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Principles of Corporate Finance + S&P Market Insight (10th Edition)

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Problem

Several years ago The Wall Street Journal reported that the winner of the Massachusetts State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. The prize was $9,420,713, to be paid in 19 equal annual installments. (There were 20 installments, but the winner had already received the first payment.) The bankruptcy court judge ruled that the prize should be sold off to the highest bidder and the proceeds used to pay off the creditors.

a. If the interest rate was 8%, how much would you have been prepared to bid for the prize?

b. Enhance Reinsurance Company was reported to have offered $4.2 million. Use Excel to find the return that the company was looking for.

Step-by-step solution

The prize of the country M lottery should be sold at highest price and the creditors will be paid with that proceeds. This prize involves the 19 equal annual instalments. Total amount of the 19 equal annual instalments is $9,420,713.

Comment

a)

The bid for the prize will be equal to the present value of the annual installments. The present value of the annual instalments can be calculated using the present value of an annuity formula.

Annuity is a cash flow stream which ends after a particular time period. Hence, the same amount will be occurred over the particular period.

Following is the formula of the present value of an annuity:

Here,

Comment

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To find the present value of the annual installments, it is required to find the annual installment.

Calculate the annual instalment as follows:

Hence, the annual instalment is $495,827.

Comment

Calculate the present value of the annual instalments as follows:

Therefore, the bid for the prize is $4,761,724 .

Comment

b)

The company E is offered to pay the amount of $4,200,000. The rate of return that can be earned by the company E will be calculated using RATE function in a spreadsheet.

Follow the below steps to calculate the rate of return:

Step 1: Open a spreadsheet.

Step 2: Go to formulas.

Step 3: Select financial formulas and choose Rate.

Step 4: Following dialogue box will appear.

Comment

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Recommended solutions for you in Chapter 2

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Nper is the number of periods. Pmt is the annuity payment (in this case-annual instalment), Pv is the present value (in this case-offered amount), Fv is the future value, and Type is the type of the payment (payment starts at the beginning of the period-1 (or) payment starts at the end of the period-0).

In the present situation, Type is 0 as the payment will be made at the end of the year. Ignore FV as it is not given.

Comment

Step 5: Enter the values in the dialogue box as follows:

Therefore, the rate of return that can be earned by the company E is 0.0981 (or) 9.81%.

Comment

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7 0

Chapter 2, Problem 3SSQ Chapter 2, Problem 2P

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