Question

You have been hired as a financial advisor to Michael Jordan. He has received two offers for playing professional basketball and wants to select the best offer, based on considerations of money only. Offer A is a $10m offer for $2m a year for 5 years. Offer B is a $11m offer of $1m a year for four years and $7m in year 5. What is your advice? (Hint: compare the present value of each contract by assuming a range of interest rate, say 8% - 14%)

Please show work and formular

Answer 1

We will evaluate based on present value the option which has more present value shall be accepted

Option 1

2 million each for 5 year

= 2(PVIFA 8% 5 years )

= 2(3.9927) = 7.98

At discount rate 14%

= 2(PVIFA 14% 5years)

= 2(3.4331) = 8.6662

Option 2)

1 million in 4 years and 7 million in 5th year

= 1(PVIFA 8% 4) + 7/(1.08)^5

= 3.3121+ 4.764

= 8.07

At 14% discount rate

=1(PVIFA 14% 4y) + 7/(1.14)^ 5

= 2.9137 + 3.6355 = 6.5523

At 8% discount rate option 1 is accepted

At 14% discount rate option 2 is accepted

Alternatively PVIFA can be calculated by given formula

This is annuity where periodic payments are made at the end of period

Formula

Future value of annuity is

P((1+r)^n -1)/r

Where p is periodic payment

R is rate per period

N is no of periods