A generous university benefactor has agreed to donate a large amount of money fo

Question

A generous university benefactor has agreed to donate a large amount of money for student scholarships. The money can be provided in one lump-sum of $10mln, or in parts, where $5.5mln can be provided in year 1, and another $5.5mln can be provided in year 2. Assuming the opportunity interest rate is 6%, what is the present value of the second alternative? Which of the two alternatives should be chosen and why? How would your decision change if the opportunity interest rate was 12%? Please, show all your calculations.

Explanation / Answer

When opportunity interest rate is 6%

Present value of second alternative = 5.5/1.06 + 5.5/(1.06)^2 = 10.08 million.

The present value is more than 10 million. Therefore, second alternative should be chosen. If the money is invested in a return of 6%, second alternative will have more money at the end of year 2.

If the opportunity interest rate is 12%,

Present value of second alternative = 5.5/1.12 + 5.5/(1.12)^2 =9.30 million, which is less value then taking a lump-sum immediately. Therefore, first option should be chosen.

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