Your friend wants to borrow $2,000 and pay it back in one year. She is someone who keeps her word. She agrees to repay you $2,080 in one year. The bank annual interest rate is 5%. Which of the following statements is TRUE?
A)You will be financially worse off if you make the loan rather than deposit $2,000 in the bank.
B)You will be financially better off if you make the loan rather than deposit $2,000 in the bank.
C)The present value of $2,080 payable in one year with an interest rate of 5% is $1,904.76, which is less than the value of the $2,000 you have been asked to lend.
D)None of the statements is true.

Question

Quizplus · Accepted Answer

If you deposit $2,000 in the bank at 5% annual interest rate, you will earn $100 in one year ($2,000 x 0.05). Therefore, the value of your deposit in one year will be $2,100.

On the other hand, if you lend $2,000 to your friend at a repayment of $2,080 in one year, you will earn $80 in one year ($2,080 - $2,000). Therefore, the value of your loan repayment in one year will be $2,080.

Since the value of your deposit in one year ($2,100) is greater than the value of your loan repayment in one year ($2,080), you will be financially worse off if you make the loan rather than deposit $2,000 in the bank.

Your Friend Wants to Borrow $2,000 and Pay It Back