Question

According to the theory underlying the present-value formula, would a rational individual prefer to receive (a) $75 one year from now, (b) $85 two years from now, or (c) $90 three years from now, or would he be indifferent between all three choices?
Assume that the relevant annual market interest rate is 10 percent and will remain at 10 percent for the next three years.

a. He will prefer $75 one year from now.
b. He will prefer $85 two years from now.
c. He will prefer $90 three years from now.
d. He will be indifferent between all three choices.

Answer 1

Answer:

b. He will prefer $85 two years from now.

Explanation:

Before making the choice, lets first calculate the present values of these cash flows,

PV factors @ 10% are as follows,

Year 1 = 0.909

Year 2 = 0.8265

Year 3 = 0.7513

Present value of 75 = 75 * 0.909 = 68.175

Present value of 85 = 85 * 0.8265 = 70.25

Present value of 90 = 90 * 0.7513 = 67.617

A rational individual thus would chose $85 two years from now as it yields the max present value.

Hope that helps.