Sign up  |  Log in

TVM question - 2 interest rates in Question


Q: Couple is saving for child’s tuition for 4 years starting 18 yrs from now. current annual cost of college is 7K, and is expected to rise at an annual rate of 5%. In planning, couple assumes they can earn 6% annually. How much must they put aside each year starting next year, if they plan to make 17 equal payments?

I understand finding the future value of each tuition payment at 18, 19, 20, and 21, and then using the PV formula to equate the tuition payments back to t = 17, BUT shouldn’t the rate used for the PV formula be 5% to find the PV of the tuition payments at t = 17??? The book uses 6%, but my understanding is that is what the couple CAN earn, but what they NEED is what tuition will actually cost and in that case it will only rise by 5%. 

Please let me know where I’m missing something. Thanks for any help you can offer.

The best just got better. Schweser's upgraded content and redesigned study platform are exactly what you need to pass the Level I exam. Save 10% when you preorder a Premium Package for a limited time.

As they can earn 6% p.a. during the 4 year university time the money they need to have saved in year 17 (=PV of annual payments during the 4 years) is less. It would be more if they could earn only 5% - but the text explicity says that they can earn 6% p.a.

Oh wow, it just clicked. So because they can earn 6% while child is at school, I can use that 6% rate to discount each payment back to t =17. Thank you very much for your help Oscar! It is much appreciated.

Plus the 5% is used to determine what the actual dollar amounts needed at times 18 to 21 will be.

“Mmmmmm, something…” - H. Simpson