FINANCE PLANNING
Finance is
the study of how investors
allocate their assets over time
under conditions of certainty and uncertainty.
A key point in
finance, which affects decisions, is the time value of money, which states that a unit of currency
today is worth more than the same unit of currency tomorrow.
Finance aims to
price assets based on their risk level, and expected rate of return.
Finance can be
broken into three different sub categories:
Areas of finance
Personal finance :: Questions in personal finance revolve around
·
How can
people protect themselves against unforeseen personal events, as well as those
in the external economy?
·
How can
family assets best be transferred across generations (bequests and inheritance)?
·
How does
tax policy (tax subsidies and/or penalties) affect personal financial decisions?
·
How does
credit affect an individual's financial standing?
·
How can
one plan for a secure financial future in an environment of economic instability?
Personal financial
decisions may involve paying for education, financing durable goods such
as real estate and
cars, buying insurance, e.g.
health and property insurance, investing and saving for retirement.
Personal financial
decisions may also involve paying for a loan, or debt obligations.
The six key areas
of personal financial planning, as suggested by the Financial Planning
Standards Board, are:
1.
Financial position:
is concerned with understanding the personal resources available by examining
net worth and household cash flow.
Net worth is a person's balance sheet,
calculated by adding up all assets under that person's control, minus all
liabilities of the household, at one point in time.
Household
cash flow totals up all the expected sources of income within a year, minus all
expected expenses within the same year.
From
this analysis, the financial planner can determine to what degree and in what
time the personal goals can be accomplished.
These risks can be divided into
1.
Liability,
2.
Property,
3.
Death,
4.
Disability,
5.
Health and
6.
Long term care.
Some
of these risks may be self-insurable, while most will require the purchase of
an insurance contract.
Determining
how much insurance to get, at the most cost effective terms requires knowledge
of the market for personal insurance.
Business
owners, professionals, athletes and entertainers require specialized insurance
professionals to adequately protect themselves.
Since
insurance also enjoys some tax benefits, utilizing insurance investment
products may be a critical piece of the overall investment planning.
3.
Tax planning:
typically the income tax is the single largest expense in a household.
Managing taxes is not a question of if you
will pay taxes, but when and how much. Government gives many incentives in the
form of tax deductions and credits, which can be used to reduce the lifetime
tax burden.
Most
modern governments use a progressive tax.
Typically,
as one's income grows, a higher marginal rate of tax must be paid.
4.
Investment and accumulation goals: planning how to accumulate enough money for
large purchases, and life events is what most people consider to be financial
planning.
Major reasons to accumulate assets include,
purchasing a house or car, starting a business, paying for education expenses,
and saving for retirement.
To achieve these goals requires projecting
what they will cost, and when you need to withdraw funds.
A major risk to the household in achieving
their accumulation goal is the rate of price increases over time, or inflation.
Using net present value calculators, the
financial planner will suggest a combination of asset earmarking and regular
savings to be invested in a variety of investments.
In order to overcome the rate of inflation,
the investment portfolio has to get a higher rate of return, which typically
will subject the portfolio to a number of risks.
Managing these portfolio risks is most often
accomplished using asset allocation, which seeks to diversify investment risk
and opportunity.
This asset allocation will prescribe a
percentage allocation to be invested in stocks, bonds, cash and alternative
investments.
The allocation should also take into
consideration the personal risk profile of every investor, since risk attitudes
vary from person to person.
1.
Retirement planning
is the process of understanding how much it costs to live at retirement, and
coming up with a plan to distribute assets to meet any income shortfall.
Methods for retirement plan include taking
advantage of government allowed structures to manage tax liability including:
individual (IRA) structures, or employer sponsored retirement
plans.
2.
Estate
planning involves
planning for the disposition of one's assets after death. Typically, there is a
tax due to the state or federal government at your death.
Avoiding
these taxes means that more of your assets will be distributed to your heirs.
You
can leave your assets to family, friends or charitable groups.
Corporate finance
Managerial or corporate finance
is the task of providing the funds for a corporation's activities (for small business,
this is referred to as SME
finance).
Corporate finance generally involves
Balancing risk and profitability,
While attempting to maximize an
entity's wealth and
The value of its stock, and
Generically the
corporate entails three interrelated decisions.
