BUS 365: Investments

Solution to Practice Problems

Time Value of Money

1) You recently inherited $50,000 and plan to invest that money at 10%
interest. You also plan to save $5,000 per year for each of the next five
years. You then plan to spend two years traveling before settling down.
During those two years, you will not be able to save money. Rather, you will
spend $10,000 out of your savings each year. How much money will you
have in seven years? For simplicity, assume that the $5,000 in annual
savings occurs at the end of each year (the first one occurs one year from
today). Also, assume that the $10,000 withdrawals occur at the end of the
year (the first one occurs six years from today).

Answer: V7 = $50,000 × 1.17 + $5,000 × FVIFA10%,5 × 1.12 -

$10,000 × FVIFA10%,2
= $113,371.71

2) As an investment advisor, you are developing an investment plan for a

new client.

Information on the client follows.

- The client plans to retire in 30 years.
- The client desires an annual retirement income that will provide purchasing
power (measured in today’s dollars) of $60,000.
- The client has saved $40,000 to date.
- The client’s salary will likely grow at 5% per year.
- The client’s daughter plans to go to college in three years and the client
wishes to pick up the expected cost of $10,000 per year for four years.
- The client is conservative and currently has a portfolio with a beta of 0.8.
You believe a beta of 0.8 is appropriate given the client’s level of risk
aversion. Once the client retires, however, you believe a beta of 0.2 will be
more appropriate for the client’s portfolio.

Other information follows.

- The yield on long-term Treasury securities is 4.0%.
- The expected return on the Russell 3000 index is 9.0%.
- Inflation is expected to be 2% per year indefinitely.
- To be conservative, your policy is to develop a plan based on a client life
expectancy of 50 years following retirement.

Develop a reasonable retirement plan for the client. Specifically, describe a

well-reasoned savings plan that will meet the client’s goals. In doing so, you
should assume that the client’s savings will increase at the rate of his/her
salary growth.

Answer:
Expected return, working years = 4.0%+0.8×(9.0%-4.0%) = 8%
Expected return, retirement years = 4.0%+0.2×(9.0%-4.0%) = 5%
Expected withdrawal, 1st year of retirement = $60,000×1.0231 =
$110,855.33
Account balance needed at retirement = $110,855.33×PVIFGA5%,2%50
= $2,827,858.44
Value of savings = $40,000×1.0830 - $10,000×FVIFA8%,4×1.0823 +
C×FVIFGA8%,5%,30

Then,
$2,827,858.44 = $40,000×1.0830 - $10,000×FVIFA8%,4×1.0823 +
C×FVIFGA8%,5%,30
and C = $14,057.10

3) You recently inherited $100,000. You plan to save $8,000 during the next
year (year 1) and increase that amount by 5% per year until you retire in 35
years. During that period, you plan to plan to invest entirely in stocks that
are expected to earn 11% per year. During retirement, you plan to invest in
safer investments that earn 6% per year. The expected inflation rate is
2.5%.

a) If you plan as if you will live forever and you wish to maintain constant
annual purchasing power during retirement, how much can you withdraw
each year during retirement?

Answer:
Value of savings = V35 = $100,0001.1135 + $8000FVIFGA11%,5% =
$8,265,330
Value of withdrawals = V35 = C/(0.06-0.025)  $8,265,330
Setting these equal to each other and solving for C gives C =
$289,287.

So, we can withdraw $289,287 36 years from now and then increase
that amount by 2.5% each year forever.

b) What is the purchasing power of those annual withdrawals in today’s

dollars?
Answer:
Purchasing power in today’s dollars = $289,287/1.02536 = $118,924
4) You plan to save $7,000 each of the next 40 years, and invest that money
in an account that pays 9% annual interest. In addition, you plan to pay for
your child’s college education beginning in 20 years. You expect that
education to cost $30,000 per year for four years. To pay for the education,
you will simply withdrawal money from your investment account. In addition,
you currently have an outstanding loan with a balance of $15,000 and an
annual interest rate of 9%. You plan to pay off that loan over the next few
years. A timeline depicting this situation follows.

Date 0 1-19 20-23 24-40

Deposits $7,000 $7,000 $7,000
Withdrawal $30,000
s
Loan $15,000
Balance

a) How much money will you have just after you make your last deposit forty
years from today?

Answer:
Value of deposits in 40 years = $7,000FVIFA9%,40 = $2,365,177
Value (i.e., opportunity cost) of debt in 40 years $15,0001.0940 =
$471,141
Value of college withdrawals in 23 years = $30,000FVIFA9%,4 =
$137,194
Value of college withdrawals in 40 years = 1.0917 = $137,1941.0917
= $593,725
Account Balance in 40 years = $2,365,177-$471,141-$593,725 =
$1,300,311

b) [2 pts] How much money will you have 5 years later (year 45) if you make
no additional deposits or withdrawals?

