the value of her investments and her borrowing power. 4. What would be the value of Karen’s $15,000 in three years if it earned an annual interest rate of 7 percent? The value of Karen’s $15,000 in three years at an annual interest rate of 7 percent would be $18,375 according to the time value of money table Exhibit A-1 in Appendix A (15,000 x 1.225). 5. Conduct a Web search to obtain information that Karen may find useful. Recommend a Web site that they might consult when making financial planning decisions. Student answers will vary. Some possibilities are www.cafp.org and www.canadianfinance.com. FINANCIAL PLANNING PROBLEMS (p. 28) (Note: Some of these problems require the use of the time value of money tables in Appendix 1B) 1. Ben Collins plans to buy a house for $65,000. If that real estate property is expected to increase in value 5 percent each year, what would its approximate value be seven years from now? $65,000 × 1.407 = $91,455 2. Using the rule of 72, approximate the following amounts: a. If land in an area is increasing six percent a year, how long will it take for property values to double? About 12 years (72 / 6) b. If you earn ten percent on your investments, how long would it take for your money to double? About 7.2 years (72 / 10) c. At an annual interest rate of five percent, how long would it take for your savings to double? About 14.4 years (72 / 5) 3. In the late 1990, selected automobiles had an average cost of $12,000. The average cost of those same motor vehicles 10 years later is $16,000. What was the rate of increase for this item between the two time periods? ($16,000 - $12,000) / $12,000 = .3333 (33.33 percent) 4. How much should you deposit today to have $7,000 in five years? 7000/(1.03)5 = $6,038.26 5. The Benevolent Company has agreed to lend you funds to complete the last year of your degree. The Company will lend you $2,400 today, if you agree to repay a lump sum of $4,000 4 years from now. What is the approximate annual rate of interest that Benevolent is charging you? (Obj. 3) $2400 = 4000 (DF i%, 4); Solution: I% = 14% 6. How long will it take to double your money with a growth rate of 5 percent and 12 percent respectively? (Obj. 3) 72/5 = 14.4 Years. 72/12 = 6 Years. 7. You discover $40,000 under your pillow, which can be invested at a rate of 18% per year. If you spend $11,435 per year, how long will the money last? (Obj. 3) $40,000 = $11,435 (PVAF 18%, n) = (PVAF 18%, n) Solution n= 6 years. 8. What annual payment would be required to pay off a four year, $20,000 loan if the interest rate being charged is 7%. (Obj. 3) Payments = [$20,000 / (PVAF 4, 7%) ] = $20,000 / 3.387 = $5905 9. You have $100,000 to purchase a 20-year annuity at 5 percent. What will be the annual payment from the annuity? $100,000 = Payment x PVA factor (Exhibit 1B-4) and Payment = $100,000 ÷ 12.462 = $8,024. 10. Using time value of money tables, calculate the following: a. The future value of $450 six years from now at 7 percent. $450 × 1.501 = $675.45 b. The future value of $800 saved each year for 10 years at 8 percent. $800 × 14.487 = $11,589.60 c. The amount that a person would have to deposit today (present value) at a 6 percent interest rate in order to have $1,000 five years from now. $1,000 × .747 = $747 d. The amount that a person would have to deposit today in order to be able to take out $500 a year for 10 years from an account earning 8 percent. $500 × 6.710 = $3,355 11. Elaine Romberg prepares her own income tax return each year. A tax preparer would charge her $60 for this service. Over a period of 10 years, how much does Elaine gain from preparing her own tax return (assumes that she earn 6 percent on a savings account)? $60 × 13.181 = $790.86 12. You have $800 in a savings account which earns 6% interest compounded annually. How much additional interest would you earn in 2 years if you moved the $800 to an account which earns 6% compounded semi-annually? $800 (1.06)2 = $898.88 $800 (1 + .06/2)2X2 = $900.41 Difference = $1.53 13. What is the future value of $20,000 received in 10 years if it is invested at 6% compounded annually for the next six years and at 5% compounded semi annually for the remaining four years? FV = $20,000 (FV 6, 6%)(FV 8, 2.5%) = $34,567 14. Your parents have promised to give you a graduation present of $5,000 when you graduate in four years time. If interest rates stay at 6% compounded annually for the next four years, how much is this money worth in today’s dollars? PV = $5,000 (.792) = $3,960 FINANCIAL PLANNING ACTIVITIES (p. 29) 1. Using Web sites such as www.canadianfinance.com, www.cafp.org, www.quicken.intuit.ca, and search engines, obtain information about commonly suggested actions related to various personal financial planning decisions. What are some of the best sources of information on the Internet to assist you with financial planning? An extensive amount of personal finance information is available on the Internet. Students should also be referred to the end of each chapter for some of the most useful Web sites. 2. Survey friends, relatives, and others to determine the process they use when making financial decisions. How do these people measure risk when making financial decisions? This activity can be beneficial to both students and to whom they talk. Be sure students do not ask questions that are too personal. It can be helpful to have students ask questions such as “What do you believe are the main financial problems faced by individuals and families?” or “How should risk be considered when selecting an investment?” With this format, the people being interviewed do not feel pressured into talking about their personal situations. 