Question

1. Assume that you just won the Open Golf Championship. Your prize can be taken either in the form of RM50,000 at the end of each of the next 25 years (That is RM1,000,000 over 25 years) or as a single amount of RM500,000 paid immediately. If you expect to be able to earn 5% annually on your investments over the next 25 years, ignoring taxes and other considerations, which alternative should you take? Why?

                                                                                                          

2. You were offered two choices of prizes that is whether to accept RM80,000 today or RM15,000 at the end of each year for 5 consecutive years. If the cash flow is discounted at a yearly rate of 12% and compounded twice a year, which prize would you choose?

                                                                                                

Answer 1

Question 1:

P = Annual Prixe = RM50,000

n = 25 years

r = interest rate = 5%

Present Value of future cash flows = P * [1 - (1+r)^-n] / r

= RM50,000 * [1 - (1+5%)^-25] / 5%

= RM50,000 * 0.704697228 / 0.05

= RM704,697.228

Present Value of future cash flows is RM704,697.23

Lump sum amount = $500,0000

Therefore, it will be better to accept RM50,000 at the end of each year for 25 years.

Question 2:

P = Annual Prixe = RM15,000

n = 5 years

r = interest rate = [1+(12%/2)]^2 - 1 = 0.1236 = 12.36%

Present Value of future cash flows = P * [1 - (1+r)^-n] / r

= RM15,000 * [1 - (1+12.36%)^-5] / 12.36%

= RM15,000 * 0.441605223 / 0.1236

= RM53,592.8669

= RM54,071.64

Lump sum amount = RM80,000

Therefore, it is better to accept lump sum amount (RM80,000) today.