Your Uncle Otto Has Struck It Rich by Investing in Racehorses

question 9

Essay

Your Uncle Otto has struck it rich by investing in racehorses and desires to share some of his newfound wealth with you. Assume that you must choose from among the following three options:
Receive a lump sum of $400,000 in 20 years.
Receive $20,000 at the end of each year for the next 10 years.
Receive $90,000 now.
A. Why is it inappropriate to compare $400,000 (no. 1) vs. $200,000 (no. 2) vs. $90,000 (no. 3) and conclude that no. 1 is the best option? Explain.
B. What should you do to determine which option is the best? What does this process do?
C. If Uncle Otto agreed to revise option no. 1 so that you could receive $200,000 in 10 years and the remaining $200,000 in another 10 years, would you likely prefer the revision or the option as originally stated? Why?
D. What is an annuity? Do any of the options involve an annuity?

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Definitions:

APT

Stands for Arbitrage Pricing Theory, a financial model that estimates the returns on assets based on their risk relative to macroeconomic factors.

Portfolio's Beta

A measure of the volatility, or systematic risk, of a portfolio in comparison to the market as a whole.

S&P 500

Standard & Poor's 500, a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.

Contracts

Legal agreements between two or more parties that outline the terms and conditions under which certain actions or exchanges will take place.