Question

An asset which pay you $25,000 per year has a maturity of 10 years. Instead of buying the asset, you may either investment your money on a certificate of deposit which gives you an annual return of 7% or lend your money to Mrs. Kuo who pays you 5% interest annually. How much should you pay for this asset?

Answer 1

There are 3 options available:

1. Purchase the asset which pays $25000 per year for 10 years.

2. Investment in certificate of deposit with 7% annual return.

3. Lend money to Mrs. Kuo who pays 5% interest annually.

I would not pay more than $357143 for this asset because if I pay anymore amount than this, then spending tme money to purchase asset will not be benficial to me. Instead option 2 of investing in certificate of deposit at 7% p.a will provide me with return of $25000 annualy by investing $357143.(357143*7% = 25000)

As purchasing the asset is giving me fixed return it is not right option to invest as any amount invested above $357143 is siting idle which could give better returns by investing in option 2.