TIME VALUE OF MONEY 1) Rain Makers Corporation is negotiating a five-year contra

Question

TIME VALUE OF MONEY

1) Rain Makers Corporation is negotiating a five-year contract with its new CEO, Earl Honeywood. The corporation

has proposed two contract options for the CEO, outlined as follows:

OPTION 1: A five-year contract, starting January 1, Year 1, for $7,000,000. Earl Honeywood would be

paid $1,400,000 each year at the end of the year (December 31) for five consecutive years.

OPTION 2: A five-year contract, starting January 1, Year 1, for $7,800,000. Earl Honeywood would be

paid at the end of each year (December 31). He would receive $1,100,000 in Years 1 through

3, and then $2,250,000 in Years 4 and 5.

You have been hired as Earl’s investment manager, and believe that Earl should consider the time value of money at

12% before making his decision. Calculate the present value of the two contract options to aid Earl in his decision.

A) Present Value of OPTION 1:

B) Present Value of OPTION 2:

Explanation / Answer

Hence , Present value of option 1 is less than option two , so investment should be option 1 is most probable .

Year Option 1 Option 2 P V Factor Amount Present Value P V Factor Amount Present Value 1 0.893 $1,400,000 $1,250,200 0.893 $   1,100,000 $ 982,300 2 0.797 $1,400,000 $1,115,800 0.797 $   1,100,000 $ 876,700 3 0.712 $1,400,000 $996,800 0.712 $   1,100,000 $ 783,200 4 0.636 $1,400,000 $890,400 0.636 $   2,250,000 $ 1,431,000 5 0.567 $1,400,000 $793,800 0.567 $   2,250,000 $ 1,275,750 Total $7,000,000 $5,047,000 Total $   7,800,000 $ 5,348,950

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