Question

You will receive $5,000 a year in real terms for the next 5 years. Each payment will be received at the end of the period with the first payment occurring one year from today. The relevant nominal discount rate is 10.725 percent and the inflation rate is 3 percent. What are your winnings worth today in real dollars?

Answer 1

In order to calculate the winnings worth today in real dollars, we need to discount the real term payment with real discount rate.

We first need to calculate the real discount rate, which we can do by application of Fischer's relation:

(1 + Nominal rate) = (1 + Real rate) * (1 + Inflation)

(1 + 10.725%) = (1 + Real rate) * (1 + 3%)

(1 + Real rate) = 1.10725/1.03 = 1.075

Real rate = 7.5%

Now, we would use this rate to find PV of an ordinary annuity that makes $5000 every year payment for 5 years.

PV = 5000 * 4.0459

PV = $20,229.42 ---> Answer