posted by Julia Coon .
You are considering two lottery payment options: Option A pays $10,000 today and Option B pays $20,000 at the end of ten years. Assume youc an earn 6 percent on your savings. Which option will you choose if you base your decision on present values? Which option will you choose if you base your decision on future values? Explain why your answers are either the same or different.
If I base my decision on present values I’d go with Option B. The PV of Option A is $10,000 as it’s year one and we have $10,000 in hand. If I elect to go with Option B than I receive $20,000 at the end of ten years, assuming 6% discount rate. Via the formula below, the present value of Option B is over $11,000. PV Option B (>$11,000) is greater than PV Option A ($10,000), thus I’d go with Option B.
PV = FV (1/(1+r)^n
Where FV = Future value; r= rate of return and n = number of periods.
However, if I’m basing my decision on the future value, and I believe I can make more than 6% on my money via the stock market, treasury bonds, corporate bonds or other alternatives than I’d choose Option A. To play this scenario out; if I make 6% on my money annually via savings interest, I’d turn my $10,000 in Option A into ~$18,000. This is not as lucrative as the $20,000 I’d get in Option B. However, if I can make 8% on my $10,000 annually than my future value would be ~$21,500. Given my risk tolerance and basic investment philosophy, I’d take my chances and try to return 8% a year. I’d included FV formula for reference.
FV = PV x (1+r)^n
Where PV = Present value; r = rate of return and n = number of periods.