Question

A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return (IRR) of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct

Answer 1

Answer:

Yes, her decision was correct because of Net present value rule.

Explanation:

the net present value (NPV) applies to a series of cash flows occurring at different times.

The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.

Time value of money dictates that time affects the value of cash flows.

Answer 2

Answer:

She was correct, the IRR for the cash flow is 6.15% compared to the 4% discount rate.

Explanation:

The two basic ways to decide whether a project is feasible or not are the net present value (NPV) and the internal rate of return (IRR).

The net present value is the prime test that you must always use first. But in this case, you do not need to calculate it because the IRR is higher than the discount rate. The IRR is the discount rate at which the NPV will equal 0. So an IRR higher than the discount rate will always yield a positive NPV.

Projects are considered feasible when the NPV ≥ 0, and if you have to choose between two or more mutually exclusive projects and both have positive NPVs, you should choose the project with the highest IRR (or MIRR if you really like math).

Since I like math, the NPV = $991,377, and you need more information to calculate MIRR.