Course: Fundamentals of Financial Planning
Lesson 5: Using the Calculator

Student Question:

Good afternoon.  Can you explain why we didn’t take inflation into consideration for the second calculation in the first problem?

Dawn wants to have $25,000 in today’s dollars for a round-the-world cruise when she retires 11 years from now. She assumes she can earn 6% after-tax and that inflation will be 2.5%. She wants to set aside equal monthly contributions at the beginning of each month to reach her goal. What does she need to save at the beginning of each month to reach her goal? Remember, it is a very good idea to write out the steps and keystrokes before you use the calculator. Round your answer to the nearest cent.

To correctly answer this question, remember that this is a two-step question that involves the “accumulation phase” and thus includes a “target inflation calculation” and then a level monthly payment calculation. Be sure to note that in the second step, we are dealing with monthly payments and you must convert both the interest rate and the payment periods to monthly by using the “g” key.

Solution Keystrokes:

Part 1:

f CLX
g 8
25,000 CHS PV
2.5 i
11 n
FV
This adjusts Dawn’s need for income in today’s dollars of $25,000 to $32,802.17 after 11 years of inflation.

Part 2:

f CLX
g 7
FV 32,802.17
6 g i
11 g n
PMT
Monthly investment required to accumulate $25,000 in today’s dollars in 11 years = $175.17.

Kind regards,

Austin


Instructor Response:

Hi Austin,

Happy to help here.  We don’t account for inflation in the second part because we already accounted for it in Step 1 when we solve for our inflated goal.  Once we know what that future inflated dollar amount is, we no longer need to make an interest adjustment to our interest rate.  

It may be easier to think about it by taking interest rate completely out of it.  Let’s just assume that in 10 years, I want the equivalent of $10,000 today.  And I’m just going to put cash under my mattress.  I would need to figure out what the value of $10,000 today will be in 10 years.  I would inflate that by whatever our assumed inflation rate is.  Once I solve that, and for this example we’ll assume it’s $12,000, then I just need to determine how much cash I need to put under my mattress each month so that I have $12,000 in 10 years.  The answer would be $1,000 per month.

Now, instead of putting it under my mattress, I’m going to put it into a savings account that earns 1%.  I still have the same future goal of $12,000 in 10 years, but now my money will earn interest in the savings account.  So, all I will account for now is my 1% earnings when I calculate my new monthly amount needed to save.

Does that help to clarify?  Let me know.

Dan