Suppose that your college offers you two payment plans for your last two years of college. You may either pay tuition of $20,000 per year at the beginning of each of the next two years, or pay just $38,000 before the start of freshman year
What would the interest rate have to be for you to be indifferent between these two deals? Explain.
One is indifferent when the future stream of tuition payments has a present value of $38,000.
$20,000 ? [1 + 1/(1 + irr)] = $38,000
1/(1 + irr) = 0.9 or irr = 11.11%
If the interest rate is 11.11%, the student can pay the first year's tuition and deposit $18,000 in a bank account today and withdraw $20,000 at the end of the first year to make her second payment. If the interest rate exceeds 11.11%, the student can deposit $18,000 today, make the $20,000 payment in year 2, and still have something left over. If the interest rate is less than 11.11%, the student is better paying the $38,000 all at once.
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