Author Question: The lottery this evening is worth 50 million dollars in your state. There are two people in your ... (Read 119 times)

deesands · **on:** Jun 29, 2018

The lottery this evening is worth 50 million dollars in your state. There are two people in your neighborhood that are buying lottery tickets. One is a student with little financial knowledge or business acumen.

The other is a successful entrepreneur that is earning 20 rate of return on his business. Which of these people is likely to check off the cash option on the ticket and which is likely to choose the structured payout and why?

Question 2

As the president of your firm, you are considering the purchase of a new piece of machinery. The machine is expected to increase profits by 5,000 per year for five years. After that, the machine will have no value.

If the machine costs 22,000 and the market rate of interest is 5 percent, should your firm purchase the machine? Explain.

eliasc0401 · **Reply #1 on:** Jun 29, 2018

Answer to Question 1

It is more likely that the entrepreneur will choose the cash option because he can invest this money in his business and earn a handsome return. The present discounted value of the structured payout is likely to be less than the cash option. Just the opposite is likely to be true for the student.

Answer to Question 2

No. The present value of the income stream is (5,000/1.05) + (5,000/1.1025) + (5,000/1.157625) + (5,000/1.2155063) + (5,000/1.2762816) = 4,761.90 + 4,535.15 + 4,319.19 + 4,113.51 + 3,917.63 = 21,647.38 . Since the cost of the machine is greater than the present value of the income stream, the machine should not be purchased.