Question

Are you able to answer this in terms of how to solve using a financial calculator? What to enter for [N, I/YR, PV, PMY, FV] as well as how you determined these numbers? Please verify answer below and explain any discrepancies.

Question:

You just inherited $1,000,000. Instead of taking a lump sum, a financial planner has suggested two additional options. First, you invest in an annuity that will pay you $125,000 per year for 10 years. The discount rate is 8% for both options. The second option is an annuity that pays you $10,000 per month for 10 years. Of the three distribution options, which is the best?

option 1:PV = $1,000,000

option 2 : N:10, I/YR:8, PMT:125000, PV: unknown, FV:0

PV=$838,730.17

option 3: N:10, I/YR:8, PMT:10000, PV:unknown, FV:0

PV=$67,100.81

Answer is option 1, as it has the highest PV.

Answer 1

We will need to calculate the present value (PV) of all the future cash flows and find out the option with the highest PV.

PV can be calculated using the financial calculator with the following inputs:

N = number of periods

I/Y = interest rate per period

PMT = Payment per period

FV = future value

Option 1: Entire payment of $1,000,000 occurs immediately in lump sum. Hence, the PV = $1,000,000

Option 2: N = 10, I/YR = 8%, PMT: 125,000, FV = 0, PV = ??

PV = $838,760.17 (your calculation is correct)

Option 3: Your inputs are wrong. Please note that the period here is a month. Hence, all the inputs have to expressed per period.

N = 12 x 10 = 120, I/YR = 8% / 12 = 0.6667%, PMT = 10,000, FV = 0, PV = ??

PV = $824,214.81

Option 1 has the highest PV, the best option is option 1.