The MBA Decision 1

The MBA Decision

Rahul Parikh

BUS650: Managerial Finance (MAH1209A)

Dr Charles Smith

March 4, 2012.

MBA Decision 2

The MBA Decision:

1. How does Ben’s age affect his decision to get an MBA?

Ben graduated 6 years ago, as a Finance Major, and has a goal to become an investment

banker. Ben’s age is one of the critical factors affecting his decision to get an MBA, because

of following reasons: 1) his age determines how much longer he can work. 2) Time is a

critical factor for him to retire safely at an early age. 3) Lose of opportunity of potentially

higher earnings as time passes or age increases. 4) Being away from studies for many years

can cause difficulty in getting back into the study mode, and 5) Adjustments to the rigors of

an MBA program increases with age.

Analysis: He graduated from college six years ago at an age of 22 years, and he is now 28

years old, which is the standard age to get an MBA, and it will help Ben to achieve his goal

faster in short time. Assuming that he wants to work for 40 years more, he must decide to get

his MBA as early as possible, so that within 1 or 2 years (depending on school he chooses),

he can graduate with MBA, and soon start his career of investment banker at age of 29 or 30

years, and then he can safely retire at age of 69 or 70.

Secondly Ben must evaluate the cost of completing a MBA program against the higher

earning potential after graduating. Working at East Coast Yachts only pays him $50,000/

year, with expected 3% increases per year until retirement. If he earns his MBA, he would

qualify to get job offer from $78,000 or $90,000 per year (depending on school he chooses),

with 4% increases in salary per year. So looking to this figures, the earning potential after

completing his MBA, would play an important role for his life, if he completes MBA at early

age.

Thirdly, MBA program combines high-quality core curriculum with the finance

specialization curriculum that is consistently updated to ensure real-world relevancy to today

global marketplace. In MBA program, Ben has to face the problems such as dissimilar

MBA Decision 3

subject, communication, and teamwork. So, the willingness of Ben to overcome all these

strictness, and challenges, in this age is important.

Finally, Ben was away from studies for many years, which is an additional and very difficult

point to get him back into the study mode.

2. What other, perhaps non-quantifiable factors, affect Ben’s decision to get an MBA?

In case of Ben, there can be perhaps a list of Non-quantifiable factors that can affect Ben’s

decision to get an MBA, such as:

1) Family: Whether or not he is married, and if he has any children. With a spouse and/or

children, he may be less inclined to go for an MBA (especially full-time), since his family

may be less willing to the time, and money, constraints imposed by classes. His family should

consider that increased earning potential associated with MBA can help him to take better

care of family.2) Necessity to alter his attitude and divert it towards education: Since he had a

6-year gap from university or study, this can be an important factor in his decision to go for

study. 3) Necessity of at least two years experiences in respective field of his MBA

specialization: Assuming that Ben has already worked for about six years since graduated

from college, he would be having this job experience. 5) Willingness to continue the study: If

he is eager to continue the study, he will continue the study. But if he has not willingness to

study, he could do anything else, for example having jobs that would pay more or open his

own business. 6) The value he attaches to education: Completing a higher degree or a sense

of accomplishment may positively affect his decision. On the other hand the stress of a MBA

program, the time commitment, or the intellectual challenge may be negative factors in Ben’s

decision-making process. 7) Considering the geographical diversity: He has to consider the

location of his preferred university.8) other factors such as desire to pursue an MBA, job

satisfaction, and the prestige of a job, regardless of the salary, may play role in his decision

for MBA studies.

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3. Assuming all salaries are paid at the end of each year, what is the best option for Ben

— from a strictly financial standpoint?

In order to find best option for Ben, strictly from a financial point of view, I need to compare

three options: 1) Stay at his current job at East Coast Yachts; 2) Pursue a Wilton MBA; or 3)

Pursue a Mt. Perry MBA.

The net present value (NPV) of the three options must be calculated. NPV is the present

value of future cash flows minus the present value of all costs associated in a decision (Ross,

Westerfield, Jaffe, & Jordan, 2011). In this analysis, room and board costs are irrelevant since

they will remain same irrespective of college he attends. We need to find the after-tax value

of each, as follows:

Option 1: To stay at East Coast Yachts: Ben has an annual salary of $50,000; and expected

annual salary increase of 3%; work 40 more years; has an average tax rate of 26%; and an

applicable discount rate of 6.5%. The present value of Ben’s lifetime salary is calculated by

formula for Present Value of Growing Annuity: PV = C [1-(1+g/1+r)T/ (r-g)] (Ross,

Westerfield, Jaffe, & Jordan, 2011, p.146). The average tax rate of 26% reduces Ben’s salary

to $37,000. The present value of receiving $37,000 at the end of each year for 40 years can be

calculated by using formula for Present Value of Growing Annuity, and it comes out to be

$1,057,140.49

Calculation:

