1) Rain Makers Corporation is negotiating a five-year contract with its new CEO,
ID: 1203991 • Letter: 1
Question
1) Rain Makers Corporation is negotiating a five-year contract with its new CEO, Earl Honeywood. The corporation
has proposed two contract options for the CEO, outlined as follows:
OPTION 1: A five-year contract, starting January 1, Year 1, for $7,000,000. Earl Honeywood would be
paid $1,400,000 each year at the end of the year (December 31) for five consecutive years.
OPTION 2: A five-year contract, starting January 1, Year 1, for $7,800,000. Earl Honeywood would be
paid at the end of each year (December 31). He would receive $1,100,000 in Years 1 through
3, and then $2,250,000 in Years 4 and 5.
You have been hired as Earl’s investment manager, and believe that Earl should consider the time value of money at
12% before making his decision. Calculate the present value of the two contract options to aid Earl in his decision.
A) Present Value of OPTION 1:
B) Present Value of OPTION 2:
Explanation / Answer
A)
B)
Option 1 has lower Present value
Option 1 Dates Cash Flow DCF @ 12% Present value Year 1 1-Jan (7,000,000) 1.000 (7,000,000) Year 1 31-Dec 1,400,000 0.893 1,250,000 Year 2 31-Dec 1,400,000 0.797 1,116,071 Year 3 31-Dec 1,400,000 0.712 996,492 Year 4 31-Dec 1,400,000 0.636 889,725 Year 5 31-Dec 1,400,000 0.567 794,398 Total (1,953,313)B)
Option 2 Dates Cash Flow DCF @ 12% Present value Year 1 1-Jan (7,800,000) 1.000 (7,800,000) Year 1 31-Dec 1,100,000 0.893 982,143 Year 2 31-Dec 1,100,000 0.797 876,913 Year 3 31-Dec 1,100,000 0.712 782,958 Year 4 31-Dec 2,250,000 0.636 1,429,916 Year 5 31-Dec 2,250,000 0.567 1,276,710 Total (2,451,360)Related Questions
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