In the first, "the investment decision", management must decide which
"projects" to undertake.
The discipline of capital budgeting
is devoted to this question, and may employ standard business valuation techniques or even extend to real options valuation;
The second, "the financing decision" relates to how these investments
are to be funded:
capital here is provided by
shareholders, in the form of equity,
the firm's operations (cash flow).
Short-term funding or working capital is
mostly provided by banks extending a line of credit.
The balance between these elements
forms the company's capital structure.
The third, "the dividend decision", requires management to determine
whether any unappropriated profit is to
be retained for future investment / operational requirements, or
instead to be distributed to
shareholders, and if so in what form.
Short term financial management is often
termed "working capital
management", and relates to cash-, inventory- and debtors management.
These areas often overlap with the firm's accounting function, however, financial accounting is more concerned with the reporting of
historical financial information, while these financial decisions are directed
toward the future of the firm.
Another business decision concerning
finance is investment, or fund management.
An investment is
an acquisition of an asset in the hope
that it will maintain or increase its value. In investment
management – in choosing a portfolio – one has to decide what, how much
and when to invest. To do this, a company must:
·
Identify
relevant objectives and constraints: institution or individual goals, time horizon,
risk aversion and tax considerations;
·
Identify
the appropriate strategy: active versus passive hedging strategy
·
Measure
the portfolio performance
Financial
management is duplicate with the financial function of the Accounting profession.
However, financial accounting is more concerned with the reporting of
historical financial information, while the financial decision is directed
toward the future of the firm.
Financial risk
management, an element of corporate finance, is the practice
of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk.
Other risk types
include
Shape,
Sector,
Inflation risks,
etc.
It focuses on when
and how to hedge using financial instruments; in this sense it overlaps
with financial engineering.
Similar to general
risk management,
financial risk management requires
identifying its sources,
measuring it, and
formulating plans to address these, and
can be qualitative and quantitative.
In the banking
sector worldwide, the Basel
Accords are generally adopted by internationally active banks for
tracking,
reporting and
exposing operational,
credit and
market risks.
Financial services
An entity whose
income exceeds its expenditure can lend or invest the excess income.
On the other hand,
an entity whose income is less than its expenditure can raise capital by
borrowing or
selling equity claims,
decreasing its expenses, or
increasing its income.
The lender can
find a borrower,
a financial intermediary such as a bank, or
buy notes or bonds in the bond market.
The lender receives interest, the borrower
pays a higher interest than the lender receives, and the financial intermediary
earns the difference for arranging the loan.
A bank aggregates
the activities of many borrowers and lenders.
A bank accepts
deposits from lenders, on which it pays interest.
The bank then
lends these deposits to borrowers.
Banks allow
borrowers and lenders, of different sizes, to coordinate their activity.
Finance is used by
individuals (personal finance),
by governments (public finance),
by businesses (corporate finance)
and
by a wide variety of other organizations,
including schools and non-profit organizations.
In general, the
goals of each of the above activities are achieved through the use of appropriate
financial instruments and methodologies, with consideration to their
institutional setting.
Finance is one of
the most important aspects of business management and includes decisions related to the use
and acquisition of funds for the enterprise.
In corporate finance,
a company's capital structure is the total mix of financing methods it
uses to raise funds.
One method is debt financing,
which includes bank loans and bond sales.
Another method is equity financing - the
sale of stock by a company to investors, the original shareholders of a share.
Ownership of a
share gives the shareholder certain contractual rights and powers, which
typically include the right to receive declared dividends and to vote the proxy
on important matters .
The owners of both
bonds and stock, may be institutional investors - financial
institutions such as investment banks and pension funds
or private individuals, called private investors
or retail investors.
Public finance
Public finance
describes finance as related to sovereign states and sub-national entities
(states/provinces, counties, municipalities, etc.) and related public entities
(e.g. school districts) or agencies. It is concerned with:
·
Identification
of required expenditure of a public sector entity
·
Source(s)
of that entity's revenue
·
The
budgeting process
Central banks,
such as the Federal Reserve System banks in the United States and Bank of England in
the United Kingdom, are strong players in public finance, acting
as lenders of last resort as well as strong influences on monetary
and credit conditions in the economy.
