Yue Zhao

E-Portfolio TVM Assignment

According to the given information, before John was injured, he was the president of his familys
business, and earned approximately $200,000 per year.
Suppose John could work 25 more years before retirement, and he could earn the same
amount of $200,000 each year, then the $200,000 could be viewed as an annuity, for the same
amount is to be received each period, here annually.
To compensate for Johns loss, they need to compute Johns lost future income into todays
value. Because money has a time value. This means the money invested today will grow to a
larger dollar amount in the future. Usually interest rate is used to reflect the time value of money.
Suppose the interest rate would remain constant for the following 25 years, and an annual rate
of 7% (it might be an estimate based on average similar investment growth rate) could be
reached, Johns equivalent todays value (or Present Value) of his lost future income then can
be computed.
Below is the known information:
Annuity Amount = $200,000.
Periods Number = 25.
Annual Interest Rate = 7%.
We need to calculate equivalent Present Value of the 25 years annuity payments.
Present Value (PV) = ?

Suppose John gets the first payment one year from now:
PV1 * (1+ Annual Interest Rate) = 200,000
PV1 * (1+7%) = 200,000
PV1 = 200,000 * (1+7%)-1
PV1 = 200,000 * 0.93458
PV1 = 186,916

Current Year 1st Year

PV = ?
$200,000

Current Year
PV = ?

2nd Year
$200,000

PV2 * (1+ Annual Interest Rate)2 = 200,000

PV2 * (1+7%)2 = 200,000
PV2 = 200,000 * (1+7%)-2
PV2 = 200,000 * 0.87344
PV2 = 174,688

We can turn the above calculations into a table for all 25 years:
Annuity Payment

Factor

Present Value

1st Year

$200,000

(1+7%)-1 (0.93458)

$186,916

2nd Year

200,000

(1+7%)-2 (0.87344)

174,688

Yue Zhao

3rd Year

200,000

(1+7%)-3 (0.8163)

174688

25th Year

200,000

(1+7%)-25 (0.18425)

36850

25

The Accumulated Present Value for all 25 years can be found by separately calculating the PV
of each of the 25 payments, and then summing these individual present values together. That
accumulated present value (lump-sum) would be equal to the 25 years annuity. Though this
method is easy to understand, but its process is very tedious.
Fortunately we can use a more simple method to calculate the present value of annuity: To use
the table of Present Value of an Ordinary Annuity of $1.
Below is the PVA of $1 table for interest rate of 7%:
From the above examples of PV1 and
PV2, we can see that the present
value of the first 2 years annuity is
PV1 + PV2 = 186,916 + 174,688 =
$361,604.
Also, PV1 + PV2 = 200 * (0.93458 +
0.87344) = 200,000 * 1.80802 =
$361,604.
We can see the above 1.80802 is just
the factor we find from table PVA of
$1 using n=2, and i=7%.
Thus we can conclude that the two
methods can lead to the same
results.
Using table PVA of $1, we calculate
the PV of the ordinary annuity (PVA)
as following:
PVA = Annuity Amount * PVA
Factor
Here PVA factor is the number found
on table PVA of $1, where n=25, and
i=7%.
Thus, the Present Value for the 25 years annuity payment can be calculated by:
PVA = 200,000 * 11.65358 = $2,330,716
This is just the lump-sum settlement amount John was offered in the question.

Yue Zhao

As for whether the settlement is fair, it depends on whether the estimations fairly reflects real
future.
What we currently get from calculation is based on the estimations of consistent $200,000
earnings per year for 25 years, and the annual interest rate of 7%. Do these estimation really
reflects Johns lost future income? Its hard to say. John could earn more than $200,000 in some
year, or he could also earn more less in some other year. If he would use the money to invest,
can he maintain an annual growth rate of 7%? If the big economic environment is bad, think
about 2008s financial crisis, no one can guarantee a return rate of 7% for 25 years. But on the
other hand, maybe John could get luck and hit a higher rate in some year. So, estimations are
only estimations, its derived from the best information available, and describes the most likely
outcome of the uncertainty.
Thus, according to my understanding, as long as the estimation amounts are reasonable and
acceptable to Johns family, the settlement amount got from the estimations then is fair.

Reflection:
This question not only asks us to calculate the time value of money, but it also requires us to
explain the calculation to a person that has barely knowledge of the time value of money
concepts. To explain the calculation, we need to break it into steps, and illustrate it step by step.
The process helps us better comprehend TVM, for it needs us fully understand the concepts
and able to interpret it in easy-to-understand words.