Personal Finance
Seventh Edition
Chapter 1
Overview of a Financial
Plan
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Chapter Objectives
1.1 Explain how personal finance enhances your wealth
1.2 Explain how personal finance enhances your job
marketability
1.3 Identify the key components of a financial plan
1.4 Explain how financial planning affects your cash flows
1.5 Outline the steps involved in developing your financial
plan
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Definitions
• Personal finance: the process of planning your spending,
financing, and investing to optimize your financial situation
• Personal financial plan: a plan that specifies your financial
goals and describes the spending, financing, and investing
plans that are intended to achieve those goals
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How an Understanding of Personal
Finance Can Enhance Your Wealth
• Improving your finance skills and decisions
• Helping you judge the advice of financial advisors
• Enhancing your job marketability
• Entering a personal finance career
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Components of a Financial Plan
• Budgeting and tax planning
• Managing your liquidity
• Financing your large purchases
• Protecting your assets and income (insurance)
• Investing your money
• Planning your retirement and estate
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A Plan for Your Budgeting and Tax
Planning
• Budget planning: The process of forecasting future
expenses and savings
– Evaluate your current financial position
▪ Assets: what you own
▪ Liabilities: what you owe
▪ Net worth: the value of what you own minus the
value of what you owe
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Budget and Tax Planning
Exhibit 1.1 How a Budget Plan Affects Savings
Source: U.S. Bureau of Labor Statistics, 2018; date are for 2016.
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A Plan to Manage Your Liquidity
• Liquidity: access to funds to cover any short-term cash
deficiencies
• Money management: decisions regarding how much
money to retain in a liquid form and how to allocate the
funds among short-term investment instruments
• Credit management: decisions regarding how much credit
to obtain to support your spending and which sources of
credit to use
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Managing Your Liquidity
Exhibit 1.2 Managing Your Liquidity
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A Plan for Financing Your Large
Purchases (1 of 2)
• Loans often needed for large expenditures
– College tuition, car, house
– Managing loans
▪ How much can you afford to borrow?
▪ Determining maturity of the loan
▪ Selecting a loan with a competitive interest rate
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A Plan for Financing Your Large
Purchases (2 of 2)
Exhibit 1.3 Financing Process
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A Plan for Protecting Your Assets and
Income
• Risk: Uncertainty surrounding cash flows
• Insurance is one way you can reduce risk
• Insurance planning: Determining the types and amount of
insurance needed to protect your assets
– Automobile and homeowner’s insurance protect
assets
– Health insurance limits potential medical expenses
– Disability and life insurance protect your income
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A Plan for Your Investing Your Money
• Any funds beyond what you need to maintain liquidity
should be invested
– Primary objective to earn a high return
– Potential investments include stocks, bonds, mutual
funds and real estate
– Risk: uncertainty surrounding the potential return on
an investment
– Manage investments to keep risk at a tolerable level
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A Plan for Your Retirement and Estate
• This includes insurance planning, retirement planning,
and estate planning
– Retirement planning: determining how much money
should be set aside each year for retirement and how
you should invest those funds
– Estate planning: determining how your wealth will be
distributed before or upon your death
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Building Your Own Financial Plan
• Enhances your net worth
• Builds your wealth
• All components of your financial plan affect your cash
inflows and outflows and how much cash you have
available
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How Financial Planning Affects Your
Cash Flows (1 of 13)
• How the components relate to your cash flows
– Cash inflows are cash that you receive
– Cash outflows are cash that you spend
– Budgeting balances income and spending
– Liquidity deals with cash excesses or shortages
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How Financial Planning Affects Your
Cash Flows (2 of 13)
• Part 1 – Tools for Financial Planning
– Budgeting allows you to plan how you will use the
cash you receive in a given period
▪ How much should you work this month (if your
employer allows flexibility)?
– Budget decisions determine how much you spend
and the amount of your cash outflows each month
▪ What products or services should you purchase
this month?
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How Financial Planning Affects Your
Cash Flows (3 of 13)
Cash flows due to your budgeting decisions
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How Financial Planning Affects Your
Cash Flows (4 of 13)
• Part 2 – Managing Your Liquidity
– If you have excess cash this month, how much cash
should you add to your checking or saving account?
– If you have a cash deficiency this month, how much
cash should you withdraw from your checking or
savings account?
– If you have a cash deficiency this month, how much
credit should you use from credit cards or other
sources?
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How Financial Planning Affects Your
Cash Flows (5 of 13)
Cash flows due to your liquidity management decisions
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How Financial Planning Affects Your
Cash Flows (6 of 13)
• Part 3 – Personal Financing
– Should you lease a car?
– Should you borrow money to purchase a car?
– Should you borrow money to purchase a home?
– How much cash will you need to borrow?
– How long a period will you need to borrow funds?
– What is the ideal source from which you will borrow
funds?
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How Financial Planning Affects Your
Cash Flows (7 of 13)
Cash flows due to your financing decisions
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How Financial Planning Affects Your
Cash Flows (8 of 13)
• Part 4 – Protecting Your Wealth
– What types of insurance do you need?
