Question

Tom is deciding if he should pursue his MBA. His choices are University A, which requires 2 yrs full time enrollment, at $63,000 each year. Books are $2,500 per year. Tom expects after graduation to get a job offer for $98,000 per year with a $15,000 signing bonus. The salary at this job will increase at 4 percent per year. His average income tax rate will be 31 percent. The other choice is University P, which has a 1 year program costing $80,000. Books at $3,500. If he chooses this school, he expects a job offer after graduation with $81,000 salary per year and a $10,000 signing bonus. The salary at this job will increase at 3.5 percent per year. His average income tax rate will be 29 percent. The appropriate discount rate is 6.5 percent. Assuming salaries are paid at the end of each year, which school is the best option for Tom from a financial standpoint?

Answer 1

From a financial standpoint, University A is the better option for Tom.

To determine which school is the best option for Tom from a financial standpoint, we need to calculate the present value (PV) of the costs and benefits associated with each choice.

Let's start with University A:

1. The total cost of University A for the 2-year program is:

Tuition: $63,000/year * 2 years = $126,000

Books: $2,500/year * 2 years = $5,000

Total cost: $126,000 + $5,000 = $131,000

2. Next, we calculate the present value (PV) of the job offer after graduation at University A. The salary increases at a rate of 4% per year. Using the formula for the present value of a growing annuity, we find:

PV = [Salary / (Discount Rate - Growth Rate)] * (1 -
`(1 + Growth Rate) ^ -n`)

Salary: $98,000

Growth Rate: 4%

Discount Rate: 6.5%

n: number of years = 2

PV = [$98,000 / (0.065 - 0.04)] * (
`1 - (1 + 0.04) ^ -2`) ≈ $175,530.67

3. The present value (PV) of the signing bonus at University A is simply the face value since it is received immediately:

PV = $15,000

4. Now, let's calculate the after-tax present value (PV) of the job offer at University A. The average income tax rate is 31%. We can calculate this as:

After-tax PV = PV * (1 - Tax Rate)

After-tax PV = $175,530.67 * (1 - 0.31) ≈ $120,999.47

5. Finally, we can calculate the total present value (PV) of University A by adding the after-tax PV of the job offer and the PV of the signing bonus:

Total PV = After-tax PV + PV of Signing Bonus

Total PV = $120,999.47 + $15,000 = $135,999.47

Now let's move on to University P:

1. The total cost of University P for the 1-year program is:

Tuition: $80,000

Books: $3,500

Total cost: $80,000 + $3,500 = $83,500

2. Next, we calculate the present value (PV) of the job offer after graduation at University P. The salary increases at a rate of 3.5% per year. Using the same formula as before, we find:

PV = [Salary / (Discount Rate - Growth Rate)] * (1 -
`(1 + Growth Rate) ^ -n`)

Salary: $81,000

Growth Rate: 3.5%

Discount Rate: 6.5%

n: number of years = 1

PV = [$81,000 / (0.065 - 0.035)] * (1 -
`(1 + 0.035) ^ -1`) ≈ $69,641.78

3. The present value (PV) of the signing bonus at University P is again the face value since it is received immediately:

PV = $10,000

4. Now, let's calculate the after-tax present value (PV) of the job offer at University P using the average income tax rate of 29%:

After-tax PV = PV * (1 - Tax Rate)

After-tax PV = $69,641.78 * (1 - 0.29) ≈ $49,390.21

5. Finally, we can calculate the total present value (PV) of University P by adding the after-tax PV of the job offer and the PV of the signing bonus:

Total PV = After-tax PV + PV of Signing Bonus

Total PV = $49,390.21 + $10,000 = $59,390.21

Comparing the total present values (PV) of both choices, we find that University P has a lower total present value ($59,390.21) compared to University A ($135,999.47). Therefore, from a financial standpoint, University A is the better option for Tom.