Question

Provide Sue with financial advice on which option has the potential to yield the highest monetary value. Support your rational with calculations using time value of money and comment on the risk return relationship for each option, assume interest rate on savings is 4% and is compounded semi-annually.

Sue James is a 55-year old accountant who works at Ernst and Young (EY) who is about to retire. She has the following decision to make:

Option A – Select a lump sum gratuity payment of $120,000 with a reduced pension of $1,750 per month.

Option B – Select a monthly pension of $3,300 with no lump sum gratuity payment.

In addition, Sue has a loan of $72,000 with loan payments of $1,200 per month for the next five years.

Answer 1

EAR(Effective Annual Rate)=(1+4%/2)^2-1=4.04%

Monthly interest rate=4.04%/12=0.337%

Option A:

He will get $120000 lump sum and he can repay the loan of $72000.He will have (120000-72000)=$48000

Hence, PV=$48000 and pension of $1750 per month in perpetuity (Since term is not given)

Hence, Present Value of Perpetuity = Cash Flow/interest rate= 1750/0.337%=$519802

Total present value of Option A= 519802+48000=$5,67,802

Option B:

He will repay $1200 out of his $3300 pension payment.

Hence. he will have (3300-1200)=$2100 for a month upto 5 year or 60 month

Present Value of $2100 for next five year is $113916.36

At the end of 5 year present value of $3300 in perpetuity= 3300/0.337%=980198

Total present value= 113916.36+980198/(1+4.04%)^5=$918020.12

Hence, Option B has more present value than Option B

Hence, Option B should chosen by Sue.