Question

Why is it important to prepare a financial budget?

Explain what is meant by the term "time value of money". For example, why might it be better to receive $8 today, over receiving a promise of $9 seven years from now?

How should one consider the time value of money when planning for retirement? Please share examples within your response.

Answer 1

(1). Important to prepare a financial budget

Budgeting is that the most elementary and therefore the simplest tool for managing your cash. Yet, the majority avoid doing it as a result of its further work, very like cutting your field or fixing the roof. Budgeting conjointly connotes that you simply got to surrender and stop yourself from enjoying stuff.

What budgeting really will clearly show you ways you apportion your cash and gift you the alternatives on what stuff to get pleasure from – supported your monetary limitations. it'll prevent the grief of overspending and being an excessive amount of in debt. Budgeting doesn't stop you from enjoying stuff, it ensures that you simply get pleasure from stuff once you wish it.

Benefits of Budgeting

• Offers your management over your cash – A budget may be an approach of being intentional regarding the approach you pay and save your cash. it's aforesaid that with budgeting, you manage your cash and not your cash controls you. Budgeting saves you the strain of suddenly having to regulate to a scarcity of funds as a result of you probably did not ab initio arrange the way to pay them. It conjointly helps you opt if you would like to sacrifice short term payment like shopping for low a day in exchange for a protracted-term profit like cruise vacation or a brand new HDTV.
• Keeps you centered on your cash goals – You avoid payment unnecessarily on things and services that don't contribute to attaining your monetary goals. If you're operating with restricted resources, budgeting makes it easier to create ends meet.
• Causes you to awake to what's happening together with your cash – With budgeting, you're clear on what cash is coming back in, how briskly it goes out, and wherever it's aiming to. Budgeting saves you from inquisitive each finish of the month wherever your cash went. A budget allows you to understand what you'll afford, make the most of shopping for and investment opportunities, and arrange the way to lower your debt. It conjointly tells you what's necessary to you supported however you apportion your funds, however, your cash is functioning for you, and the way you're towards reaching your monetary goals.
• Helps you organize your payment and savings – By dividing your cash into classes of expenditures and savings, a budget causes you to aware that class of expenditure takes that portion of your cash. That way, it's simple for you to create changes. The budget conjointly is a reference for organizing your bills, receipts, and monetary statements. once all of your monetary transactions are organized for tax time or mortal queries, you save time and energy.
• It causes you to decide prior to however your cash can work for you.

• Allows you to avoid wasting for expected and surprising prices – Budgeting permits you to arrange to put aside cash for emergency prices.
• Allows you to speak {with your|together with your|along with your} vital others regarding cash – If you share your cash with your relation, family, or anyone, a budget will communicate however you utilize cash as a bunch. This promotes cooperation in operating for common monetary goals and prevents conflict on however cash is employed. making a budget in bicycle-built-for-two together with your relation can avoid conflicts and resolve personal variations in however your cash is spent. Budgeting teaches members of the family payment responsibility and answerability.
• Provides you with AN early warning for potential issues – once your budget and take a “big picture” read, you'll see potential cash issues prior to, and be able to create changes before the matter seems.
• Helps you identify if {you will|you'll|you'll be able to} take debt and the way abundant – Taking debt isn't essentially a nasty factor if the debt is important otherwise you can afford it. Budgeting shows you ways abundant a debt load you'll really take while not being stressed or if taking the debt load is worthwhile.
• Allows you to provide extra cash – In budgeting, you get to spot and eliminate superfluous spendings like late fees, penalties, and interests. These on the face of it little saving will add up over time

(2) . what is meant by the term "time value of money".

• Definition

Time Value money} may be a construct that acknowledges the relevant value of future cash flows arising as a result of monetary choices by considering the chance value of funds.

• Concept

Money loses its price over time that makes it a lot of fascinating to possess it currently instead of later.

There area unit many reasons why cash loses price over time. Most clearly, there's inflation that reduces the shopping for power of cash.