Answer:
Value in 45 years = $1,300,3111.095 = $2,000,690

c) As an intelligent and informed financial planner, you have been asked to

evaluate the assumptions and analysis above. What specific flaws do you see
(if any)?

Answer: The analysis fails to incorporate potential increases in

salary, which would allow you to save more and more over time. It
also fails to incorporate inflation, which can dramatically affect the
purchasing power of the retirement savings.
5) You plan to work for 35 years and then retire. You currently have nothing
saved toward retirement, but you plan to save 10% of your salary each year
for the next thirty years. Your current salary is $60,000 per year and you
expect that salary to grow at about 6% per year. Inflation is expected to be
2% per year indefinitely. All of your savings will be invested in a portfolio of
stocks that is expected to pay an 11% annual return. At the time you retire,
you plan to move your money into a safer portfolio that is expected to pay
7% per year. As an eternal optimist, you expect to live forever. Assume that
you want your purchasing power to be the same each year during retirement
and that you want to spend the maximum amount possible under the
assumptions above.

a) How much money can you withdraw during the first year of retirement (in
36 years)?

Answer:
Vsavings in 30 years = $6,000FVIFGA11%,6%,30 = $2,057,857
Vsavings in 35 years = Vsavings in 30 years1.115 = $3,467,608
Vsavings in 35 years = $3,467,608  Vretirement withdrawals = C/(0.07-0.02)
Solving gives C = $173,380

b) What is the purchasing power of a given annual retirement withdrawal in

today's dollars?

Answer:
Purchasing power today = $173,380/1.0236 = $84,995

6) You have discovered a magical elixir that will allow you to live forever. You
subsequently sold the rights to that elixir for $15,000,000 and have invested
that money at 10% interest. The expected inflation rate is 2.5% forever.
Finally, you wish to pay for your daughter’s wedding which you estimate will
occur in 25 years. Measured in today’s dollars, you plan to spend $500,000
on the wedding. Assuming that you plan to never work again and that you
wish to have the same purchasing power each year (excluding the wedding
cost) during your retirement, what is the maximum amount you can
withdraw during your first year of retirement? For simplicity, assume that the
first withdrawal will occur in one year, the second in two years, etc.

Answer: We expect to spend $500,000×1.025^25 = $926,972 on the

wedding. Using the concept of indifference, we know that spending
$926,972 in 25 years is equivalent to spending $926,972/1.125 =
$85,556 today. Said differently, if we set aside $85,556 today, it will
have grown to $926,972 in 25 years. So, we effectively have
$15,000,000-$85,556 = $14,914,444 available today for our
retirement planning. We know that the present value of a growing
perpetuity is V0 = C1/(R-g), which gives us C1 = V0×(R-g). It follows
that we can withdraw $14,914,444×(0.1-0.025) = $1,118,583 during
our first year of retirement.

7) You plan to save $8,000 each of the next 35 years, and invest that money
in an account that pays 9% annual interest. In addition, you plan to pay for
your child’s college education beginning in 20 years. You expect that
education to cost $30,000 per year for four years. To pay for the education,
you will simply withdrawal money from your investment account. In addition,
a long-lost relative recently died, leaving you $50,000. A timeline depicting
this situation follows.
Date 0 1-19 20-23 23-35
Deposits $50,000 $8,000 $8,000 $8,000
Withdrawal $30,000
s
How much money will you have just after you make your last deposit 35
years from today?

Answer: Using the concept of indifference, we can simply calculate

the value of each set of cash flows at date 35 and then add them
together.
Value at date 35 of $50,000 inheritance = $50,000×1.09 35 =
$1,020,698
Value at date of 35 of $8,000 annuity = $8,000×FVIFA9%,35 =
$1,725,686
Value at date 23 of $30,000 college payments = $30,000×FVIFA9%,4 =
$137,194
Value at date 35 of $30,000 college payments = $137,194×1.0912 =
$385,880
Total at date 35 = $1,020,698 + $1,725,686 - $385,880 = $2,360,504

8) You plan to save $8,000 each of the next 40 years, and invest that money
in an account that pays 8% annual interest. In addition, you plan to pay for
your child’s college education beginning in fifteen years. You expect that
education to cost $20,000 per year for four years. To pay for the education,
you will simply withdrawal money from your investment account. In addition,
a long-lost relative recently died, leaving you $50,000. A timeline depicting
this situation follows.

