Problem:
Mr. Boone wife was killed in a car accident late one night. Mr. Boone is looking to sue the Frozen Food Company because the driver of the Frozen Food Company's truck was drunk and caused the accident that killed Mrs. Boone.
After much negotiating with the law firm that represented the Frozen Food Company. The attorney for Mr. Boone received (3) proposals for an out-of-court settlement to be paid to Mrs. Boone family. The intent of the proposals was to replace the future earnings power of Mrs. Boone, less any of the earnings she would have personally needed for her normal living requirements. In addition, the value that she provided for her family as a wife and mother, quite aside from her earning power, had to be considered. Finally, there was the issue of punitive damages that Frozen Food Company was exposed to because of letting an unqualified driver operate its truck. If the case went to court, there was no telling how much a jury might assign to this last factor.
The (3) proposals are listed below. An actuarial table indicated that Allison, age 37 at the time of the accident, had an anticipated life expectancy of 40 more years.
1. Pay the family of Allison Boone $300,000 a year for the next 20 years, and $500,000 a year for the remaining 20 years.
2. Pay the family a lump sum payment of $5 million today.
3. Pay the family of Allison Boone a relatively small amount of $50,000 a year for the next 40 years, but also guarantee them a final payment of $75 million at the end of 40 years.
In order to analyze the present value of the (3) proposals, the attorney called on a financial expert to do the analysis. You will aid in the process.
Required to do:
1. Assume a discount rate of 6% is used, which of the three projects has the highest present value? In analyzing the first proposal, take the present value of the 20-year $300,000 annuity. Then take the present value of the deferred annuity of $500,000 that will run from the 21st through the 40th year. The answer you get for the second annuity will represent the value at the beginning of the 21st year (the same as the end of the 20th year). You will need to discount this lump sum value back for 20 years as a single amount to get its present value. You then add together the present value of the first and second annuity. The second and third proposals are straightforward and require no further explanation.
2. Now assume that a discount rate of 11% is used instead of 6%. Which of the (3) alternatives provide the highest present value?
3. Explain why the change in outcome takes place between question 1 and question 2.
4. If Mr. Boone attorney thinks punitive damages are likely to be $4 million in a jury trial, should he be more likely to settle out-of-court or go before the jury?