In: Finance
An insurance company is offering a new policy to its customers. Typically the policy is bought by a parent or a grandparent for a child at the child's birth. The details of the policy are as follows: The purchaser(say, the parent) makes the following six payments to the insurance company:
First birthday: $400
Second birthday: $500
Third birthday: $600
Fourth birthday: $700
Fifth birthday: $800
Sixth birthday: $900
After the child's sixth birthday, no more payments are made. When the child reaches age 65, he or she receives $250,000. If the relevant interest rate is 11 percent for the first six years and 7 percent for all subsequent years, is the policy worth buying?
First we calculate present value of payments made to insurance company and payments received from insurance company. | ||||||||
If present value of Payment received from insurace company is more than payments made to insurance company, then policy is worth buying. | ||||||||
Otherwise, not. | ||||||||
Interest rate for six years = | 11% | |||||||
Interest rate for subsequent years = | 7% | |||||||
Present value of payments made to Insurance company | ||||||||
Year | Cash Outflow | P.V.F. @ 11% | Present value | |||||
1 | 400 | 0.900901 | $360.36 | |||||
2 | 500 | 0.811622 | $405.81 | |||||
3 | 600 | 0.731191 | $438.71 | |||||
4 | 700 | 0.658731 | $461.11 | |||||
5 | 800 | 0.593451 | $474.76 | |||||
6 | 900 | 0.534641 | $481.18 | |||||
Total | $2,621.94 | |||||||
Present value of payments received by insurance company | ||||||||
Future value = | 250000 | |||||||
I = | 7% | |||||||
n = | 65 | |||||||
Present value = Future value / (1+i)^n | ||||||||
250000 / (1+0.07)^65 | ||||||||
$3,076.06 | ||||||||
Decision : Present value of payments received by insurance company is $3076.06 more than payments made to insurance company ($2621.94) | ||||||||
So, Policy is worth buying. | ||||||||