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Counting and Using Your Money

Hufht, tomorrow will be the day for financial planning course’s mid-term test. I does not feel like studying at all. Hence I think I will try to absorb things by writing the material here on this post. I hope I can sum up the whole things I have learned since January into a single blog post. Beware that the material in this post will be pretty technical stuffs.

Stages of Economic Life

Briefly, it is a process of managing your money so you can fulfill your financial goals. There are a few steps that you have to follow;

  1. Define financial goals
  2. Develop financial plans and strategies
  3. Implement financial plans and strategies
  4. Develop and implement budgets
  5. Use financial statements to evaluate results
  6. Redefine goals and revise plans as situations change

The list basically sums it all. Sounds easy? Yeah, but the planning part is actually very hard (and after you finish it, the reality most of the times never give you easy money as you have planned) 😦 There are a lot of risks such as default risk, credit risk, tax risk,  inflation risk, currency risk, politic risk, market risk, event risk, prepayment risk, extension risk, and opportunity risk. But yeah the plan can help you to be aware of your own expenses and incomes.

Elementary things to know are assets, liability, and net worth. Assets are what you own, liabilities are what you owe, and net worth are the differences between the previous two. The more positive the net worth, it means the richer you are. Before doing any investment, it is suggested that you take a risk profiling to know what kind of profile do you have. Are you a conservative person? Or are you aggressive? Or are you somewhere between the two? Your profile will give you a hint of what kind of investment will be comfortable for you. For example, a conservative person will have hard times if he decides to invest things on stocks; because the pressure and the risk is so high usually stock investment is not matched to conservative person.

Next thing is time value of money. Do you agree that 1 $ today worth less than a dollar 10 years ago? If you have the money in the past, you can either buy things which worth more or you can invest the money. Inflation takes part in it. I do not really understand about it and I also do not want to discuss it. What I want to describe is how you determine money’s future value. An example; what will $1000 become if invested at 7% for 5 years? It will be: $1.000 x 1,403 = $1.403

Where does the 1,403 come from? It is a factor you can find (1 + r)^n where r is the interest rate (the percentage %) and n is the years. So (1 + 0,07)^5 = 1,40255 which can be rounded to 1,403. To find the present value of the money, you can just divide the future value of the money with the factor. Quite simple isn’t it? In summary, (FV = future value, PV = present value, f = factor)

FV = PV x f and PV = FV/f.

Next is to calculate the total value of money if you add it annually. Which usually be said as annuity. If you want to have $1 million in 5 years, how much do you have to set aside from your saving annually to meet the goal? Say that you invest it on something with an interest rate of 8%. How do you do the math? The answer is $170.444,86. How? The formula is: (FVA = future value annuity, K = periodic cash flow, FVIFA = future value interest factor of annuity = (((1 + r)^n) – 1)/r | r is the interest rate and n is the years)

FVA = K x FVIFA

PVA = K x PVIFA

The second formula is for present value annuity. (PVA = present value annuity, K = periodic cash flow, PVIFA = present value interest factor of annuity = (1 – (1/((1 + r)^n)))/r ) – Sorry if the brackets are a bit confusing. PVA means the value of money in the present (NOW). You can say that FVIFA = PVIFA x f where f is the factor I said above = (1 + r)^n. I hope you understand my messy explanation about the time value of money.

Quick quiz! Do you choose to be given IDR 400 million now or IDR 55 million every year for the next 10 years? (Assumed that the money will be invested at 5% interest rate)

Oh yeah, in making a financial plan, remember always to put aside money for emergency situations. How big your emergency fund is your choice, but there is an advice that says if you are single, your emergency fund should be 3 months of your monthly income. For family with two kids it is 6 months. And for fertile dad and mom who have 3 kids or more, it is 9 to 12 months. This fund is something you will use in case you are fired from your job or if some random accidents occur; so that your financial status will not be shaken up too much. OK it is not really complicated. NEXT!

Do you know what are the differences of debt and equity? Debt includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. Equity consists of funds provided by the firm’s owners (investors or stockholders) that are repaid subject to the firm’s performance. I myself is not really well informed on this matter so I will not write anything more about this thing – and I do not intend to really understand all about stocks and bonds in a few hours. The quick formula firsts! Because the test will be about calculating things and not conceptual, haha.

Common stock valuation can be categorized as 3 types. One is the zero growth model. Two is the constant growth model. Three is the variable growth model. Briefly:

Common Stock Valuation Equations

The upper most equation is for zero-growth. The next two are for constant-growth. The variables: D1 is the dividend at year 1, p0 is the stock’s price at year 0, rs is the required return of the stock, g is the average return, and N is the years. The last is for variable-growth. The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year. The constant-growth model is a widely cited dividend valuation approach that assumes that dividends will grow at a constant rate, but a rate that is less than the required return. The variable-growth model is a dividend valuation approach that allows for a change in the dividend growth rate.

Risk and Returns

With the three formulas above, you can compute expected returns and compare risks between one asset and another. How? You can find the return with the first equation. The standard deviation can be used to calculate the risk while the coefficient of variation is used to find the relative risk. Sorry for the lack of explanation.

I think I have jotted down the formulas that is commonly used. Now is a good time to do little exercises and then go to sleep, preparing for tomorrow morning – I don’t want to be late for sure!

PS: Yay! The word count has exceeded 1000 haha.

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2 comments on “Counting and Using Your Money

  1. veehcirra
    March 7, 2012

    You are speaking Greek here 😉 am not a numbers girl whatsoever. Wish you the best in your test.

    • tida
      March 7, 2012

      haha 😀 thanks! I hope i will do well in today’s test.

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This entry was posted on March 6, 2012 by in Academics and tagged , , , , , , .

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