Question

You are offered the choice of two payment streams: (a) \(150 paid one year from now and \)150 paid two years from now; (b) \(130 paid one year from now and \)160 paid two years from now. Which payment stream would you prefer if the interest rate is 5 percent? If it is 15 percent?

Short answer

When the interest rate is 5%, then stream (a) will be preferred, and when the interest rate is 15%, then also stream (a) will be preferred.

Step-by-step solution

Step 1. Explanation for present value when r = 5%

A rational investor will prefer a higher present value of the payment stream as it gives greater worth today.

The present value of the payment stream (a) is calculated below:

The present value for stream (a) is higher than stream (b); thus, stream (a) will be preferred.

Step 2. Explanation for present value when r = 15%

The present value of the payment stream (a) is calculated below:

The present value for stream (a) is higher than stream (b); thus, stream (a) will be preferred.