Question

You have been given a choice between two retirement policies as described below. Which policy would you choose? Assume a required rate of return of 6 percent.

1. Policy A: You will receive equal annual payments of $10,000 beginning 35 years from now for 10 years
2. Policy B: You will receive one lump-sum of $100,000 in 40 years from now.

Answer 1

Solution

Here we need to find the present value of the policies

For Policy A

Present value of annuity due=Annual payment*((1-(1/(1+r)^n))/r)*(1+r)

where

r=rate of intrest=6%

n=number of periods=10

Present value of annuity due (Policy payments) due at the beginning of 35th year=10000*((1-(1/(1+.06)^10))/.06)*(1+.06)

Present value of annuity due (Policy payments) due at the beginning of 35th year=78016.92

For policy B

Present value= Cashflow/(1+i)^m

Where i=rate of intrest or rate of return=6%

m= number of periods=5

Present value of policy payment at the beginning of 35th year=100000/(1+.06)^5

Present value of policy payment at the beginning of 35th year=74725.82

Since present value of policy payment at the beginning of 35th year is more for Policy A as compared to policy B

,thus policy A must be chosen

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