Calculating present value of an incentive
You have been offered a job with an unusual bonus structure. As long as you stay with the firm, you will get an extra $70,000 every seven years, starting seven years from now. What is the present value of this incentive if you plan to work for the company for a total of 42 years and the interest rate is 6% (EAR)
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First for the formula for figuring this discount based upon the future payments:
Formula is NPV = Principal/(1+i) for 6 periods encompassing 42 years --- so we would apply it 6 times over the 42 year period.
In lieu of that, we can apply the present value table listing net present value factors for this period in time. Using this table we find that the factors for discounting are:
7 years @ 6% = .665
14 years @ 6% = .442
21 years @ 6% = .294
28 years @ 6% = .196
35 years @ 6% = .122
42 years @ 6% = .056
Now we simply ...
Solution Summary
Applying future bonus payments will result in applying the time value of money principle to these future payments, which results in discounting future flows of cash to the present in order to gain perspective on the true current value of these future cash flows.
Incentive program by car dealer to offer a 'tires for life' program: Calculate amount to add to the price of a car
I saw a commercial on TV last night in which a local car dealer was trying to attract customers by offering them a "Tires for Life" program. The way it works is if you buy a car from the dealership, they agree to replace the tires whenever needed at no charge for as long as you own the car.
When I saw the commercial I was instantly reminded of how many, many of the problems that finance people deal with every day out in the real world are simply present value problems like we studied last week. The tires for life incentive program is a classic example, as it calls for answering the question "How much does the dealer have to add to the price of the car to finance the incentive program?"
Some simplifying assumptions. For example, let's assume the following:
One customer is going to take advantage of the deal, and the car purchase is to take place today.
Then length of time the car is expected to be owned is 6 years.
Replacement tires will be needed every 2 years.
A set of replacement tires costs $200.
Funds set aside to finance the incentive program can be invested at 5%.
Now, assume you are a financial analyst working for the car dealership and the CEO has asked you to report how much they need to add to the price of a car to finance this initiative. They need an answer by the end of this week.
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