Aftertax salary = $50,000(1 – .26) = $37,000

His salary will grow at 3 percent per year, so the present value of his aftertax salary is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

PV = $37,000{[1/(.065 – .03)] – [1/(.065 – .03)] × [(1 + .03)/(1 + .065)]40}

PV = $1,057,140.49

Option 2: Attending an MBA program at Ritter College of business at Wilton University:

This option can give Ben a new job after completing MBA with a starting salary of $90,000;

MBA Decision 5

a $15,000 signing bonus; an expected annual salary increase of 4%; and an average income

tax rate of 31%. Assuming Ben is planning on retiring at the same age, as if he would have

stayed at East Coast Yachts, then Ben would need to work for 38 more years. Ben’s effective

salary will be $62,100, and the present value of his lifetime salary would be $$2,483,996.20.

This salary is discounted back by two years to the present time, and it equals to

$2,190,038.31.

Calculation of Future salary:

Aftertax salary = $90,000 * (1 – .31) = $62,100

His salary will grow at 4 percent per year. We must also remember that he will now only work for 38 years, so the present value of his aftertax salary is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

PV = $62,100 * {[1/(.065 – .04)] – [1/(.065 – .04)] * [(1 + .04)/(1 + .065)]38}

PV = $2,483,996.20

Since the first salary payment will be received three years from today, so we need to discount

this for two years to find the value today, which will be:

PV = $2,483,996.20 / (1.065)2

PV = $2,190,038.31

The signing bonus of $15,000 will have an effective tax rate of 31%. The present value of the

signing bonus that Ben would receive when accepting his job after graduating from Wilton

University will be $9,125.17.

Calculation for signing bonus to be paid in 2 years:

PV of aftertax bonus paid in 2 years = $15,000 * (1 – .31) / (1.065)2 = $9,125.17

The cost of attending Wilton University, and lost opportunity costs are also relevant. The

annual cost of attending Wilton University are $65,000 in tuition; $2,500 for books and

supplies; health insurance $3,000; and additional room and board expenses of $2,000; which

MBA Decision 6

totals to $72,500 annually. Discount rate will be 6.5% (R = 6.5%); and number of years for

study will be 2 years (T = 2); so the present value of two years costs will be $140,575.12.

Calculation of the total direct costs:

PV of direct expenses = ($65,000 + 2,500 + 3,000 + 2,000) + ($65,000 + 2,500 + 3,000 + 2,000) / 1.065

PV of direct expenses = $140,575.12

Ben will miss the opportunity of earning 2 years of salary at East Coast Yachts, which is also

a relevant factor in financial decision-making in this case. The present value of the two years

in salary can be found by performing calculations for a growing annuity, and it is $68,341.82.

Calculation of the indirect costs:

It is the lost salary, so the values of the indirect costs are:

PV of indirect costs (lost salary) = $37,000 / (1.065) + $37,000 * (1 + .03) / (1 + .065)2

PV of indirect costs (lost salary) = $68,341.82

Adding the present value of Ben’s salary, and signing bonus, and then deducting the present

value of the two year costs associated with attending Wilton University, and the opportunity

cost of his foregone salary, will result in a total net present value of $1,990,246.54.

Calculation for the total value of a Wilton MBA:

Value = –$140,575.12 – 68,341.82 + 9,125.17 + 2,190,038.31 = $1,990,246.54

Option 3: is to attend an accelerated one-year program at Mount Perry College, and Ben is

expected to get a job with an annual salary of $78,000; a $12,000 signing bonus; an annual

expected salary increase of 3.5%; and have an applicable average tax rate of 29%. If Ben

plans to retire at the same age as if he would have stayed at East Coast Yacht, then he would

have to work for 39 years more.

The 29% tax rate decreases Ben’s salary to $55,380; and the present value of his lifetime

salary is $1,845,997.04. This salary is discounted back one year to the present time, so it will

come out to $1,733,330.55.

MBA Decision 7

Ben’s signing bonus of $12,000 have average 29% tax rate. The present value of Ben’s

signing bonus is $8,000 for accepting a job after graduating from Mount Perry College.

The costs of attending Mount Perry College are $75,000 in tuition costs; $3,500 for books

and supplies; $3,000 for health insurance; and $2000 in additional boarding expenses; so total

sum will be $83,500. Ben will miss out one year of salary at East Coast Yachts, and the

present value of missing this salary is $34,741.78. Ben’s total cost for attending Mount Perry

College is $1,623,088.77 (–$83,500– 34,741.78 + 8,000 + 1,733,330.55).

Complete calculation:

The direct costs will occur today, and includes tuition, books and supplies, health insurance,

and the room and board expenses. So the total direct costs are:

Total direct costs = $75,000 + 3,500 + 3,000 + 2,000 = $83,500.

[Note, this is also the PV of the direct costs since they are all paid today.]

