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Question: John Ross graduated from college 6 years ago with a finance undergraduate degree. Although he is ...

John Ross graduated from college 6 years ago with a finance undergraduate degree. Although he is satisfied with his current job, his dream is to become an investment banker. To become an investment banker, he would need to take an MBA degree. He is, thus, looking for colleges. After some time, John has narrowed his choice to Brandeis University, Carlton College, or Northeastern University. Both schools allow and encourage internships. However, the Northeastern University will allow students to work while enrolled in a MBA program.

I will describe below the four alternatives that John Ross can evaluate as of today.

Alternative (1)

He can keep his current job at the management firm D&L. His annual salary at the firm is $65,000 per year and is salary is expected to increase at 3% per year until retirement. He is currently 28 years old and he expects to work for 40 more years. His current job includes a full paid health insurance plan and is current average tax rate is 26%. Ben has a savings account with enough money to cover the entire cost of the MBA program.

Alternative (2)

The MBA program at Brandeis University requires two years of full-time enrollment at the university. The annual tuition is $70,000. Books and other supplies are estimated to cost $3,000 per year. John expects that after graduation from Brandeis University he will receive a job offer of $110,000 per year with a signing bonus of $20,000. The expected salary will increase at 4% per year. Because of the higher salary, the average income tax rate will be 31%.

Alternative (3)

The Carlton College offers a one-year program. The tuition cost is $85,000 to be paid upon matriculation. Books and other supplies for the program are expected to cost $4,500. John thinks that after the Carlton degree he will be able to receive an offer of $92,000 per year with a $18,000 signing bonus. The salary at this job will increase at 3.5% per year. His average tax rate at this level of income will be 29%.

Alternative (4)

Northeastern University offers a two-years program. The annual tuition is $90.000. Northeastern allows students to work while enrolled in the MBA program. After some research, John has found out that he can potentially work for his marketing professor as research assistant. The annual stipend for this position at Northeastern University is $25,000 for the first year and $27,000 for the second year. Books and other supplies are estimated to cost $2,000 per year. John expects that after graduation from Northeastern University he will receive a job offer of $85,000 per year with a signing bonus of $10,000. The expected salary will increase at 2% per year for the first 10 years. The growth rate will be 4% thereafter. The average income tax rate is 30%.

All schools offer a health insurance plan that will cost $3,000 per year. John also estimates that room and board expenses will cost $2,000 more per year at all schools than his current expenses. The appropriate discount rate is 6.3%.

Determine the NPV for each of the four alternatives. Please provide formula calculations.

Answer 1

To calculate the NPV of each alternative, we first calculate the cash inflows and outflows for each year as below :

Alternative 1 :

Inflow for year 1 is the current salary ($65000) increased by 3%, which is $66,950. Inflow for year 2 is $66,950 increased by 3%, and so on for each year.

Net inflow after tax for each year is Inflow multiplied by (1 - tax rate)

Discount factor for year x is = 1/(1+0.063)^x

In this way, we calculate the PV of cash inflows for each year upto 40 years. The sum of these PVs is the NPV of Alternative 1.

NPV of Alternative 1 is $1,076,070

Alternative 2 :

Cash outflow for the first two years = (tuition fee + books + health insurance + increased living expenses), which is ($70,000 + $3,000 + $3,000 + $2,000), or $78,000. Cash inflow in year 3 is $130,000 (salary + signing bonus). Cash inflow in year 4 is $110,000 increased by 4%, which is $114,400. Cash inflow for each succeeding year is increased by 4%. Tax outflow is the cash inflow multiplied by tax rate, which is 31%. Net cash inflow = inflow - tax outflow - outflow. Discount factors remain the same as Alternative 1. The sum of PVs is calculated to find the NPV of Alternative 2.

NPV of Alternative 2 is $1,517,625

Alternative 3 :

Cash outflow for the first year = (tuition fee + books + health insurance + increased living expenses), which is ($85,000 + $4,500 + $3,000 + $2,000), or $94,500. Cash inflow in year 2 is $110,000 (salary + signing bonus). Cash inflow in year 3 is $92,000 increased by 3.5%, which is $95,220. Cash inflow for each succeeding year is increased by 3.5%. Tax outflow is the cash inflow multiplied by tax rate, which is 29%. Net cash inflow = inflow - tax outflow - outflow. Discount factors remain the same before. The sum of PVs is calculated to find the NPV of Alternative 3.

NPV of Alternative 3 is $1,342,134

Alternative 4 :

Cash outflow for the first two years = (tuition fee + books + health insurance + increased living expenses), which is ($90,000 + $2,000 + $3,000 + $2,000), or $97,000. Cash inflow for the first two years is the stipend earned. Cash inflow in year 3 is $95,000 (salary + signing bonus). Cash inflow in years 4 to 14 is $95,000 increased by 2% each year. Cash inflow for year 15 to 40 is the salary in year 14 increased by 4% each year. Tax outflow is the cash inflow multiplied by tax rate, which is 31%. Net cash inflow = inflow - tax outflow - outflow. Discount factors remain the same as before. The sum of PVs is calculated to find the NPV of Alternative 2.

NPV of Alternative 4 is $970,009