Date 0 1-14 15-18 19-40

Deposits $50,000 $8,000 $8,000 $8,000
Withdrawal $20,000
s
How much money will you have just after you make your last deposit forty
years from today?

Answer:
Value of deposits in 40 years = $8,000×FVIFA8%,40 = $2,072,452
Value of inheritance in 40 years = $50,000×1.0840 = $1,086,226
Value of college expenses in 18 years = $20,000×FVIFA8%,4 =
$90,122
Value of college expenses in 40 years = V18×1.0822 = ×1.0822 =
$489,953
Amount saved after 40 years = $2,072,452 + $1,086,226 - $489,953
= $2,668,725

9) You plan to work for 30 years and then retire. You currently have $25,000
saved toward retirement and you plan to save 10% of your salary each year
for the next thirty years. Your current salary is $55,000 salary year and you
expect that salary to grow at about 5% per year. Inflation is expected to be
2% per year indefinitely. All of your savings (including the $25,000 saved and
the money taken out of your savings) will be invested in a portfolio of stocks
that is expected to pay a 10% annual return. At the time you retire, you plan
to move your money into a safer portfolio that is expected to pay 8% per
year. As an eternal optimist, you expect to live forever. Assume that you
want your purchasing power to be the same each year during retirement and
that you want to spend the maximum amount possible under the
assumptions above.

a) How much money can you withdraw during the first year of retirement (in
31 years)?

Answer:
Savings in 30 years
Value of $25,000 already saved = $25,000×1.130 = $436,235
Value of additional savings = $55,000×10%×FVIFGA10%,5%,30 =
$1,444,021
Total savings = $436,235+$1,444,021 = $1,880,256

Retirement Withdrawals
Value of Withdrawals in 30 years = $C×PVIFGA8%,2%,∞ = $C/(0.08-
0.02)
where C is the first retirement withdrawal

Total Savings = Total Withdrawals, so

$1,880,256 = $C/0.06
Solving gives C = $112,815

b) What is the purchasing power of that withdrawal in today’s dollars?

Answer:
Purchasing power = $112,815/1.0231 = $61,061

10) A university decides to offer students two different tuition options. In the
first, a new freshman can pay a one-time fixed payment of $100,000. In the
second, the student would make four annual payments of $29,000 each. The
university would guarantee the student that there would be no tuition
increase during the four years. Assume that the first of the $29,000
payments would be due at the same time that the $100,000 would be due. If
the appropriate discount rate is 6%, which option should students prefer?

Answer: There are several ways to compute the value of the four-
payment option. First,
V-1 = $29,000PVIFA6%,4 = $100,488
V0 = V-11.06 = $106,517.

Second,
V0 = $29,000 + $29,000PVIFA6%,3 = $106,517

In either case, the single fixed payment option is better.

11) You plan to save $10,000 next year. In each subsequent year, you plan to
save 5% more than the prior year. You plan to save for a total of 35 years. In
addition, you currently have total savings of $25,000. Those savings and all
subsequent deposits will be invested in an account that pays 10% annual
interest. Upon retiring, however, you plan to move that money into a safer
account that earns 7% annual interest. A timeline depicting this situation
follows.

Date 0 1 2 ... 35
Deposits $10,000 $10,0001. ... $10,0001.
05 0534
Current $25,00
Savings 0

a) How much money will you have just after you make your last deposit 35
years from today?
Answer:
Value of current savings in 35 years = $25,0001.135 = $702,561
Value of deposits in 35 years = $10,000FVIFGA10%,5%,35 = $4,517,284
Total amount saved = $702,561+$4,517,284 = $5,219,845

b) Suppose that inflation is expected to be 2.5% per year indefinitely.

Suppose further that you want each of your annual retirement withdrawals to
have the same purchasing power. If you plan to live forever, what is the
largest amount you can withdrawal during your first year of retirement?
Answer:
Let W be the amount of the first withdrawal. We know that
WPVIFGA7%,2.5%, = $5,219,845
Solving for W gives W = $234,893

c) What is the purchasing power of an annual retirement withdrawal,

measured in today's dollars?
Answer: Purchasing power = $234,893/1.02536 = $96,563

12) You decide to wait for five years before saving money toward retirement.
You then wish to save a certain amount each year for 30 years, at which time
you hope to have saved $1,500,000. If you invest in an account that earns
8% annual interest, how much must you invest each year to meet your goal?
A timeline depicting this situation follows.

Answer: Let C be the amount we save each year. We know that

CFVIFA8%,30 = $1,500,000
Solving for C gives C = $13,241