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EAR calculation is correct. PV of future tuition is wrong. If the first year's tuition is paid 14 years from now you have to discount 14 times. Remember, all PV calculations need to be performed as of the same date. You want the PV as of today of both expenditure and revenue.
Inflation applies to tuition only, not to investment return. Each year tuition is more expensive than the previous year by the tuition inflation rate. And since there are only 4 years of tuition to be paid, I suggest you calculate each annual tuition and discount it to the present.
This is what I'm not understanding. I know I'm supposed to grow the tuition (inflation:FV) appropriately but I don't know how to compute since years 1 through 5 have a 3% inflation rate, .25% thereafter... Also, I have not figured out what each annual payment will be for the first 14 years, so how do I add inflation to a PMT I don't know? Am I making this more complicated than it really is??? Really wish I had finance for dummies right now...
This is what I'm not understanding. I know I'm supposed to grow the tuition (inflation:FV) appropriately but I don't know how to compute since years 1 through 5 have a 3% inflation rate, .25% thereafter... Also, I have not figured out what each annual payment will be for the first 14 years, so how do I add inflation to a PMT I don't know? Am I making this more complicated than it really is??? Really wish I had finance for dummies right now...
Inflation works like this:
Suppose the cost in year X is a and the inflation rate is r. Then the cost in year X+1 is a*(1+r). Do this for each year using that year's inflation rate.
Suppose the cost in year X is a and the inflation rate is r. Then the cost in year X+1 is a*(1+r). Do this for each year using that year's inflation rate.
Makes sense?
Excuse my ignorance but no... I apologize as this is probably annoying that I am not grasping what you are trying to explain.
How do I figure out the cost in year 1,2,3,etc.? $6018.48 is apparently incorrect. The calculation you just posted looks like the FV calculation.
Do you mind breaking this down into simpleton terms even more? I'm to the point of just asking for the work to solve the answers and the answers I'll probably have just as many questions as to how you solved for each step.
This is embarrassing.
Thank you for continuing to chime in with help, it's much appreciated.
Let's try this. What does inflation of 10% per year mean? That means next year things will be 10% more expensive. So something that costs $100 today will cost $110, or $100*(1+10%), next year. What about the year after? Say the inflation next year is 5% per year. Then $110 next year will become $110*(1+5%), or $115.5, the year after. So after 2 years something that costs $100 today will cost $115.5.In this case, that something is tuition.Makes more sense now?
Let's try this. What does inflation of 10% per year mean? That means next year things will be 10% more expensive. So something that costs $100 today will cost $110, or $100*(1+10%), next year. What about the year after? Say the inflation next year is 5% per year. Then $110 next year will become $110*(1+5%), or $115.5, the year after. So after 2 years something that costs $100 today will cost $115.5.In this case, that something is tuition.Makes more sense now?
Ok, one step back..
In your example you already have something that costs $100 today and adding inflation. In the actual problem, How do I figure out what tuition will cost today so I can calculate inflation over the next 14 years?
I know that tuition will be $35,000 a year x 4 years, starting 14 years from today. I'm under the assumption that I cannot add things in different points in time so I can't use a value today of $140,000.
How do I find what my very first payment will be in year one so that I can add *(1+3%)?
1) If you wanted to save for your child's education and predict tuition to be $35,000 a year and project her or him to begin 14 years from today. You also predict tuition inflation to be 3% for the next 5 years and then 0.25% a year thereafter.
Quote:
Originally Posted by AmFest
Q1: the future expenditure is tuition. You calculate each year's tuition based on the current year's tuition and future inflation, and discount it back to the present using the effective annual interest rate. You have to convert a compounded annually interest rate to an effective annual interest rate; I'm sure you can handle this conversion.
There you go. Don't add up 4 years of tuition before you factor in inflation. Factor inflation into each year's tuition. Each year's tuition costs $35k today. How much it will cost when the payment is made depends on future inflation. Keep in mind that the interest rate does not yet play a role in this calculation.
The weekend is almost over, so I'm not sure if I'll be able to respond to your posts in a timely manner. Looks like what you're struggling with is inflation, so let me just post my answer for the present value of the tuition piece:
Tuition in year 14: 35k * 1.03^5 * 1.0025^9 = $41,496.7
Tuition in year 15: $41,496.7*1.0025 = $41,600.45
Similar, year 16 and 17's tuition is $41,704.45 and $41,808.91 respectively.
The present value of these tuition payments is :
Tuition in year 14 / (1+i)^ 14 + Tuition in year 15 / (1+i)^ 15 + Tuition in year 16 / (1+i)^ 16 + Tuition in year 17 / (1+i)^ 17
Where i is of course the appropriate periodic interest rate.
Hopefully you can figure out the rest of steps on your own or with someone else's help. Good luck!
The weekend is almost over, so I'm not sure if I'll be able to respond to your posts in a timely manner. Looks like what you're struggling with is inflation, so let me just post my answer for the present value of the tuition piece:
Tuition in year 14: 35k * 1.03^5 * 1.0025^9 = $41,496.7
Tuition in year 15: $41,496.7*1.0025 = $41,600.45
Similar, year 16 and 17's tuition is $41,704.45 and $41,808.91 respectively.
The present value of these tuition payments is :
Tuition in year 14 / (1+i)^ 14 + Tuition in year 15 / (1+i)^ 15 + Tuition in year 16 / (1+i)^ 16 + Tuition in year 17 / (1+i)^ 17
Where i is of course the appropriate periodic interest rate.
Hopefully you can figure out the rest of steps on your own or with someone else's help. Good luck!
Thank you for all of your help, AmFest! The assignment is due by midnight tonight but it's not looking very good..
I see that you posted the annual tuition for years 14,15,16, and 17 with inflation included, so do I add them up and use that number as my PV?
Didn't I give you the formula for the PV of tuition payments in the same post?
Yes, you did.
Given that EAR is 7.07% or .0707
$41,496.7/(1+.0707)^ 14 =
$41,600.45/(1+.0707)^15 =
$41,704.45/(1+.0707)^16 =
$41,808.91/(1+.0707)^17 =
Last edited by jmramirez009; 12-02-2013 at 08:40 PM..
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Really wish I had finance for dummies right now... 
I'll probably have just as many questions as to how you solved for each step.
