Question

You inherit $545,000. You can receive the $545,000 in one lump sum payment today or, alternatively,...

You inherit $545,000. You can receive the $545,000 in one lump sum payment today or, alternatively, receive two amounts: $345,000 in 10 months and $220,000 in 21 months from today. If you can earn 11.6% per annum compounding monthly on your monies, what is the value of the option to receive two payments (in present day value)?

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Answer #1

The concept used in the solution is time value of money along with understanding of compound rates.

Calculation

Option 1

Value = $ 545000 [ Since money is receiving today. Hence it already at present value]

Option 2

Value = 345000 * PVIF(11.60/12, 10) + 220000 * PVIF(11.60/12, 21)  

[Explanation : PVIF(r, n) = Present value interest factor at peroidic rate "r" for "n" periods. ]

= 345000 * 0.9083 + 220000 * 0.8171

= $ 493126

Since option I is greater than option 2, option 1 should be selected.

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