3. Prepare a list of financial planning specialists (investment advisors, credit counsellors, insurance agents, real estate brokers, tax preparers) in your community who can assist people with personal financial planning. Prepare a list of questions take might be asked of these financial planning professionals by (a) a young person just starting out on his or her own, (b) a young couple planning for their children’s education and for their own retirement, and (c) a person nearing retirement. Refer students to page 7 in the text as well as Appendix 1B. These references provide an extensive basis for obtaining information regarding the many aspects of financial planning. Point out to students the importance of being able to find the answer to a question rather than trying to learn everything since various factors (laws, economic conditions, and personal situations) change quite frequently. 4. Create one short-term and one long-term goal for people in these life situations: (a) a young single person, (b) a single parent with an eight year old child, (c) a married person with no children, and (d) a retired person. Be sure students consider life situation, opportunity costs, and other factors. Differences among the groups mentioned will relate to their values, financial needs, and goals. These factors will influence how money is spent, saved, borrowed, and invested as well as the trade-offs that are present with every financial decision. Financial needs are different for people with children than people without children, and the risk associated with a decision investment is different for a young person with few financial responsibilities than a retired person with no other income source. 5. Ask friends, relatives, and others how their spending, saving, and borrowing activities changed when they decided to continue their education, change careers, or have children. This activity will provide students with an opportunity to better understand the impact of changing life situations on personal financial planning. 6. Use library resources or Web sites to determine recent trends in interest rates, inflation, and other economic indicators. Information about the Consumer Price Index (measuring changes in the cost of living) may be obtained at www.statcan.com. Report how this economic information might affect your financial planning decisions. This activity can help students appreciate the influence of the overall economy on personal financial decisions. Exhibit 1-6 provides specific examples for this activity. Students may also ask people questions such as “How do higher consumer prices and interest rates affect the financial situation and decisions of people in our society?” 7. What actions would be necessary to compare a financial planner that advertises “One Low Fee Is Charged to Develop Your Personal Financial Plan” and one that advertises “You Are Not Charged A Fee, My Services Are Covered By The Investment Company for Which I Work”. Students should consider the reputation of the organizations for which the financial planners work. In addition, students should consider the questions listed in Appendix 1A of this chapter. 8. What is the relationship between current interest rates and financial opportunity costs? Using time value of money calculations, state one or more goals in terms of an annual savings amount and the future value of this savings fund. This activity can help students start to apply the skills associated with goal setting and time value of money. Students should be encouraged to develop specific goals that can be measured using future value and present value calculations. 9. Visit software retailers to obtain information about the features and costs of various personal financial planning activities. Information about programs such as Microsoft Money and Quicken may be obtained on the Internet. This assignment can assist students with developing an understanding of using the Internet and software for planning and implementing personal financial goals. LIFE SITUATION CASE Triple Trouble for the “Sandwich Generation” (p. 30) 1. What actions have the Blakes taken that would be considered to be wise financial planning choices? Wise financial actions by the Blakes include funds set aside for the education of their children and deposits to a retirement fund. 2. What areas of financial concern do the Blakes face? What actions might be appropriate to address these concerns? The financial burdens of raising children and paying for their education, the care of aging parents, and setting aside funds for retirement. 3. Using time value of money calculations (tables in Appendix 1B), compute the following: a. At 12 percent, what would be the value of the $22,000 education funds in three years? $22,000 × 1.405 = $30,910 b. If the cost of long term care is increasing at 7 percent a year, what will be the approximate monthly cost for Fran’s mother eight years from now? $2,050 × 1.718 = $3,522 c. Fran and Ed plan to deposit $1,500 a year to their RRSPs for 35 years. If they earn an average annual return of 9 percent, what would be the value of their RRSPs after 35 years? $1,500 × 215.7108 (FVA 9%, 35 years) = $323,566 2 MONEY MANAGEMENT STRATEGY: FINANCIAL STATEMENTS AND BUDGETING CHAPTER OVERVIEW Successful money management is based on organized financial records, accurate personal financial statements, and effective budgeting. This chapter offers a discussion of the importance and type of financial documents. This is followed by an explanation of the components and procedures for preparing personal financial statements—the balance sheet and the cash flow statement. Next, the chapter covers the basics of developing, implementing, and evaluating a budget. Finally, savings techniques for achieving financial goals are discussed. