Question

David Jetter graduated from college six years ago with a finance undergraduate degree. Although he is satisfied with his current job, his goal is to become an investment banker. He feels that an MBA degree would allow him to achieve his goal. After examining schools, he has narrowed his choice to either Prentice University or Mount Alliance College. Although internships are encouraged by both schools, to get class credit for the internship, no salary can be paid. Other than internships, neither school will allow its students to work while enrolled in its MBA program.

David currently works at the money management firm of Dewey and Louis. His annual salary at the firm is $50,000 per year, and his salary expected to increase at 3 % per year until retirement. He is currently 28 years old and expects to work for 40 more years. His current job includes a fully paid health insurance plan, and his current average tax rate is 26 %. David has savings account with enough money to cover the entire cost of his MBA program.

The Ritt College of Business at Prentice University is one of the top MBA programs in the country. The MBA degree requires two years of full time enrollment at the university. The annual tuition is $65,000, payable at the beginning of each school year. Books and other supplies are estimated to cost $3000 per year. David expects that after graduation from Prentice, he will receive a job offer for about $110,000 per year, with a $20,000 signing bonus. The salary at this job will increase at 4 % per year. Because of the higher salary, his average income tax rate will increase to 31 %.

The Bradel School of Business at Mount Alliance College began its MBA program 16 years ago. The Bradel School is smaller and less well known than the Ritt College. Bradel offers an accelerated, one – year program, with a tuition cost of $80,000 to be paid upon matriculation. Books and other supplies for the program are expected to cost $4,500. David thinks that he will receive an offer of $92,000 per year upon the graduation, with an $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 %.

Both schools offer a health insurance plan that will cost $3,000 per year, payable at the beginning of the year. David also estimates that room and board expenses will cost $2,000 more per year at both schools than his current expenses, payable at the beginning of each year. The appropriate discount rate is 6.5 percent.

1. How does David’s age affect his decision to get an MBA? Explain why?

2. What other, perhaps non- quantifiable factors affect David’s decision to get an MBA? Explain in detail

3. Assuming all salaries are paid at the end of each year, what is the best option for David – from a strictly financial standpoint? Explain why in detail with calculations.

4. David believes that the appropriate analysis is to calculate the future value of each option. How would you evaluate this statement? So what is the future value of each option?

5. What initial salary would David need to receive to make him indifferent between attending Prentice University and staying in his current position?
Explain in detail with calculations.

Answer 1

Solution:

Question 1:

Age is a very important factor for David as he analyzes the available alternatives. Age will determine the income he will get from each alternative because the value of each alternative is based on the number of years he will be receiving income. In essence, if David delays his MBA program he will have less time to work and as a consequence will earn less than if he decides to pursue the MBA program immediately. Age is, therefore, a critical factor when it comes to this decision.

Question 2:

Apart from age, there are other non-quantifiable factors which will affect David’s decision and the factors are equally important for David as he weighs his alternatives. The factors include; credibility of the MBA program, the length of time it will take to complete the program and finally David’s determination to pursue his life goals. Colleges are rated differently based on a number of factors and this rating will affect the credibility and regard of MBAs from the colleges. Looking at Prentice University and Mount Alliance College it is evident that they are regarded differently by employers because the salary one receives with an MBA from Prentice University is much higher than the salary received with an MBA from Mount Alliance College. Credibility is therefore an important factor for David to consider before enrolling in either college. The period of the program is another factor because different colleges offer MBAs but the programs differ in duration depending on the college. Ritt College MBA program takes two years while an MBA in Bradel School takes just one year. Finally, ambition and desire to pursue one’s goals is another factor which cannot be ignored. If David is so determined to achieve his goal of becoming an investment banker he will enroll for an MBA program the sooner. As much as he likes his current job, he has a goal to become an investment banker and this is a driving force and if David is that determined to achieve his goal then he will have no choice but to enroll for an MBA program.

Question 3:

To decide the best option it is important to calculate the present values of each option.

Option 1: Continue Working

Salary after tax = $50,000*(1-0.26) = $37,000

C = $37,000, g = 3%, r = 6.5%, n = 40

Present value of a growing annuity

= C*[1-{(1+g)/(1+r)}^n]/(r-g)

= 37,000*[1-{(1+0.03)/(1+0.065)}^40]/(0.065-0.03)

= $779,402.90

Option 2: Enroll for an MBA at Ritt College

Salary after tax = $110,000*(1-0.31) = $75,900

C = $75,900, g = 4%, r = 6.5%, n = 38

Present value of a growing annuity

= C*[1-{(1+g)/(1+r)}^n]/(r-g)

= 75,900*[1-{(1+0.04)/(1+0.065)}^38]/(0.065-0.04)

= $1,804,927.68

Present value of bonus = Future value/(1+r)^n

Future value = $20,000, r = 6.5%, n = 2

= 20,000/(1.065)^2

= $17,633.19

Total present value = $1,804,927.68 + $17,633.19 = $1,822,560.87

College Expenses and Tuition cost

Insurance expenses + tuition + books and other supplies + room and board expenses

