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Bob and Carol are planning for the birth of their first child exactly four years from today. They are now ready to start their savings plan for the big event. The current hospital cost for having a healthy baby at the local hospital is $6500 after all insurance payments. Pre-natal care for the immediate 12-month period prior to having the baby amounts to $2000 in out-of-pocket costs. Carol’s best friend is planning a baby shower, so only a crib, a baby carrier, and other miscellaneous items will be needed, which all cost $1,200 today. However, these items will be purchased and paid for on the day of the child’s birth, and the items are expected to increase in costs by 10% each year over the next four years due to inflation.
Bob and Carol now have $500 in cash that they plan to put in the bank in order to cover all the new costs. Also, Uncle Ted has promised to contribute $1000 at the end of year two, as a present to Bob and Carol for baby expenses.
Currently, Bob and Carol can earn 6% compounded annually on this money. In order to be able to pay cash for all these expenses on the day the baby is born, how much will Bob and Carol have to save, assuming the baby is born exactly four years from today
Questions:
Draw the timeline that illustrates the timing of all the events of the situation described above.
How much will Bob and Carol need to have in the bank on the day the baby is born in order to achieve all their goals?
What amount needs to be saved at the end of each year in order for Bob and Carol to reach their financial goals?
Sample Solution
In order to calculate the amount of money needed to cover all expenses, a timeline illustrating all events must be drawn out. Bob and Carol are now four years away from the day of their baby’s birth and thus have four years in which they can make use of compound interest earning potential. Over this period, there are several expenses that will need to be taken into consideration: hospital costs at $6500; pre-natal care costs at $2000; baby items costing $1200 today but increasing by 10% each year due to inflation; cash savings of $500 initially with an additional contribution from Uncle Ted at the end of year two for a total promised contribution of $1000.
Timeline:
Year 0 (Today): Bob and Carol start saving plan for baby’s birth 4 years later – they have initial cash savings amounting to$500.
Year 1–3: Pre-natal care monthly payments amounting to 2000 over 12 months prior to birth– starting one year before expected date of delivery.
Year 2: Uncle Ted promises a contribution of 1000 towards expenses on this day.
Year 3: Baby items costing 1200 purchased and paid for on this day.
Year 4 (Expected Date Of Delivery): Hospital cost incurred on this day totaling 6500 .
By plotting out these events as above, it becomes clear that Bob and Carol need at least 8600 dollars ($6500 + 2000 + 1200) available in order for them pay off these bills when their baby is born four years from today. With an initial capital investment of 500 plus uncle ted’s promised 1000 dollar contributions two years from now, Bob and Carol will need an additional 7100 ($8600 – 500 – 1000) dollars saved up in order cover all costs associated with having a healthy baby delivered at the local hospital. In addition, if they want to take advantage compound interest earnings – they must ensure that they save enough money so that when compounded annually over four years ,it amounts up to 7100 dollars.