Question

Provide Sue with financial advice on which option has the potential to yield the highest monetary value. Support your rational with calculations using time value of money and comment on the risk return relationship for each option, assume interest rate on savings is 4% and is compounded semi-annually.

Sue James is a 55-year old accountant who works at Ernst and Young (EY) who is about to retire. She has the following decision to make:

Option A – Select a lump sum gratuity payment of $120,000 with a reduced pension of $1,750 per month.

Option B – Select a monthly pension of $3,300 with no lump sum gratuity payment.

In addition, Sue has a loan of $72,000 with loan payments of $1,200 per month for the next five years.

Answer 1

OPTION A

LOPTION. Parod. Cashflow PUE @24. (6 molbs) o 120,000 l-10 3,300+ 8.9826 1 525 000** 0.8043 PRESENT VALUE OF NET CASH INFLOW 181750 $1200 x 6 months = 3300 ** 6*$170/2y = 525 000 Discounted Cash Flow 120,000 29,643 422, 25% 571, 901

OPTION B

From above calculations, it is clear that present value of cash inflow will be higher if Sue had opted Option B (Select a monthly pension of $3,300 with no lump sum gratuity payment). Hence, sue is recommended to opt Option B.

OPTION B Period Cashflow DUF@27 (6 month) 1-10 12,600* 8.9826 999,00** 0.8043 PRESENT VALUE OF Net cash inflow Discounted Cash Flow 113.180 796 257 909 437 *($3300-1200) x6 months 2 $12,600 ** 6x $3300 - 27.

However, if risk is considered, the cash received today haves less risk while compared to cash receivable on a future date. If Sue is risk averse person, then Option A would be better for him as huge amount of money would be receiving initially itself.