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Recognize the relationships among financial documents and money management activities. Successful money management requires effective coordination of personal financial records, personal financial statements, and budgeting activities. Obj. 2 Create a system for maintaining personal financial records. An organized system of financial records and documents is the foundation of effective money management. This system should provide ease of access as well as security for financial documents that may be impossible to replace. Obj. 3 Develop a personal balance sheet and cash flow statement. A personal balance sheet, also known as a net worth statement, is prepared by listing all items of value (assets) and all amounts owed to others (liabilities). The difference between your total assets and your total liabilities is your net worth. A cash flow statement, also called a personal income and expenditure statement, is a summary of cash receipts and payments for a given period, such as a month or a year. This report provides data on your income and spending patterns. Obj. 4 Create and implement a budget. The budgeting process involves four phases: (1) assessing your current personal and financial situation; (2) planning your financial direction by setting financial goals and creating budget allowances; (3) implementing your budget; and (4) evaluating your budgeting program. Obj. 5 Calculate needed savings for achieving goals. Future value and present value calculations may be used to compute the increased value of savings for achieving financial goals. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 47). • Point out the learning objectives (p. 47) in an effort to highlight the key points in the chapter. • Ask students to provide examples of problems that could result from not having a definite system for storing personal financial records and documents. • Point out common methods of budgeting that help a household achieve financial goals and prevent money problems. CHAPTER 2 OUTLINE I. Planning for Successful Money Management A. Opportunity Cost and Money Management B. Components of Money Management II. A System for Personal Financial Records III. Personal Financial Statements for Measuring Financial Progress A. The Personal Balance Sheet: Where Are You Now? B. The Cash Flow Statement: Where Did Your Money Go? C. Evaluating Your Financial Position IV. Budgeting for Skilled Money Management A. Starting the Budgeting Process B. Characteristics of Successful Budgeting V. Savings Techniques to Achieve Financial Goals A. Selecting a Savings Technique B. Calculating Savings Amounts C. Two-Income Households CHAPTER 2 LECTURE OUTLINE PLANNING FOR SUCCESSFUL MONEY MANAGEMENT (p. 50) • Instructional Suggestions • Text Highlight: The list on page 50 points out trade-offs associated with money management activities and decisions. • Concept Check 2-1 (p. 49) • Exercise: Have students suggest methods that could be used to organize and quickly access personal financial documents and records. • Concept Check 2-2 (p. 50) Money management refers to the day-to-day financial activities necessary to handle current personal economic resources while working toward long-term financial security. Opportunity Cost and Money Management (p. 48) • Trade-offs are associated with every spending, saving, borrowing, and investing decision. Opportunity costs may be viewed in terms of both personal and financial resources. Time spent studying, working, or shopping cannot be used for other activities. Money allocated for one purpose cannot be used for another. Components of Money Management (p. 48) • Personal financial records, financial statements, and spending plans (budget) are the foundation for planning and implementing money management activities. A SYSTEM FOR PERSONAL FINANCIAL RECORDS (p. 49) • Organized money management requires a system of financial records including the following categories: 1. personal and employment records 2. money management records 3. tax records 4. financial services records 5. credit records 6. consumer purchase and automobile records 7. housing records 8. insurance records 9. investment records 10. estate planning and retirement records PERSONAL FINANCIAL STATEMENTS FOR MEASURING FINANCIAL PROGRESS (p. 51) • A personal balance sheet and cash flow statement provide information about a person’s or household’s current financial position and a summary of current income and spending. The Personal Balance Sheet: Where Are You Now? (p. 51) • • • • • • • • • • • • • A balance sheet, also known as a net worth statement, specifies what you own and what you owe. Items of value minus amounts owed equals net worth. Assets, the first item on the balance sheet, are cash and other property that has a monetary value. Liquid assets are cash and items of value that can easily be converted into cash. Real estate includes a home, condominium, vacation property, or other land that a person or family owns. Personal possessions are the major portion of assets for most families. Investment assets consist of money set aside for longterm financial needs. Liabilities are amounts owed to others but do not include items not yet due, such as next month’s rent. Current liabilities are debts that must be paid within a short time, usually less than a year. Long-term liabilities are debts that are not required to be paid in full until more than a year from now. Your net worth is the difference between your total assets and your total liabilities: Assets - Liabilities = Net worth The balance sheet of a business is usually expressed as: Assets = Liabilities + Net worth Insolvency is the inability to pay debts when they are due; it occurs when a person’s liabilities far exceed his or her available assets. The Cash Flow Statement: Where Did Your Money Go? (p. 53) • • • Cash flow is the actual inflow and outflow of cash during a given time period. A cash flow statement is a summary of cash receipts and payments for a given period, such as