Question

Suppose you are choosing between two assets. Asset X pays $500 each year for the next 2 years. Asset B pays $1100 at the end of the second year. If the interest rate is 5%, which asset do you buy? Explain your choice.

Answer 1

ANS) Given

Asset X pays $500 each year for the next 2 years at interest rate 5%. So, Present value of asset X will be

Present value (P.V.) = 500/(1 + r) + 500/ (1+r)2

= 500/(1+0.05) + 500/(1+0.05)²

= 500/(1.05) + 500/(1.05)²

= 476.20 + 454.55

= 930.75

Now, Asset B pays $1100 at the end of the second year at interest rate 5%. So, Present value of asset B will be

  Present value (P.V.) = 1100/ (1+r)²

= 1100/(1.05)²

= 1100/1.10

= 1000

hence we buy Asset B as its present value is greater than the Asset X