Question

Your annual salary is $100,000. You are offered two options for a severance package. Option 1 pays you 6 months' salary now. Option 2 pays you and your heirs $6,000 per year forever (first payment at the end of this year.) If you are required return is 11%, which option should you choose?

1. How much is the value for alternative 1?
2. How much is the value of alternative 2?

Answer 1

Answer:

Option 1 is more convenient.

Explanation:

Giving the following information:

The annual salary is $100,000. You are offered two options for a severance package. Option 1 pays you 6 months' salary now. Option 2 pays you and your heirs $6,000 per year forever

The present value of option 1 is:

PV= 6*100,000= $600,000

To calculate the present value of option 2 we need to use the present value formula of a perpetual annuity:

PV= Cash flow/i

PV= 6,000/0.11= $54,545

There is no doubt that option 1 is better.