a month or a year. Income is the inflows of cash to an individual or a household. For most people, the main source of • Discussion Question: How accurate is a balance sheet for measuring the financial progress of an individual or household? • • • • • • income is money received from a job. Cash payments for living expenses and other items make up the second component of a cash flow statement. Fixed expenses are payments that do not vary from month to month. Variable expenses are flexible payments that change from month to month. The difference between your income and your cash outflows can be either a positive (surplus) or negative (deficit) cash flow. A deficit exists if more cash goes out than comes in during a month. This amount must be made up by withdrawals from savings or borrowing. Take-home pay or disposable income is a person’s earnings after deductions for taxes and other items. Discretionary income is money left over after payment for necessities such as housing and food has been made. • Discussion Question: What information does a cash flow statement provide that is not available on a personal balance sheet? • Exercise: Have students list all the sources of income (cash inflows available for spending) for people in our society. • Discussion Question: What relationship exists between the balance sheet and cash flow statement? • Concept Check 2-3 (p. 57) Analyzing Your Current Financial Situation (p. 56) • • • • • • A person or household experiences financial improvement if net worth increases over time. Debt ratio—liabilities divided by net worth—may be used to indicate a person’s financial situation; a low debt ratio is desired. Current ratio—liquid assets divided by current liabilities—how well a person will be able to pay upcoming debts. Liquidity ratio—liquid assets divided by monthly expenses—indicates the number of months that expenses can be paid if an emergency arises. Debt-payment ratio—monthly credit payments divided by take-home pay—provides an indication of how much of a person’s earnings goes for debt payments (excluding a home mortgage). Savings ratio—amount saved each month divided by gross income—financial experts recommend a savings rate of about 10 percent. BUDGETING FOR SKILLED MONEY MANAGEMENT (p. 59) • A budget, or spending plan, is necessary for successful financial planning. The main purposes of a budget are to help you 1. live within your income 2. spend your money wisely 3. reach your financial goals 4. prepare for financial emergencies 5. develop wise financial management habits • Discussion Question: Is every individual and household forced to budget, with some more organized and planned than others? Starting the Budgeting Process (p. 58) • • Exercise: Have students suggest common financial goals. • Text Highlight: Exhibit 2-6 (page 64) provides budget share of major spending category by income quintile • Exercise: Have students allocate budget categories (using percentages) for different household situations. • A personal balance sheet is an effective scorecard for assessing personal economic progress. Your lifestyle is how you spend your time and money and is strongly influenced by your career, family, and personal values. Step 1. Setting Financial Goals (p. 59) • • Financial goals are plans for future activities that require you to plan spending, savings, and investing. How much you budget for various items will depend on current needs and plans for the future. Sources that can assist with planning your spending include: ∗ your cash flow statement ∗ sample budgets from government reports ∗ articles in personal financial planning magazines ∗ estimates of future income and expected inflation Step 2. Estimating Income (p. 59) • • Available money should be estimated for a given time period—such as a month. Income variations (due to seasonal work or sales commissions) should be based on the recent past and realistic expectations. Step 3. Budgeting Emergency Fund and Savings (p. 59) • An emergency fund and savings for irregular payments should be first set aside to avoid not having anything left for savings. Step 4. Budgeting Fixed Expenses (p. 61) • • • Definite obligations (rent, mortgage, and credit payments) should be allocated first. Assigning amounts to spending categories can be based on your cash flow statement, government data, current magazine articles, and estimates of future income and expenses. A “spending diary” of past expenses can also assist with this task. Step 5. Budgeting Variable Expenses (p. 61) • • Planning for variable expenses is more difficult than fixed expenses. These expenses will fluctuate based on household situation, time of the year, health, economic conditions, and other factors. Step 6. Recording Spending Amounts (p. 62) • A budget variance is the difference between amount budgeted and the actual amount received or spent. A deficit exists when actual spending exceeds planned spending. A surplus is when actual spending is less than planned spending. Step 7. Reviewing Spending and Saving Patterns (p. 62) • • The results of your budget may be obvious—having extra cash, falling behind in payments. Or the results may need to be reviewed in detail to determine areas of needed changes. The most common overspending areas are entertainment and food, especially awayfrom-home meals. At this point of the budgeting process, you should also evaluate, reassess, and revise your financial goals. Characteristics of Successful Budgeting (p. 65) • A successful budget should be: ∗ well-planned ∗ realistic ∗ flexible ∗ clearly communicated • Discussion Question: What factors can contribute to unsuccessful budgeting? How can these situations be avoided? • Concept Check 2-4 (p. 65) • Current Example: People unable to save regularly are usually: ∗ individuals without specific savings goals ∗ people who always