Question

Henry has to choose one of the following three bonus options:

I. $30,000 today. .

II. $10,500 for the next three years starting from one year from today (i.e., he receives three equal payments starting from one year from today).

III. $8,000 today and a 2% increase each year for the next three years (i.e., he receives four payments including $8,000 he receives today).

His opportunity cost of capital is 3%. He is planning to work for his company at least for the next three years and assume that there is zero probability that his company will not make those promised future payments. Which option should he choose? Why?

Answer #1

Option 1: $30,000

Option 2: The opportunity cost of capital= 3%

Present Value of the bonus recieved in installments= {[10500/(1.03)]+[10500/(1.03^2)]+[10500/(1.03^3]}

= 10194.17+9897.26+9808.99 = $29,700.42

Option 3: The opportunity cost of capital= 3%

Today= 8000

1st year= 8000*1.02= 8160

2nd year= 8160*1.02= 8323.2

3rd year= 8323.2*1.02= 8489.6

Present Value of the bonus recieved in installments= {8000+[8160/(1.03)]+[8323.2/(1.03^2)]+[8489.6/(1.03^3)]}

= 8000+7922.33+7845.41+7769.19 = $31,536.93

Since option 3 gives the highest return,Henry should opt this one.

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