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Financial Management Sankar

Akshay GoyalJitesh Agarwal

Srikanth Erraballi

Lottery Winnings

Looks Can Be Deceptive!

+Case Description

State Sponsored Lotteries Annual Sales: $1.69 bn Net Revenues: $618.5 Retailer Commission: $120.3 mn Lottery Prizes: $ 920.8 mn

The Big Game 7 States – Georgia, Illinois, Maryland, Massacheusetts,

Michigan, New Jersey & Virginia JackPot: $5 mn -- $ 363 mn Winning Amount: Annuitized Amount of $181.5 mn

The Michigan Lottery Two Ways – Annuity & Lump Sum Income Tax: 27% State Tax: 4.6%

{ Amount> $5,000}

+Option 1: Annuity Payments

A total of $181.5 mn is paid over a period of 25 years through 25 equal installments.

Option 2: Cash Payment

60% of the total jackpot amount

+ Annuity Option

Future Value (FV) = $181.5 mn

Present Value (PV) = 60% of $181.5 mn = $108.5 mn

Number of Annuities = 25

FV = PV(CVF i,25yrs)

$181.5 mn = $108.5 mn (CVF i, 25yrs)

=> i = 2%

FV= A (CVFA2%, 25yrs)

=> A = $5.67 mn

+ Taxation on Annuity Option

+Lump Sum Option

+Question 1

If you were one of the winners, which option would you select?

ANSWER

Since we get a greater amount through the annuity scheme, we would prefer to receive the lottery amount in annuities for a period of 25 years.

+Question 2

If you decide to select the annuity option, how much money would you receive each year after taxes?

ANSWER

As has already been shown, the annuity receivable each year is $3.87828 mn.

+Question 3

Is the state of Michigan justified in advertising the prize amount as $363 mn?

ANSWER

No. Since the winner receives only 60% of the prize amount at the time of winning, the prize amount should be advertised as $217.8 mn instead. In the annuity scheme, the advertised amount of $363 mn is the amount receivable after 25 years.

+Question 4

If the only option available were an annuity payment plan, what could Larry do to maximize the value of his winnings assuming that the risk free rate of interest is 4%?

ANSWER

Larry could start investing the annuities that he receives at the risk free market rate. This would increase the value he receives after 25 years!

+Question 5

Why do most winners select the cash option plan when given a choice?

ANSWER

Since the amounts receivable through both the plans are almost equal (approx. $124 mn), the winners go with the cash option.

A RUPEE IN HAND IS BETTER THAN TWO IN THE FUTURE!

+Question 6

If Michigan would like to give the annuity option an equal chance of being selected, how would it have to structure its payments?

ANSWER

Since the future value received through annuities depends more on the amount of each annuity than the number of annuities, the state could increase the annuity amount and decrease the number of years.

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Thank You!!!

Any doubts or queries are welcome