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A financial planning service offers a college savings program
A financial planning service offers a college savings program. The plan calls for you to make six annual payments of $15,000 each, with the first payment occurring today, your child's 12th birthday. Beginning on your child's 18th birthday, the plan will provide $27,000 per year for four years. What return is this investment offering?
Expert Solution
Investments made are considered negative cash flows, while the return or payout on the investment is considered a positive cash flow, as noted below.
- Year 1: -15,000,
- Year 2: -15,000,
- Year 3: -15,000,
- Year 4: -15,000,
- Year 5: -15,000,
- Year 6: -15,000,
- Year 7: 27,000,
- Year 8: 27,000,
- Year 9: 27,000,
- Year 10: 27,000
When there are multiple cash flows, we utilize the Internal Rate of Return (IRR) calculation to take into consideration the discounting or compounding of the cash flows over time. The manual formula is very complex. The best way to calculate the IRR is to utilize the IRR function in Excel, which is as follows:
=IRR (values, guess of a rate)
The values would be the range of cells representing the annual cash flows.
The guess is the guess of a rate of return. (We will use a guess of 10% in this example.)
| Cell | A1 | B1 | C1 | D1 | E1 | F1 | G1 | H1 | I1 | J1 |
|---|---|---|---|---|---|---|---|---|---|---|
| ($15,000) | ($15,000) | ($15,000) | ($15,000) | ($15,000) | ($15,000) | $27,000 | $27,000 | $27,000 | $27,000 |
The resulting formula in Excel is =IRR (A1:J1,0.1).
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