A couple wants to save for their daughter’s college expense. The daughter will e

Question

A couple wants to save for their daughter’s college expense. The daughter will enter college 10 years from now and she will need $45,000, $46,000, $47,000 and $48,000 in actual dollars for 4 school years. Assume that these college payments will be made at the beginning of the school year. The future general inflation rate is estimated to be 5% per year and the annual inflation-free interest rate is 6%. What is the equal amount, in actual dollars, the couple must save each year until their daughter goes to college?

Explanation / Answer

We can assume that couple wants save money for ten years beginning from now.

First we will have to calculate the PV of the cash stream at the end of 10th year.

Considering inflation rate is 5%

45000 + 46000/(1.05)^1 + 47000/(1.05)^2 + 48000/(1.05)^3

This much amount is needed ay the end of 10th year.

Now we will have to calculate the annual payment with 6% real interest rate for 10 years which will be equal to sum at the end of 10th year.

We can use financial calculator or excel for this purpose as it is quite difficult to do these calculations.

In excel, I have used PMT function which gives us required annual investment made for 10 years

= 172904.114

This is the amount they require at the end of 10th years
13117.8821

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