Question

Explain how to compare the payouts (lump-sum and annuity) and evaluate which is a better financial choice. Specifically, what discount rate equates the gross annual annuity payments to the present value of the lump sum cash option? What happens to the attractiveness of each option as the relevant discount rate changes? What do you see as a reasonable hurdle rate, i.e., an investment ‘hurdle rate’ whereby if you take the lump sum you can reliably expect to earn this return on your investment, then ending up with more money than the annuity option

Answer 1

we can compare the payout through either lump sum or installment by looking at the interest rates which will be required by the investors and these interest rates are opportunity cost which are to be lost, because the investor will be receiving the payment late in the installment so he will be trying to compare the overall loss due to late receipt of payment in installment method and he will be comparing that with additional money provided by opting for installment.

It is a simple comparison of time value loss for the investor.

When the discount rate will be going higher, it will mean that the lump sum method will always be preferred and the discount rate will be going lower, it will mean that installment method will be becoming more attractive.

For me, A reasonable hurdle rate will be around 8% which is just above the risk-free rate because I can only make a risk free rate of return by opting for lump sum as I do not have that capability of constantly managing with double digits rate of return.

I will generally be investing into moderately risky securities which will provide me with the rate of return which will be just constantly beating the rate of return of market and which can help me to gain a higher rate of return.