Sally Hamilton has performed well as the chief financial office of the Maxtech C

Question

Sally Hamilton has performed well as the chief financial office of the Maxtech Computer Company and has earned a bonus. She has a choice among the following three bonus plans:

1. A $50,000 cash bonus paid now.

2. A $10,000 annual cash bonus to be paid each year over the next six years, with the first $10,000 paid now.

3. A three-year $22,000 annual cash bonus with the first payment due three years from now.

Required: Evaluate the three alternative bonus plans. Sally can earn a 6% annual return on her investments.

Explanation / Answer

Present value of option (2):
Present value of annuity due = P+P×[1-(1÷(1+r))^(n-1)]÷r

r is interest rate per period

P is payment per period

n is number of payments

= $10,000+$10,000×[1-(1÷(1+6%))^(6-1)]÷6%

= $52,123.64

Present value of option (3):
Present value of annuity = P×[1-(1÷(1+r)^n)]÷r

r is interest rate per period

P is payment per period

n is number of payments

= $22,000×[1-(1÷(1+6%)^3)]÷6%

= $58,806.26

Present value= P×(1÷(1+r)^n)

P is payment

r is interest rate per period

n is number of periods

= $58,806.26×(1÷(1+6%)^3)

= $49,374.87

Option (3) has least cost.

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