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Question: Erika and Kitty, Who Are Twins, Just Received $30,000 Each For Their 25th Birthday. They Both Hav..

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Question: Erika and Kitty, Who Are Twins, Just Received $30,000 Each For Their 25th Birthday. They Both Hav..

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Question: Erika and Kitty, who are twins, just received $30,000
each for their 25th birthday. They both hav...

Erika and Kitty, who are twins, just received $30,000 each for their 25th birthday. They both have
aspirations to become millionaires. Each plans to make a $5,000 annual contribution to her “early
retirement fund” on her birthday, beginning a year from today. Erika opened an account with the
Safety First Bond Fund, a mutual fund that invests in high-quality bonds whose investors have
earned 6% per year in the past. Kitty invested in the New Issue Bio-Tech Fund, which invests in
small, newly issued bio-tech stocks and whose investors have earned an average of 20% per year in
the fund’s relatively short history.

a If the two women’s funds earn the same returns in the future as in the past, how old will each
be when she becomes a millionaire?
b How large would Erika’s annual contributions have to be for her to become a millionaire at
the same age as Kitty, assuming their expected returns are realized?
c Is it rational or irrational for Erika to invest in the bond fund rather than in stocks?

Solve using a nancial calculator and explain why FV is negative.

Expert Answer

Anonymous Chegg expert


answered this

Please note that the sign of the cash ows such PV, FV or PMT is primarily to tell us whether we are
parting away with that particular cash low or we are receiving the same. If we part away with our PV and
PMT, then we will be entitled to get the FV. In such a case, PV and PMT should have a negative sign as
they signify cash out ow for us. FV is what I get in return so it should then have a positive sign because I
am receiving the money.

Alternatively you can have the cash out ows inputs such as PV and PMT as positive number (so a positive
sign signify cash outlow, hence an in ow will be represented by a negative sign), then in that case the FV
will have a negative value. In a nutshell, your in ows and out ows will have different sign.

Part (a)

I will follow the convention that my out ows have negative sign, so my output FV, which is in ow, will have
a positive sign.

PV = - 30,000, PMT = -5 ,000, FV = 1,000,000

For Erika, i = 6% = 0.06

Hence, n = number of years = NPER (Rate, Payment, PV, FV) = NPER (6%, -5000, -30000, 1000000) =
38.74218224

Please note that the same output could have been obtained, if I had used = NPER (6%, 5000,
30000,-1000000).

So FV need not be negative. It just needs to have a different sign in comparison to that of PV and PMT.

Thus, for Erika, n = 38.74.

So her age when she becomes millionaire = 25 + 38.74 = 63.74 i.e. 64 years old.

For Kitty, i = 20% = 0.20

Hence, n = number of years = NPER (Rate, Payment, PV, FV) = NPER (20%, -5000, -30000, 1000000) =
16.04371287

So her age when she becomes millionaire = 25 + 16.04 = 41.04 i.e. 41 years old.

---------------------------------------------------------------------

Part (b)

We now need to calculate the annual payment i. e. PMT for Erika such that she ends up becoming a
millionaire in the same time frame as Kitty.

Hence, n = 16.04, i = 6% = 0.06

The desired annual payment = PMT(rate, period, PV, FV) = =PMT(0.06,16.04,-30000, 1000000) = - $
35,825.33

Please note that the negative sign indicates that Erika needs to part away this much money every year.

Hence,  Erika’s required annual contributions to become a millionaire at the same age as Kitty, assuming
their expected returns are realized = $ 35,825.33

----------------------

Part (c)

There is nothing rational or irrational here. Every individual has a speci c risk reward requirement.
Securities which give higher returns do have higher risks and vice versa. Erika's risk pro le appears to be
"Cautious" and hence she chose a debt fund where the reward is low but so is her risk.

Given that she is just 25 years old and still a way to go, the general behavior is to go for equity funds. But if
she chose debt fund, there is nothing irrational about it.

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