– How much insurance should you purchase to protect
your assets?
– How much insurance should you purchase to protect
your income?
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How Financial Planning Affects Your
Cash Flows (9 of 13)
Cash flows from protecting your assets and income
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How Financial Planning Affects Your
Cash Flows (10 of 13)
• Part 5 – Personal Investing
– How much cash should be used to make investments?
– What types of investments should you make?
– How much risk should you tolerate when making
investments?
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How Financial Planning Affects Your
Cash Flows (11 of 13)
Cash flows from investing
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How Financial Planning Affects Your
Cash Flows (12 of 13)
• Part 6 – Retirement and Estate Planning
– How much cash should you invest toward your
retirement each month?
– What types of investments should you make for your
retirement accounts?
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How Financial Planning Affects Your
Cash Flows (13 of 13)
Cash flows from retirement and estate planning
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Summary of Financial Plan
Components (1 of 3)
• Notice how the financial plan components are integrated
• Each component can be a source of cash or a use of cash
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Summary of Financial Plan
Components (2 of 3)
• Summary of sources of cash from each component
– Attempt to work more hours (Part 1)
– Withdraw cash from savings (Part 2)
– Obtain a loan (Part 3)
– Cash in an insurance policy (Part 4)
– Sell some of your investments (Part 5)
– Withdraw funds from your retirement account (Part 6)
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Summary of Financial Plan
Components (3 of 3)
• Summary of uses of cash
– Purchase products and services (Part 1)
– Deposit cash in your checking or savings account
(Part 2)
– Pay interest payments on a loan or pay off a loan
(Part 3)
– Make insurance payments (Part 4)
– Make new investments (Part 5)
– Contribute toward your retirement account (Part 6)
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How Financial Planning Relates to
Cash Flow
Exhibit 1.4 How Financial Planning Affects Your Cash Flows
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Integration of the Financial Plan
Components (1 of 2)
• Budgeting decisions affect liquidity management decisions
• Liquidity management decisions can affect your financing
decisions
• Financing decisions can affect your insurance decisions
• Insurance decisions can affect your investment decisions
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Integration of the Financial Plan
Components (2 of 2)
• Investment decisions can affect your retirement planning
decisions
• Retirement planning decisions can affect your budgeting
decisions
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How Psychology Affects Your Financial
Plan (1 of 2)
• Psychology has a major impact on human behavior and
decision making
• Psychology has a major impact on spending behavior and
ability to implement an effective financial plan
• Consider two different types of spending behavior
– Focus on immediate satisfaction and peer pressure
– Focus on the future
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How Psychology Affects Your Financial
Plan (2 of 2)
• Assess your own spending behavior
– Do you pay rent for a single apartment rather than
share an apartment?
– Do you have large monthly car payments?
– Do you have credit card bills that you only make the
minimum monthly payment toward each month?
– Do you spend all of your income that is not needed for
rent or car loans payments within the first day or two of
receiving your paycheck?
– Do you always find a reason each month to spend all
of your income?
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Developing the Financial Plan (1 of 9)
• Step 1. Establish Your Financial Goals
– Types of financial goals
▪ Car, home, college, wealth, charity
– Set realistic goals
▪ Stronger likelihood of reaching goals
– Timing of goals
▪ Short term (within one year)
▪ Intermediate (between 1–5 years)
▪ Long term (beyond five years)
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Developing the Financial Plan (2 of 9)
• Step 2. Consider Your Current Financial Position
– You current financial position determines many of your
financial decisions
– Do you have low debt or high debt?
– Are you single or married?
– How old are you?
– The answer to these questions and more affect your
financial plan
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Developing the Financial Plan (3 of 9)
– How your future financial position is tied to the
economy
▪ Economic conditions affect types of jobs available,
salaries offered, price of services, value of assets
▪ Financial crisis of 2008-2009 affected financial
positions in many ways
– Reduction in new job opportunities
– Elimination of some jobs
– Lower salaries for existing jobs
– Value of many assets declined
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Developing the Financial Plan (4 of 9)
• Step 3. Identify and Evaluate Alternative Plans That Could
Achieve Your Goals
– Plans could be conservative or aggressive
– Pursue additional education
– Selecting your major is one of the most important
financial decisions you will ever make
– In the following exhibits you can see how education
and career choice affect your income and wealth
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Developing the Financial Plan (5 of 9)
Exhibit 1.5 Comparison of Income among Education Levels
Source: U.S. Bureau of Labor Statistics, 2018; data are for 2016.
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Developing the Financial Plan (6 of 9)
Exhibit 1.6 Comparison of Unemployment Percentage
among Education Levels
Source: U.S. Bureau of Labor Statistics, 2018; data are based on 2016.
