Concept explainers
To select: The preferable salary arrangement offered by an investment bank.
Introduction:
The cash flow is the overall money that is transacted inside and outside the business mainly while affecting the liquidity of the business.
Answer to Problem 35QP
The first salary arrangement gives a present value
Explanation of Solution
Given information:
Person X has joined an investment banking company. The company provides two various salary arrangements to Person X. The first one is that Person X will be provided $6,700 per month for the upcoming two years. The second arrangement is that Person X will be provided $5,400 per month for the upcoming two years including a bonus of $25,000 at present. The rate of interest is given at 7% compounded on a monthly basis.
Note: It is necessary to compare the two cash flows by finding the cash flows value at a common period. Hence, we have to compute the present value of every cash flow stream. As the cash flows are monthly, it is necessary to use the monthly rate of interest.
Formula to compute the monthly rate:
Compute the monthly rate:
Hence, the monthly rate is 0.58%.
Formula of present value
Note: C denotes the annuity payment or annual cash flow, r denotes the rate of interest, and t denotes the period.
Compute the present value annuity for first arrangement:
Hence, the present value annuity for the first salary arrangement is $149,645.17.
Compute the present value annuity for second arrangement:
Hence, the present value annuity for the second salary arrangement is $120,609.54.
Note: The first choice is best in the above case.
Formula to compute the value of second option:
Compute the value of second option:
Hence, the value of second option is $145,609.54.
Formula to compute the difference in the value at present:
Compute the difference in the value at present:
Hence, the difference in the value at present is $4,035.63.
Note: Compute the future value for the two cash flows.
Formula to compute the future value annuity:
Where,
“C” denotes the annual cash flow or annuity payment,
“r” denotes the rate of interest,
“t” denotes the period.
Compute the future value annuity for the first arrangement:
Hence, the future value annuity for the first arrangement is $172,062.91.
Compute the future value for the second arrangement:
Hence, the future value for the second arrangement is $167,422.72.
Note: The first option is again the best choice.
Formula to compute the difference in the future value:
Compute the difference in the future value:
Hence, the difference in the future value is $4,640.19.
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Chapter 5 Solutions
EBK ESSEN.OF CORP.FINANCE
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