Question

Provide John  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.

John Samuel is a 55-year old accountant who works at A-accounting who is about to retire. He 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, John has a loan of $72,000 with loan payments of $1,200 per month for the next five years.

Answer 1

Option A:

	A		B
1. Pension Received Monthly		1750		3300
2. Yearly Pension Received	1750 x12	21000	3300x12	39600
3. Yearly Interest received (Compounded Semi-annually)	120000 x (1+4/200)2 -120000	2400	0	0
4. Loan Payment Monthly	1200		1200
5. Yearly Loan payment	1200 x 12	14400	1200 x 12	14400
6. Yearly Savings	21000-14400	6600	39600-14400	25200
7. Net Worth after 5 years	120000+6600x5	153000	25200x5	126000

After 5 years, John's loan payments would have been complete.

Thus for option A would give him a yearly pension of $ 21000 and interest income of $ 2400 making an annual income of $ 23400. Thus his net worth in another 5 years (i.e. 10 years total) would be $(120000+23400x5) =$237000

and for option B, he would get a yearly of $ 39600 with no interest income. Thus his net worth in another 5 years (i.e. 10 years total) would be $ (126000+39600x5) =$ 324000

Hence it can be said that Option B is the best plan for John as it provides the highest monetary value of the two options.

For option B, it suffers from firm specific risk such as the firm giving him pension may face bankruptcy. In such a case, he will not have a single penny left in his savings account to meet his spending requirements. Thus it has the highest risk and John gets handsomely rewarded for it later.

Option A is a much diversified Portfolio that has varied sources of income. Hence if his firm faces closure in the future, he still has $120000 in his savings to fall upon. Hence, Option B is a safer option of the two.