Howie Long has just learned he has won a $500,000 prize in the lottery. The lott
ID: 2379390 • Letter: H
Question
Howie Long has just learned he has won a $500,000 prize in the lottery. The lottery has given him two options for receiving the payments: (1) If Howie takes all the money today, the state and federal governments will deduct taxes at a rate of 46% immediately. (2) Alternatively, the lottery offers Howie a payout of 20 equal payments of $36,000 with the first payment occurring when Howie turns in the winning ticket. Howie will be taxed on each of these payments at a rate of 25%."
Instructions:Assuming Howie can earn an 8% rate of return (compounded annually) on any money invested during this period, which pay-out option should he choose?
Explanation / Answer
PV of the first payout is 500000 * ( 1- 0.46 ) = $270,000
PV of 2nd option is,
annual payment is 36000 * ( 1-0.25 ) = 27,000
PV = 27000 + 27000/1.08 + ... + 27000/1.08^19 = $286,297.18
As $286,297.18 > $270,000, option 2 must be chosen
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