Masters in Financial PlanningIntroduction to Financial Planning

Financial Planning Skills By: Associate Professor Dr. GholamReza Zandi

zandi@segi.edu.my

Introduction

• Financial planning requires specialist knowledge across diverse areas

• Technical skills are required in a number of business disciplines particularly in the area of investments

• It is important that investments are considered in terms of the time value of money, the effect of inflation and taxation, timing of cash flows and compounding frequency

Preparing Personal Financial Statements

Personal financial statements can be prepared in two parts:• Personal cash flow budget/statement includes:– Anticipated income from all sources– Items of spending or expenditure

• Personal balance sheet includes:– Personal assets– Personal liabilities

Personal Cash Flow Budget

• Income includes money received from salary, wages, interest, profits, bonuses, fees charged, dividends, distributions, social security pensions or allowances, and any other earnings

• Expenditure includes payments for food, clothing, gas, electricity, rent, interest on loans, rates, and any other expenses

• Net Savings where Income > Expenditure• Negative Savings where Expenditure > Income

Personal Cash Flow Budget Continued

• Personal cash flow budget example:

Personal Cash Flow Budget Continued

• Projected cash flow budget example:

Personal Balance Sheet

• Demonstrates financial well being• Assets are things of value we own such as bank

deposits, property, managed funds, etc.• Liabilities are amounts of money we owe to other

people or organisations such as credit card debt, loans and mortgage.

• Net worth is the difference between assets and liabilities

Personal balance sheetcontinued

• Personal balance sheet example:

Using Financial Ratios As A Planning Tool

• The personal financial statements can be used to calculate the following useful financial ratios to analyse the family’s financial position:– Equity or net worth ratio– Liquidity ratio– Savings ratio and– Debt service ratio

Using Financial Ratios As A Planning Tool Continued

1. Net Worth Ratio= Net worth x 100 Total assets

Using Financial Ratios As A Planning Tool Continued

= $673 000 x 100 $957 000

= 70.3%• This means that the Wong family owns 70.3%

of the assets that they have acquired and other people, institutions own 29.7%

Using Financial Ratios As A Planning Tool Continued

2. Liquidity Ratio

= Liquid assets x 100 Current debt

Using Financial Ratios As A Planning Tool Continued

= $12 000 x 100 $22 000 (assumed)

= 54.5% This shows the percentage of assets available to cover current debt.

Using Financial Ratios As A Planning Tool Continued

3. Savings Ratio

= Savings x 100 Net income

Using Financial Ratios As A Planning Tool Continued

= $7 000 x 100 $123 000= 5.7%

• It is likely that the savings ratio will be low or negative for a young couple with small children and also for an elderly couple

Using Financial Ratios As A Planning Tool Continued

4. Debt Service Ratio (Monthly)= Annual debt commitments/12 mths x 100

Annual net income/12 mths

Using Financial Ratios As A Planning Tool Continued

= $22 000/12 x 100 $123 000/12= $1 833.3 x 100 $10 250

= 17.9%• This ratio can be used to indicate the financial

effect of undertaking a particular course of action

Financial Mathematics Skills Applied In Financial Planning

• Financial planners require strong working knowledge of fundamental mathematical concepts that relate to investment and retirement planning.

• These include a basic understanding of:– The nature of compound interest– The time value of money

Compound Interest And The Time Value Of Money

• Most financial decisions involve benefits and costs spread over time.

• A dollar in the hand today is worth more than a dollar to be received in the future.

• People prefer cash now rather than later because:– Risk or uncertainty of future collection– Opportunity cost– Postponement of present consumption

Compound Interest And The Time Value Of Money Continued

Future Value Example• $1000 invested at 8% for 4 yearsInterest in year 1 = 8% x $1000 = $ 80.00

Interest in year 2 = 8% x ($1000+$80) = $ 86.40

Interest in year 3 = 8% x ($1000+$ 80+$86.40) = $ 93.31Interest in year 4 = 8% x ($1000+$ 80+$86.40+$93.31) = $100.78Total $1 360.49

Compound Interest And The Time Value Of Money Continued

Future Value Formula: FV = PV(1 + i)nwhere– FV = future value of an amount invested today– PV = amount of present sum of money– i = interest rate per period– n = number of periods

Using the formula for the example, we get FV = $1 000(1 + 0.08)4

= $1 360.49

Compound Interest And The Time Value Of Money Continued

Present Value ExampleHow much do we need to invest now at 8% to accumulate $1 360.49 in 4 years time?

Compound Interest And The Time Value Of Money Continued

Present Value FormulaPV = FV(1 + i)–n

PV = $1 360.49(1 + 0.08)–4

= $1 000

Compound Interest And The Time Value Of Money Continued

Annuity Example (FV) How much will we have at the end of 5 years if we invest $500 at the end of each year at 7%?

Compound Interest And The Time Value Of Money Continued

Annuity Formula (FV)FV = PMT[(1 + i)n – 1]

iFV = $500[(1 + 0.07)5 – 1]

0.7= $2 875.37

Compound Interest And The Time Value Of Money Continued

Annuity Example (PV)What is the present value of an annuity of $500 for 5 years at 7%?

Compound Interest And The Time Value Of Money Continued

• Annuity Formula (PV)• PV = PMT [1 – (1 + i)–n]

i• PV = $500[1 – (1 + 0.07)– 5]

0.7• = $2 050.10

Nominal And Effective Interest Rates

• A nominal interest rate is the stated interest rate that a bank might quote.

