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I was watching CFA level1 videos and found this odd question.

Elmer has won his $4 million state lottery and has been offered 20 annual payments of $200,000 each beginning today or a single payment of $2,267,000. What is the annual discount rate used to calculate the lump-sum payout amount?

I know how to type in calculator by 
Begin Mode, N=20, FV=0, PMT=-200,000, PV=2,267,000
ANS: I/Y = 7%

However, I am interested in mathematical calculation. I have tried EMI, i=N√FVPV−1, etc. equations. Doesn't see one of them working. I am wondering which equation is used for calculation interest rate of lump sum? Why following formula doesn't work? -200,000 * (I/Y**20) = 2,267,000

3 Answers 3

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If you accepted the $200,000 per year you could deposit each payment at zero interest and end up with $4m after 20 years. If you accepted the single payment of $2,267,000 you would have to deposit it in a bank at 2.87987 % per annum to end up with $4m after 20 years.

4000000 = 2267000 (1 + r)^20 ∴ r = 2.87987 %

The OP only asks for the single payment calculation. Nevertheless, here is the rest.

The advantage of annual payments would remain up until the bank deposit rate reached slightly over 7% at which point the advantage turns to the single payment. I.e. future value of an annuity due for the annual payments:

Future value s equals the sum of the appreciated payments a. Formula is by induction.

annuity due

Choosing r slightly over 7% for an example

  r = 0.070008
  a = 200000
  n = 20
∴ s = (a (1 + r) ((1 + r)^n - 1))/r = $8,773,867.36

vs. single payment

2267000 (1 + 0.070008)^20 = $8,773,886.56

In this case the future value from the single payment is greater.

With r > 7.00077 % is it advantageous to take the single payment. The plot below illustrates the cross-over point with the exact intercept found by solver.

Note the answer as stated by the OP is 7%.

enter image description here

Solution via solver

enter image description here

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The mathematical calculation is an iterative root-finding algorithm. There's not a known closed form equation for the interest rate that results in a specific present value, except for very simple cases like a single cash flow. So the calculator tries various interest rates until it finds one that gives the correct present value of the coupon stream.

Why following formula doesn't work? -200,000 * (I/Y**20) = 2,267,000

It looks like you're trying to calculate the future value of a cash flow, but are comparing it to the present value. The idea of present value is "At what interest rate could I invest 2,267,000 now, and 200k per year, and end up with the same amount in the end".

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  • Thank you. That make senses. No wonder I couldn't find any formulas. Appreciate it!!!
    – Eric.P
    Commented Aug 21, 2023 at 15:21
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FV = PV (1+r)^n

This will help you.

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  • Indeed 4000000 = 2267000 (1 + r)^20 ∴ r = 2.87987 % Commented Aug 23, 2023 at 18:46
  • For this to be useful, define the variables and explain why the formula works.
    – keshlam
    Commented Sep 7, 2023 at 4:17

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