John won the lottery on Monday and can take either $50,000 per year for 20 years, or $500,000 today. Bill won
the same lottery on Tuesday and has the same options for receiving the cash.
A well respected financial advisor
is hired by both John and Bill. The advisor recommends that John take the $50,000 per year for 20 years but
advises Bill to take the $500,000 up front payment. How is it possible to give different advice to two clients
regarding the exact same cash flows?
The time value of money is based on opportunity cost. If John and Bill have different opportunity costs for funds, they
can each be making rational choices. For example, suppose Bill can earn 20% on the funds he receives by investing
them in his business, but John expects to earn only 2% by investing the lottery winnings in a certificate of deposit. Bill
will end up with more cash if he takes the $500,000 up front and invests it wisely, even though he is giving up $500,000
of future winnings. John, however, is better off taking the $50,000 per year, for a total of $1,000,000 over 20 years,
because he would not be able to make up the lost $500,000 by earning only 2% per year.
You might also like to view...
The retained earnings account is closed at the end of the fiscal year
Indicate whether the statement is true or false
In the equal store organization, buying functions are decentralized, but selling functions are centralized
Indicate whether the statement is true or false
The law will carefully scrutinize contracts between Pete, a trustee, and Mason, a beneficiary of the trust, to make sure there was no undue influence by Pete
a. True b. False Indicate whether the statement is true or false
Qiana gives Rick a $50 check as payment for a debt. Rick crudely raises the amount of the check to $500 and transfers it to SmartPhones & MinutesStore for a new phone. SmartPhones & Minutes deposits the check in its Trade Market Bank account. Qiana is liable for the payment of $500 to
a. no one. b. Trade Market Bank. c. Rick. d. SmartPhones & Minutes.