Mr. Thomas has $100 income this year and zero income next year. The market interest rate is 10% per year. Mr. Thomas also has an investment opportunity in which he can invest
$50 this year and receive $80 next year. Suppose Mr. Thomas consumes $50 this year and invests in the project. What will be his consumption next year?

Question

Quizplus · Accepted Answer

If Mr. Thomas does not invest in the project, he will consume $100 this year and nothing next year. If he invests $50 in the project, he will have only $50 left to consume this year, but he will receive $80 next year. To calculate the present value of $80 received next year, we use the formula:

Present value = Future value / (1 + interest rate)^n

Where n is the number of years in the future (which is 1 in this case). Plugging in the numbers, we get:

Present value = $80 / (1 + 0.1)^1 = $72.73

So by investing $50, Mr. Thomas is giving up $50 in consumption this year for a gain of $72.73 in future consumption. Therefore, his total consumption next year will be:

$50 (from current income) + $72.73 (from investment return) = $122.73

However, since he only has $100 income this year, he will not be able to consume $50 this year and invest $50. Therefore, his best option is to consume $50 this year and invest nothing, which means his consumption next year will be zero.

Mr Thomas Has $100 Income This Year and Zero Income