Question

You can receive $10,000 today or $2.500 per year for the next five years. If the required rate of return is 10%, what option should be selected? (The present value of an ordinary annuity at 10% for five periods is 3.7908. The present value of one at 10% for five periods is 0.6209.)

a) Receive $2,500 per year for the next five years.

b) The results are the same for both options.

c) Neither option is desirable.

d) Receive $10,000 today

Answer 1

Option D i.e. Receive $10,000 today

Explanation :-

The decision of which option is best is based on which option has higher Present Value

Present value of $10,000 today = 10,000 x PVF@10%, year 0

= 10,000 x 1 = $10,000

Present value of $2,500 per year = 2,500 x PVAF@10%,year 5

= 2,500 x 3.7908 = $9,477

Received $10,000 today has higher Present value.

Answer 2

To determine which option is better, we need to calculate the present value of each option and compare them.

Option A: Receive $2,500 per year for the next five years.

The present value of an ordinary annuity of $2,500 per year for five years at 10% is:

PV = $2,500 x (1 - 1/1.1^5) / 0.1 = $9,765.40

Option D: Receive $10,000 today.

The present value of $10,000 today at 10% for five periods is:

PV = $10,000 x 0.6209 = $6,209

Comparing the two options, we see that option A has a present value of $9,765.40, while option D has a present value of $6,209. Therefore, the better option is option A: receive $2,500 per year for the next five years.