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    Time Value of Money

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    Old Alfred Road, who is well-known to drivers on the Maine Turnpike, has reached his seventieth birthday and is ready to retire. Mr. Road has no formal training in finance but has saved his money and invested carefully.

    Mr. Road owns his home?the mortgage is paid off?and does not want to move. He is a widower, and he wants to bequeath the house and any remaining assets to his daughter. He has accumulated savings of $180,000, conservatively invested.

    The investments are yielding 9 percent interest. Mr. Road also has $12,000 in a savings account at 5 percent interest. He wants to keep the savings account intact for unexpected expenses or emergencies.

    Mr. Road's basic living expenses now average about $1,500 per month, and he plans to spend $500 per month on travel and hobbies. To maintain this planned standard of living, he will have to rely on his investment portfolio. The interest from the portfolio is $16,200 per year (9 percent of $180,000), or $1,350 per
    month.

    Mr. Road will also receive $750 per month in social security payments for the rest of his life. These payments are indexed for inflation. That is, they will be automatically increased in proportion to changes in the consumer price index.
    Mr. Road's main concern is with inflation. The inflation rate has been below 3 percent recently, but a 3 percent rate is unusually low by historical standards. His social security payments will increase with inflation, but the interest on his investment portfolio will not.

    What advice do you have for Mr. Road? Can he safely spend all the interest from his investment portfolio? How much could he withdraw at year-end from that portfolio if he wants to keep its real value intact?

    Suppose Mr. Road will live for 20 more years and is willing to use up all of his investment portfolio over that period. He also wants his monthly spending to increase along with inflation over that period. In other words, he wants his monthly spending to stay the same in real terms. How much can he afford to spend per month?

    Assume that the investment portfolio continues to yield a 9 percent rate of return and that the inflation rate will be 4 percent

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    Solution Preview

    Please see the attached file.

    I would advise Mr. Road to cut costs and/or reduce the amount he intends to spend on travel or hobbies. He might also consider working at a part time job somewhere to supplement his income as he does not have sufficient earnings to support his intended lifestyle (based on interest earnings alone). He might also consider withdrawing some of the principal from his portfolio to help pay for his hobbies.

    At this point, he cannot afford to withdraw all the interest earned on his portfolio because inflation will erode the ...

    Solution Summary

    A detailed account of monthly income relative to total investments for a retiree. Includes a spreadsheet that demonstrates the effects of living on interest income only versus consuming the principal over a given time period.

    $2.19