The real cash flow occurring in year 2 is $60,000. If the inflation rate is 5 percent per year and the real rate of interest is 2 percent per year, calculate the nominal cash flow for year 2.
A)$60,000
B)$62,424
C)$66,150
D)$63,654

Question

Quizplus · Accepted Answer

Using the Fisher equation, we can find the nominal interest rate as follows:
(1 + nominal rate) = (1 + real rate) × (1 + inflation rate)
(1 + nominal rate) = (1 + 0.02) × (1 + 0.05)
(1 + nominal rate) = 1.07 × 1.02
(1 + nominal rate) = 1.0914
nominal rate = 0.0914 or 9.14%
To find the nominal cash flow, we multiply the real cash flow by the ratio of the nominal cash flow in year 2 to the real cash flow in year 2:
Nominal cash flow = Real cash flow × (1 + inflation rate)
Nominal cash flow in year 2 = $60,000 × (1 + 0.05) = $63,000
The ratio of nominal to real cash flow is:
Nominal cash flow in year 2 / Real cash flow in year 2
$63,000 / $60,000 = 1.05
Therefore, the nominal cash flow in year 2 is:
Nominal cash flow in year 2 = Real cash flow in year 2 × (Nominal cash flow in year 2 / Real cash flow in year 2)
= $60,000 × 1.05 = $66,150
Hence, the best choice is C.

The Real Cash Flow Occurring in Year 2 Is $60,000