Case summary:
Person B has completed his graduation six years before, with an undergraduate degree in finance. His aim is to become an investment banker; however, he is satisfied with his present job. Person B was searching for the best college to do an MBA program, which he thinks would assist him in achieving his aim. He was looking for University W and College M. The details of Person B's current job and his course structure are provided.
Characters in the case:
- Person B
- University W
- College M
- Company DL
- College R
- College M
- School B
Adequate information:
- Person B is not allowed to work anywhere until the completion of the MBA program.
- The salaries are not paid for the internship course.
To calculate: The best option for Person B assumes that the increase in salary payment occurs at the end of every year.
Answer to Problem 3MC
Solution:
As the computed total value for each option is greater in the second option, the best option for Person B is to pursue an MBA at University W.
Explanation of Solution
Given information:
Person B currently works at a money management Company DL, whose salary is $65,000 for a year and is expected to rise to 3% in a year, until retirement. He is 28 years old and expects to be in employment for 40 more years. The average rate of tax payable by Person B is 26%.
College R at University W is one of the best programs for an MBA. It is a two-year full-time course. The fee is $70,000 annually and the cost of the book and other supplies is $3,000 for a year. After graduation, he will be employed for $110,000 with a bonus of $20,000. The salary will increase by 4% in a year and the rate of tax will rise by 31%.
School B at College M is less familiar than College R. It provides an accelerated program for one year with an annual fee of $85,000. The cost of books and other supplies for the program is expected to be $4,500. Person B would get an offer of $92,000 for a year after graduation, with a bonus of $18,000. The salary would rise to 3.5% for a year and the average rate of tax will be 29%.
Both the schools provide health insurance plans for the cost of $3,000 for a year, which must be paid at the beginning of the year. The board and room expenses will be $2,000 more for a year in both the schools. The rate of discount is 6.3%.
Note: Here, Person B has three choices; one is to remain in the same job, or to pursue an MBA at University W or at College M. As the board and room costs are not relevant, they will be the same even if Person B stays in his present job or attends the college. Compute the after-tax value under each choice.
If Person B chooses to remain at the present job, then his present after-tax value will be the following:
Formula to calculate after-tax value:
Compute the after-tax salary:
Hence, the after-tax value is $48,100.
Formula to calculate the present value for a growing
Note: g denotes the growing rate of annuity,
r denotes the rate of discount,
t denotes the number of years.
Compute the present value for a growing annuity:
Hence, the present value is $1,044,728.37.
If Person B chooses to pursue an MBA at University W, then his total value will be the following:
Formula to calculate the total direct costs:
Compute the total direct costs:
Hence, the total direct cost is $78,000.
Formula of present value of direct costs:
Compute the present value of direct costs:
Hence, the present value of the direct costs is $151,377.23.
Formula to calculate the present value of after-tax bonus:
Compute the present value of after-tax bonus:
Hence, the present value of the after-tax bonus of Person B is $12,212.72.
Formula to calculate the after-tax value:
Compute the after-tax value:
Hence, the after-tax value if Person B pursues MBA at University W is $75,900.
Note: As Person B’s salary will increase by 4% a year, compute the present value of after-tax of the increasing salary. Remember that Person B is expected to work for 38 more years.
Formula to calculate the present value for a growing annuity:
Note: g denotes the growing rate of annuity,
r denotes the rate of discount,
t denotes the number of years.
Compute the present value for a growing annuity:
Hence, the present value is $1,862,801.41.
As the initial payment of salary will be obtained three years from the present, discount the number of years to 2 to compute the present value.
Formula to calculate the present value for 2 years:
Compute the present value for 2 years:
Hence, the present value for 2 years is $1,648,542.05.
Formula to calculate the total value:
Compute the total value:
Hence, the total value, if Person B pursues an MBA in the University W is $1,509,377.54.
If Person B chooses to pursue an MBA at College M, then his total value will be the following:
Formula to calculate the total direct costs:
Compute the total direct costs:
Hence, the total direct costs are $94,500.
Note: This is also the present value costs, as they all are paid at present.
Formula to calculate the present value of the after-tax bonus:
Compute the present value of the after-tax bonus:
Hence, the present value of the after-tax bonus of Person B is $12,022.58.
Formula to calculate the after-tax value:
Compute the after-tax value:
Hence, the after-tax value if Person B pursues an MBA at the College M is $65,320.
Note: As Person B’s salary will increase at a rate of 3.5% in a year, compute the present value of after-tax of the increasing salary. Remember that Person B is expected to work for 39 more years.
Formula to calculate the present value for a growing annuity:
Note: g denotes the growing rate of annuity,
r denotes the rate of discount,
t denotes the number of years.
Compute the present value for a growing annuity:
Hence, the present value is $1,509,165.86.
As the initial payment of salary will be obtained two years from the present year, discount the number of years to 1 to compute the present value.
Formula to calculate the present value for 1 year:
Compute the present value for 1 year:
Hence, the present value for 1 year is $1,419,723.29.
Formula to calculate the total value:
Compute the total value:
Hence, the total value, if Person B pursues an MBA in College M is $1,337,245.87.
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Chapter 4 Solutions
Loose Leaf for Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
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