Mini Case Study A - Time Value of Money Sandra Gilbert, Retiree

Sandra Gilbert, would reach the age of 65 next year and was preparing for retirement. She had been working for Wolfson Manufacturing Company as an accountant and quality control engineer for the last 25 years and accumulated $400,000 in her retirement account. Her husband, Warren, had passed away two years ago at the age of 70 and they had no offspring. Al Wistert, from the Human Relations Department, came to visit with Sandra in anticipation of her retirement. He explained to her that there were a number of options she could take.

Four Options

1. The first option was to take the entire $400,000 when she retired next year. She could then take the funds and invest them on her own. She would be in a tax bracket of 35 percent and would have to pay this rate on $400,000 before she could invest her funds. Thirty-five percent is used for ease of computation.

2. Sandra's life expectancy is 20 more years, and she could receive an annuity of $35,000 a year for the next 20 years. Because her annual income would be relatively small, a tax rate of 15 percent would apply.

3. Because females often outlived males, a CFP (Certified Financial Planner) suggested 90 years would be a more realistic life expectancy. This would mean she could expect to live 25 more years. Under that scenario, she could expect to receive $31,000 a year and pay taxes at the rate of 15 percent.

4. A fourth and final choice would be to take half the $400,000 initially and balance annually over the next 10 years in equal payments. The tax rate on the initial payment would be 35 percent, and 15 percent on the subsequent payments.

There could be many other options for drawing down the $400,000 but Sandra preferred to consider these options for now.

Required

1. Calculate the after tax proceeds from option 1.

2. Assuming a discount rate of 8 percent, calculate the net present value of the aftertax benefits of the 2nd option.

3. Once again assuming a discount rate of 8 percent, calculate the net present value of the aftertax benefits of the 3rd option.

4. What is the net present value of the fourth option based on the specified tax rates and an 8 percent discount rate?

5. Which of the four options provides the highest net present value?

6. In comparing option 2 and 3, if a discount rate of four percent instead of eight percent were used, would your answer change? Explain the reasoning behind your conclusion.