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If the interest rate is 5%, which of these investments would you prefer? A payment of...

If the interest rate is 5%, which of these investments would you prefer?

  • A payment of $51 a year for 20 years starting at the end of 1st year.

  • A payment of $614 today.

  • A single payment of $607 at the end of 1st year.

  • An ordinary perpetuity of $29.

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Answer #2

The present value of option 1 is computed as follows:

Present value = Annual payment x [ (1 – 1 / (1 + r)n) / r ]

= $ 51 x [ (1 - 1 / (1 + 0.05)20 ) / 0.05 ]

= $ 51 x 12.46221034

= $ 635.57

Present value of option 2 will be $ 614 since the same is received today

Present value of option 3 will be as follows:

= $ 607 / 1.05

= $ 578.10

Present value of option 4 will be as follows:

= Amount / interest rate

= $ 29 / 0.05

= $ 580

Since the present value of option 1 is the largest, hence same shall be preferred

answered by: anonymous
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