Answer to Question 3:

Consider a $600 loan to the Catholic Church that will be paid back without interest (the Church does not believe in usury) in two equal installments of $300, the first to be received at the end of one year and the second at the end of two years. The person who made this loan is strapped for cash and wants to sell it to you. How much is it worth, assuming that the market interest rate on virtually risk-free securities is 5 percent?

1. $600.

2. $558.

3. Nothing because the loan doesn't pay interest.

Choose the correct option?

The correct answer is 2. The present value of $300 to be received next year is $300/1.05 = $285.71 and the present value of $300 to be received two years from now is $300/[(1.05)(1.05)] = $300/1.1025 = $272.11 yielding a total present value of $285.71 + $272.11 = $557.82.

If you picked option 3 you should remember that whether or not the loan pays interest is irrelevant. All that matters is the funds, be they principal or interest, that will be received in the future, the dates that they will be received, and the market interest rate on alternative investments. If you picked option 1 you should go to the beginning of this topic and start again.

Return to Lesson