Question

7. You are negotiating for the terms of a legal settlement, and your opponent’s attorney has presented you with the following alternative settlement alternatives:

a. $38,000 today in one lump sum.

b. $50,000 to be paid to you in five equal payments of $10,000 at the end of each of the next five years.

c. If your discount rate is 10%, what is the present value of each of the alternatives and which alternative would you choose, and why?

Answer 1

c)

Present value of option a) = $ 38,000

Computation of Present value of option b)

Formula for PV of ordinary annuity can be used for computation of PV of the annuity as::

PV = P x [1-(1+r)^-n/r]      

P = Periodic Payment = $ 10,000

r = Rate per period = 10 % or 0.1 p.a.

n = Numbers of periods = 5

PV = $ 10,000 x [1-(1+0.1)^-5/0.1]

      = $ 10,000 x [1-(1.1)^-5/0.1]

     = $ 10,000 x [(1- 0.620921323)/0.1]

    = $ 10,000 x (0.379078677/0.1)

    = $ 10,000 x 3.790786769

   = $ 37,907.86769 or $ 37,907.87

Present value of five $ 10,000 equal payments is $ 37,907.87

Option a) should be chosen as present value of lump sum is higher than option b.