Question

A. Your best friend has asked to assist him in making the best investment out of the following options. Which would you advise him to choose and why? SHOW WORKINGS TO JUSTIFY YOUR ANSWER.

Option 1: $12,000 in 5 years’ time at 6 percent interest.

Option 2: $15,000 in 2 years’ time at 9 percent interest.

Option 3: $15,000 today. No strings attached.

Option 4: $5,000 each year for 2 years at 7 percent interest compounded semi-annually.

B. Betty Kay has a contract in which she will receive the following payment for the next 5 years: $1,000, $2,000, $3000, $4,000 and $5,000. She will the receive an annuity of $8,500 a year for the end of the 6th through the end of the 15th year. She is offered a $30,000.00 to cancel the contract. If they payments are discounted at 14 percent should she cancel the contract? SHOW ALL WORKINGS.

Answer 1

1.
Present Value of Option 1 = Amount / (1 + Interest)^Years = 12000 / 1.06^5 = $8967.10

Present Value of Option 2 = Amount / (1 + Interest)^Years = 15000 / 1.09^2 = $12625.20

Present Value of Option 3=$15000.00

Present Value of Option 4=Amount/rate*(1-1/(1+rate)^n=5000/7%*(1-1/1.07^2)=9040.0908

Choose Option 3 as it has the highest present value

2.
PV of payments=1000/1.14+2000/1.14^2+3000/1.14^3+4000/1.14^4+5000/1.14^5+8500/1.14^5*1/14%*(1-1/1.14^10)=32433.44666

Do not cancel the contract as payments have higher present value compared to 30000