Question

You are planning to take a spring break trip to Canada your senior year. The trip is exactly two years away, but you want to be prepared and have enough money when the time comes. Explain how you would determine the amount of money you will have to save in order to pay for the trip.

2. Identify the steps involved in computing the present value when you have multiple cash flows.

Answer 1

1.

• First, determine the current cost it takes to accommodate a trip
• Then if historical data is available for the cost we can find the inflation rate of the cost otherwise we can assume the inflation rate of the economy
• Once the inflation rate is found then the current cost has to be compounded for two years to reach an expected cost of the trip after two years
• That will be the FV of the savings I will be doing. Now, this is an annuity case where a certain amount would be deposited regularly in a savings account that pays a certain interest rate.
• The future value formula of annuity is : FV = A*{(1+i)^n - 1}/i , where we have to find A with given n (period of deposit), i = interest rate offered in that saving scheme, FV = future value.

2.

• Identify future cash flows
• Determine the interest rate on the deposit
• Find the cashflow timeline i.e. monthly or quarterly or semi-annually or yearly
• Find the effective interest rate according to the timeline
• For finding the PV we have to discount each future cash flows with an effective interest rate found earlier
• Sum of all the PV of all future Cash Flows will be the PV