Thomas is considering the purchase of two different annuities. The first begins in three years and pays $1,000 per year for five years. The second begins in 10 years and pays $2,500 per year for seven years. Thomas is currently very risk-averse as he has a young family and little income, and thus his current opportunity cost of capital is 4%. In nine years, Thomas expects to be more financially secure and his cost of capital will increase to 9% from then on. If each annuity costs $5,000 today, which annuity (or annuities), if any, should Thomas purchase? How much value will Thomas realize from his purchase(s), if he makes any purchases? Show work
Answer: He should purchase the second annuity; he will realize $3,840.21 in value
Annuity-1 | ||||||||||||||||||
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | |||||||||
Payment | 1000 | 1000 | 1000 | 1000 | 1000 | |||||||||||||
Rate | 0.04 | $4,451.82 | ||||||||||||||||
Cost of annuity | 5,000.00 | |||||||||||||||||
NPV | -1,042.35 | Using NPV to find present value of annuity at year 3 using 4% rate, and discounting back the PV at year 3 to today at 4% rate | ||||||||||||||||
Annuity-2 | ||||||||||||||||||
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14 | 15 | 16 | 17 |
Payment | 2500 | 2500 | 2500 | 2500 | 2500 | 2500 | 2500 | |||||||||||
Rate | 9% | 12,582.38 | ||||||||||||||||
Cost of annuity | 5,000.00 | |||||||||||||||||
NPV | 3,840.21 | Using NPV to find present value of annuity at year 9 using 9% rate, and discounting back the PV at year 9 to today at 4% rate | ||||||||||||||||
So he should go for Annuity 2 as NPV is positive with value 3840.21 |
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