seem to use up savings for unexpected expenses ∗ those who overuse credit SAVING TO ACHIEVE FINANCIAL GOALS (p. 65) • Common reasons for saving include: ∗ to set aside money for irregular or unexpected expenses ∗ to replace expensive items ∗ to buy special items ∗ to provide for long-term expenses ∗ to earn interest for additional income Selecting a Savings Technique (p. 66) • Since most people find saving difficult, financial advisers suggest several methods: ∗ write a check each payday and deposit it in a ∗ ∗ ∗ ∗ distant financial institution use payroll deduction save coins spend less on certain items ∗ people who buy to have the same things as others individuals who lack common financial goals with other family members Calculating Savings Amounts (p. 66) • To achieve financial objectives, you should convert your savings goals into specific amounts. • Your use of an interest-earning savings plan is vital to the growth of your money and the achievement of your financial goals. Two-Income households • Dual income households should convert to alternative budgeting strategies, such as: ∗ Pool Incomes ∗ Share bills ∗ 50/50 ∗ Proportionate contributions • Concept Check 2-5 (p. 67) CONCLUDING ACTIVITIES • Point out the chapter summary (p. 69) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 2 QUIZ ANSWERS True-False 1. F 2. T 3. T 4. T 5. T 6. T 7. F 8. T Multiple Choice 9. A 10. C 11. D 12. B 13. C 14. B 15. C 16. B Name ________________________________________ Date____________________________ CHAPTER 2 QUIZ TRUE-FALSE _____1. Most financial records should be kept in a safe-deposit box. _____2. A personal balance sheet reports the financial position of a person or family on a given date. _____3. Current liabilities represent amounts owed to others that must be paid within the next year. _____4. Planning your spending is essential to successful personal financial management. _____5. A budget deficit exists when actual spending exceeds projected spending. _____6. You have a positive net worth when the value of your assets is larger than the value of your debt. Financial advisors suggest that a good rule of thumb for an emergency fund is to have three to six weeks of living expenses saved. Spending less than your income will increase net worth. _____7. _____8. MULTIPLE CHOICE _____9. A(n) __________ is a specific plan for spending. a. budget b. balance sheet c. income statement d. bank statement _____10. An example of a liquid asset would be a. a home. b. an automobile. c. a checking account. d. retirement account. _____11. __________ represent amounts owed to others. a. Current assets b. Expenses c. Mutual funds d. Liabilities _____12. A personal cash flow statement presents a. amounts earned from savings. b. income and payments. c. assets and liabilities. d. amounts owed to others. _____13. Which of the following will not increase your net worth? a. increasing savings. b. decreasing spending. c. reducing value of assets owned. d. reducing amounts owed. _____14. Which of the following is part of the investment records you should keep? a. Home repair records b. Records of mutual fund purchases c. Warranties on major appliances d. Checking account statements _____15. _________ are those liabilities that you do not have to pay in full until more than a year from now. a. Liquid Assets b. Personal Possessions c. Long term liabilities d. Current liabilities _____16. Definite financial obligations are referred to as a. variable expenses. b. fixed expenses. c. equity. d. investment assets. SUPPLEMENTARY LECTURE Financial Ratios to Measure and Evaluate Financial Progress Type A. Debt ratio Calculations Example liabilities divided by net worth $50,000/$40,000 = 1.25 Interpretation: These items express the relationship between your debts and personal net worth. A lower debt ratio is desired. B. Current ratio liquid assets divided by current liabilities $7,000/$4,000 = 1.75 Interpretation: Indicates how well you will be able to pay upcoming debts. A higher number is more desirable. C. Liquidity ratio liquid assets divided by monthly expenses $7,000/$2,800 = 2.5 Interpretation: Indicates the number of months a person will be able to pay expenses if an emergency arises. Again, a higher number is desired especially if uncertainty exists regarding continual employment. D. Solvency ratio total assets divided by total liabilities $98,000/$67,000 = 1.46 Interpretation: Shows the relationship between the value of assets and what is owed. A higher number is desired. E. Debt Payments ratio monthly credit payments divided by monthly take $450/$2,500 = 0.18 Interpretation: Expresses portion of monthly earnings going for credit payments. A lower ratio is desired. F. Savings ratio additions to savings plans divided by take-home pay $2,080/$32,800 = 0.063 Interpretation: Presents the portion of annual earnings that has been saved. G. Investment assets ratio investment assets divided by net worth $77,000/$101,000 = 0.76 Interpretation: Indicates portion of net worth that contributes to long-term financial goals. