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Erika and Kitty, who are twins, just received $30,000 each for their 25th birthday.

They both have aspirations to become millionaires. Each plans to make a $5,000
annual contribution to her “early retirement fund” on her birthday, beginning a year
from today. Erika opened an account with the Safety First Bond Fund, a mutual fund
that invests in high- quality bonds whose investors have earned 6% per year in the
past. Kitty invested in the New Issue Bio-Tech Fund, which invests in small, newly
issued bio-tech stocks and whose investors have earned an average of 20% per year in
the fund’s relatively short history. a. If the two women’s fund earn the same
returns in the future as in the past, how old will each be when she becomes a
millionaire? b. How large would Erika’s annual contributions have to be for her to
become a millionaire at the same age as Kitty, assuming their expected returns are
realized? c. Is it rational or irrational for Erika to invest in the bond fund
rather than in stocks?

The future value F of such payments that are made on a yearly basis and have their
interest compounded (annuities) is given by the following formula.

(1  r ) n 1  (r  1)
F  P[ ] (1)
r
where P is the yearly payment ($5,000 in this case), r is the annual interest rate,
and n is the number of years.

In this case F is given (one million) and we need to solve for the number of years
n. The above formula can be written in terms of n as

 Fr  
log     r  1 
n  P   1 (2)
log r  1
a) For Erika’s case F = 1,000,000, r = 0.06, P = 5,000 which, using the equation (2)
above, gives n = 43.1 years. Thus Erika will be just over 68 years old by the time
she becomes millionaire.

For Kitty’s case F = 1,000,000, r = 0.2, P = 5,000 which, using the equation (2)
above, gives n = 19.4 years. Thus Kitty will become a millionaire by the time she is
about 45.5 years old, i.e. almost 20 years before Erika.

b) Using equation (1) above we can determine how much Erika will have to contribute
each year to become a millionaire in 19.4 years. F is 1,000,000, r = 0.06, n is
19.4, P is unknown. Solving for P we get $27,000. Thus Erika will have to invest
$27,000 each year to become a millionaire at the same time as Kitty.

c) From the analysis above it is not rational for Erika to invest in the bond fund.
However, it should be kept in mind that stock funds are historically unlikely to
yield steady 20% returns for 19+ years and it will go up and down a lot. Erika’s
investment will grow more steadily, so she is getting more mental peace.