Question

Show your calculations and answer the following questions

- An investment will pay you $120 in one year and $200 in two years. Calculate the present value of these cash flows if the interest rate is 4%. -Suppose you invest $1000 in an account paying 6% interest per year. What is the balance in the account after 3 years? Calculate how much of this balance corresponds to “interest on interest” - If Brandon receives 6 percent interest rate on his bank account and the inflation rate is 4 percent. Calculate the real interest rate will he earn.

Answer 1

Question 1

We will have to find out present value of both the cash flow using discount rate 4%

Present Value = [120 / 1.04] + [200 / (1.04)^2]

Present Value = 115.38 + 184.91 = 300.30

Question 2

First of all we will calculate the compound interest after 3 years at interest rate 6% per annum compounded annually

Balance after 3 years = 1000 * (1.06)^3 = 1000 * 1.19101 = 1191.01

Interest earned in 3 years = 1191.01 - 1000 = 191.01

Now we will calculate simple interest for 3 years

Simple Interest for 3 years = 1000 * 0.06 * 3 = 180

Now we will calculate the difference (ie interest on interest)

Interest on interest = 191.01 - 180 = 11.01

Question 3

Real Interest Rate = [(1 + Nominal Interest rate) / ( 1 + Inflation)] - 1

real Interest rate = [1.06 / 1.04] - 1 = 0.01923 or 1.92%