Question

You have just won first prize in the publisher’s book contest. You are given the following payoff options:
Option 1. $7,000,000 today
Option 2. $2,000,000 today plus $225,000 per year forever beginning one year from today.
At what interest rate are you indifferent between options 1 and 2?

 

 

Answer 1

Working:
the rate at which we would be indifferent would lead to same Present value of the cash flows.

Let the indifferent rate be X

PV of Option 1 would be same as $7,000,000

PV of Option 2 would be = $2,000,000 + Cash flow of $225,000/X

 

Comparing both equations we get

$7,000,000 = $2,000,000 + $225,000/X

$7,000,000 - $2,000,000 = $225,000/X

$5,000,000 = $225,000/X

X = $225,000/$5,000,000

X = 0.045

 

Thus the indifference rate is 0.045 or 4.50%.

Thus the indifference rate is 0.045 or 4.50%.