Question

A) After a 1 year investment you receive 7% interest (nominal) from your bank. However, looking at how prices have changed, you soon realize that the real rate of interest was actually 1.9%. How much was inflation during that year?

B) You are offered a court settlement in the following terms: you will receive 7 equal payments of $4,185 each every year, with the first payment being made 2 years from now. The current annual interest rate is 5%. Assume yearly compounding. What is this settlement worth in present value terms?

Answer 1

A) We know that

Real Rate of interest = Nominal Rate of interest - inflation rate

Given Nominal Rate of interest = 7%

Real Rate of interest = 1.9%

1.9% = 7% - Inflation Rate

Inflation Rate = 7% - 1.9%

Therefore Inflation rate is 5.1%

B) Computation of Present Value

Year	Amount	Discount rate@ 5%	Discounting Factor	Discounted Cash flows
2	$4,185	1/( 1.05)^2	0.9070	$3,795.92
3	$4,185	1/( 1.05)^3	0.8638	$3,615.16
4	$4,185	1/( 1.05)^4	0.8227	$3,443.01
5	$4,185	1/( 1.05)^5	0.7835	$3,279.06
6	$4,185	1/( 1.05)^6	0.7462	$3,122.91
7	$4,185	1/( 1.05)^7	0.7107	$2,974.20
8	$4,185	1/( 1.05)^8	0.6768	$2,832.57
		Total		$23,062.83

Therefore the Present value of Settlement is $ 23062.83 .

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