Question

John is looking at several options to fund his son’s 4-year university degree.
The university fees of $45,000 a year will have be paid starting 11 years from today. He is analysing an insurance plan that pays out $45,000 a year for 4 years with the first payout 11 years from today. The insurance plan has several payment options:

Option 1
Pay $60,000 today.

Option 2

Beginning 1 year from today, pay $12,000 a year for the next 8 years.

Option 3

Beginning 1 year from today, make payments each year for the next 8 years. The first payment is $11,000 and the amount increases by 5% each year.
Answer the following questions regarding the options above:
(a) Calculate the present value of each option. Use a 10% discount rate.
(b) Analyse which option John should choose.
(c) If the discount rate is not given to you, what would be an appropriate discount rate to use?

Answer 1

a]

Present value of each payment = payment / (1 + discount rate)ⁿ

where n = number of years after which the payment is made

The calculations are below ;

b]

John should choose Option 1 because it has the lowest PV

c]

if the discount rate is not given, the interest rate earned on John's current/existing investments should be used. If John has no other current/existing investments, then the rate of return on John's hypothetical portfolio (as if he has investments, and they are invested according to his risk-return profile) should be used.