Question

Your younger brother has come to you for advice. He is about to enter college and has two options open to him. His first option is to study engineering. If he does this, his undergraduate degree would cost him $30,000 a year for four years. Having obtained this, he would need to gain two years of practical experience: in the first year he would earn $35,000, in the second year he would earn $40,000. He would then need to obtain his master’s degree, which will cost $35,000 a year for two years. After that he will be fully qualified and can earn $60,000 per year for 30 years. His other alternative is to study financial accounting. If he does this, he would pay $25,000 a year for four years and then he would earn $50,000 per year for 35 years. The effort involved in the two careers is the same, so he is only interested in the earnings the jobs. provide. All earnings and costs are paid at the end of the year. What advice would you give him if the market interest rate is 5 percent?

a. Tell him to choose Engineering since its NPV is $526,611.09

b. Tell him to choose Financial Accounting since its NPV is $584,905.75

c. Tell him to choose Engineering since its NPV is $341,155.80

d. Tell him to choose Financial Accounting since its NPV is $409,205.58

e. Tell him to choose Engineering since its NPV is $599,134.32

Answer 1

Net Present Value = Present value of all cash-inflow – Present value of all cash outflow

Present value = Amount / (1+r)ⁿ

Present value of equal cash-flows for multiple periods = R x {[1 – (1+r)^-n] / r}

Where, “R” is amount, “r” is discount rate and “n” is number of discounting periods

NPV for Engineering:

Present value of all earnings when it starts = $60,000* {[1-(1+0.05)^-30]/0.05}
=> $60,000*{0.768622551/0.05}
= $922,347.10

Present Value of all earnings today = $922,347.10 / (1.05)⁸ = $624,280.80

Present of earnings as part of two years working experience after under-graduation:
=> ($35,000/1.05) + ($40,000/1.05²) = $33,333.33 + $36,281.18 = $69,614.51

Present value of this earning today = $69,614.51 / 1.05⁴ = $57,272.03

Present value of all cost = $30,000*{[1-(1+0.05)^-4]/0.05} = $106,378.50

Net Present Value of Master’s Degree = $624,280.80 + $57,272.03 - $106,378.50 = $575,174.30

NPV for Financial Accounting Degree:

Present value of all costs = $25,000*{[1-(1+0.05)^-4]/0.05} = $88,648.76

Present value of all earnings when it starts = $50,000* {[1-(1+0.05)^-35]/0.05} = $818,709.70
Present value of earnings today = $818,709.70 / 1.05⁴ = $673,554.50

Net Present Value = $673,554.50 - $88,648.76 = $584,905.70

Since the NPV for Financial Accounting option is higher, he should choose this course.

Option B (Tell him to choose Financial Accounting since its NPV is $584,905.75) is correct.