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Chapter 6: Q5P (page 307)

(Analysis of Alternatives) Julia Baker died, leaving to her husband Brent an insurance policy contract that provides that the beneficiary (Brent) can choose any one of the following four options. (a) \(55,000 immediate cash. (b) \)4,000 every 3 months payable at the end of each quarter for 5 years. (c) \(18,000 immediate cash and \)1,800 every 3 months for 10 years, payable at the beginning of each 3-month period. (d) \(4,000 every 3 months for 3 years and \)1,500 each quarter for the following 25 quarters, all payments payable at the end of each quarter.

Instructions If money is worth 2½% per quarter, compounded quarterly, which option would you recommend that Brent exercise?

Short Answer

Expert verified

The best option is option C which has the highest Present Value.

Step by step solution

01

Present Value of part A

The present value of is $55,000.

02

Calculation of present value of option B.

PresentValue=Presentvalueofquarterlypayment=4,000×15.58916=$62,357

03

Calculation of present value of option C

PresentValue=InitialPayment+Presentvalueofquarterlypayment=18,000+1,800×25.73034=$64,315

04

Computation of present values of option D

PresentValue=Presentvalueofquarterlypayment=4,000×10.25776+1500×18.42438×0.74356=41,031+20,549=$61,580

The best option is option C.

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Most popular questions from this chapter

Zach Taylor is settling a \(20,000 loan due today by making 6 equal annual payments of \)4,727.53. Determine the interest rate on this loan, if the payments begin one year after the loan is signed.

Steve Madison needs $250,000 in 10 years. How much must he invest at the end of each year, at 5% interest, to meet his needs?

Using the appropriate interest table, provide the solution to each of the following four questions by computing the unknowns.

(a) What is the amount of the payments that Ned Winslow must make at the end of each of 8 years to accumulate a fund of \(90,000 by the end of the eighth year, if the fund earns 8% interest, compounded annually?

(b) Robert Hitchcock is 40 years old today and he wishes to accumulate \)500,000 by his sixty-fifth birthday so he can retire to his summer place on Lake Hopatcong. He wishes to accumulate this amount by making equal deposits on his fortieth through his sixty-fourth birthday. What annual deposit must Robert make if the fund will earn 8% interest compounded annually?

(c) Diane Ross has \(20,000 to invest today at 9% to pay a debt of \)47,347. How many years will it take her to accumulate enough to liquidate the debt?

(d) Cindy Houston has a \(27,600 debt that she wishes to repay 4 years from today; she has \)19,553 that she intends to invest for the 4 years. What rate of interest will she need to earn annually in order to accumulate enough to pay the debt?

Murphy Mining Company recently purchased a quartz mine that it intends to work for the next 10 years. According to state environmental laws, Murphy must restore the mine site to its original natural prairie state after it ceases mining operations at the site. To properly account for the mine, Murphy must estimate the fair value of this asset retirement obligation. This amount will be recorded as a liability and added to the value of the mine on Murphy’s books. (You will learn more about these asset retirement obligations in Chapters 10 and 13.) There is no active market for retirement obligations such as these, but Murphy has developed the following cash flow estimates based on its prior experience in mining-site restoration. It will take 3 years to restore the mine site when mining operations cease in 10 years. Each estimated cash outflow reflects an annual payment at the end of each year of the 3-year restoration period.

Restoration Estimated Probability Cash Outflow Assessment $15,000 10% 22,000 30% 25,000 50% 30,000 10%

Instructions (a) What is the estimated fair value of Murphy’s asset retirement obligation? Murphy determines that the appropriate discount rate for this estimation is 5%. Round calculations to the nearest dollar. (b) Is the estimate developed for part (a) a Level 1 or Level 3 fair value estimate? Explain.

Consider the following independent situations. (a) Mike Finley wishes to become a millionaire. His money market fund has a balance of \(92,296 and has a guaranteed interest rate of 10%. How many years must Mike leave that balance in the fund in order to get his desired \)1,000,000? (b) Assume that Sally Williams desires to accumulate \(1 million in 15 years using her money market fund balance of \)182,696. At what interest rate must Sally’s investment compound annually?
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