Is that lottery ticket really worth the $10 million today?
Lets assume that John has no knowledge of the finance industry. He gets his tax done by a tax professional, and the only money-matter that he deals with is paying his bills. All in all, he does not even have the basic know-how of the financial world and it does not seem to bother him…until one day.
John stepped into a grocery store on a Tuesday night after a busy and hectic day at work and decided to purchase a lottery ticket. It was his first time purchasing a lottery of any type and was not expecting much from it; and let us not forget that he considers himself to be highly unlucky in all aspects of life. He went up to the counter and paid a good $10, went back home and gave the ticket to his mum to asked her to keep an eye on the TV this Friday to which she responded, “I have a good feeling about this Johnny boy”.
Friday came along and to his surprise he had won. He contacted the lottery company and provided all his information and was asked to wait for the company to contact him. A few days later, the company was at his doorstep wanting to interview and take pictures with him being handed a cheque for $10 million, which promises to pay $500,000 each year for the next 20 years.
John is quite happy and goes back home to his family.
His stepfather, Frank did a Master in Finance and realized that John really has not won $10 million, as over the years the value of his $10 million will diminish, ultimately to approximately $4.68 million. John was furious and wanted Frank to prove himself.
“Now you see here John, the concept of present value is based on the commonsense notion that a dollar paid to you one year from now is less valuable than a dollar paid to you today. This notion is true because you can deposit $1 in a savings account that earns interest and have more than $1 in one year. Now in the case of your $10 million jackpot, the current year the value of your $500,000 is $500,000, but the value of your $500,000 next year is $454,546, which you can see is a lot less than the promised $500,000. Let me go a step further and tell you what you should expect the year after where you will only get $413,223.
Fast forward to the last year you end up with $81,754, which clearly is nowhere near the promised $500,000. This is of course considering a 10% opportunity cost to discount your money, because if you would have received the money today you could have invested and earned interest on it.
So, did you really win the $10 million? Not really, instead you won almost a third of the promised amount. You did win about $4.68 million over 20 years, but as you were not aware of the concept of present value.”
Submitted by: AB