Proposal 1
Pay the family of Boone $300,000 a year for the next 20 years, and $500,000 a year for the remaining 20 years.
Proposal 2
Pay the family a lump sum payment of $5 million today.
Proposal 3
Pay the family of 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 these three proposals, attorney Knox Hollister called on a financial expert to do the analysis. You will aid in the process.
Required
1. Assume a discount rate of 6 percent 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 percent is used instead of 6 percent. Which of the three alternatives provides the highest present value?
3. Explain why the change in outcome takes place between question 1 and question 2.
4. If Knox Hollister thinks additional 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?
Excel explanation