You wish to buy a high cost item in the future.
Examples might be school fees, saving for comfortable retirement, or a luxury villa in the middle of the Pacific. We chose a plot of land, as an example.
Where will you get your money?
Sections below:
Lump Sum: What size lump, if invested, do you need to reach your target?
–Price after Inflation
–Lump Sum Value after investing
–Example: Mercy and her Plot of Land
Regular savings: How much should you save monthly to reach your target?
Irregular Lumps of Money: How do you manage irregular savings?
Lump Sum
An Example: What lump sum do you need now to buy your plot of land in the future?
You wish to buy this plot in 10 year’s time.
The present price is 10,000,000/-.
You estimate the average annual inflation rate over 10 years is 7%.
You estimate the average annual return on any long term savings that you invest is 10%.
To calculate The Price after Inflation there are a number of simple steps:
-Present Price :
Find TODAY’S price of your piece of land. In our example this is KSh10,000,000
-Future Price:
Calculate the future price of the land.
-Present Investment amount:
Present amount of money to invest now to reach the ‘future value of the land’.
So to calculate:-
Present Price
In our example this is KSh10,000,000
Future Price:
The future price will be determined by land price inflation.
How do we calculate this future price?
We use the formula
FP=PP(1+r)^n
Where-
FP is Future Price
PP is Present Price i.e. 10,000,000/-
r is inflation rate i.e. 7% (used as 7/100 or 0.07 in the calculation)
n is number of years i.e. 10
^ is to the power of (1.07^10 is 1.07 to the power of 10)
So: FP=PP(1+r)^n
FP=10,000,000(1+0.07)^10
Future Price of the plot of land = 19,671,514/-
We estimate that our KSh10,000,000 piece of land will have increased to 19,671,514/- if inflation is 7%
(Note: you can input ‘What is 1.07 to the power of 10.’ into google and it will give you the answer)
(Calculating inflation: See Appendix- Calculating Inflation below for a fuller explanation):-
Lump Sum Value after Investing
Present Investment Amount:
We estimate we can get 10% a year after costs and tax from investing in Kenya Treasury Bonds.
What Lump sum do we need now to be able to pay for our piece of land in 10 years’ time if we receive 10% a year?
FP=PP(1+r)^n
FP=PV(1+0.1)^10
Adjusting the equation:
PV=FP divided by (1+0.1)^10
PV=19,671,514/(1+0.1)^10
PV=19,671,514/2.5937
PV = 7,584,220/-
That is if I have just over KSh7.5 million invested at 10% a year I will be able to buy the piece of land if its price increases by an inflation rate of 7% per year.
Example: Mercy and her Plot of Land
Mercy and her husband wish to buy a plot of land. Do they have enough money?
Mercy wants to know if she has got enough money to buy a plot of land (shamba) in 10 years time?
She thinks that NOW this plot of land will costs KSh 1,000,000.
She adds up the money in her husband’s account and adds this to the money in her own account.
Mercy finds they have together a KSh 700,000 lump of money.
The question she asks herself is: “If I invest this lump will it be enough to reach my goal of a plot of land in 10 years time?”
Price of land after Inflation:-
What is the first thing Mercy has got to take into consideration?- INFLATION.
She believes the average inflation over the next 10 years will be 7%. This is what it was in the past. She believes land in the area she wants to buy has, over the long term, followed the inflation rate.
So, what will the Price of land be in 10 years’ time?
The Price of land in the future will be FP=PP (1+r)^n
FP= Future Price of land
PP= Present of the land (KSh1,000,000)
r= inflation rate (7%)
N= Number of years time i.e. 10
^= To the power of
so
FP=PP(1+r)^n
FP=1,000,000 (1+0.07)^10
FP= KSh1,967,151
(For a fuller explanation of the Maths:- Appendix- Calculating Inflation)
The Future Value of Mercy’s Investment
So Mercy can now say that the land will cost about KSh2,000,000 in 10 years time.
That sounds like a huge amount of money.
Will the KSh700,000 be enough to cover KSh2,000,000 if she invests the money?
Mercy finds that she will get 10%, after tax, from investing in Kenya Government T Bonds.
How much money will she have, in 10 years time, if she invests KSh700,000 in T Bonds that she and her husband have together in their bank accounts?
You can calculate this again by using the Formula FV=PV(1+r)^n .
FV = Future Value
PV = Present Value
r = interest rate (Annual interest Mercy estimates to be earned from T Bonds 10% or 0.1)
n = Number of years
^ = ‘to the power of’
FV = PV(1+r)^n
FV = 700,000(1+0.1)^10
FV = KSh1,815,620
So Mercy will not have quite enough money to buy her land. She will, however, only have to find approximately an extra KSh185,000.
Mercy and her husband decide to invest this money to purchase the land in the future.
They believe that they should be able to find the extra KSh185,000 within the next 10 years from other sources.
- Regular Savings
The situation is now different.
Jim is 30 years old and has a serious girlfriend He is starting to get a nervous feeling in his tummy. He can’t continue to spend everything he makes. He wants a nest egg, in case……….