But very often, {the cost|the price|the price} of receiving cash within the future instead of currently is larger than simply the loss in its real value on account of inflation. the chance value of not having money|the money} at once additionally includes the loss of extra financial gain that you just may have attained just by having received the cash earlier. Moreover, receiving cash within the future instead of currently could involve some risk and uncertainty relating to its recovery. For these reasons, future money flows area unit value but the current money flows.

Time Value of cash construct makes {an attempt|tries} to include the higher than issues into monetary choices by facilitating an objective analysis of money flows from completely different time periods by changing them into gift price or future price equivalents. This ensures the comparison of 'like with like'.

The present or future price of money flows area unit calculated employing a discount rate (also called the value of capital, WACC and needed rate of return) that's determined on the premise of many factors such as:

• Rate of inflation: -Higher the speed of inflation, higher the come that investors would need on their investment.
• Interest Rates:-Higher the interest rates on deposits and debt securities, larger the loss of interest financial gain on future money inflows inflicting investors to demand the next come on investment.
• Risk Premium :- Greater the chance related to future money flows of associate degree investment, higher the speed of come needed by associate degree investors to make amends for the extra risk.

Consider an easy example of a monetary call below that illustrates the employment of your time price of cash.

Example
Suppose that you just have attained a money bonus for an impressive performance at your job throughout the last year.

Your happy boss provides you two choices to decide on from:

● possibility A: Receive $10,000 bonus currently
● possibility B: Receive a $10,800 bonus once one year

Further info that you'll think about in your decision:
- rate of inflation is five-hitter once a year.
- charge per unit on bank deposits is twelve-tone music once a year.

Which possibility would you choose?

Solution
Although in absolute terms possibility B provide the upper quantity of bonus, possibility A provides you the selection of receiving bonus one-year previous possibility B. this could be useful for the subsequent reasons:

To start with, you'll be able to purchase a lot of with $10,000 currently than with $10,800 in one year's time because of the five hundred inflation.
Secondly, if you receive the bonus currently, you'll invest the profit a deposit and earn a secure annual come of twelve-tone music. in distinction, you stand to lose this interest financial gain if you decide on possibility B.
Thirdly, the future is unsure. In the worst-case situation, the corporate you're employed for may become bankrupt throughout the consequent year which might considerably scale back your possibilities of receiving any bonus. The likelihood of this happening could be remote, however, there would be a chance none the less.

(3).   The time value of money when planning for retirement

Time value of money is one of the most fundamental concepts in finance and states that one dollar is more valuable today than one dollar is a year from now. This is because a dollar today can be invested to earn interest, and this interest can be reinvested in order to earn more interest and so on in a process called compounding interest.

Scenario (Power of Time)

This concept is much easier understood in an example. If an investor has $10,000 to invest today and they can earn 4.00% a year by investing it in individual bonds, the first year they will earn $400, which can then be reinvested to earn interest in the next period. In the next period, the investor will earn $416.00 in interest due to the larger principal amount at the beginning of the period, and by year ten the investor will be earning almost $570 in interest, or 42% more than year one without adding any additional funds to the portfolio. A breakdown of a ten-year investment of $10,000 earning 4% interest annually can be seen below. This chart shows the power time and compound interest can have on the value of a portfolio and highlights the importance of investing money rather than keeping it in cash and cash-like investments.

Retirement Planning

This concept is crucial to retirement planning, as when someone begins investing may be one the most important factor in the size of their nest egg at retirement. To highlight the importance of time in investing, below is a chart showing three scenarios. All three scenarios involve investing $200,000 throughout the course of a career, however, each one involves beginning investing at different ages. This scenario assumes a 5% annual growth rate for all invested funds.

The Blue line represents a scenario of an investor who begins investing $5,000 per year at age 25 for 40 years. This scenario results in a total portfolio value of $604,000 at age 65, with over $400,000 in interest earned, or double their own contributions to the portfolio.

The Orange line represents someone who begins investing $6,666.67 per year at age 35 resulting in a nest egg of $443,000 at age 65.

The Yellow line represents someone who beings investing $10,000 per year at age 45 resulting in a nest egg of only $330,000 at age 65.

This example highlights the importance of investing early and the drastic impact time can have on a portfolio’s value at retirement.