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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comennt.**

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