Chapter 6, Problem 61QP

Summary Introduction

To calculate: The size of settlements, and if Person X is a plaintiff what will be his choice on the interest rate.

Introduction:

The series of payments that are made at equal intervals is an annuity payment. The amount of annuity payments is mainly calculated based on the particular situation.

Answer to Problem 61QP

The size of the settlement or the award is $410,051.58.

Explanation of Solution

Given information:

Person X serves on a jury. A plaintiff sues the city for the injuries that are continued after the accident of the sweeper in the Street F. In the trial, the doctors testified that it will be 5 years earlier the plaintiff is able to return back to work. The decision made by the jury was in favour of the plaintiff. Person X is the foreperson of the jury, and the jury proposes that the plaintiff will be provided an award that is as follows:

1. a) The present value of the 2 years back pay. The annual salary of the plaintiff for the last 2 years would have been $41,000 and $44,000.
2. b) The present value of the 5 years future salary is assumed to be $48,000 for a year.
3. c) The sum that has to be paid for the pain and suffering is $100,000.
4. d) The amount of the court costs is $20,000.

It has to be assumed that the payment of the salary is paid at the month end in equal amounts. The rate of interest is 8% at an effective annual rate.

Note: The cash flows here would have occurred in the past and will occur in the future. It is essential to find the present cash flows. Before computing the present value of the cash flow, it is essential to adjust the rate of interest, thus the effective monthly interest rate can be found. Finding the annual percentage rate with compounding monthly and dividing it by twelve will provide the effective monthly rate. The annual percentage rate with the monthly compounding is calculated as follows:

Compute the annual percentage rate with the effective annual rate:

$\begin{array}{c}\text{Annual percentage rate}=12\left({\left(1+\text{EAR}\right)}^{\frac{1}{12}}-1\right)\\ =12\left({\left(1+0.08\right)}^{0.083333333}-1\right)\\ =12\left(1.00643403-1\right)\\ =0.077208361\end{array}$

Hence, the annual percentage rate is 0.0772 or 7.72%.

To determine the today’s value of the back pay from 2 years ago, it is essential to find the future value of annuity an then the lump sums future value.

Formula to calculate the future value of an annuity:

$\text{Future value annuity}=C\left\{\frac{\left[{\left(1+r\right)}^t-1\right]}{r}\right\}$

Note: C denotes the payments, r denotes the rate of exchange, and t denotes the period.

Compute the future value annuity:

$\begin{array}{c}\text{Future value annuity}=C\left\{\frac{\left[{\left(1+r\right)}^t-1\right]}{r}\right\}\\ =\frac{\$41,000}{12}\left\{\frac{\left[{\left(1+\frac{0.077208361}{12}\right)}^{12}-1\right]}{\frac{0.077208361}{12}}\right\}\\ =\$3,416.666667\left\{\frac{\left[1.08-1\right]}{0.006434030083}\right\}\\ =\$42,482.45\end{array}$

Hence, the future value of annuity is $42,482.45.

Formula to compute the future value:

$\text{Future value}=\text{PV}{\left(1+\text{r}\right)}^{\text{t}}$

Note:C denotes the annual cash flow or annuity payment, r denotes the rate of interest, and t denotes the number of payments.

Compute the future value:

$\begin{array}{c}\text{Future value}=\text{PV}{\left(1+r\right)}^t\\ =\$42,482.45\left(1+0.08\right)\\ =\$45,881.046\end{array}$

Hence, the future value is $45,881.046.

Note: The future value of the annuity is determined by the effective monthly rate and future value of the lump sum is determined by the effective annual rate. The other alternate way to determine the future value of the lump sum with the effective annual rate as long it is utilized for the 12 periods; the solution would be the same in either way.

Now the today’s value of the last year’s back pay is calculated as follows:

Compute the future value annuity:

$\begin{array}{c}\text{Future value annuity}=C\left\{\frac{\left[{\left(1+r\right)}^t-1\right]}{r}\right\}\\ =\frac{\$44,000}{12}\left\{\frac{\left[{\left(1+\frac{0.077208361}{12}\right)}^{12}-1\right]}{\frac{0.077208361}{12}}\right\}\\ =\$3,666.666667\left\{\frac{\left[1.08-1\right]}{0.006434030083}\right\}\\ =\$45,590.92\end{array}$

Hence, the future value of the annuity is $45,590.92.

Next, it is essential to determine today’s value of the 5 year’s future salary.

Formula to calculate the present value annuity:

$\text{Present value annuity}=C\left\{\frac{\left[1-\left(\frac{1}{1+r^t}\right)\right]}{r}\right\}$

Note: C denotes the payments, r denotes the rate of exchange, and t denotes the period.

Compute the present value annuity for without fee:

$\begin{array}{c}\text{Present value annuity}=C\left\{\frac{\left[1-\left(\frac{1}{{\left(1+r\right)}^t}\right)\right]}{r}\right\}\\ =\frac{\$48,000}{12}\left\{\frac{\left[1-\left(\frac{1}{{\left(1+\frac{0.077208361}{12}\right)}^{12\left(5\right)}}\right)\right]}{\frac{0.077208361}{12}}\right\}\\ =\$4,000\left\{\frac{\left[1-\left(\frac{1}{{\left(1+0.006434030083\right)}^{60}}\right)\right]}{0.006434030083}\right\}\\ =\$4,000\left\{\frac{\left[1-\left(\frac{1}{1.469328074}\right)\right]}{0.006434030083}\right\}\end{array}$

$\begin{array}{c}=\$4,000\left\{\frac{\left[0.319416801\right]}{0.006434030083}\right\}\\ =\$198,579.61\end{array}$

Hence, the present value of the annuity is $198,579,61.

The today’s value of the jury award is calculated by adding the sum of salaries, the court costs, and the compensation for the pain and sufferings. The award amount is calculated as follows:

$\begin{array}{c}\text{Award}=\$45,881.046+\$45,590.92+\$198,579.61+\$100,000+\$20,000\\ =\$410,051.58\end{array}$

Hence, the award amount or the size of the settlement is $410,051.58.