BA 2802 – PRINCIPLES OF FINANCE

1. Your sister is just engaged today and she is going to be married exactly 2 years from today. Your
sister and her fiancée would like to pay for their wedding themselves and do not accept any money
from your and the groom’s parents. Therefore, your parents decided to surprise them with a gift of
a week-long honeymoon in the Caribbean. Your parents talked to a travel agent and learned that a
honeymoon travel package to the Caribbean 2 years from today will cost $20,000 excluding the
airfare. However, if your parents can pay 6 months before the travel time, they will get a 5%
discount on this price. They also talked to the airline company and learned that two tickets to the
Caribbean 2 years from today will cost $3,000. However, if they can buy the tickets 9 months
before the travel time, they have to pay just $2,700. Your parents would like to save enough money
to buy the airline tickets for the couple 9 months before the travel time to qualify for the discount
price and pay for the honeymoon package 6 months before the travel time so that they can qualify
for a 5% discount.

Your parents’ bank is running a special for honeymoon accounts and pays a 9% interest rate with
monthly compounding on these accounts for the next two years. Your parents set up a honeymoon
account.

a. After careful calculations, your parents determine that they can deposit $1,750 every two
months starting today and continuing until the day of the payment for the honeymoon package.
Determine if your parents will have enough money accumulated in their bank account to
purchase this honeymoon package (6 months before their wedding) and the airline tickets (9
months before their wedding) for your sister and her fiancée as they originally planned. If not,
calculate the deposits your parents have to make into the honeymoon account every two
months to achieve this goal.

Amount your parents need to save for the airline tickets and the honeymoon in 18 months from
today:

For the honeymoon with 5% discount they need to have

The cost of airline tickets at t = 15 is $2,700. The FV of these airline tickets at the end of the
18th month:

To calculate this FV we need the monthly interest rate (periodic rate).

( )
1
0.09 12 × 12 0.09
Effective 1-month interest rate = 1+ −1= =0.0075=0.75 %
12 12

3
FV 18=2,700 × ( 1.0075 ) =2,761.21
OR

To calculate this FV we need the quarterly interest rate (periodic rate).

( )
1
0.09 12 × 4
The effective 3-month rate = 1+ −1=0.022669=2.2669
12

1
FV 18=2,700 × ( 1.022669 ) =2,761.21
1
 Total amount needs to be saved by your parents = 19,000+2,761.21 = $21,761.21

We need to find the FV of the annuity savings in order to figure out if they have enough money
saved. Since deposits are made every 2-months, we need to calculate the effective two-month
interest rate.

( )
2
0.09 12 × 12
Effective 2−month Rate= 1+ −1=0.0151=1.51 %
12

During the next 18 months your patents will make deposits at t=0, 2, 4, 6, 8, 10, 12, 14, 16 and
18. Hence, they will make a total of 10 bimonthly deposits into the account. FV of these on the
day of last deposit into the account is:

( 1.0151 )10−1
FVA 18=1,750 × FVIFA ( 1.51 % , 10 )=1,750 × =18,738.3
0.0151

It will not be enough.

To accumulate $21,761.21 in the account by the end of 18 th month, bimonthly deposits your
parents have to make into the account is

( 1.0151 )10−1
FVA 18=C × FVIFA ( 1.51 % ,10 ) =C × =21,761.21
0.0151

C = $2,032.31

b. Suppose your parents purchased the airline ticket 9 months before your sister’s wedding.
Moreover, today (six months before the wedding), they paid for the honeymoon package of
your sister and her fiancée. After seeing the power of savings, they decided to start saving for
their retirement. They both have state-sponsored retirement plans. Each will be paid $1,200 at
the beginning of every month during their retirement from these state-sponsored plans as long
as they live. They would like to have a monthly income of $6,000 in addition to the money they
will get from their state-sponsored retirement plans during their retirement. They also would
like to receive this $6,000 additional income at the beginning of every month during their
retirement. They hope to live for 20 more years after retirement. They will get the first monthly
income from this account on the day they retire and the last income one month before their 20 th
retirement anniversary. They plan to work for 16 more years and then retire. To achieve their
retirement goal, your parents open up a retirement account in their bank. Their bank pays a
7.5% interest rate per year with monthly compounding on retirement accounts until the account
owners die. Determine the amount of money your parents need to accumulate in their account
by the time of their retirement to achieve their retirement goal.

The amount of money they need to have in their account when they retire (16 years from
today):

Monthly withdrawals from the account = $6,000

2
 Number of monthly withdrawals from the account = 20×12 = 240

( )
1
0.075 12 × 12
Effective monthly rate = 1+ −1=¿0.075/12 = 0.00625 = 0.625%
12

1
1−
( 1+0.00625 )240
PVIFA ( 0.625 % , 240 ) = =124.1321
0.00625

The first withdrawal from this account will be exactly 16 years from today. We will find the PV
of these annuity withdrawal 1 periods (month) before the first withdrawal. This will be 15
years and 11 months from today.

PVA 15 years∧11months ¿ today ¿=6,000× PVIFA ( 0.625 % , 240 )

We need to find the value of this at the time of retirement, t=16.

FV16 = PVA15 years and 11 months from today×(1+0.00625) = 744.792.60×(1.00625) = $749,447.55

c. Your parents decided to make quarterly deposits into their retirement account starting today.
Their last deposit into the account will be on their retirement day. Determine the quarterly
deposits your parents have to make into their retirement account.

They want to accumulate $749.447.74 in their account when they retire 16 years from today by
making quarterly deposits.

Number of quarterly deposits = 16×4+1 = 65

( )
1
0.075 12 ×
Effective quarterly Rate= 1+ 4
−1=0.0189=1.89 %
12

( 1+0.0189 )65−1
FVIFA ( 1.89 % , 65 )= =125.7756
0.0189

FVA 16=C × FVIFA ( 1.89 % ,65 )=749,447.55

749,447.55
C= =$ 5,958.61
125.7756

d. With your sister moving out and you having a scholarship covering all of your college
expenses, your parents decided that they can deposit $7,200 every quarter into their retirement
account. Any money that they cannot use during their retirement period will be divided equally
between you and your sister. Determine the amount of money each of you will get from your
parents when they die.

With quarterly deposits of $7,200, money they will have in their account when they retire at
t=16 is:
3
FVA 16=7,200 × FVIFA ( 1.89 % , 65 ) =7,200× 125.7756=905,584.32

After subtracting the amount they need for their retirement:

905,584.32 – 749,447.55 = $156,136.77 extra amount in the account at t=16

The amount each of you will have 20 years (240 months) later:

156,136.75 240
FV 20= × ( 1.00625 ) =348,2483.74
2