Question

An MBA student's aging parent mentions that their insurance agent has offered to sell them a product to provide some security for their descendants. This product's first payout will be 5 years from today, will be $3,000 per month and grow at 0.25% per month indefinitely. Their opportunity cost of funds is 8% per year, compounded monthly.

What is the maximum price the parent should pay for this insurance product? Create and label a CF timeline.

Answer 1

Answer: The maximum price the parent should pay for this insurance product is the present value of the future cash flows, which is $540,000 for the payments starting in year 5 and the present value of the payment at year 5. To calculate the present value of the payment at year 5, we need to discount it back to its present value using the same opportunity cost of funds of 8% per year, compounded monthly. Assuming the payment is made at the end of year 5, the present value of the payment at year 5 is:

PV = Payment / (1 + Discount Rate)^n

PV = $36,000 / (1 + 0.08/12)^60

PV = $17,533.39

Therefore, the maximum price the parent should pay for this insurance product is the sum of the present value of the payments starting in year 5 and the present value of the payment at year 5:

Maximum Price = $540,000 + $17,533.39

Maximum Price = $557,533.39

So the parent should not pay more than $557,533.39 for this insurance product.

Explanation: Above.