Question

You are considering two lotery payment options: Option A pays $20000 today and option B pays $40000 at the end of ten years. Assume you can earn 8 percent on your savings.

a) Which option will you choose if you base your decision on present values?

b) Which option will you choose if you base your decision on future values?

c) Explain why your answers are either the same or different.

Answer 1

1. Which option will you choose if you base your decision on present values?

Option A) Today’s option to have $20000

Future value = 40000 ; Rate = 8% ; Years = 10 ;

Present Value = Future Value/(1+Rate)^Years

Present Value = 40000/(1+8%)^10

Present Value = $18527.74 - As present value is less than Option A which is $20000

Choosing Option, A would be beneficial as per decision based on present values.

1. Which option will you choose if you base your decision on future values?

Option B) having $ 40000 after 10 years

Present Value = 20000; Rate = 8%; Years = 10

Future Value = Present Value x (1+Rate)^Years

Future Value = 20000 x (1+8%)^10

Future Value = $43178.50

Future value of Option A) is higher is than Option B). Hence as per decision based future values Option A proves to be better option.

1. Explain why your answers are either the same or different.

In case of a) we calculated present value of future cash flow of $ 40000 and we got answer as $ 18527.74

In case of b) we calculated future value of present cash flow and that resulted in $43178.50

In both the cases answers are different only because we are using different methods to arrive at decision. Choosing one option over other is totally on merits of its time value of money.