Question

2. You just won a Million Dollar lottery and you can choose one of the following two options to claim your winning. If you choose Option A, you will receive $40,000 every year for 25 years (40,000 x 25 = $1,000,000 hence the name), with the first payment to occur one year from today. But you may also choose Option B, in which case you will receive a single payment of $600,000 today. The applicable tax rate for the annual payment from Option A is 15%, while the applicable tax rate for the single payment from Option B is 18%. The appropriate discount rate for both options is 5%. Which option is better from a strictly financial standpoint?

Answer 1

Option A.

Operating cash flows = 40000-15%(40000) = 34000

Present value factor at 5% for 25 years = 14.09

Present value of cash inflows = 34000×14.09= 479060

Option B.

Operating cash flow= 600000-18%= 492000

We will not discount this cash flow because it it received today i.e at present not in future.

Option B is better bacause cash inflow at option B is more than cash inflow at option A.

Note: Present Value factor can be checked in your book or at Google. Therein look at 5% and their values corresponding to the particular year. Sum up present value factor at 5% till year 25 to get 14.09.