Question

Bruce Sprungsteen is a washed up rock star. He has a recording contract that will pay him $5,000,000 each year for the next 3 years. Since Bruce is no longer cool, the recording company want to cancel his contract. To encourage Bruce to cancel, the recording company offers him an immediate payment of $13,000,000 – if he accepts that amount, he will not receive the 3 payments of $5,000,000. If he does not accept the $13,000,000. He is legally entitled to the 3 payments under the contract. So he needs to choose one or the other. If Bruce’s discount rate is 9%, which should he choose AND what formulas would you use on excel?

Answer 1

Option 1: To accept $ 13,000,000 in lieu of Cancellation of Contract
Option 2: To receive $ 5,000,000 for 3 years legally under the contract
Bruce's Discount Rate = 9%
Comparing both the Options by Computing Present value of Cashflows
Option 1:
Amount is received Immediately.
Therefore, Present Value of Cash flows = $ 13,000,000.
Option 2:
Amount of $ 5,000,000 is received annually for 3 years.
Present Value = $ 5,000,000 * PVAF(9%, 3 years)
Present Value = $ 5,000,000 * 2.531
Present Value =	$        12,655,000
(or) Year Cashflow PVF @ 9% PVF PV 1 $        5,000,000 1/(1.09) = 0.9174 $    4,587,156 2 $        5,000,000 1/(1.09)^2 = 0.8417 $    4,208,400 3 $        5,000,000 1/(1.09)^3 = 0.7722 $    3,860,917 $ 12,656,473
Answer: As the present value is higher in Option 1, it is beneficial to accept the amount of $ 13,000,000
Calculation of PVAF
PVAF(i%, n Periods)	=	(1-(1+i)^-n)/i
(1+i)^-n	=	(1+0.09)^(-3)	= 0.7722
(1-(1+i)^n)/i	=		2.531