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Author Question: A financial services company offers to pay you 1,000 a year for life in exchange for 20,000 today. ... (Read 64 times)

ishan

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on: Jul 1, 2018
A financial services company offers to pay you 1,000 a year for life in exchange for 20,000 today. What factors affect your decision to take this offer?
 
  What will be an ideal response?

Question 2

Suppose that your college offers you two payment plans for your last two years of college. You may either pay tuition of 20,000 per year at the beginning of each of the next two years, or pay just 38,000 before the start of freshman year. What would the interest rate have to be for you to be indifferent between these two deals? Explain.
 
  What will be an ideal response?
Microeconomics ¦ Perloff ¦ 8th Edition
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tofugiraffe

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Reply #1 on: Jul 1, 2018
Answer to Question 1

This policy has an internal rate of return of 1/20 = 5. If the interest rate exceeds 5, then there are better investments elsewhere. If the interest rate is less than 5, this is a good deal.

Answer to Question 2

One is indifferent when the future stream of tuition payments has a present value of 38,000.

20,000  1 + 1/(1 + irr) = 38,000
1/(1 + irr) = 0.9 or irr = 11.11

If the interest rate is 11.11, the student can pay the first year's tuition and deposit 18,000 in a bank account today and withdraw 20,000 at the end of the first year to make her second payment. If the interest rate exceeds 11.11, the student can deposit 18,000 today, make the 20,000 payment in Year 2, and still have something left over. If the interest rate is less than 11.11, the student is better paying the 38,000 all at once.


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