• However, the value of the investment is affected by the frequency at which the interest rate is determined.

• The effective interest rate is the real rate after adjusting for frequency of compounding.

Nominal And Effective Interest Rates Continued

• Since the time value of money formula assumes annual compounding, to obtain the periodic interest rate (i) an adjustment must be made:– The number of years (n) is multiplied by the

number of compounding periods (m).– The annual interest rate (j) is divided by the

number of compounding periods (m).• Periodic interest rate formula is:

i = j/m

Nominal And Effective Interest Rates Continued

Example• We can illustrate the importance of understanding the difference

between nominal and effective interest rates by considering the following interest rates quoted by three banks:

Bank A: 15%, compounded dailyBank B: 15.5%, compounded quarterlyBank C: 16%, compounded annually

What is the effective interest rates for these three banks?

Nominal And Effective Interest Rates Continued

The effective interest rates for these three banks are as follows:

Credit Cards

• Credit card lending has grown over the past two decades

• Interest rates on credit cards are generally quoted as effective interest rates

• For example a credit card which charges 19.2% per month,

What is the effective annual rate?

Credit Cards

The effective annual rate will be:

(1 + 1.6%)12 – 1 = 20.98%

Net Present Value (NPV)

NPV = PV (Future cash flows) – Investment today• NPV can also be expressed in a formula as:

• whereNPV = net present value of the projectCF0 = the initial outlay of the investment

CFi = the future cash flows over the period i

r = the discount rate or cost of capitali = number of periodsn = the number of the last year of the project

Net Present Value Continued

• NPV is effectively a measure of the net change in the value or wealth of the client from undertaking an investment

• NPV Rule – if the NPV of an investment is:< 0 then the investment is generally financially

unacceptable= 0 then the investment may be regarded as marginal> 0 then the investment is generally regarded as

financially acceptable

Advantages of NPV• The NPV technique:– always ensures the selection of projects that maximise the

wealth of shareholders– takes into account the time value of money– considers all cash flows expected to be generated by the

project – this can also be thought as a weakness of the technique because it requires extensive forecasting which may not be accurate

Net Present Value Continued

NPV Example:• If an investment costs $300 today and is expected to

return $100 at the end of each of the next 4 years with an interest rate of 10% p.a.

What is the NPV?

Net Present Value Continued

Net Present Value Continued

we can see the NPV as follows:NPV = –300 + 100/(1 +0.1)1 + 100/(1 + 0.1)2 + 100/(1 + 0.1)3 + 100/(1 + 0.1)4

• We can see the result in the following table:NPV = -300 + 90.91 + 82.64 + 75.13 + 68.31 = 16.99Thus as NPV is positive the investment is acceptable

Year 0 1 2 3 4

Cashflow -300 100 100 100 100

Discount factor

1 0.9091 0.8264 0.7513 0.6831

Discounted cash flow

-300 90.90 82.64 75.13 68.31

Net Present Value Continued

Internal Rate Of Return (IRR)

• The IRR is the discount rate that equates the PV of a project’s cash inflows with the PV of its cash outflows

• In other words, the IRR is the discount rate at which the NPV of a project is equal to zero

Internal Rate Of Return Continued

• Steps for calculating IRR:1. Apply an estimated discount rate, say 10%2. Calculate NPV using this discount rate ($16.99 from

the previous NPV example)3. Estimate a second discount rate that will produce a

negative result, say 15%4. Calculate NPV for the second discount rate5. Calculate the IRR using the formula (previous slide)

Internal Rate Of Return Continued

• We can see the result in the following table:NPV = -300 + 86.96 + 75.61 + 65.75 + 57.18 = -14.5If the result is not negative you need to calculate using another

rate

Year 0 1 2 3 4

Cashflow -300 100 100 100 100

Discount factor

1 0.8696 0.7561 0.6575 0.5718

Discounted cash flow

-300 86.96 75.61 65.75 57.18

Internal Rate Of Return Continued

• Calculate the IRR:• IRR = 10 + (10 – 15) x 16.99 / (-14.5 – 16.99)= 10 + (-5 x 16.99 / -31.49)= 10 + 2.7= 12.7%

Internal Rate Of Return Continued

• An investment is attractive when the investment’s IRR has a positive NPV and its return is higher than the discount rate.

• IRR decision rule – if the IRR of an investment is:< r then the investment is generally financially unacceptable= r then the investment is marginal> r then the investment should be financially acceptable

Fixed-interest Securities

• The price of fixed-interest securities has an inverse relationship to movements in interest rates

• Consider the following example:• Howard buys an investment for $1,000 that pays 12%

p.a. interest every 6 months (6% each half year)

Fixed-interest Securities Continued

• A few days later interest rates drop from 12% p.a. to 8% p.a. or 4% every 6 months

• Howard also need to sell his investment to fund emergency expenses for his home

• When he sells he finds his investment is now worth $1072.60 – how did this happen?

Fixed-interest Securities Continued

• The answer is based on the time value of money concept of the future cash flows of the investment:

• The present value of the future returns is:• PV = FV / (1 + i)n

• Where: PV = present valueFV = future value or cash flowsi = the interest rate per periodN = the number of compounding periods

Fixed-interest Securities Continued

Effect Of Inflation And Tax On The Rate Of Return

• Both inflation and tax affect the net returns of an investment

• Advisers need to inform their clients of this effect• The rate of return stated by an investment is nominal

rate of return• The real rate of return of a client is reduced by

taxation and inflation.

Effect Of Inflation And Tax On The Rate Of Return Continued

The End