Wk 2 - Assessing your financial position

Compounding

earning interest on interest

real interest rate equation

nominal interest rate - inflation

what is nominal interest rate?

the interest quoted by banks

Difference between explicit and implicit assets

explicit - the types of assets you can convert to cash

implicit - when you cannot convert to cash quickly eg house

Human capital is ___ but also ____

real asset, risky - if you realise risks you can avoid risks to maximise human capital

What is the growth rate of human capital?

3% so we can estimate how much the median salary is going to be in the future

When we discuss human capital it is

the present value of future income

Present value is discounted future value equation

• Present value = future value / (1 + discount rate)t

What do we need to estimate human capital:

• Income

• How income changes/grows

• The risk of that income, impatience in waiting for income, other opportunities for income, inflation, the discount rate

Human capital (present value) equation over years

Year 1 wage/ discounted + year 2 wage/ discounted + year 3 wage/discounted

Wht is the tricky part of estimating human capital?

•  the discount rate

• The larger discount rate we have, the lower the present value

Another human capital equation

∑ (wage t -1 X (1 + wage growth) X survival t / (1 + discount rate) t )

• We include _____ in calculation of human capital - because not everybody is …

survival, alive until retirement age

What does discount rate reflect?

risks in your future income - major factor could be health issue

What is t in the human capital equation?

t is the term of the discount

This present value formula shows up everywhere

• How much can I borrow?

• How much will my savings grow to?

• How long will it take to pay off my loan?

• What rate of return am I making?

We assume the return rate but there are many risks before you get the money:

risk, inflation, opportunity cost

Orders of magnitude (the rule of 72)

Divide 72 by the number of years it takes to double give the rate you earn. For example: return rate of 6%:  72/6% = takes 12 years to double wealth

What should your takeaway be of TVM?

• Size of future cash flows - larger future cash flows, present values

• Timings/numbers of cash flows

  • Longer you wait for cash flows the samller present values

• Risk (impatience/inflation) or cash flows

  • High risk, higher discount rate, smaller PVs

What is the annual inflation rate in Aus?

4%

What is the target for inflation?

2-3%

Inflation experience

• Being a milllionaire isn’t what it used to be

• In 1972 if you had $100k you had the equivalent purchasing power of $1 million in 2017