Bilbo Baggins wants to save money to meet three objectives. First, he would like
ID: 2734658 • Letter: B
Question
Bilbo Baggins wants to save money to meet three objectives. First, he would like to be able to retire 30 years from now with retirement income of $27,000 per month for 15 years, with the first payment received 30 years and 1 month from now. Second, he would like to purchase a cabin in Rivendell in 10 years at an estimated cost of $355,000. Third, after he passes on at the end of the 15 years of withdrawals, he would like to leave an inheritance of $700,000 to his nephew Frodo. He can afford to save $2,000 per month for the next 10 years. Required: If he can earn a 12 percent EAR before he retires and a 10 percent EAR after he retires, how much will he have to save each month in years 11 through 30?
Explanation / Answer
The cash flows for this problem occur monthly, and the interest rate given is the EAR. Since the cash flows occur monthly, we must get the effective monthly rate. One way to do this is to find the APR based on monthly compounding, and then divide by 12. So, the pre-retirement APR is:
EAR = 0.12 = [1 + (APR/12)] 12- 1;
APR = 12[(1.12) 1/12- 1] =0 .1134 or 11.34%
And the post-retirement APR is:
EAR = 0.10 = [1 + (APR/12)] 12 -1
APR = 12[(1.10) 1/12 -1] = 0.0953 or 9.53%
First, we will calculate how much he needs at retirement. The amount needed at retirement is the PV of the monthly spending plus the PV of the inheritance. The PV of these two cash flows is:
PVA = $27000{1 -[1/(1 + .0953/12) 12(15) ]}/(.0953/12) = $27000{0.7593/0.0079}=2,595,075.95
PV = $700,000/[1 + (.0953/12)]180 =139,536.74
So, at retirement, he needs:
$2,595,075.95+ $139,536.74= $2734612.69
He will be saving $2,000 per month for the next 10 years until he purchases the cabin. The value of his savings after 10 years will be:
FVA = $2,000[{[1 + (.1134/12)] 12(10) -1}/(.1134/12)] =2000[3.0916 /0.00945]=$654,298.12
After he purchases the cabin, the amount he will have left is:
$654,298.12-355,000 =$299198.12
He still has 20 years until retirement. When he is ready to retire, this amount will have grown to:
FV = $299198.12[1 + (.1134/12)] 12(20) = $2859656.24
So, when he is ready to retire, based on his current savings, he will be excess by:
$2734612.69-2859656.24 = $-125043.55
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.