BUSN380 Week 1Threaded Discussion - Time Value of Money & Opportunity Costs
BUSN380 Week 1Threaded Discussion - Time Value of Money & Opportunity Costs
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BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs Incorporating timevalueofmoney concepts and information from welldeveloped personal financial statements, identify your longterm financial goals and discuss the pertinent aspects for realizing these longterm financial goals. You know, I read all this and I feel like I am a million light years behind everyone. I must be real dear colleagues; I have never had a financial goal in my life! Not by any of the standards displayed here at least. Growing up in Trinidad I saw both my parents work to pay bills, buy a house (after renting for decades), borrow money for a new car every two or three years, and scrape together the rest for what was necessary to send four kids to school. Conversations around the dinner table did not consist of such uplifting topics as savings or investment, and certainly not shortterm and longterm financial planning. Some monthend weekends were cause for panic when the landlord came knocking, and as the eldest, I learned to lie about the whereabouts of my folks, as we bought more time to come up with rent money. But come Christmas time, the larder was impressive, booze and food and toys and bought on credit. Every three years a new car … never mind dear old Dad kept each one in mint condition….we lived by the maxim: “be mindful of the resale value.” Therefore, it is no wonder that I find myself entering middle age not even trying to pretend that I am saving for retirement, or to pay off a mortgage, or send some kid to college. Robert Kiyosaki was right! Money without financial intelligence is money soon gone! I imagine my folks were working with what they knew, what their own parents did or didn’t teach them. After all, if personal financial planning is the process of managing your money to achieve personal economic satisfaction, then my folks were financial planners….they just didn’t manage to keep any of it. The debtaddiction and consumerism of my forebearers continue to reside in my DNA, and college tuition in only the latest of the sums of dough yet another creditor will be ringing my phone off the hook about in the near future. But guess what? Every year I take an expensive vacation overseas, I eat and drink the best of everything, and I must have my creature comforts. Financial plan that! Ultimately I’m thinking my plan should be to figure out how to keep from imploding under the weight of my mismanaged finances and avoid ending up under a bridge somewhere. I figure by week three I should have some idea, do you? BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs These are some excellent thoughts regarding opportunity cost, class! Understanding the opportunity cost of different decisions to make with our money (spend vs. investment, vacation vs. taking a class) are part of evaluating alternatives, which is step 4 in the financial planning process in Chapter 1 of our text. What are the other steps in the financial planning process? Why is it important to follow the financial planning process? The other steps in the financial planning process start with Step 1, which is to determine your current financial situation. Here you would gather all the information you have about your income, savings, living expenses, and debts, and prepare a list of current assets, debt balances, and expenditure. At step 2 the challenge begins to take hold and might be cause for a great deal of anxiety if you are in dire straits. This is where you attempt to develop your financial goals and decide whether to spend, save, or invest the money you have. The text and every worthwhile financial planning resource recommend you analyze values & goals several times a year, to separate wants from needs a noble venture and one I find particularly daunting in the absence of any mentoring influence to suggest in my formative years that I master financial literacy. Step 2 is where you face up to the fact about how you really feel about money and why; who influenced those attitudes and whether you can separate that influence from the actual facts about it. It is where you examine whether you set financial goals and priorities according to social pressures, household needs, or desires for luxury items, or more realistically, current economic conditions. At step 3 you identify alternative courses of action possible courses of action namely, do you stick with the current program, save the same amount each month? Do you expand your current situation and save more, sell some CD’s, have a bake sale, take a second job? Or do you change up your current situation by opting for a money market account instead of regular savings; quit your deadend job and start up a hydroponic herb farm and sell aromatics to your friends and neighbors? Or do you take a whole new course of action, and funnel a large part of your monthly savings budget toward systematically chipping away at your mountain of credit card debts until they are eliminated, forsaking