= $3,000 + $65,000 + $3,000 + $2,000

= $73,000 per year

Present value = Total expenses + Future value/(1+r)^n

Future value = $73,000, r = 6.5%, n= 1

= 73,000 + 73,000/(1+0.065)^1

= $141,544.60

Present value of salary and bonus – present value of cost

= $1,822,560.87 - $141,544.60

= $1,681,016.27

Option 3: Enroll for an MBA at Bradel School

Salary after tax = $92,000*(1-0.29) = $65,320

C = $65,320, g = 3.5%, r = 6.5%, n = 39

Present value of a growing annuity

= C*[1-{(1+g)/(1+r)}^n]/(r-g)

= 65,320*[1-{(1+0.035)/(1+0.065)}^39]/(0.065-0.035)

= $1,462,896.46

Present value of bonus = Future value/(1+r)^n

Future value = $18,000, r = 6.5%, n = 1

= 18,000/(1.065)^1

= $16,901.41

Total present value = $1,462,896.46 + $16,901.41 = $1,479,797.87

College Expenses and Tuition cost

Insurance expenses + tuition + books and other supplies + room and board expenses

= $3,000 + $80,000 + $4,500 + $2,000

= $89,500 per year

Present value of salary and bonus – present value of cost

= $1,479,797.87 - $89,500

= $1,390,297.87

Recommendation:

The best option for David is to enrol for an MBA at Ritt College because it has the highest present value.

Question 4:

Future value is not the best technique to use in analyzing the various alternatives. Present value is an appropriate technique which is preferred when evaluating projects and investment decisions. Even for the situation facing David, the future value is not the appropriate tool to analyze the alternatives. However, the future value can still be used to evaluate the alternatives despite it not being the appropriate option.

Future values;

Option 1: Continue Working

Salary after tax = $50,000*(1-0.26) = $37,000

C = $37,000, g = 3%, r = 6.5%, n = 40

Future value of a growing annuity

= C*[(1+r)^n-(1+g)^n]/(r-g)

= 37,000*[(1+0.065)^40-(1+0.03)^40]/(0.065-0.03)

= $9,677,124.56

Option 2: Enroll for an MBA at Ritt College

Salary after tax = $110,000*(1-0.31) = $75,900

C = $75,900, g = 4%, r = 6.5%, n = 38

Future value of a growing annuity

= C*[(1+r)^n-(1+g)^n]/(r-g)

= 75,900*[(1+0.065)^38-(1+0.04)^38]/(0.065-0.04)

= $19,758,087.37

Future value of bonus = Present value*(1+r)^n

Future value = $20,000, r = 6.5%, n = 38

= 20,000*(1.065)^38

= $218,934.95

Total Future value = $19,758,087.37 + $218,934.95 = $19,977,022.32

College Expenses and Tuition cost

Insurance expenses + tuition + books and other supplies + room and board expenses

= $3,000 + $65,000 + $3,000 + $2,000

= $73,000 per year

Future value = Future value*(1+r)^n

Present value = $73,000, r = 6.5%, n= 40

= 73,000*(1+0.065)^40

= $906,373.44

Future value of salary and bonus – future value of cost

= $19,977,022.32 - $906,373.44

= $19,070,648.88

Option 3: Enroll for an MBA at Bradel School

Salary after tax = $92,000*(1-0.29) = $65,320

C = $65,320, g = 3.5%, r = 6.5%, n = 39

Future value of a growing annuity

= = C*[(1+r)^n-(1+g)^n]/(r-g)

= 65,320*[(1+0.065)^39-(1+0.035)^39]/(0.065-0.035)

= $17,054,865.26

Future value of bonus = Present value*(1+r)^n

Present value = $18,000, r = 6.5%, n = 39

= 18,000*(1.065)^39

= $209,849.15

Total future value = $17,054,865.26 + $209,849.15 = $17,264,714.41

College Expenses and Tuition cost

Insurance expenses + tuition + books and other supplies + room and board expenses

= $3,000 + $80,000 + $4,500 + $2,000

= $89,500 per year

Present value = $89,500, r = 6.5%, n = 40

Future value of cost

= present value*(1+r)^n

= $89,500*(1+0.065)^40

= $1,111,238.67

Future value of salary and bonus – future value of cost

= $17,264,714.41 - $1,111,238.67

= $16,153,475.74

Question 5:

To be indifferent between attending Prentice University and staying in the current position, David has to earn a salary whose present value equals net present value of enrolling for an MBA Prentice University.

Present value of a growing annuity

= C*[1-{(1+g)/(1+r)}^n]/(r-g)

Present value = $1,681,016.27, C is salary net of tax, r = 6.5%, g = 3%, n = 40

$1,681,016.27 = C*[1-{(1+ 0.03)/(1+0.065)}^40]/(0.065-0.03)

$1,681,016.27 = C*21.0649

C = $79,801.60

Salary = 79,801.60/(1-tax rate)

= 79,801.60/(1-0.26)

= $107,840