Question

If you are indifferent between receiving $100 today and receiving $120 two years later, your required annual rate of return must be close to:

6.5 percent.

9.5 percent.

20 percent.

15.5 percent.

Please provide step-by-step instructions for solving the problem

Answer 1

In this question today we have $100 and received $120 after two years means we received interest on first year and closing balance at the end of year-1 $100 plus interest and on that received interest in second year.

We can solve this by using Compoun Interest formula.

A = P (1+r)t

Where:

A = Maturity amount

P = Principal Amount / Investment amount

r = Interest rate

t = Time

$120 = $100 (1+r)2

(1+r)2 = $120 / $100

(1+r)2 = 1.2

(1+r) = 1.095 (Square remove)

r = 1.095 - 1

r = 0.095 or say 9.5%

So answer 9.5%