Instead of having a lump to invest he can save a bit every month. He would like to build up a nest egg by saving each month and investing these savings.
This should be able to buy what KSh2,000,000 can buy now, but in 7 years’ time.
What does he need to save monthly to achieve this?
Inflation: If he ends up with KSh2,000,000 in 7 years’ time he will not be able to buy what he can buy with KSh2,000,000 today because of inflation.
Inflation is 8% per year.
He works out how much he needs in 7 years’ time to equal the buying power of KSh2,000,000 today.
FV=PV(1+r)^n
FV=2,000,000(1.08)^7
FV=2,000,000 x 1.7138
FV=3,427,649
Jim will need to have saved KSh3,427,649 in 7 years’ time to buy what KSh2,000,000 can buy him today.
How much will he have to save a month to reach this figure?
He believes he can make 10% per annum after charges and tax.
The calculation is super complicated so we will have to rely on Google.
Searching for a Savings Calculator:
To find a savings calculator write ‘savings calculator’ into a search engine (Google) on the internet and you will have a choice of a number of Savings Calculators.
An option is a UK Government site https://www.moneyhelper.org.uk/en/savings/how-to-save/use-our-savings-calculator
(The site is self-explanatory. Just ignore the pound sign.)
The answer using the UK site is he must save KSh26,185 per month to reach KSh3,427,649 in 7 years.
Irregular Lumps of Money
If you know when you will have different lumps of money to invest, calculate the Final Value of each lump separately (as above i.e. FV=PV( 1+ r)^n ). Again, add them all together to give you a final sum.
If you don’t know when you will be receiving the extra lumps of money estimate how much you will receive annually. Then treat each year as a lump invested.
Calculate each final value and add them all the final values together to give you an approximate final sum.
- If you can’t save enough to reach your goals?
You need to use a bit of sensible judgement here.
What if the final amount you will need for your choice of purchase is way out of reach? Then you might have to think through lower cost options.
For example, you might choose a private school that is not quite so expensive.
You might educate your children in the lower cost school initially and then change school to the more expensive option for only the last two years of your children’s careers.
In the case of insufficient savings for retirement, you might decide to delay retirement for 5 years.
In addition you might decide to cut back on your monthly expenditure, and so save more.
Timing of our goals:
We may have two equally important requirements e.g. children’s school fees and financially independent retirement.
You may not be able to cover both at the same time.
An option could be to direct your initial savings towards the earlier requirement e.g. school fees.
Subsequently, contributions can go towards the second item- retirement.
At that later point you may even be in a higher wage bracket.
Budget
We have decided what we want to save for.
We, however, just seem unable to end the month with money in our pockets.
How do we manage our income so that we have money to invest for the future? Plan your spending by designing a useful Budget.
Spend so that you save- a Budget
Appendix: Calculating Inflation
What are the different ways of calculating inflation?
THE RESULT OF INFLATION: Things will cost more in the future. (For example the little boarding school I went to in the 1960s cost 100 pounds a term (KSh2000). The same school now costs over 900,000/- a term in 2021.)
1st Way of calculating:
Let’s assume the inflation rate is 7%.
7% of something is the same as 7/100 or 0.07/1 of something.
Add 1 to 0.07 and we get 1.07.
We multiply the previous year’s figure by 1.07 to get the next year’s price.
An example:
Jane thinks that her child’s school fees will increase by 7% a year.
Presently the fees are KSh1,000,000.
What will she have to pay at the beginning of year 3?
Beginning of Year 1:- the fees are KSh 1,000,000.
Beginning of Year 2:- Year 2 fees will be KSh1,070,000 (KSh1,000,000 x 1.07 = KSh1,070,000)
Beginning of Year 3:- the fees will be KSh1,144,900 (KSh 1,070,000 x 1.07 = KSh1,144,900)
Note that if the general inflation rate is 7% the prices of everything around Jane will have gone up by approximately 7%. Hopefully her salary and her savings have also gone up by about 7%.
2nd Way of calculating Inflation:
Use the formula FP = PP (1+r)^n
Where FP = Future Price
PP = Present Value
r= the interest rate written as a decimal ( for example 7% = 0.07)
^n is ‘to the power of’ . That is to the power of the number of years of fee increases.
So in Jane’s example:-
The Present Price of the school fees PP = 1,000,000
Inflation = 0.07 (7%)
Number of years the fees have increased = 2
FP =1,000,000 (1 + 0.07)^2
FP = KSh1,144,900
The school has put up the fees two times. At the beginning of the 3rd year the fees will be KSh1,144,900
Third Way of Calculating:
On your computer search (Google) ‘How to adjust for Inflation calculator’ and follow the instructions.
Note:
Rule of 72: If you Divide 72 by the inflation rate, this is how long it will take to halve the value of your money.
For Designing a Budget please see:-
Spend so that you save: a Budget
Important: This information on this WEB site ALONE should not be used to make investment decisions. Investing is particularly personal and is dependent upon your circumstances. You are strongly advised to take independent expert advice before deciding whether to/ or whether not to invest your money.