Description
Student 1 Kimberly
Considering the time value of money (TVM) should winners of a lottery take the lump sum payment or the annuity?
The time value of money can also be expressed as the value of money over time and includes Present Value and Future Value. The present value of money is how much you would need at the present moment to equal a certain amount in the future (Khan). For example, at 10% interest, you would need $100 to end up with $121 in 2 years. Future value of money is how much the present amount will equal in a certain amount of time (Khan). For example, at 10% interest, the 1 yr future value of $100 is $110 and the 2 yr future value would be $121.
If you won $1,000,000 in the lottery and you earn 2% interest in your bank account, you would earn $20,000 in interest in one year. So the 1yr future value would be $1,020,000. In two years you would have $1,040,400. Unfortunately, most low-risk investments dont pay even 2%. According to Marquit (2022), the national average yield on all savings account is 0.07%, 5-yr CDs are 0.39%, and money market accounts are 0.08%.
There are numerous high-risk investments that can earn you a lot more than 2% on your earnings; however, you have to be willing to risk losing the money. Most people wouldnt be willing to risk losing $1,000,000.
My recommendation for lottery winners would be to the lump sum payment and use what you need now, put a portion of it in high-risk investments, and the rest in low-risk investments.
References
Khan, S. (Creator). (YEAR). Time Value of Money [YouTube]. Retrieved fromhttps://youtu.be/733mgqrzNKs (Links to an external site.)
Marquit, M. (2022, June 16). Low Risk, Stable Returns: 6 Best Ways to Earn Interest in 2022. Time.com. Retrieved from https://time.com/nextadvisor/banking/best-ways-to-earn-interest/ (Links to an external site.).
Student 2 Bryan
Good evening class,
Considering the time value of money (TVM) should winners of a lottery take the lump sum payment or the annuity?
Time value of money is the difference in value between money today and money in the future (Berk, pg. 69). Knowing this I would like to evaluate whether a lottery winner should take a lump sum payment or the annuity. I would also like to reference professor Rahahlehs question proposed as a comment to Noelys post for the state lottery scenario for my evaluation.
The question was you just won the state lottery, you have a choice between receiving 2,550,000 today or a 20-year annuity of 250,000, with the first payment coming one year from today. The present value or PV would be 2,550,00 today and FV would be 5,000,000. At first glance it would seem beneficial to accept the annuity as it is almost double the PV value. If you were to solely invest in the S&P 500 with your lump sum payment it would have an estimated 15-year annualized rate of return 8.08 (Thune, 2022).
Some initial benefits of taking the lump sum are as I mentioned about the S&P 500 which is the ability to invest in high yielding markets such as stocks and real estate. We all know it takes money to make money, and if you have a large amount of it, you can use that vehicle to generate additional wealth easier than a smaller net amount. You will also avoid long term tax complications by paying a large amount of taxes one time and not having to file for high earnings every year. With 88,000 more IRS agents you know the government will be patiently waiting for that tax return.
Referring to the invest option with the lump sum, the FV with an estimated 8.08% return would be
2,550,000 x 1.08^20 = 11,005,038. This option is nearly double that of the annuity option with a hands-off investment approach. You could argue that you could do the same with the annuity payments but the rate on returns would be must lower. Not to mention that you will probably need 100,000 of that as your income every year if you choose not to work and live comfortably. In conclusion, the time value of money will suggest taking a lump sum payment as the best option only if you directly invest the proceeds to grow the initial investment.
Reference
Thune, K. (2022, January 23). What Is the Average Mutual Fund Return? The Balance. https://www.thebalance.com/what-is-the-average-mutual-fund-return-4773782 (Links to an external site.)
Berk, J. B., & Demarzo, P. M. (2020). Corporate finance (5th ed.). Pearson.