luxuries such as cable TV and your cell phone? As a group, we have many of the same concerns... One strategy for dealing with loans that have a monthly payment, like the oftenmentioned mortgages and student loans, is to add a 12th of an annual payment each month, resulting in one extra payment BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs a year. The extra payment chips away at the principle, reducing the amount of overall interest paid and shortening the life of the loan. There are many reliable sources on the web cited in your text to help you calculate how this works. One is: http://mortgages.interest.com/content/calculators/mortgage_calculator.asp Now that we have discussed some longterm financial goals, and we have touched on the topic of Present Value and Future Value computations, let's try a specific problem: If we wanted $100,000.00 at age 65, and your present age is 20, how much money would you need to set aside right now, assuming an interest rate of 7%? So let me understand the question. This is a straightforward "present value of a sum" problem. I determine the present value of a future amount using the technique of discounting. In this case, I need to know the Present Value (PV) of money that will earn me $100,000 fortyfive years down the road, is at 7% interest rate. Or, how much money I need to deposit, in order to earn $100,000.00 in 45 years, assuming an interest rate of 7%. The longhand formula is: PV = FV/(1+r) = FV (where PV = Present Value FV = Future Value r = annual interest rate n = number of periods) FV = $100,000 Annual interest rate = 0.07 Number of periods = 45 45 PV = $100,000 / (1+0.07) = $100,000 / 21.0025 = $4,761.337936 rounded to the nearest 100 = $4761.35 The “easy” way to figure this is to use the =PV financial function in an Excel spreadsheet to calculate the value needed 45 years from now at age 65. I use 7% interest rate, 0 payment amounts, start with a present value of 0, since I have not started saving for this yet, and the future value of 100,000 since that is the goal. In Excel, the format looks like this: =PV(i,n,Payment,FV) so my input is: =PV(0.07,45,0,100000) which results in: =$4,761.35 required at Age 65 BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs http://www.collegecram.com/study/finance/timevalueofmoney/annuitiespresentvalueand futurevalue/ http://www.mathsisfun.com/money/compoundinterest.html Some have called compound interest the 8th wonder of the world! Important: the Rule of 72 is used to determine how long it takes for an amount of money earning compounding interest to double. For example, 72 divided by the interest rate of 8 percent is 9, so something that compounds over time at 8 percent will double in 9 years! Question: What interest rate is compounding on a sum of money which doubles in 12 years? (Use the Rule of 72 to figure this out) As we look at the tables on pages 3639 in our text, we will notice that there are FV and PV tables for a single sum compounding interest over time as well as for annuities. How would you describe the difference between an annuity and a lump sum that compounds over time (hint: a lump sum is left alone)? Also, what are some common annuities we all have in our lives An annuity is a stream of payments made over time. One party invests money with another party who promises to pay it back with interest. Annuities are described as ordinary, and annuity due. Ordinary annuity payments are due at the end of each period; annuity due payments are due at the start of each period, e.g., lease payments. The various types are: Fixed Annuity – Here the time between payments doesn't vary, the interest rate stays the same, and the amount of the payments is always the same. You know what you are getting with a fixed annuity. Variable Annuity This is where none of the time, interest rate, or payment amounts is fixed. Variable annuities sold as investments are subject to securities regulations. Equity Indexed Annuity A specialized variable annuity where interest/investment returns are indexed to equities, e.g., the stock market. BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs http://www.collegecram.com/study/finance/timevalueofmoney/annuitiespresentvalueand futurevalue/ To wrap up you should work to be able to: 1) Determine simple interest. 2) Determine the PV and FV of a lump sum compounded at given interest rate for a given number of periods using the tables in our text (pages 36 and 38). 3) Determine the PV and FV of annuity payments compounded at a given interest rate for a given number of periods using the tables in our text (pages 37 and 39). 4) Understand how to calculate an inflation rate from changes in pricing as well as how to calculate a price over a given number of periods given an inflation rate (this is the same as the calculation of FV and PV for a compounding lump sum). I will go over this on Saturday in TDA # 1 Time Value of Money. 5) Understand opportunity cost and its role in financial decisionmaking. 6) Understand the format of the personal balance sheet (A = L + NW). 