Time Value Of Money Application

Assume you have recently graduated with your business degree, and landed a new position at a company you had been researching during your senior year in college. You have been offered a lump-sum sign-on bonus of $5,000. You currently have a credit card with an outstanding $3,000 balance. You also recently purchased a new condominium and vehicle. These items, in addition to your student loans, comprise your personal debt. Consider your debt reduction and investment earnings potential, as well as any applicable taxes. Assume that tax rates are stable over the next 10 years, and inflation is low (<1% per year) and does not change. Would you personally choose to invest the $5,000 sign-on bonus, or use it to pay down your debt? Regardless of your decision to either invest or pay down debt, be specific regarding the type of investment or debt payment you would make. Provide specific rationale for your decision. You may develop a quantitative example to support your rationale.

Sample Solution

Quantitative Example

Assumptions:

Sign-on bonus: $5,000
Credit card balance: $3,000
Interest rate on credit card: 20%
Investment return: 7%

Scenario 1: Pay down credit card debt

If you choose to pay down your credit card debt, you will save $600 per year in interest payments (20% of $3,000). You will also improve your credit score, which can lead to lower interest rates on future loans.

Full Answer Section

Scenario 2: Invest the sign-on bonus

If you choose to invest the sign-on bonus, you could potentially earn $350 per year in investment income (7% of $5,000). However, you will also be taking on investment risk.

Rationale for Decision

I would personally choose to pay down my credit card debt with the $5,000 sign-on bonus. The interest rate on my credit card is very high, and paying down the debt will save me a significant amount of money in interest payments. Additionally, improving my credit score will make it easier and cheaper to borrow money in the future.

I am also young and have a long time horizon for investing. I can afford to take on more investment risk in the future, once my debt is paid off and I have a larger financial cushion.

Conclusion

I believe that paying down high-interest debt is the best financial decision for me at this time. It is a guaranteed return on investment, and it will improve my credit score. I can always start investing once my debt is paid off and I have a larger financial cushion.

Note: This is just a quantitative example to illustrate the difference between paying down debt and investing. Your individual circumstances may vary, and you should consult with a financial advisor to make the best decision for you.

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