Steven Bendtsen

S00404648
10/30/2014
Accounting 2310


http://bendtsen.weebly.com/accounting-2310.html

The Time Value of Money

On a rainy afternoon two years ago, John Smiley left work early to attend a family
birthday party. Eleven minutes later, a careening truck slammed into his SUV on the
freeway causing John to spend two months in a coma. Now he cant hold a job or make
everyday decisions and is in need of constant care. Last week, the 40-year-old Smiley won
an out-of-court settlement from the truck drivers company. He was awarded payment for
all medical costs and attorney fees, plus a lump-sum settlement of $2,330,716. At the time of
the accident, John was president of his familys business and earned approximately
$200,000 per year. He had anticipated working 25 more years before retirement.

Johns sister, an acquaintance of yours from college, has asked you to explain to her how
the attorneys came up with the settlement amount. They said it was based on his lost future
income and a 7% rate of some kind, she explained. But it was all legal-speak to me.

1- How was the amount of the lump-sum determined? Create a calculation that might
help Johns sister understand.
2- Was the settlement fair? Explain.
3- Write a brief reflection on how this assignment fits into your program and prepares
you for your field of study.


















1.
I have reviewed the settlement in your brothers case and will explain how the award
amount was determined.
Based on your brothers yearly income of $200,000, and the expectation that he would
continue to work for another 25 more years, an equation for the present value of an
annuity was applied. The basic concept behind the determination is that a dollar received
today is worth more than one received tomorrow. Had all of your brothers anticipated
future wages been received immediately, and in full, they would have totaled $5,000,000.
The difference between that amount, and the $2,330,716 received, is what is called the
time value of money. The amount received was reduced to account for its interest-
earning potential when received as a lump-sum. Had the money been received in annual
disbursements, $5,000,000 would have been awarded, and your brother would have been
no better or worse off, assuming that the 7% rate was an appropriate valuation.

Below is a breakdown of how the Time Value of Money was accounted for per year of lost
salary.
Years of Lost Income Est Yearly Income Time Value of Money Factor TVM Adjusted Income
Year 1 $ 200,000.00 0.93458 $ 186,916.00
Year 2 $ 200,000.00 0.87344 $ 174,688.00
Year 3 $ 200,000.00 0.8163 $ 163,260.00
Year 4 $ 200,000.00 0.7629 $ 152,580.00
Year 5 $ 200,000.00 0.71299 $ 142,598.00
Year 6 $ 200,000.00 0.66634 $ 133,268.00
Year 7 $ 200,000.00 0.62275 $ 124,550.00
Year 8 $ 200,000.00 0.58201 $ 116,402.00
Year 9 $ 200,000.00 0.54393 $ 108,786.00
Year 10 $ 200,000.00 0.50835 $ 101,670.00
Year 11 $ 200,000.00 0.47509 $ 95,018.00
Year 12 $ 200,000.00 0.44401 $ 88,802.00
Year 13 $ 200,000.00 0.41496 $ 82,992.00
Year 14 $ 200,000.00 0.38782 $ 77,564.00
Year 15 $ 200,000.00 0.36245 $ 72,490.00
Year 16 $ 200,000.00 0.33873 $ 67,746.00
Year 17 $ 200,000.00 0.31657 $ 63,314.00
Year 18 $ 200,000.00 0.29586 $ 59,172.00
Year 19 $ 200,000.00 0.27651 $ 55,302.00
Year 20 $ 200,000.00 0.25842 $ 51,684.00
Year 21 $ 200,000.00 0.24151 $ 48,302.00
Year 22 $ 200,000.00 0.22571 $ 45,142.00
Year 23 $ 200,000.00 0.21095 $ 42,190.00
Year 24 $ 200,000.00 0.19715 $ 39,430.00
Year 25 $ 200,000.00 0.18425 $ 36,850.00

Total = $ 2,330,716.00

As you can see, I have arrived at the same amount that was awarded. In year one, receiving
$200,000 at the end of the year would be the equivalent of receiving 93.458%, or $186,916,
of that amount immediately. For year two, the amount is decreased to 87.344% because
two years of interest earning potential is available to that income, and so on.

2.
I believe the settlement was insufficient. The loss of future income was calculated correctly.
However, your brother and his family have suffered more than just the loss of future
income. There was no consideration for pain and suffering, loss of quality of life, the effect
it would have on the family, etc. The amount received accounted for the present value of
money, but was determined under the assumption that your brothers income would not
increase for the remainder of his 25 year career, which is obviously an incorrect
assumption. However, it did not reduce your brothers futures wages to account for the
taxes he would have paid. As a general rule, the proceeds received from most personal
injury claims are not taxable under federal or state law. So the income, though adjusted for
time value, is tax free. While the amount his income would have likely increased is
unknown and unaccounted for, this tax exemption will likely overshadow that deficiency.
Compensation for the loss of quality of life, and other like factors, was ignored, and should
have far exceeded the amount granted to cover loss of future income.

3.
I am undecided on my major. Im split between Accounting, Economics and Finance. This
time value of money calculation applies to all of them. Im heavily considering attending
law school, and this knowledge will be extremely useful to have. The time value of money
illustrates what is actually fair, instead of just arbitrarily deciding whether or not you think
2.3 Million sounds like a big enough number.
Ive been involved in accounting at my work from an operations standpoint for quite some
time. I have just begun working directly in accounting which is a great opportunity to
reinforce what I am learning in my coursework. Our company has grown violently this
year. Due to this growth weve had to finance our operations and some of the capital has
come at a high cost. The time value of money illustrates the exact cost of permissive
payment terms to vendors, like net 90, especially when your WACC is temporarily quite
high. These calculations can pin down the exact value of early payment discounts to
vendors, and show the actual value of accounts receivable.