Check Your Understanding

1. Question

   Consider the three hypothetical projects shown in Table 24.1. This time, however, suppose that the interest rate is only 2%.

   1. Calculate the net present values of the three projects. Which one is now preferred?

      The net present value of project A is unaffected by the interest rate since it is money received today; its present value is still $100. The net present value of project B is now −$10 + $115/1.02 = $102.75. The net present value of project C is now $119 − $20/1.02 = $99.39. Project B is preferred.

   2. Explain why the preferred choice is different with a 2% interest rate than with a 10% interest rate.

      When the interest rate is lower, the cost of waiting for money that arrives in the future is lower. For example, at a 10% interest rate, $1 arriving one year from today is worth only $1/1.10 = $0.91. But when the interest rate is 2%, $1 arriving one year from today is worth $1/1.02 = $0.98, a sizable increase. As a result, project B, which has a benefit one year from today, becomes more attractive. And project C, which has a cost one year from today, becomes less attractive.