Professor Wendy Smith has been offered the following opportunity: A law firm wou

Question

Professor Wendy Smith has been offered the following opportunity: A law firm would like to retain her for an upfront payment of $50,000. In return, for the next year the firm would have access to eight hours of her time every month. As an alternative payment arrangement, the firm would pay Professor Smith's hourly rate for the eight hours each month. Smith's rate is $540 per hour and her opportunity cost of capital is 15% per year. What does the IRR rule advise regarding the payment arrangement? (Hint: Find the monthly rate that will yield an effective annual rate of 15%.) What about the NPV rule?

Explanation / Answer

hourly versus upfront IRR:

0=-50000+(540*8)/(1+IRR/12)+(540*8)/(1+IRR/12)^2............

IRR=6.725%

As IRR is less than opportunity cost of 15%, he should accept upfront payment

hourly versus upfront NPV:-50000+(540*8)/(1+15%/12)+(540*8)/(1+15%/12)^2............

NPV=-2137.37

So he should accept upfront payment

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