Question

Discussion 1 – due 23 February 2020, 11:55 PM ECT (5% of coursework marks)

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.

word limit 200 words

Answer 1

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

Monthly interest rate= 4.04%/12=0.337%

Option A:

He could repay the loan with the lumpsum amount of $120,000 and enjoy $1750/month pension

Value of lumpsum amount after re-payment of loan= (120000-72000)=$48,000

Present Value of $1750/month annuity in perpetuity= cash flow/interest rate= 1750/0.337%=$519802

Present Value of total net pension benefit=48000+519802=$567802

Option B:

He will repay $1200 each month for his loan and he will have (3300-1200)=$2100 after loan cash inflow

The present value of $2100 per month for 5 year is $113,916.35. Calculation is given below:

After 5 year he will get $3300 in full per month. After 5 year,Present Value of this perpetuity amount= 3300/0.337%=$980,198

Present Value of total benefit=113916.36+980198/(1+4.04%)^5=$918020.1

As the net present value of Option B is more than Option A. He should choose Option B.