Question

Richard e-mailed me that he and Monica differed about the impact of his extra spending over the past 15 years. He calculated it at about $3,000 a year. He said the total cost of $45,000 was well within his capability to make up. Monica said the cost was much higher and asked that they compute it. They had been offered an investment of $20,000 that would pay $70,000 in 20 years. They want to know if they should take it. Finally, Richard could sign up for an annuity at work. It would cost $100,000 at age 65 and provide payments of $8,000 per year over his expected 17-year life span. He wants to know if it is attractive. The appropriate market rate of return on investments is 7 percent after tax.

a. Calculate what the $3,000-per-year deficit, had it been invested, would have amounted to at the end of the 15-year period.

b.

Calculate the return on the proposed $20,000 investment and indicate the factors entering into your recommendation to accept or reject it.

Choose TRUE if you accept it

Choose FAlSE if you reject it.

Answer 1

a.$3,000-per-year deficit, had it been invested, would have amounted to at the end of the 15-year period = This is a case of annuity.

Amount = 3,000[{(1+0.07)¹⁵-1}/0.07]

= $75,387.07

b.Return on Investment will be calculated as follows:

Let the return be x%

70,000*PVF(x%, 20 years) = 20,000

PVF(x%, 20 years) = 0.2857

From present value table, return is close to 6.5%

factors entering into your recommendation to accept or reject it are:

1.Return on Other investments

2.Opportunity Cost

3.Availability of funds

FALSE, i.e. reject it since The appropriate market rate of return on investments is 7 percent after tax and this investment is offering less than 7% return.