Question

John just won the lotto Jackpot of $25,000,000; based on the rules however John has the option of either accepting a lump sum payment of $17,000,000 or collect 2,500,000 annually for the next 10 years. John heard that you are an ‘A’ student in Financial Management and came to you for advice. How would you advise John? What factors would you need to take into consideration to properly advise John?

Answer 1

Solution:

Option 1 : Lumpsum payment = $17,000,000

Option 2: received $2,500,000 annually for next 10 years.

Now to chose option 1 and 2, we have to calculate implied rate of interest of option 2.

At implied rate of interest, both option will be indifferent to each other. Therefore present value of option 2 will be equal to $17,000,000

Let implied rate of interest is i.

Now

$2,500,000 * cumulative PV Factor at i rate for 10 periods = $17,000,000

Cumulative PV factor at i rate for 10 periods = 6.80

Cumulative PV factor at 7% for 10 periods = 7.023582

Cumulative PV factor at 8% for 10 periods = 6.710081

Now i = 7% + (7.023582 - 6.80) / (7.023582 - 6.710081)

= 7.71%

Therefore in order to chose lumpsum payment or annual payment we have to see market rate of interest. If interest rate in market is lower than 7.71% then i will advise to John to accept annual payments as it will results in higher return. If interest rate in market is higher than 7.71% then i will advise to john to accept lump sum payment as it will result in hgiher return.