Suppose you have an investment which returned 11.65% last year. If the inflation

Question

Suppose you have an investment which returned 11.65% last year. If the inflation rate was 3.4%, what "REAL" return was earned on the investment? You have just been awarded a $ 400,000 settlement in a personal injury lawsuit. The terms of the settlement provide for twenty equal annual installments of $ 20,000 beginning one year from today. J.G. Wentworth has offered to buy the contract from you for $175, 600 TODAY. Disregarding any desire for current cash, should you take the offer if you expect to be able to earn an 8% annual return on investments during the projected payout period? Explain.

Explanation / Answer

7. Real rate of return = [(1 + Investment return) / (1 + Inflation rate) - 1] * 100%

= [(1 + 11.65%) / (1 + 3.4%) - 1] * 100%

= 7.98%

8. Present value of the settlement money = Annual installment * [1 - (1 + Annual return)-No. of years] / Annual return

= $20,000 * [1 - (1 + 8%)-20] / 8%

= $196,363

Since, the offered price ($175,600) is less than the present value of the annual installments, the offer should be rejected.

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