Question

Your professor has offered to give you $100, starting next year, and after that growing at 3% for the next 20 years. You would like to calculate the value of this offer by calculating how much money you would need to deposit in the local bank so that the account will generate the money you would need to deposit in the local bank so that the account will generate the same cash flows as he is offering you. Your local bank will guarantee a 6% annual interest rate so long as you have money in your account.

1. How much money will you need to deposit into your account today?

2. Using an excel spreadsheet, show explicitly that you can deposit this amount of money into the account, and every year withdraw what your brother has promised, leaving the account with nothing after the last withdrawal.

3. Change the bank annual interest rate from 6% to 10% what is the difference?

Answer 1

To calculate the amount of money needed to deposit into the account today, we can use the concept of present value. The present value represents the current value of future cash flows, taking into account the time value of money.

1. To calculate the present value of the cash flows, we can use the formula for the present value of an annuity:

PV = C * (1 - (1 + r)^(-n)) / r

Where PV is the present value, C is the cash flow per period, r is the interest rate per period, and n is the number of periods.

In this case, the cash flow per period is $100, the interest rate per period is 6% (0.06), and the number of periods is 20.

Plugging in the values into the formula:

PV = 100 * (1 - (1 + 0.06)^(-20)) / 0.06

Calculating this value gives us the amount of money needed to deposit into the account today.

2. To show explicitly using an Excel spreadsheet, you can set up a column for each year, starting from year 0 (the present year) to year 20. In the first row, enter the initial deposit amount calculated in step 1. In the subsequent rows, use a formula to calculate the value for each year by adding the interest earned and subtracting the annual withdrawal of $100. The last value in year 20 should be zero, indicating that the account will have no remaining balance after the last withdrawal.

3. If the bank's annual interest rate changes to 10%, you would need to recalculate the present value using the new interest rate. Repeat step 1 with the new interest rate of 10% (0.10) to find the updated amount of money needed to deposit into the account today. Compare this value with the previous amount calculated with a 6% interest rate to determine the difference.