7) Understand how to compare taxable benefits with nontaxable benefits using the equation in the upper left hand corner of page 56 in our text. I will go over this on Saturday in TDA #2 Opportunity Cost. If I have $5000 right now and have found a great investment vehicle that will guarantee me 6% interest for each of the next 20 years, how much money will have I have at the end of the term? Please let's all go to page 36 of our text book and determine what number we must multiply times $5000 to get our future amount. It is important that everyone understand how to use the tables... Or…we could do it in longhand using the compounding formula PV x (1+r)^n = FV = $5000(1+0.06)^20 = 5000 x 3.207= $16,035.68 Before we think about budgets (which will be one of our Projects in a couple of weeks), let's make sure we all understand the beginning point, or how to best go about taking a look at our current financial situation. On page 81 of your text is a tool to help with this. I would like to know, what are your thoughts regarding this BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs format? This is something businesses do all the time, but do you think it would be helpful to individuals, and if so why? A personal balance sheet is useful for discovering things about your finances that you never knew. It is a great tool for understanding your financial position, i.e., what personal resources you have available by examining net worth and household cash flow. It puts everything in perspective so that you can better manage your current finances and your financial future. In managing your finances, you want to make sure that everything balances out. A balance sheet can easily indicate whether your liabilities exceed your assets and where you need to make some changes. It helps individuals identify useless assets that only represent a possible tax burden. It provides adequate protection, a breakdown of how to protect a household from unforeseen risks such as liability, property, death, disability, health, and longterm care. From such an analysis, you can determine insurance needs. Let's recap. First, we discussed the opportunity costs of our education. Then, we learned opportunity cost is part of evaluating our financial decisions. Finally, we touched on the personal balance sheet (page 81 of our text) and how it is beneficial in helping us find out just where we stand financially. Now Let's make sure we are all clear on the format of the balance sheet: ASSETS = LIABILITIES + NET WORTH We can see that net worth is defined as the amount by which assets are greater than liabilities because ASSETS = LIABILITIES + NET WORTH is the same as ASSETS LIABILITIES = NET WORTH. To help us create our own balance sheet, what are some examples of your assets? What about your liabilities? I run a small catering business out of my home and the assets listed below are to be used for more than a year and are therefore depreciable longterm assets: One commercial stove with oven, a dishwasher, two sets of cookware, and two sets of dishware, and a refrigerator. Other assets include: One van with rolling racks built in (a rolling rack is a wheeled rolling cart system that is insulated for both hot and cold food). Assorted serving trays and utensils, knives and cutting boards. Oak workstation desk and office chair, and BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs Computer with printer/fax, CDRW, Microsoft Office, Adobe Acrobat, and QuickBooks Pro. My Current liabilities: Rent Utilities Charge Account & Credit Card Balances $ Longterm liabilities: Student Loans – Outstanding principal $47, 750 Outstanding interest $2,944 Using the PV annuity table, find the future value of the annuity. The table value in Exhibit 1B (pg 37) we are looking for is at the intersection of 6% (vertically) and 20 (horizontally). We have deposited $1500.00 for 20 years (20 periods) and the guaranteed earnings will be 6% per year. Simply take the number at the intersection of 20 and 6%, which is 36.786, and multiply it by the periodic payment of $1500.00. You will find you will end up with $55,179.00. To get the value of the annuity savings plan, calculate 20 payments of $1500.00: 20 * 1500.00 = $30,000.00. Then, Earned Interest = $55,179.00 $30,000.00 = $25,179.00. In other words, depositing a sum every period for 20 periods has enabled you to nearly double your money. By the way, a corrective clarification has been made regarding how I stated the problem. I did say $1500.00 a year might be saved on a monthly basis. To use the table for 20 periods and be correct, the savings contribution of $1500.00 would have to be made once at the end of the year. If BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs monthly payments were made instead, the interest earned would be slightly higher, as Joseph and David stated. This is the case because money deposited earlier and throughout the year would be earning interest. So, great work on pointing that out! Now that we have a stronger handle on using the PV annuity table , let's talk about the FV annuity table. Determine the periodic payment on a loan over a given number of periods at a given interest rate . If we borrow $12,000.00 from a friend