Question

Ann is a recent engineering graduate with two years experience in her current role and is currently looking at getting a Masters degree.

She is currently paid $60,000 per year, which she expects to increase at a 4 percent rate until she finally retires. Ann is currently 25 and expects to work for 40 more years. Her current employer offers a benefits package that includes health insurance. Ann has saved enough money to pay for a possible tuition expense and is currently taxed at 23 percent.
Ann was accepted at two of the programs she was applying to and is debating whether she should enroll in one of those programs. The details for each of the programs are as follows:

• Program A is a two-year full time program with an annual tuition of $50,000 due at the beginning of each academic year. According to the program's website, books and other required supplies are estimated to cost about $3,000 per year. The school offers a health plan for $5,000 per year.
• Program B is a one-year full time program with a tuition of $70,000 due at the beginning of the program. Although the supplies were not listed specifically on their information packet, Ann estimates a total cost for supplies and books of around $7,000. The school offers a health plan for $6,000 per year.

Both Programs offer on-campus housing which, according to Ann's estimates, should save her about $5,000 per year. Since both programs are full-time, she will need to leave her current employer if she decides to accept any of the offers.

Ann is anticipating that she will be able to secure a job offer for about $85,000 per year after graduating from program A, with a $7,000 signing bonus. The salary at this job will probably increase at 5 percent per year. Since the pay is much higher than her current income, Ann expects her average tax rate will increase to 30 percent.

For program B, Ann thinks that she will most likely be able to get an offer of $75,000 per year upon graduation, with a $6,000 signing bonus. The salary at this job will increase at 4.75 percent per year and, due to the increased level of income, her average tax rate will be 28 percent.

Given the risk of starting a new degree, Ann feels that the appropriate discount rate is 6 percent.

1. Does Ann's age have any impact on her decision to get a Masters degree?
2. Are there other factors that could impact Ann's decision? If so, what are those?
3. What is the best option from a strictly financial standpoint? For simplicity, assume all salaries are paid in full at the end of each year.
4. Ann was discussing her analysis with a friend, who mentioned she should calculate the future value of each of the scenarios. How would you evaluate this statement?
5. Although Ann believes she'll be able to get jobs paying the amount stated above for each of the programs, she is trying to understand better how much the initial salary estimate is impacting her decision. Assuming all else equal, what would the initial salaries be for each of the programs so that Ann is financially indifferent between attending that specific program or staying in her current position?
6. Discuss the impact that initial salary and growth rates have on the analysis.
7. Suppose that you need to borrow money at a rate of 5%. Does that change the answers above? What about at 10%?

Answer 1

(1) As Ann is quite young and in the early phase of her career, she can afford stop working for 1 or 2 years and invest that time in a masters degree. The masters degree would better her career prospects and increase the probability of higher salary in the future. It can be seen as investment in her future and career

(2) Yes, there are other factors that could impact Ann's decision. These are :

• The satisfaction and status achieved by having a master's degree
• networking and soft skills provided by an masters degree
• opportunity for career growth

(3) To find the best alternative from a financial standpoint, we calculate the NPV of each alternative

Alternative 1: continue in current job

Inflow for year 1 is the current salary ($65,000) increased by 4%, which is $67,600. Inflow for year 2 is $67,600 increased by 4%, 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+0.06)^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 = $1,387,796

Alternative 2 : Program A

Cash outflow for the first two years = (tuition fee + books + health insurance - decreased housing expenses), which is ($50,000 + $3,000 + $5,000 - $5,000), or $53,000. Cash inflow in year 3 is $92,000 (salary + signing bonus). Cash inflow in year 3 is $85,000 increased by 5%, which is $89,250. Cash inflow for each succeeding year is increased by 5%. Tax outflow is the cash inflow multiplied by tax rate, which is 30%. 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 is $1,636,058

Alternative 3 : Program B

Cash outflow for the first year = (tuition fee + books + health insurance - decreased housing expenses), which is ($70,000 + $7,000 + $6,000 - $5,000), or $78,000. Cash inflow in year 2 is $81,000 (salary + signing bonus). Cash inflow in year 3 is $75,000 increased by 4.75%, which is $78,586. Cash inflow for each succeeding year is increased by 4.75%. Tax outflow is the cash inflow multiplied by tax rate, which is 28%. 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 = $1,558,192

As calculated, the highest NPV is for Alternative 2, which is $1,636,058

this is the best option from a financial standpoint

(4) Either future value or present values for each alternative can be calculated. The important thing is to be consistent in the analysis and use one method throughout the analysis. Comparing present value of one alternative with the future value of another alternative is meaningless.

If the future value is being calculated, the cash flows would remain the same. However, each cash flow would be compounded at 6% to the end of 40 years, and then each alternative compared. The alternative with the highest future value should be chosen

Either method should give the same decision, as long as the same discount rate is applied