Required Readings

1. Required Readings Chapter 12. Pages 262-268, 270-276. Chapter 13. Pages 294-297.

2. Overextension of Credit “Good habits are easy to break and bad habits are hard to break” Overuse of credit leads to financial burden and loss of enjoyment in life. Consumer credit is the most expensive kind of credit.

3. Debt Capacity Question: What is your debt capacity? Page 263 - 264 in your text book. Debt capacity is defined as, “the amount of debt that a borrower can reasonably expect to be able to repay under the terms of the loan agreements, given his current and expected financial situations – assets, liabilities, cash flows, income, expenditures, etc. Normally, the borrower’s obligation is to make future payments (interest and principal) to the lender, so debt capacity does not look only at what the borrower has today, but also at what she will have in the future. The most important determinant of one’s ability to generate sufficient cash flow after living expenses and required capital outlays, to pay the interest and principal of all loans to maturity. The lender is interested in both the borrower’s short-run and long-run ability to pay interest and principal” Remember the Financial Life Cycle.

4. Liquidity and Solvency Liquidity is the ability of a family to meet its debt service payments in the short run. Solvency is the long-run ability of the family to pay its debts. The young doctor may have a problem meeting her short-run financial commitments (liquidity) but has excellent long-run potential. The factory worker who is nearing retirement may have no problem with his financial obligations in the short-run (liquidity), but may be worried about supporting himself during his retirement (solvency). Remember the Life Cycle

5. Repayment: Assets vs. Cash Flow Remember. The lender must get his money back (principal) + his profit (interest) to earn a living OR he too will have problems meeting his personal financial obligations. Remember. The lender has a life too. His income is derived from taking a risk and lending money to you! They will collect! YOU can use your Cash Flow or Sell Your Assets. Selling assets is usually a painful experience because you usually do not get the replacement value for them (e.g., diamond ring). Remember your Cash Flows Statement and Net Worth Equation

6. The higher the expected Net Cash Flow (after taxes are paid) and the higher the Net Assets (real value), the higher the debt capacity. Remember: Live within your means and always consider the financial life cycle.

7. Risk and Variability of Cash Flow The future is uncertain. Look at the American economy! Question. Do you know why there are so many American teachers in China? US unemployment is up. People are out of work. Question. Will the Chinese economy ever slow down, resulting in job loss, reduced production? Yes. Question. What happens to prices when fewer goods are produced? Inflation. People must make choices about what to do without. Examples include less recreation, drive the same car for more years (higher repair bills?)

8. What are some other examples of the consequences of inflation?

9. Causes of variation in earning streams It is during the time when cash flow is low that YOU will have problems meeting YOUR debt obligations. What are some real life examples that will affect your earning stream? Loss of employment Pay cut or reduced hours If a commissioned salesperson, poor sales, seasonal fluctuations Death of a breadwinner Disability or poor health (mental health) Failure of a small business (sometimes beyond your control – Walmart is a good example that led to many small business failures in the West) Withdrawal from work for pregnancy (benefits?)

10. Asset Values change over time Depreciation = a decrease in the value of an asset. What are some examples of assets that your family owns that are depreciating right now? Furniture, cars, household appliances, etc. What are some examples of assets that appreciate (increase) in value in the long-run? Houses, stocks, gonds, mutual funds, etc. Remember. Long-run appreciation has its up and down fluctuations. Personal example of my own portfolio.

11. Asset Values (continued) What are some examples that can cause the decrease in asset values? Depreciation due to wear and tear What is important to know when an asset nears the end of it useful life (car, shingles on the roof of your house, furnace that heats your house)? Negative changes in the economy Increases in interest rates (Article Summary: financial literacy month in Canada – mortgage rates going up with increase in prime lending rate. Explanation…) Disaster such as fire, burglary or termite or ant infestation Closing of a major factory in a small town (GM in St. Catharines, ON, Canada – Technology, computer assisted robots – automation - leads to less need to pay people) obsolescence of your professional skills (leads to a decrease in the value of your human capital)

12. Risk Management Not all variability in cash flow and asset value can be controlled. However, it can be managed to a degree. What are some examples of forward thinking that can help you to prepare for the worst, and manage your risk by minimizing your losses? Life Insurance for DEATH Disability Insurance in the case of an accident that makes it impossible for me to work. Unemployment Insurance for job loss (if an employee but not if self-employed). Property Insurance for Damage due to Fire or Natural Disaster.

13. Question. Can you name the risks that you will face in the next 25 years of your life? In the next 2 years? In the next 3-7 years? In the 8-15 years? In the next 16-25 years?

14. How Much Debt Can You Afford The three characteristics of a family’s assets and cash flow include, Liquidity Solvency Risk Question. Is there a theory that can accurately assess the amount of debt that your family can afford? Answer. NO.

15. Question. Why is there not a theory that can assess a family’s debt capacity? Answer. Families make different choices based on their needs. Example. My friend has a child that was hit by a car and suffered a brain injury. His child suffers from some very bad health problems, social problems, no friends, fits of anger, disorganized thinking. My friend requires special health care workers (nurses) to watch his child when he goes to work. He had to build a large fence in his back yard so the child does not wander away. There are more examples. These all cost money and my friend has not yet won the lottery.

16. More examples. Some people have “ Vices “ that are expensive. A vice is a bad habit or destructive activity, like smoking cigarettes, alcohol abuse, gambling and wasting time on-line gaming. In Canada, imagine a person who earns $50,000 annually. See the next slide….

17. What If? Property Taxes Increase? You need a major repair to your house or car? There are no loans in this equation. The cigarettes and alcohol are referred to as Sin Taxes (not syntax) and the prices can increase by 10% or 20% with a government decision and because they are vices and addictive, consumption is not easy to reduce. Is it easy to quit smoking? Do you know anyone with an alcohol abuse problem? These people know that what they are doing to themselves is damaging to their careers and will damage their health in the long run, but they don’t quit.

18. Questions Q. What if this person / family has to take an airplane to the other side of the country for an emergency funeral or replace their car. Are they going to eliminate their vices? Q. How much debt can this person afford? Q. Will they move to a rental apartment, pay $9,000 annually instead of $13,000 for housing? Will that make a big difference in the a) short term or b) long term? Q. What else is missing from this simplified cash flows statement?

19. Subjectivity – Sensibility: Income and Expenditures The most useful tool for assessing debt capacity is a: Budget of income and expenditure (Cash Flows income and expenses) Accompanied by a: Statement of Net Worth (assets minus liabilities = net worth). Tips: Budget for the entire period of your loans so that you can see your liquidity and solvency.