Project # 1 Instructions

Introduction
In this project, you are going to make a mathematical model of one of three of the most
important financial decisions you are likely to make in your life. Please note that this
project may prove helpful to you later in life when you are actually making these decisions
for real, but its usefulness will depend entirely on the amount of effort and realism you put
into it now. So, I highly encourage you to put more than the minimum effort into this and to
be as honest with yourself to achieve a very real, authentic result.

The three life events we will model are saving for retirement, buying a car and buying a
house. While I encourage you to work together to do research and to work with the
formulae, each part will require you to make some personal decisions, so I expect every
project to be unique. I chose these three life events because of their universality.

Assumptions
To make the project manageable without an MBA, we will need to make a few assumptions.
Indeed, every mathematical model has assumptions built in to simplify the calculations. As
long as the assumptions are realistic and their consequences are understood, the
inaccuracies they introduce are tolerated and a good model can be achieved.

Our first assumption will be that you will indeed graduate with a degree in the major
towards which you are currently working (officially or otherwise). I say that this is an
assumption not because I doubt the abilities of any of you, but because some students
change majors, become delayed by outside forces or postpone their studies for personal
reasons. Some students become discouraged by the lack of funding our school has and the
limited number of classes that result. Others find jobs outside their major and become
complacent with the paycheck they are earning and stop attending school. For whatever
reason, it is not a given that all of you will graduate in your current major, but we will make
this simplifying assumption, nevertheless.

The second assumption we will make will detract from the realism of our experiment, but
to a small and calculable degree. We will assume there to be no inflation during the period
of time we will be considering. Now, since the historic rate of inflation in the U.S. has been
between 2% and 3%, it may seem irresponsible to make such an assumption. I just want to
make it very clear that a successful project can be completed without any concern for
inflation.
Income
Now, you might have noticed that the common theme with these three life events is the
requirement of income. Without income, none of these things are possible. So we will need
to begin by modeling an expected income for you. So, considering your major area of study,
level of experience and desired career path, you will need to find between 3 to 5 examples
of entry-level jobs you might expect to get upon graduation.

Of course, if your experience warrants it, find jobs one or two promotions away from entry-
level. You should probably also find a few national and/or local averages for starting
salaries in the job you are modeling. Therefore, when this data is collected, you should have
between 5 to 8 numbers to consider as a possible starting salary for you. You might choose
to average these or take the median. However, you do it, choose a number that you feel
represents a realistic income you will expect to earn once you land your first job out of
college. Please note where each bit of data comes from and how you chose your final
number. Again, since this is the starting point for the rest of the project, you might want to
spend a good amount of time and effort researching these values.

Retirement
One of the first things you should do once you have begun your career is to plan on how you
will end it. By that, I mean retirement. If you learn only one thing from this project, I hope it
is that being young people, time is your best friend when it comes to securing your
retirement. Indeed, the longer you wait to begin saving, the higher the interest rate (and
larger deposits) you will need to earn to generate the same amount in your retirement
account.

To begin this part of the model, you should already have completed the Income part. The
reason for this is that we will attempt to secure you that level of income (until you die) in
perpetuity. (We don't want you to "outlive your money".) Of course, our calculations will
work with any income level you choose, so if you want to have a higher income in
retirement, you may, but again, try to be as honest and realistic as you can. Let us call this
yearly desired income.

This first calculation will use simple interest. Thus, n = 1. Notice that, if we use P for
starting principal, or the amount of money in your retirement account when you retire, and
A for accumulated balance, we will have:

𝐴 = 𝑃(1 + 𝐴𝑃𝑅)

at the end of your first year of retirement. But we don't need for your account to grow, we
just need it to stay the same size. Thus, we will set 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐴 − 𝑃. In this way, you will
"live off the interest" your account generates, leaving the principal, P alone. You might have
noticed that we can simplify matters algebraically:
 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐴 − 𝑃 = 𝑃(1 + 𝐴𝑃𝑅) − 𝑃 = 𝑃 + (𝐴𝑃𝑅)𝑃 − 𝑃 = (𝐴𝑃𝑅)𝑃

This equation sets up a nice relationship between our desired income level in retirement
𝑖𝑛𝑐𝑜𝑚𝑒
and the amount in your retirement account. Solving for P, we get: 𝑃 = 𝐴𝑃𝑅 . But we have
not determined the interest rate you will earn during retirement.

Notice that this will not be the same rate you earned while you were working. This is
because you will not want to take as much market risk at that stage of your life. Thus, your
interest rate will be much lower here. Feel free to pick any rate between 3% and 6%.

Now that we have determined how much you will need in your retirement account when
you retire (P from the very last equation), we relabel this amount as A, or the accumulated
balance in the savings stage of your life. We are now ready to use the Savings Plan
Formula* to determine how much you will need to deposit regularly to attain that A. We
will set P = 0 to denote that you don't have any existing retirement account.

EXTRA: Perhaps some of you will get monetary gifts or inheritances upon graduation. You
might want to see the effect of putting that money towards your retirement. We do this by
setting P equal to that gift or inheritance value.

