Suppose the interest rate is 5 percent. Consider three payment options:
1) $500 today.
2) $520 one year from today.
3) $550 two years from today.
Which of the following is correct?
A) 1 has the lowest present value and 3 has the highest.
B) 2 has the lowest present value and 1 has the highest.
C) 3 has the lowest present value and 2 has the highest.
D) None of the above is correct.

Question

Suppose the interest rate is 5 percent. Consider three payment options: 
1) $500 today.
2) $520 one year from today.
3) $550 two years from today.
Which of the following is correct?
A) 1 has the lowest present value and 3 has the highest. 
B) 2 has the lowest present value and 1 has the highest.
C) 3 has the lowest present value and 2 has the highest.
D) None of the above is correct.

Quizplus · Accepted Answer

To compare the present values, we need to discount each option back to the present using the interest rate of 5 percent. 
1) The present value of $500 today is $500.
2) The present value of $520 one year from today is $495.24. ($520/(1+0.05)^1)
3) The present value of $550 two years from today is $500.47. ($550/(1+0.05)^2)
Therefore, option 1 has the highest present value and option 3 has the lowest present value. So, the correct answer is B.

Suppose the Interest Rate Is 5 Percent