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 2-1 (p. 49) 1. What opportunity costs are associated with money management activities? • Spending money on current living expenses reduces the amount that can be used for saving and investing toward long-term financial security. • Saving and investing for the future reduce the amount that can be spent now. • Buying on credit results in payments later and a reduction in the amount of future income available for spending. • Using savings for purchases results in lost interest earnings and an inability to use savings for other purposes. • Engaging in comparison shopping can save money and improve the quality of purchases but uses up something of value that cannot be replaced—your time. • Non-monetary opportunity costs associated with money management activities include time and effort for creating and maintaining a financial record keeping system; a personal decision to have an organized financial existence; possible disagreements among family members due to poor financial records; or weak budgeting techniques. (p. 50) 2. What are the three major money management activities? • The three major money management activities are (1) storing and maintaining financial records and documents, (2) creating personal financial statements, and (3) creating and implementing a budget. (p. 50) Concept Check 2-2 (p. 50) 1. What are the benefits of an organized system of financial records and documents? The benefits of an organized financial record system are: • Handling daily business affairs, including paying bills on time. • Planning and measuring financial progress. • Completing required tax reports. • Making effective investment decisions. • Determining available resources for current and future buying. 2. What suggestions would you give for creating a system for organizing and storing financial records and documents? Most financial documents will either be kept in a home file or a safe-deposit box depending on the importance and need to access the record. Documents that are difficult to replace (birth certificates, contracts, stock certificates) should be kept in a safe-deposit box. (Exhibit 2-2, p. 50) 3. What influences the length of time you should keep financial records and documents? If the documents will need to prove ownership or are related to certain tax matters, they should be kept almost indefinitely. Normally a tax audit will go back only three years, but under certain circumstances, the Revenue Canada may request information six years back. (p. 49) Concept Check 2-3 (p. 57) 1. What are the main purposes of personal financial statements? • Report your current financial position in relation to the value of the items you own and the amounts you owe. • Measure your progress toward your financial goals. • Maintain information on your financial activities. • Provide data that you can use when preparing tax forms or applying for credit. (p. 51) 2. What does a personal balance sheet tell about your financial situation? A balance sheet consists of assets (items of value), liabilities (amounts owed to others), and net worth (the difference between the total assets and total liabilities. (pp. 51-53) 3. How can you use a balance sheet for personal financial planning? Net worth can be used to measure overall progress of your personal financial planning activities. Reductions in your debts can also be an indication of financial progress. (pp. 51-53) 4. What information does a cash flow statement present? The cash flow statement summarizes actual inflows and outflows of cash during a given time period. The cash flow statement is a report of your spending patterns and can be used to create budget amounts for various expense categories. (pp.53-55). Concept Check 2-4 (p. 65) 1. What are the main purposes of a budget? The main purposes of a budget are to help you: • Live within your income. • Spend your money wisely. • Reach your financial goals. • Prepare for financial emergencies. • Develop wise financial management habits. 2. How does a person’s life situation affect goal setting and amounts allocated for various budget categories? Different life situations will affect household goals and plans for spending based on needs and desires of those involved. Delayed marriage might mean more spending for travel and leisure; deferred parenthood might be due to plans for advanced career training and returning to school; divorce will affect housing size needs and could mean child care expenses. 3. What are the main steps in creating a budget? The main steps in creating a budget are (1) set financial goals, (2) estimate income, (3) budgeting emergency fund and savings, (4) budget fixed expenses, (5) budget variable expenses, (6) record actual cash inflows and outflows, and compare actual amounts to budgeted amounts, and (7) reviewing spending and saving patterns. (pp. 59-61) 4. What are commonly recommended qualities of a successful budget? A successful budget is usually well planned, realistic, flexible, and clearly communicated. 5. What actions might you take when evaluating your budgeting program? An evaluation of a budget situation may require reduced spending or efforts to increase income. Concept Check 2-5 (p. 67) 1. What are some suggested methods to make saving easy? Suggested savings methods include “pay yourself first,” payroll deduction, saving coins, and eliminating spending on a certain item. (p. 66) 2. What methods are available to calculate amounts needed to reach savings goals? Future value and present value calculations may be used to determine amounts needed to reach savings goals. OPENING CASE QUESTIONS (p. 47) 1. What would Ben and Yolanda learn by sorting their expenses into various categories? What categories should they use? This effort should give Ben and Yolanda information about their spending habits. Commonly used categories may be found in Exhibit 2-4. 2. How can knowing where the money goes help Ben and Yolanda plan their spending? This process will help them decide if their spending is going for desired purchases. It could be the basis of planning their spending to meet specific financial goals. 3. What financial goals might Ben and Yolanda consider to address some of their money management concerns? They might consider creating a budget, they may reduce spending or use of credit card, or develop a savings plan. 4. Locate a Web site that would help Ben and Yolanda improve their money management skills. Many Web sites are available including www.canadianfinance.com, www.quicken.com, and www.webfin.com, as well as the Web sites of personal finance magazines. FINANCIAL PLANNING PROBLEMS (p. 68) 1. Based on the procedures presented in the chapter, prepare your current personal balance sheet and a cash flow statement for the next month. A balance sheet represents the financial position of an individual or family on a given date; refer to Exhibit 2-3 for the process of preparing one and an example. A cash flow statement covers income and payments for a certain time period (such as a month); refer to Exhibit 2-4 for the process and an example. 