Question

show the student's calculator set-up (using the variables from a financial calculator) and answers for each of the 3 parts in the problem. For part c, give an exact percentage answer and not an approximate answer. Clearly identify your answers to each part.

Assume that you just won the state lottery. your prize can be taken either in the form of 40000 at the end of each of the next 25 years (that is 1,000,000 over 25 years) or as a single amount of 500,000 paid immediately.

a. if you expect to be able to earn 5% annually on your investments over the next 25 years, ignorning taxes and other considerations, which aternative should you take? why?

b. would your decision in part a change if you could eaern 7% rather than 5% on your investments over the next 25 years? why?

c. on a strictly economic basis, at approximately what earning rate would you be indifferent between the two plans?

Answer 1

a) Let's calculate the present value of 25 cash flows using PV function on calculator

N = 25, I/Y = 5%, PMT = 40,000, FV =0 => Compute = $563,757.78 > a single payment of $500,000

Hence, you should take the annual payment for 25 years.

b) If I/Y = 7% => PV = $466,143.33 < a single payment of $500,000

Hence, you should take the single payment.

c) Indifferent rate can be calculated using I/Y

N = 25, PMT = 40,000, PV = -500,000, FV = 0 => Compute I/Y = 6.24%