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Dowry Problem

Kevin has found the woman of his dreams and will marry soon. He has a bright financial future and quite impressed with what he will bring in monetary terms to the relationship. He's presently gainfully employed and expects that his earnings power will increase substantially after he gains more work experience and completes business school.

Kevin's fiancé is an aspiring socialite. She hopes to maintain her youthful looks for a steady schedule of social events, so tries to avoid stress at all costs. That means she intends to quit her job after they marry, and avoid the rigors of child-rearing and housework. She comes from a very wealthy family.

Knowing that he will be the sole breadwinner of the household, Kevin thinks a dowry is in order. Oddly, neither his fiancé nor her father objects. His future father-in -law is agreeable to the idea of a dowry that approximates the present value of Kevin's likely career earnings. Using the assumptions below, how much should he request?

Age: 25
No debt of financial assets
Retirement Age: 65
Years 1,2,3: Earnings = $60,000
Years 4,5: Full time business school costing $50,000 each year
Starting salary after graduate school: $120,000
Years 7-10: 5% annual earnings growth
Years 11-20: 10% annual earnings growth
Years 21-40: 3% annual earnings growth


Solution Preview

To start, we need to know what an annuity is.

An annuity is a series of cashflows paid in fixed time intervals (called period). The number of intervals of payments is referred to as number of periods. For all annuities, the payment is always made at the end of the period.

An ordinary annuity is one in which the cashflow does not growth with respect to time. For instance, with interest rate = 3%, I am obligated to receive $300 per month for 120 months in total.

A growing annuity is one in which the cashflow grows. For instance, in the previous example, if I will receive $300 per month for the first month, and a 5%/month increment for the subsequent months, this would be a growing annuity.

The present value of a growing annuity is [P/(r-g)]{1 - [(1+g)/(1+r)]^n] if g does not equal to r and Pn/(1+r) if g = r. For more information, see ...

Solution Summary

The monetary terms to the relationships are provided. The no debt of financial assets are provided.