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

The money received in the future is less in value than money received today.

So first we need to find the Present value of the annuity that will be received over the period of 10 years, and compare the PV with 17,000,000. The option which has highest PV will be selected.

However the required rate is not given in the question, so we need to find the interest rate or internal rate of return at which if we discount the cash flows if will be equal to 17,000,000.

It can be calculated in the Excel using IRR function.

Year	Cash flow
0	-17000000
1	2500000
2	2500000
3	2500000
4	2500000
5	2500000
6	2500000
7	2500000
8	2500000
9	2500000
10	2500000
IRR	7.71%
Formula used	=IRR(B3:B13)

Now we will compare the IRR with current market interest rate or required rate of return, if it is higher than the IRR we will accept the lump sum payment of 17,000,000 and vice versa.

The reason is if the interest rate is higher than IRR (suppose 10%), we can accept the Lump sum of 17,000,000 today and deposit in the bank and earn 10% on the deposit.

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Hope that helps.

Feel free to comment if you need further assistance J

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