2. Based on the following data, compute the total assets, total liabilities, and net worth. Liquid assets, $3,670 Investment assets, $8,340 Current liabilities, $2,670 Household assets, $89,890 Long-term liabilities, $76,230 Total assets = $101,900 ($3,670 + 8,340 + 89,890) Total liabilities = $78,900 ($2,670 + $76,230 Net worth = $23,000 ($101,900 - $78,900) 3. Use the following data and calculate the total assets, total liabilities and the net worth. (Obj. 3) Stock Investments = $1800 Credit card balance = $500 Jewellery = $1000 House furniture = $800 Consumer loan balance = $600 Current value of automobile = $6000 Cash in chequing account = $1200 Balance in savings account = $3500 Other liabilities = $750 Total Assets = $14,300 ($1800 + $1000 + $800 + $6000 + $1200 + $3500) Total Liabilities = $1850 ($500 + $600 + $750) Net Worth = $12,450 ($14,300 - $1850) 4. Use the following items to prepare a balance sheet and a cash flow statement. Determine the total assets, total liabilities, net worth, total cash inflows, and total cash outflows. Rent for the month, $650 Cash in chequing account, $450 Spending for food, $345 Current value of automobile, $7,800 Credit card balance, $235 Auto insurance, $230 Stereo equipment, $2,350 Lunches/parking at work, $180 Home computer, $1,500 Clothing purchase, $110 Monthly take-home salary, $1,950 Savings account balance, $1,890 Balance of educational loan, $2,160 Telephone bill paid for month, $65 Loan payment, $80 Household possessions, $3,400 Payment for electricity, $90 Donations, $70 Value of stock investment, $860 Restaurant spending, $130 Total assets = $18,250 ($450 + 1,890 + 7,800 + 2,350 + 1,500 + 3,400 + 860) Total liabilities = $2,395 ($235 + $2,160) Net worth = $15,855 ($18,250 - $2,395) Total cash inflows = $1,950 Total cash outflows = $1,950 ($650 + 345 + 230 + 180 + 110 + 65 + 80 + 90 + 70 + 130) 5. For each of the following situations compute the missing amount: a. Assets $45,000, liabilities $16,000, net worth $______. $29,000 b. Assets $76,500, liabilities $______, net worth $18,700. $57,800 c. Assets $34,280, liabilities $12,965, net worth $______. $21,315 d. Assets $______, liabilities $38,345, net worth $52,654. $90,999 6 Renée St. Clair is a 28-year old occupational therapist living in the Annex district of Toronto. She recently graduated from the University of Toronto and now works as an independent contractor assessing the legitimacy of claims made by victims of car accidents. Like many students, Renée accumulated a large student debt during her years at university and plans to pay it off within the next five years. Perform a ratio analysis of Renée’s financial statements. What does your analysis reveal? (Obj. 3) Cash Flow Statement For the Year Just Ended Income Professional billings Less: Professional expenses and taxes Professional income net of expenses and taxes Dividends (after taxes) Total Income $58,205 (23,890) $34,315 130 $34,445 Fixed Expenses Rent Student loan payments Total Fixed Expenses 9,600 5,800 $15,400 Variable Expenses Utilities, personal, food, clothing and dental Moving expenses Credit card interest Recreation/entertainment Vacations Total Variable Expenses Total Expenses Surplus/(Deficit) $12,785 225 1,010 1,890 6,200 $22,110 $37,510 ($ 3,065) Personal Balance Sheet As of Today Assets Liquid Assets Bank account Personal Possessions Investment Assets BCE shares Total Assets $ 1,540 $10,280 $ 3,025 $14,845 Liabilities Current Liabilities Credit card balances $ 7,855 Long-Term Liabilities Student loan Total Liabilities 20,580 $28,435 Net Worth Solution ($13,590) Debt ratio Renée’s net worth is negative. Her debts exceed her assets by $13,590. This is not unusual for recent graduates embarking upon a career. One point of concern is the high credit card balance she carries. As we will see in Chapter 5, high-cost credit card balances should be paid off each month. Current ratio $1,540 ÷ $7,855 = 0.20 Renée has 20 cents of liquid assets for every dollar of current liabilities. She is in serious danger of being unable to pay her immediate bills. Liquidity ratio $1,540 ÷ ($37,510 ÷ 12) = 0.5 months Renée has only ½ of a month’s expenses in liquid assets. Financial planners generally recommend a ratio of 3 to 6 months of expenses. In view of her status as a self-employed individual, she should likely keep 6 months of expenses in liquid assets. Debt-payments ratio [$5,800 + $7,855] ÷ $34,315 = 0.40 or 40% Due to her high student loan payments and credit card balance, Renée debt-payments ratio is almost double the recommended level of 20%. Savings ratio Renée does not have any systematic savings plan, including savings for retirement. In fact, her cash flow is in deficit, implying that she financed her spending habits by selling assets or, more likely, through the use of debt (credit cards). Such activity will worsen her net worth position over time. Renée should cut back on discretionary spending for recreation, entertainment and vacations (total of $8,090). This would permit her surplus cash flows to pay down her credit card debt and build up an emergency fund. 7. Fran Bowen created the following budget: Food, $350 Transportation, $320 Housing, $950 Clothing, $100 Personal expenses and recreation, $275 She actually spent $298 for food, $337 for transportation, $982 for housing, $134 for clothing, and $231 for personal expenses and recreation. Calculate the variance for each of these categories, and indicate whether it was a deficit or surplus. Food $52 surplus; transportation $17 deficit; housing $32 deficit; clothing $34 deficit; personal expenses $44 surplus. 