Solution to Case 5

Time Value of Money

Lottery Winnings Looks Can Be Deceptive!

1.

If you were one of the winners, which option would you select? Why? Most winners would select the cash option whereby 50% of the stated amount is paid out in a lump sum (less federal and state taxes) i.e. $90.75 million - .332(90.75m) = $61.53 million. Cash is liquid and certain and can be invested as per the preferences of the winner. Older winners would rather have the money now than leave it behind for their heirs to enjoy. Younger winners would probably prefer to invest the money at higher rates than the implied risk-free rate of interest that the annuity is based on.

2.

If you decide to select the annuity option, how much money would you receive each year after taxes? Under the annuity option, the winner is paid the advertised prize money in 26 equal installments after taxes are withheld. The calculation is as follows: Before-tax annuity = $181,500,000/26 = $6,980,769.23 After-tax annuity = $6,980,769.23 - .322($6,980,769.23) = $4,732,961.54 Tax Rate

3.

Is the State of Michigan justified in advertising the prize amount as $363 million? Explain. The State of Michigan is paying $363 million to the 2 winners but over 26 years. In terms of time value of money, the amount that is being paid out (cash option) or for that matter, set aside for winnings from the lottery sales, is approximately 50% of the stated value. Technically speaking, the prize amount is over stated. However, since the objective of the 1

lottery is to fund public projects, especially education, the advertising value of stating the higher amount is justifiable. 4. If the only option available were an annuity payment plan, what could Larry do to maximize the value of his winnings assuming that the risk-free rate of interest is 5%. Larry could sell off the annuity to professional firms in exchange for a lump sum and then invest the money in a balanced portfolio that would probably yield about 10% per year. As long as the discount rate used to figure the lump sum is around 5%, Larry will be able to come out ahead. 5. Why do most winners select the cash option plan when given a choice? Most winners select the cash option plan when given a choice because cash is risk-less and liquid and most investors feel that they can then invest the money in higher yielding portfolios albeit at higher levels of risk. 6. If Michigan Lottery would like to give the annuity option an equal chance of being selected, how would it have to structure its payments? Although the cash value option is equivalent to the present value of the annuity option, most investors are enticed by the higher dollar amount of $61m versus $4.732 million each year for 26 years. Perhaps if the annuity is based on a higher rate of interest 8% - 9% or if there are some tax advantages given to the annuity payment plan, it would become more attractive as an option.