Endowments are funds designed to permanently provide an income for somebody/thing/organization, usually with a growth rate built into the amount donated. When endowing a position/organization/etc., a common tactic is for the donor
to place a large sum of money in an investment
fund, and the position/organization/etc. is paid for in perpetuity
by the interest income. In a basic finance class, students typically learn how to calculate simple endowments (simple meaning sweeping generalizations are made about future plans and interest rates so that the concept is quickly understood).
The University wishes to endow a position in the Business College. The starting salary is $120,000, and the University had decided on a 4% annual pay increase. How much should the donors provide in order to endow this position?
This $4,000,000 will be enough, then, to pay this professor's salary
forever. The calculation is the same one used for calculation of other types of perpetuities.
= payment (time 1)
I = interest rate (assumed to be static)
G = growth rate
I - G
Clearly, if we don't require a growth rate, the principal needn't be as large. Consider the original problem. If the salary were to remain at $120,000 forever (a raw deal, that), we would only require $120,000/0.7 = $1,714,285 for the salary to be paid forever. However, thinking long term and considering inflation, $120,000 won't be worth much 100 years from now!
On the other hand, an Endowment Policy
is a type of insurance
policy which is getting quite popular because of its primary benefit
over whole life and term life policies: the sum assured (the amount of insurance you asked for when you signed up) is paid out after a set amount of years, usually 25. Whether you died or not.