You are offered an insurance policy that will pay you and your heirs $25,000 a year...

You are offered an insurance policy that will pay you and your heirs $25,000 a year forever, with the first cash flow coming 40 years from today. The policy will cost you $130,000 today. If the interest rate is 4%, is this a good deal?

Expert Solution

We know that the policy will cost $130,000. The deal will be good if present value of benefits exceed or equate to the cost of the policy i.e. $130,000. Let's calculate present value of future benefits.

The value of all the cash flows in perpetuity will be estimated by discounting the annual cash flows by interest rate. Hence value of all the cash flows in perpetuity = $25,000/4% = $625,000. However this value is as of 40 years after the current date. Hence the present value of this cash flow in perpetuity = $625,000/(1+4%)^40 = $130,181.

Since the present value of these benefits ($130,181) exceed the cost ($130,000), the deal is good.

jeff jeffy answered 2 years ago

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