Capital
Capital, in the financial sense, is the money that gives the
business the power to buy goods to be used in the production of other goods or
the offering of a service.
The capital has
two types of resources Equity and Debt.
The deployment of
capital is decided by the budget. This may include the objective of
Business,
Targets set, and
Results in financial terms,
e.g., the target set for sale,
Resulting cost,
Growth,
Required investment to achieve the
planned sales, and
Financing source for the investment.
A budget may be
long term or short term.
Long term budgets
have a time horizon of 5–10 years giving a vision to the company; Short
term is an annual budget which is drawn to control and operate in that
particular year.
Budgets will include proposed fixed asset
requirements and how these expenditures will be financed.
Capital budgets are often adjusted annually and
should be part of a longer-term Capital Improvements Plan.
A cash budget is also required. The working capital
requirements of a business are monitored at all times to ensure that there are
sufficient funds available to meet short-term expenses.
The cash budget is basically a detailed
plan that shows all expected sources and uses of cash.
The cash budget has the following six main
sections:
1.
Beginning
Cash Balance - contains the last
period's closing cash balance.
2.
Cash
collections - includes all
expected cash receipts (all sources of cash for the period considered, mainly
sales)
3.
Cash
disbursements - lists all
planned cash outflows for the period, excluding interest payments on short-term
loans, which appear in the financing section. All expenses that do not affect
cash flow are excluded from this list (e.g. depreciation, amortization, etc.)
4.
Cash
excess or deficiency - a
function of the cash needs and cash available. Cash needs are determined by the
total cash disbursements plus the minimum cash balance required by company
policy. If total cash available is less than cash needs, a deficiency exists.
5.
Financing - discloses the planned borrowings and
repayments, including interest.
Financial theory
Financial economics
Financial economics is the branch of economics studying
the interrelation of financial variables, such as prices,
interest rates and
shares, as opposed to those concerning the real economy.
Financial economics concentrates on
influences of real economic variables on financial ones, in
contrast to pure finance.
It centres on decision making
under uncertainty in the
context of the financial markets, and the resultant economic and financial models.
It essentially
explores how rational investors would apply decision theory to
the problem of investment.
Although closely
related, the disciplines of economics and finance are distinctive.
The “economy” is a social institution that
organizes a society’s
Production,
Distribution, and
Consumption of goods and
Utilisation of Services,”
all of which must
be financed.
They generally
regard financial markets that function for the financial system as an efficient
mechanism.
Instead, financial
markets are subject to human error and emotion.
New research
discloses the mischaracterization of investment safety and measures of financial
products and markets so complex that their effects, especially under conditions
of uncertainty, are impossible to predict.
The study of
finance is subsumed under economics as financial economics, but the
scope,
speed,
power relations
and
practices of the
financial system can uplift or cripple whole economies and
the well-being of
households,
businesses and
governing bodies
within them—
sometimes in a
single day.
Financial mathematics
Financial
mathematics is a field of applied mathematics, concerned with financial markets.
The subject has a close relationship with the discipline of financial
economics, which is concerned with much of the underlying theory.
Experimental finance
Experimental finance aims to establish different market
settings and environments to observe experimentally and provide a lens through
which science can analyze
agents' behavior
and
the resulting
characteristics of trading flows,
information
diffusion and
aggregation, price
setting mechanisms, and
returns processes.
Research may
proceed by conducting trading simulations or by establishing and studying the
behaviour of people in artificial competitive market-like settings.
Behavioral finance
Behavioral Finance studies how the psychology of investors or
managers affects financial decisions and markets. Behavioral finance has grown
over the last few decades to become central to finance.
Behavioral finance
includes such topics as:
1.
Empirical
studies that demonstrate significant deviations from classical theories.
2.
Models
of how psychology affects trading and prices
3.
Forecasting
based on these methods.
4.
Studies
of experimental asset markets and use of models to forecast experiments.
Intangible asset finance
Intangible asset
finance is the area of finance that deals with intangible assets such as
patents,
trademarks,
goodwill,
reputation, etc.
HE WHO COMMANDS MONEY, COMMANDS EVERYTHING.
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