1) Rain Makers Corporation is negotiating a five-year contract with its new CEO,

Question

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

A)  Present Value of OPTION 1

B) Present Value of OPTION 2:

Present Value Year Cash flow $ PV@12% PV $ 1       1,400,000      0.8929 1,250,000 2       1,400,000      0.7972 1,116,071 3       1,400,000      0.7118     996,492 4       1,400,000      0.6355     889,725 5       1,400,000      0.5674     794,398 5,046,687

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