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Developing the Financial Plan (7 of 9)
Exhibit 1.7 Fastest-Growing Occupations
Growth Rate Over
the 2016–2026 Period
Annual Median
Pay
Solar photovoltaic installers
105%
$39,240
Wind turbine service technicians
96%
$52,260
Home health aides
47%
$22,600
Personal care aides
37%
$21,920
Physician assistants
37%
$101,480
Nurse practitioners
36%
$100,910
Statisticians
33%
$80,500
Physical therapist assistants
31%
$56,610
Software developers, applications
31%
$100,080
Mathematicians
29%
$105,810
Occupation
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Developing the Financial Plan (8 of 9)
Exhibit 1.7 [Continued]
Growth Rate Over
the 2016–2026 Period
Annual Median
Pay
Bicycle repairers
29%
$27,630
Medical assistants
29%
$31,540
Physical therapist aides
29%
$25,680
Occupational therapy assistants
29%
$59,010
Information security analysts
28%
$92,600
Genetic counselors
28%
$74,120
Operations research analysts
27%
$79,200
Forest fire inspectors and prevention specialists
27%
$36,230
Health specialties teachers, postsecondary
26%
$99,360
Derrick operators, oil and gas
26%
$48,130
Occupation
Source: U.S. Bureau of Labor Statistics, 2017.
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Developing the Financial Plan (9 of 9)
• Step 4. Select and Implement the Best Plan for
Achieving Your Goals
– The Internet has valuable financial planning
information
– Numerous websites provide financial tools you can
use to develop you financial plan
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Using the Internet to Facilitate
Financial Planning (1 of 2)
• Provides updated information on all parts of your financial
plan
– Current tax rates and regulations
– Investment performances
– New retirement plan rules
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Using the Internet to Facilitate
Financial Planning (2 of 2)
• Online calculators
– Estimating taxes
– Determining how your savings will grow over time
– Determining whether buying or leasing a car is more
appropriate
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Developing the Financial Plan (1 of 8)
• Focus on Ethics: Personal Financial Advice
– Your objective is to get the best advice appropriate to
your needs
– Be wary of unethical behavior
▪ Difficult to discern
– Be wary of incompetent advice
▪ Be alert, ask questions, carefully consider advice
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Developing the Financial Plan (2 of 8)
• Step 5. Evaluate Your Financial Plan
– Keep plan in an accessible place and monitor your
progress
• Step 6. Revise Your Financial Plan
– Change plan as financial condition and financial goals
change
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Developing the Financial Plan (3 of 8)
Exhibit 1.8 Summary of Steps Used to Develop a Financial Plan
1.
Establish your financial goals.
– What are your short-term financial goals?
– What are your intermediate-term financial goals?
– What are your long-term financial goals?
2.
Consider your current financial position.
– How much money do you have in savings?
– What is the value of your investments?
– What is your net worth?
3.
Identify and evaluate alternative plans that could achieve your goals.
– How can you obtain the necessary funds to achieve your financial goals?
– Will you need to reduce your spending to save more money each month?
– Will you need to make investments that generate a higher rate of return?
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Developing the Financial Plan (4 of 8)
Exhibit 1.8 [continued]
4.
Select and implement the best plan for achieving your goals.
– What are the advantages and disadvantages of each alternative plan that could be
used to achieve your goals?
5.
Evaluate your financial plan.
– Is your financial plan working properly? That is, will it enable you to achieve your
financial goals?
6.
Revise your financial plan.
– Have your financial goals changed?
– Should parts of your financial plan be revised to achieve your financial goals? If so,
how?
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Developing the Financial Plan (5 of 8)
Exhibit 1.9 Summary of Steps Used to Develop a Financial Plan
Step 1. Financial Goals:
I would like to:
• buy a new car within a year,
• buy a home within two years,
• make investments that will allow my wealth to grow over time, and
• build a large amount of savings for retirement in 20 to 30 years.
Step 2. Current Financial Position:
I have very little savings at this time and own an old car. My income,
which is about $36,000 a year after taxes, should increase over time.
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Developing the Financial Plan (6 of 8)
Exhibit 1.9 [continued]
Step 3. Plans to Achieve the Goals:
Since my current financial position does not provide me with sufficient
funds to achieve these financial goals, I need to develop a financial plan
for achieving these goals. I want to save enough money to make a down
payment on the car and home and to obtain financing to cover the rest of
the cost.
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Developing the Financial Plan (7 of 8)
Exhibit 1.9 [continued]
Step 4. Selecting and Implementing the Best Plan:
Financing the purchase of a car and a home is an appropriate plan for
me. I will prepare a budget so that over time I can accumulate savings
that will be used to make a down payment on a new car. Then, I will
attempt to accumulate savings to make a down payment on a new
home. I need to make sure that I can afford financing payments on any
money that I borrow.
Step 5. Evaluating the Plan:
Once I establish a budget, I will monitor it over time to determine
whether I am achieving the desired amount of savings each month.
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Developing the Financial Plan (8 of 8)
Exhibit 1.9 [continued]
Step 6. Revising the Plan:
If I cannot save as much money as I desire, I may have to delay my
plans for purchasing a car and a home until I can accumulate enough
funds to make the down payments. If I am able to exceed my savings
goal, I may be able to purchase the car and the home sooner than I had
originally expected.
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