Question

Linda Reed, an executive at VIP Inc. has earned a performance bonus. She has the option of accepting $80,000 now or $130,000 5 years from now. What would you advise her to do? Explain and support with calculations. Calculate what rate Linda would be indifferent between these two performance bonus options. Using the table, select rate for the discount factor that matches the closest to your calculation. If using Excel or financial calculator, round interest rate to the nearest whole number (i.e., 0.0968 = 10%). Answer______

Based on the rate calculated above, select the best option for Linda.

A.If the current interest rate is 9%, Linda should choose to defer her payment and receive $130,000 5 years from now.

B.If the current interest rate is 8%, Linda should choose to accept the immediate payment of $80,000.

C.If the current interest rate is 11%, Linda should choose to defer her payment and receive $130,000 5 years from now.

D.If the current interest rate is 7%, Linda should choose to accept the immediate payment of $80,000.

Answer 1

Based on the rate calculated above, select the best option for Linda.

Calculate the PV of Each option and compare to 80000

A. If the current interest rate is 9%, Linda should choose to defer her payment and receive $130,000 5 years from now.

(1/1.09)^5 = Present value interest factor, 9%, 5 = 0.6499

Choose PV = 130000 * (1/1.09)^5 = 130000 * 0.6499 = 84487

Immediate payment = 80000

NPV = 84487 - 80000 = 4487

B. If the current interest rate is 8%, Linda should choose to accept the immediate payment of $80,000.

(1/1.08)^5 = Present value interest factor, 8%, 5 = 0.6806

PV = 130000 * (1/1.08)^5 = 130000 * 0.6806= 88478

Choose immediate payment = 80000

NPV = 80000 - 88478 = -8478

C. If the current interest rate is 11%, Linda should choose to defer her payment and receive $130,000 5 years from now.

(1/1.11)^5 = Present value interest factor, 11%, 5 = 0.5935

Choose PV = 130000 * (1/1.11)^5 = 130000 * 0.5935 = 77155

Immediate payment = 80000

NPV = 77155 - 80000 = 2845

D.If the current interest rate is 7%, Linda should choose to accept the immediate payment of $80,000.

(1/1.07)^5 = Present value interest factor, 7%, 5 = 0.7130

PV = 130000 * (1/1.07)^5 = 130000 * 0.7130 = 92690

Choose immediate payment = 80000

NPV = 80000 - 92690 = -12690

> here the highest NPV is for the option A,so, select the option A.

Indifferent point

Rate which indifferent in both option

80000 = 130000 * PVIF,r,5

Which means the 80000 is the present value of 130000 discounted using a rate.that rate is indifferent rate.

PVIF,r,5 = 80000 / 130000 = 0.6154

Look at the PVIF table, 5^th row, find where is the 0.6154 is located, and find its correspondent interest rate, which is the approx. Interest rate.

10% is the rate

Approx. Interest rate to indiffenrent = 10%