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Compound Interest / Annuities problem

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  1. May 23, 2009 #1
    Suppose that you are negotiating your bonus with your boss. She offers you three options for your bonus:

    Option A: You get $5000 right now
    Option B: You get 8 monthly payments of $650 starting 1 month from now
    Option C: You get $5300, but you have to wait 8 months before you get it

    Using an interest rate of 10% compounded monthly, calculate the options to determine which option is best. Justify your thinking.

    My Answer:

    I want to find the total value of the investment at the end of 12 months from now. I show option A and C first since they are the simplest.

    Option A
    A = P(1 + i)^n
    A = 5000(1 + 0.1 / 12)^12
    A = $5523.57

    Option C
    A = P(1 + i)^n
    A = 5300(1 + 0.1 / 12)^4
    A = $5478.89

    Option B
    A = R[(1 + i)^n - 1] / i
    A = 650[(1 + 0.1 / 12)^8 - 1] / (0.1 / 12)
    A = $5354.22

    A = P(1 + i)^n
    A = 5354.22(1 + 0.1 / 12)^3
    A = $5489.19

    I first get the value of the annuity during the 8 monthly payments (skipping month 1), and then get the compound interest for 3 months on that amount.

    Solution
    Therefore option A will result in the largest amount of money after 12 months.


    I was hoping that someone could quickly look over and see that I have the right idea? Also I was wondering if selecting 12 months was correct or if I should have only tried after 9 months which would have been the end period of option B?

    Thanks!

    EDIT:

    I just now ran through all of the same logic using 9 months so that option C only used the annuities calculation, option B is 5300 with no interest, and option A has 9 months of compound interest. Option A is still the best option to invest.

    I'm just not sure which one I should hand in with my course work, either 9 month or 12 month
     
    Last edited: May 23, 2009
  2. jcsd
  3. May 23, 2009 #2

    danago

    User Avatar
    Gold Member

    It does not matter which time period you decide to compound/discount the cash flows to, as long as you are consistent with the interest rates and discount them all to the same period. You could have discounted all of the cash flows to the current period (i.e. find the present value of the cash flows), or you could have compounded the cash flows to 123 months in the future, either way, you will get the same result.

    I didnt check your calculations, so i havent confimed if they are correct or not, but just answering your last question.
     
    Last edited: May 23, 2009
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