UNIVERSITY OF MISSOURI ROLLA DEPARTMENT OF ENGINEERING MANAGEMENT

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UNIVERSITY OF MISSOURI ROLLADEPARTMENT OF
ENGINEERING MANAGEMENT

• EMGT 105
• PERSONAL FINANCE II
• Winter Semester, 2003
• Aditi Paluskar
• Winger, Frasca Chapter 1
• Chapter 2
• January 22nd 2003

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Goals in Life

• Non Financial Goals
• Financial Goals
• Current Consumption
• Goods or services used in current time period
• Future Consumption
• Goods or services to be used in future periods
• Saving
• The portion of current income not consumed

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Financial Success and Financial Independence

• Financial Success
• Obtaining maximum benefits from limited
  financial resources
• Financial Independence
• Having sufficient income or financial resources
  to be self reliant

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Important Economic Trends

• Continuing Inflation
• How high ? Modest rates 1-3
• Persistent Business Cycles
• Is your job safe?
• Do you have cash reserves to weather a recession?
• A Perplexing Tax System
• High tax rates
• Selectively rewarding retirement plans(IRAs)

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Financial Planning - Why Its Important ?

• Increased emphasis on self reliance
• Less from Government. E.g. social security
• Less from Employer. E.g. reduced role of
  traditional retirement plans
• Achieving Financial Independence
• Coping with economic uncertainties and shocks.

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Planning Areas

• Consumption and Savings Planning
• How much to allocate for current consumption and
  how much to save for the future?
• Financial statements and budgeting
• Debt Planning
• Debt must be managed carefully
• Avoid excessive debt
• Tap lowest-cost sources of credit

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Planning Areas

• Insurance Planning
• Disability insurance
• Life insurance
• Property and personal liability insurance
• Medical insurance
• Investment Planning
• How to invest the savings?
• Retirement Planning
• Estimating future consumption
• Determining how to meet those needs

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Planning Areas

• Estate Planning
• Proper will and appropriate tax strategy
• Income Tax Planning
• Familiarity with the income tax law
• Minimize tax bite
• Career Planning
• Choosing the right career
• Changing jobs, switching careers

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Marginal Analysis and Opportunity Costs

• Marginal Analysis
• Looking at changes in important variables that
  are related to changes in decision inputs you can
  control.
• Opportunity Costs
• Benefits that you give up when you choose one
  alternative over another

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Chapter 2

• Compounding
• The process of accumulating value over time from
  a single payment
• Future Value
• A sum of money received or paid in the
  future.
• Compound Interest
• A future value that includes interest on
  interest
• Simple Interest
• An assumption that interest earned in a period
  is withdrawn in that period

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Future Value of Single Payment

• Example 1
• An investment that costs 1000 today and returns
  the same amount at the end of 3 years.
• Is it a good investment ? No

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Example 1

• Compound Interest
• FV at the end of year 1 1000 (0.10)1000
  1100
• FV at the end of year 2 1100 (0.10)1100
  1210
• FV at the end of year 3 1210 (0.10)1210
  1331
• FV (1000)(1.1)(1.1)(1.1) (1000)(1.331)
  1331
• Simple Interest
• Simple Interest (Principal) x (rate) x (time)
• 300 1000 x 0.10 x 3

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Future Value of an Annuity

• Annuity
• A series of equal payments
• Ordinary Annuity
• Payments take place at the end of the period
• Annuity Due
• Payments take place at the beginning of the period

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Example 2

• Ordinary Annuity (FVOA)
• An investment requires a payment of 1000 a year
  for the next three years, with payments made at
  the end of each year. How much will this
  investment accumulate at the end of three years,
  assuming an annual investment rate of 10 ?
• First payment 1000 x 1.1 x 1.1 1210
• Second payment 1000 x 1.1 1100
• Third payment 1000 x 1.0 1000
• Total 3310

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Example 2

• Annuity due (FVOD)
• First payment 1000 x 1.1 x 1.1 x 1.1
  1331
• Second payment 1000 x 1.1 x 1.1
  1210
• Third payment 1000 x 1.1
  1100
• Total 3641
• FVAD (1.0i) x FVOA (1.0 0.10) x 3310
• 3641

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Discounting

• The process of reducing future values to present
  values
• Reverse of compounding

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Example 3

• An investment that requires an immediate 1000
  payment will pay us 1331 three years from now.
  Is it a good investment?
• Depends on the discounting rate (i)
• FV 1331 n 3 years i 10

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Example 3

• Present-value-of-1 table
• PV of 1 discounted at 10 0.7513
• PV of investment (0.7513) x FV of investment
• PV of investment (0.7513) x 1331
• 1000

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Present Value of an Annuity Example 4

• An investment pays you 5000 a year at the end of
  the year for the next three years. What is the
  present value (PVOA) of the investment assuming
  and annual discount rate of 6 ?
• PVOA 2.6730 x 5000 13,365
• PVAD (1.0 i) x PVOA 1.06 x 13,365
• 14,166,90

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Formulae

• FV FV of 1 factor n, i x PV
• FV FV of 1 annuity n, i x annuity payment
• PV PV of 1 annuity n, i x annuity payment

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Example 5

• What interest rate must be earned to achieve a
  6,000 goal in 5 years, assuming 4,000 is
  invested today?
• Answer 8.443

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Example 6

• You hope to earn 20 on a somewhat risky
  investment. You will put 3,000 into the
  investment and will cash out when the
  investment value reaches 10,000. How long will
  it take ?
• Answer 6.5815 years

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Example 7

• You are committed to saving and investing 2,500
  annual over the next 10 years. If you hope to
  accumulate 50,000 at the end of the period, what
  interest rate must you earn?
• Answer 15

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Example 8

• You are thinking of buying a lottery ticket that
  will provide you with either a lump-sum payment
  of 2,000,000 right after you win or an annual
  payment of 160,000 for the next 20 years. You
  must make a choice at the time you purchase the
  ticket. What is the implied rate of interest
  embedded in the lottery payoffs ?
• Answer 4.9665

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Until next time

• Read Goal Planning for the Steeles section in
  chapter 2.
• Read chapter 3
• Mail me your password