Question 3

A. Compute the present value of Option 1.

Option 1 is $90,000/year for five years with a $10,000 signing bonus. You invest $90,000 per
year on a continuous basis. The return on investment is 4%. This gives a continuous annuity
of $90,000 per year for five years that has to be discounted at a rate of return of 4%. We
assume that it is compounded continuously since the investment is done continuously as
well. To do this calculation you can use P A(P/ A, r,a, b) A0 . With A = $90,000/year, r=
0.04, a = 0 the start of the annuity and b = 5 the end of the annuity and A0 = $10,000 the
signing bonus which is already in present value because you get it immediately. Gives:

P= e e A0
A ra rb
r
90, 000
0.04
1 e0.045 10, 000 417,856

So the present value of Option 1 is $417,856.

B. Compute the present value of Option 2.

Option 2 is $80,000/year in the first year with 5% annual increases for the next four years
and a $20,000 signing bonus. You invest the yearly salary on a continuous basis. Note that
the salary increase is not continuously. The return on investment is still 4%. To compute the
present value we see the investment as five delayed annuities in consecutive years each
growing 5% with respect to the previous year starting at $80,000 in the first year. To do this
calculation you need to sum five present values P A(P/ A, r, a, b) with different A, a and b
values and add again A0 = $20,000. This gives with in this case A =$80,000, g=0.05 and A0 =
$20,000:

A

5
P= i e r i 1 e ri A 0
i 1 r
5
A 1 g
i 1

i 1 r

e e ri A 0
r i 1

5
80, 000 1 0.05
i 1

i 1 0.04
0.04 i 1

e e0.04i 20, 000 419, 091


So the present value of Option 2 is $419,091.

C. Which option would you choose? Explain why.

I would choose for Option 2 because the present value is higher. This means that the
invested money is worth more in the future as well. Furthermore when you decide to stay
longer with the company this contract gets better the longer you stay. However if you would
leave the company earlier Option one will result in a better present value. The