8.. Bill and Sally Kaplan have an annual spending plan that amounts to $36,000. If inflation is five percent a year for the next three years, what amount would the Kaplans need for their living expenses? $36,000 × 1.158 (FV$1, 5%, 3 years) = $41,688 9. Use future value and present value calculations (see tables in Appendix 1B to determine the following: a. The future value of a $500 savings deposit after eight years at an annual interest rate of 7 percent. $500 × 1.718 = $859 b. The future value of saving $1,500 a year for five years at an annual interest rate of 8 percent. $1,500 × 5.867 = $8,800.50 c. The present value of a $2,000 savings account that will earn 6 percent interest for four years. $2,000 × .792 = $1,584 10. Hal Thomas wants to establish a savings fund from which a community organization could draw $800 a year for 20 years. If the account earns 6 percent, what amount would he have to deposit now to achieve this goal? $800 × 11.470 = $9,176 FINANCIAL PLANNING ACTIVITIES (p. 70) 1. Using Web sites, library sources, friends, relatives, and others, obtain information on common suggestions for successful money management. This activity will provide students with an opportunity to expand their online research skills and to gain insight into various issues and topics related to money management. 2. Working with two or three others in your class, develop a system for filing and maintaining personal financial records. This activity will help students become aware of common personal finance documents and develop a system for their various records. 3. Conduct a survey of people of various ages to determine the system they use to keep track of various financial documents and records. Remind students not to ask specific details of budgeted amounts, but rather have them ask general questions about the methods used for budgeting and organizing their financial records. 4. Prepare a personal balance sheet and cash flow statement. This will help students start thinking about the practical aspects of personal financial statements for their situations. 5. Refer to exhibit 2-5 and prepare a monthly budget to cover the next six months. Pay particular attention to variable but non-repetitive expenses, such as tuition fees, textbooks, and technologyrelated costs. This exercise will permit students to apply the information given to them in the chapter to their own personal lives. It will help them to better grasp and conceptualize the concepts. 6. Using the World Wide Web or library research, find information about the assets commonly held by households in Canada. How have the values of assets, liabilities, and net worth of Canadian consumers changed in recent years? This research activity will provide students with an opportunity to view the balance sheet elements commonly held in our society. 7. Use the World Wide Web, store visits, or advertisements to determine the software a person might use to prepare personal financial statements, create a budget, and monitor spending, saving, and investing. As mentioned in Chapters 1 and 2, various software packages for financial planning are available. Samples of these may be obtained or viewed on the World Wide Web. 8. Discuss with several people how the budget in Exhibit 2-5 might be changed based on various budget variances. If the household faced a decline in income, what spending areas might be reduced first? This activity can help students better understand problems associated with money management and cash flow. In addition, students can obtain practical advice on coping with this situation. Opinions on this item will vary. Students should be ready to accept different points of views that reflect a person’s life situation, goals, and personal values. 9. Ask two or three friends or relatives about their budgeting systems. Obtain information on how they maintain their spending records. Create a visual presentation (video or slide presentation) that communicates wise budgeting techniques. This activity will allow students to gain practical information about budgeting as well as provide them with an opportunity to develop communication skills. 10. Interview a young single person, a young couple, and a middle-aged person about their financial goals and savings habits. What actions do they take to determine and achieve various financial goals? This activity can help students appreciate differences in money management activities based on differences in life situations. LIFE SITUATION CASE Out of Work but Not Out of Bills (p. 72) 1. What budget items might the Westons consider reducing to cope with their financial difficulties? Common cutbacks occur in the areas of food, clothing, savings, and personal spending. 2. How should the Westons use their savings and retirement fund during this financial crisis? What additional sources of funds might be available to them during this period of unemployment? Savings funds should be used to pay fixed expenses and necessities. Retirement funds should only be used if a lengthy unemployment time is encountered or if large, expected expenses occur. Other sources of funds may include loans, sale of investments, or sale of no longer needed household items. 3. What other current and future financial actions would you recommend to the Westons? Student answers will vary. Suggestions should include actions the family can take to meet current and future financial concerns. Solution Manual for Personal Finance Jack Kapoor, Les Dlabay, Robert J. Hughes, Arshad Ahmad 9780071320597, 9781259453144
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