Question

You will receive $150 in two years and $210 in four years. If the real rate of return is 7% and the inflation rate is 2%, find the present value of these payments.

Answer 1

The relationship between nominal rate of return, real rate of return and inflation rate is given by the below equation

Real Rate of return =( (1+nominal rate) / (1+ inflation rate) ) -1

or , 7% = ((1+nominal rate) / (1+ 2%)) - 1

or, (1.07)*(1.02) = 1+ nominal rate

or, nominal rate = 0.0914      

   

So Present Value of $150 received after 2 years =150/(1+9.14%)^2 = 125.928

So Present Value of $210 received after 4 years = 210/(1+9.14%)^4 = 148.007

So sum of these Present Value = $125.92 + $148.007 = $273.935