Question

Mr. Jackson has been awarded a bonus for his outstanding work. His employer offers him a choice of a lump-sum of $5,000 today, or an annuity of $1,250 a year for the next five years. Which option should Mr. Jackson choose if his opportunity cost is 9 percent?

Answer 1

Mr. Jackson should choose the lump-sum option of $5,000 today as it has a higher present value compared to the annuity.

Step-by-step explanation:

To determine which option Mr. Jackson should choose, we need to compare the present value of the annuity with the lump-sum amount. The present value of the annuity can be calculated using the formula PV = CF × (1 - (1+r)^-n) / r, where PV is the present value, CF is the cash flow per period, r is the discount rate, and n is the number of periods.

For the annuity, CF = $1,250, r = 9%, and n = 5. Plugging these values into the formula, we get PV = $1,250 × (1 - (1+0.09)^-5) / 0.09 = $4,703.14.

Therefore, Mr. Jackson should choose the lump-sum option of $5,000 today, as it has a higher present value compared to the annuity.