There is another thing we need in order to use that formula. That is APR. What interest rate
can you expect to earn as you are saving? Here, we will investigate the effect of interest
rates on your savings. I would prefer that you do a little research into Kiplinger's, Forbes, or
Motley Fool to determine a realistic rate of return to expect. Those sources (and many
others) give historic rates of return on many types of investments, such as mutual funds,
the most common and useful vehicle for this type of investing.

If the thought of reading those magazines or visiting those websites scares you, you may
run the calculations for 3 different rates: 6%, 8%, and 9%. History has shown the stock
market to return an average between 8% and 9%. The 6% value represents the rate of
return a very conservative, or risk averse, investor might expect.

The final element we need to nail down is time in years, Y. This of course, will be a very
personal consideration, and it depends completely on your current age (or the age you will
be when you graduate) and the age you expect to be when you retire. Alternately, you may
simply consider the number of years you plan to work. Here again, there is room to explore
the effects of a single variable on your model. Please run the calculations with at least 3
different values of Y, representing you retiring at age 55, at age 65, at age 70 and at any
other ages you choose to investigate.

Now we are all set. We have values for A, P, APR and Y. Oh! Almost forgot! Let's set n = 12 to
represent monthly compounding. This is very typical and corresponds to monthly deposits
into your account anyways. So, we expect to use the formula below at least 12 times and get
12 different values for PMT, the regular deposit you will need to make into your retirement
account to make your retirement dreams come true.
Savings Plan Formula

𝐴𝑃𝑅 𝑛𝑦
𝑃𝑀𝑇[(1+ ) −1]
𝑛
𝐴= 𝐴𝑃𝑅
𝑛

Please conclude this part of the project with a few sentences (a paragraph at most) about
your results.

Buying a Car

Buying a car was once a very simple transaction. Few car makers offered very few models
with a very limited number of added features. Thus, one would go to the dealer, choose a
color, and pay the asking price for the car.

Now, however, there are many car brands, each with various models and trim lines having a
multitude of added features. To make matters worse, because incomes have not kept up
with inflation, most of us need to consider financing the vehicle. Further, most banks now
offer the option to lease a car when the one you want is too expensive for outright
financing.

We are going to model you purchasing your next car.

First, we need to do some research. Begin by choosing a make and model of car you wish to
own. It can be any car, so long as it makes sense to you to own it. Next, we will need at least
3 different price quotes for that particular vehicle. These can be from newspaper ads, TV
ads, dealer websites, or elsewhere, as long as they represent a minimum of 3 firm offers to
sell that car. You will then average these prices to get your purchase price.

We are now ready to compare a few different situations. Using three different interest rates,
2% (representing excellent credit), 4% (average credit) and 8% (poor credit), please
calculate payments for terms of 3 years, 5, years and 7 years. Next, use these payments to
determine how much will be paid for the car overall, and how much interest you will pay.

At this point, you will have a lot of data to look at. As a conclusion to this part, write a few
sentences (a paragraph at most) about your results, including which set of terms you would
most likely use. Feel free to mention how long you plan to own the vehicle and any other
lifestyle choices that may affect your decision.
Buying a House
Ironically, the most important financial event of your life is the easiest to model. We are
already pros at calculating payments, so this part should go smoothly.

First, you will need to determine a present value, P, for the house you want to buy. A little
research online should enable you to find at least 3 houses in the area you would like to live
with similar features (square footage, number of bedrooms/bathrooms, amenities, etc.).
Take the average of these as the present value, or sale price, of your new house.

Second, we will need some information on mortgage interest rates that you can find almost
anywhere online or in the Business section of the newspapers. In case there is any
confusion, you will be looking for interest rates for a conventional, 30-year conforming
loan. (This is as opposed to a jumbo loan for higher loan amounts, which usually are a few
percentage points higher.) Once you have at least three rates, average them to get one
interest rate. This value will represent the interest rate you would pay if you had Excellent
credit. Unfortunately, not everyone has such great credit, and we cannot predict what your
credit score will be when you are ready to purchase a house. Therefore, add 1% to get the
interest rate for someone with Average credit. Finally, add another 1% to get the interest
rate for someone with Poor credit.

Third, we will want to investigate the effect of time on our mortgage payments, so we will
use 3 different terms (although we have only researched the interest rates for 30-year
loans). Let us use 15 years, 25 years, and 30 years for the lengths of our mortgage.

We are now ready to calculate. First calculate the payment, PMT, for your mortgage with Y =
30 and APR equal to the average interest rate you found above. Once you have found a value
for PMT, determine how much you will have paid for your house over the length of your
mortgage. We compute this value, which is sometimes referred to as “total paid” by
multiplying 𝑛 × 𝑌 × 𝑃𝑀𝑇.

It will be advisable to present your results in a table, with interest rates on one axis and
lengths on the other axis. Please conclude this part with a few sentences about (a
paragraph at most) about your results, specifically which option you would choose. Again,
you may include any non-financial reasons in your discussion.