at 5% over 10 years, making one payment per year, how much would we have to pay our friend at the end of each year? (hint: divide the loan amount of $12,000 by the table factor) Ok so I see how this can be fun. I think I grasp the concept, but your hint confused me. If $12,000/12.578 = $954.05, does that mean then that long way I show below is wrong? Or am I missing a step? I figure: 1. Calculate the Interest (= "Loan at Start" × Interest Rate) $12,000 *0.05 = $600 2. Add the Interest to the "Loan at Start" to get the "Loan at End" of the year $12,000 + $600 = $12,600 3. The "Loan at End" of the year is the "Loan at Start" of the next year So Year 1 = $12,000 + $600 = $12,600 Year 2 = $12,600 + 600 = $13,200 Year 3 = $13,200 + 600 = $13,800 Year 4 = $13,800 + 600 = $14,400 Year 5 = $14,400 + 600 = $14,400 http://www.mathsisfun.com/money/compoundinterestderivation.html The PV annuity table (1D) is used to find our periodic payments on a loan by dividing the loan amount by the table factor. An example is a mortgage. The FV annuity table (1B), on the other hand, is used to find how much we will have at the end of number of contributing periods in a savings plan. Denise Holloway 4 Mar 11 8:16 PM MST BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs If I did this correctly the friend will receive $1554.00 at the end of each year until the borrowed money is repaid. Number Year 10 Interest 5% Borrowed $12,000.00 Interest 7.722 Formula: Borrowed/Interest Equal Payments of: $1,554.00 Inflation is a measure of the value of a dollar of U.S. currency over time. It is nearly impossible to estimate it in advance since it responds to many market factors. Interest rate for instance, moves up or down according to the rate of inflation, which unfortunately tends to go up over time. When it swings dramatically in one direction or another, your loans may become more competitive or less competitive on the market. Lenders often use variable rate loans to compensate for changes in inflation. When the bank loans you money it is making a bet about the rate of inflation over the life of the loan. If inflation does not react in the way the lender expects profit is low, so they will use variable rate loans to protect themselves against loss. When inflation increases variable rate loans see higher interest rates, and of course rates rarely drop when inflation goes back down. To protect yourself against high adjustable rates, you should set a limit on how high your rate can climb. either as a certain amount over your initial interest or even a percentage difference over the national prime rate. The national prime rate will adjust with inflation, and this should protect both you and the lender. With a fixed rate loan, your loan becomes more competitive if the value of the dollar decreases. E.g., your auto loan charges a 6.25% fixed interest rate, resulting in a monthly payment of $225. When you take the loan, the national prime rate is 5%. Inflation goes up, so the Federal Reserve adjusts the prime rate to 6% over two years. Now, your loan is only .25% over the national prime. Not only is your loan competitive on the market, you are actually spending a little less today than you did a year ago for the loan. The same $225 has a lower value on the market, and you can get less for that sum. And since your income is likely to increase to compensate for inflation, the same $225 should be a lower percentage of your monthly income. On the other hand, if the rate of inflation is low or decreases while your loan is active, that same $225 is actually a larger portion of your spendable income over time. The lender makes more profit because the national prime rate goes down, say to 4.5%, and you are not paying 2.25% over the prime average. If you approached the same lender for the very same loan today, you would have gotten a lower interest rate. In this case, you may want to consider refinancing the loan to bring it more current with national averages. Refinancing to a current rate will save you money, but it can also be difficult to do depending on your lender. BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs http://www.loan.com/loans/howinflationaffectsyourinterestrate.html One of the underlying causes of inflation is the level of monetary demand in the economy how much money is being spent. We can demonstrate this by considering what happens when the prices of some products are rising. Imagine the price of cinema tickets has risen. If consumers want to buy the same amount of all goods and services as before, they will now have to spend more because the price of one of the products they consume has risen. This will only be possible if their incomes are rising, or alternatively if consumers are prepared to spend a bigger proportion of their incomes and save less. But if total spending does not rise, then higher prices will mean consumers either will have to buy fewer cinema tickets or buy less of something else. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes and spending are also rising. On the other hand, if the price of some goods falls, people will need to spend less to buy the same amount of all goods and services as before. But if people still earn the same, they will have the same amount of income as before. So they will be able to buy more of those goods or of something else. Demand in the economy will rise and this, in turn, might cause some prices to rise. Of course, this process takes time. And the situation will be complicated if some people's incomes are affected by the falls in prices say because lower import prices cause firms competing with imports to lose sales and reduce the number of people they employ. However, it demonstrates a key feature of inflation that it relates to the amount of demand in the economy. As my last post this week, I want to touch on inflation. We can determine the future price of an item affected by inflation in the same way we determine the future value of a lump sum. E.g, a $200.00 barbecue grill subject to a 2% annual inflation rate will cost $212.00 in three years (Table 1A, factor 1.061 * $200.00 = $212.00). What is the under lying cause of inflation? Also, what governmental index exists to help us determine the rate of inflation? One of the underlying causes of inflation is the level of monetary demand in the economy how much money is being spent. When prices are rising, people will have to spend more to get the same product. Most can do this indefinitely only if they are making more money, or if they are prepared to spend more and save less. But if total spending stays the same, higher prices will mean consumers either will have to buy less of the affected items, or buy less of something else. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs and spending are also rising. On the other hand, if prices fall people will spend less on the same quantity of items as before. If income does not increase, people will have the same amount of income as before and still be able to buy more of those or other goods. Demand in the economy will rise and this, in turn, might cause some prices to rise. Of course, this process takes time. And the situation becomes complicated if some people's incomes are affected by the falls in prices say because lower import prices cause firms competing with imports to lose sales and reduce the number of people they employ. However, it demonstrates a key feature of inflation that it relates to the amount of demand in the economy. http://www.bankofengland.co.uk/education/targettwopointzero/inflation/whatCausesInflation.htm Now that we have done a nice job determining our assets and liabilities, determining our net worth is only a matter of putting the information into the personal balance sheet format. As my last post in the opportunity cost thread, I would like to touch on a tool to help us compare non taxable benefits with taxable benefits to make better financial decisions. If your boss asks you if you would rather have $1200.00 a year placed into a taxfree pension fund (a nontaxable benefit) or receive a yearend bonus of $1000.00 (a taxable benefit), how would you go about your financial analysis to make the correct decision? Please assume a 26% tax rate and see page 56 of your text for assistance. Nontaxable employee benefits have a higher financial value than most people realize. The following calculations can help you assess and compare different employee benefits within a company or in considering different jobs. Calculate the taxequivalent value of a nontaxable benefit: Value of the benefit/(1Tax Rate) $1,200/10.26 = $1,199.74 E.g., if you are in the 26% tax bracket, a taxfree pension fund of $1200 a year is preferable to receiving a taxable yearend bonus of $1000 We prove this by calculating the tax equivalent amount as follows: $1200/10.26 = $1200/ 0.74 = $1000 Calculate aftertax value of the employee benefit as follows: BUSN380 Week 1 Threaded Discussion – Time Value of Money & Opportunity Costs Taxable value of the benefit (1Tax Rate) = 10.26 = $1000(10.26) = 1000(0.74) = $1200 Put another way a taxable benefit with a value of $1000 would have an aftertax value of $1200 since you would have to pay $200($1000x 0.26) in taxes on the benefit. Nontaxable employee benefits have a higher financial value than most people realize. The following calculations can help you assess and compare different employee benefits within a company or in considering different jobs. Calculate the taxequivalent value of a nontaxable benefit: Value of the benefit/(1Tax Rate) $1,200/10.26 = $1,199.74 E.g., if you are in the 28% tax bracket, buying a life insurance policy with taxfree yearly premiums of $350 is preferable to receiving a taxable benefit worth $486. We prove this by calculating the tax equivalent amount as follows: $350/(1 0.28)= $350/0.72 = $486 $12,000/910.260 = $1,199.74 = $1000/0.74 = $1,351.35 Calculate aftertax value of the employee benefit as follows: Taxable value of the benefit (1Tax Rate) = $486(10.28) = $486(0.72) =$350 10.26 = $1000(10.26) = 1000(0.74) = $1200 Put another way a taxable benefit with a value of $486 would have an aftertax value of $350 since you would have to pay $136($486 x 0.28) in taxes on the benefit.
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