The indirect costs are the lost salary, so the values of the indirect costs are:

PV of indirect costs (lost salary) = $37,000 / (1.065) = $34,741.78

The financial benefits are the bonus to be paid in 1 year and the future salary.

Bonus to be paid in 1 year:

PV of aftertax bonus paid in 1 year = $12,000 * (1 – .29) / 1.065 = $8,000

Future salary:

His aftertax salary at his new job will be:

Aftertax salary = $78,000 * (1 – .29) = $55,380

His salary will grow at 3.5 percent per year. We must also remember that he will now only

work for 39 years, so the present value of his aftertax salary is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

PV = $55,380 * {[1/(.065 – .035)] – [1/(.065 – .035)] * [(1 + .035)/(1 + .065)]39}

PV = $1,845,997.04

MBA Decision 8

Since the first salary payment will be received one year from today, so we need to discount

this for one year, to find the value today, which will be:

PV = $1,845,997.04 / 1.065

PV = $1,733,330.55

So, the total value of a Mount Perry MBA is:

Value = –$83,500– 34,741.78 + 8,000 + 1,733,330.55 = $1,623,088.77

Attending Mount Perry College will result in a net present value of $1,623,088.77.

Conclusion: From a strict financial standpoint, Ben should attend Wilton University, because

this option has the highest net present value.

4. In choosing between the two schools, Ben believes that the appropriate analysis is to

calculate the future value of each option. How would you evaluate this statement?

Ben is somewhat correct. Calculating the future value of each option will result in an option

with the highest present value, having the highest future value. Thus, a future value analysis

will result in the same decision. But, his statement that a future value analysis is the correct

method is wrong, because net present value analysis will give the correct answer as well.

5. What initial salary would Ben need to receive to make him indifferent between

attending Wilton University and staying in his current position? Assume his tax rate

after graduating from Wilton University will be 31 percent regardless of his income

level.

To be indifferent between attending Wilton University, and staying in his current position,

Ben needs to have a starting salary after graduating that will result in the same net present

value, as his lifetime salary of staying in his current position minus all costs. This means that

the present value of the signing bonus, and all the costs, must be added to the present value of

the lifetime salary that Ben would earn at East Coast Yachts, and it is $1,256,932.26

($1,057,140.49 + 140,575.12 + 68,341.82 – 9,125.17).

MBA Decision 9

Since Ben would start his job in two years, this present value must then be converted into a

future value. The future value of $1,256,932.26 using a discount rate of 6.5% is

$1,425,644.00. Assuming an expected annual salary growth of 4%; and using a calculator to

determine the payment amount of a growing annuity, the initial annual salary must be

$59,950.53 after taxes, and by multiplying it by 1.31 results in an annual pre-tax salary of

$86,884.83. This means if Ben would have a starting salary of $86,884.83 after completing

his MBA at Wilton University, he would be indifferent about his decision. If he would earn

more than $86,884.83, than it would be in favor of earning his degree at the university, but if

he earns less, he should decide against the MBA program at Wilton University.

Calculation:

PV = $1,057,140.49 + 140,575.12 + 68,341.82 – 9,125.17 = $1,256,932.26

This PV will make his current job exactly equal to the Wilton MBA on a financial basis.

Since the salary will not start for 3 years, we need to find the value in 2 years so that it is the

present value of growing annuity, so:

Value in 2 years = $1,256,932.26 * (1.065)2 = $1,425,644.00

Since his salary will still be a growing annuity, the aftertax salary needed is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

$1,425,644.00 = C {[1/(.065 – .04)] – [1/(.065 – .04)] × [(1 + .04)/(1 + .065)]38}

C = $59,950.53

This is the aftertax salary. So, the pretax salary must be:

Pretax salary = $59,950.53 / (1 – .31) = $86,884.83

6. Suppose that instead of being able to pay cash for his MBA, Ben must borrow the

money. The current borrowing rate is 5.4 percent. How would this affect his decision to

get an MBA?

MBA Decision 10

The cost (interest rate) of the decision depends on the riskiness of the use of funds, not the

source of the funds, means taking a loan increases the risk, and the costs, of pursuing a MBA.

If Ben is not able to find a job after graduating, he will have the loan amount, and interest

expense, to pay off. The borrowing rate of 5.4 also increases his overall costs of getting a

MBA. Once Ben knows the exact loan terms, he could calculate the present values of all

interest expenses, and include them in his net present value assessment of the various options.

In fact, whether he can pay cash or must borrow is irrelevant, so I advice that without adding

loan expense to the total coast, and thereby increase risk of using his funds, he should use his

savings, to go to Wilton University to pursue his MBA.

MBA Decision 11

References:

Ross, S., & Westerfield, R., Jaffe, J., & Jordan, B. (2011), Corporate finance: Core

principles and applications (3rd Global ed). Boston, MD: McGraw-Hill Irwin. ISBN:

978-0-07-353068-0.