Question

Suppose you win a small lottery and have the choice of two ways to be paid: You can accept the money in a lump sum or in a series of payments over time. If you pick the lump sum, you get $2,800 today. If you pick payments over time, you get three payments: $1,000 today, $1,000 1 year from today, and $1,000 2 years from today.

1) At an interest rate of 6% per year, the winner would be better off accepting the (LUMP SUM or PAYMENTS OVER TIME?), since it has the greater present value.
2) At an interest rate of 9% per year, the winner would be better off accepting the (LUMP SUM or PAYMENTS OVER TIME?), since it has the greater present value.
3) Years after you win the lottery, a friend in another country calls to ask your advice. By wild coincidence, she has just won another lottery with the same payout schemes. She must make a quick decision about whether to collect her money under the lump sum or the payments over time. What is the best advice to give your friend?
A) The lump sum is always better.
B) The payments over time are always better.
C) It will depend on the interest rate; advise her to get a calculator.
D) None of these answers is good

Answer 1

PAYMENTS OVER TIME

lump sum

c

Step-by-step explanation:

To know the better option, we have to calculate the present value of the series of cash flows

Present value is the sum of discounted cash flows

Present value can be calculated using a financial calculator

Cash flow in year 0 = $1000

Cash flow in year 1 = $1000

Cash flow in year 2 = $1000

PV when interest rate is 6 = 2833.93

PV when interest rate is 8 = 2783.26

When PV when interest rate is 6 , choose payment over time because it is higher

PV when interest rate is 8 , choose lump sum because it is higher

To find the PV using a financial calculator:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. after inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.

3. Press compute