A loan of $100,000 is taken out which requires an annual interest payment of 6%

Question

A loan of $100,000 is taken out which requires an annual interest payment of 6% of the outstanding principal. If no principal payments are made over time and inflation is 3.1% per year, the payment at the end of year four is:

A real dollar cash flow of $6,000 and an actual dollar cash flow of $5,310.
An actual dollar cash flow of $6,000 and a real dollar cash flow of $5,310.
An actual dollar cash flow of $6,779 and a real dollar cash flow of $6,000.
A real dollar cash flow of $5,310 and an actual dollar cash flow of $6,779.

Explanation / Answer

If no principal payments are made over time and inflation is 3.1% per year, the payment at the end of year four is:

* An actual dollar cash flow of $6,000 and a real dollar cash flow of $5,310.

[The nominal or actual dollar cash flow per year is $6000. Considering inflation @ 3.1%. the real dollar cash flow will decrease every year as follows: 5819.6, 5644.6, 5474.7, 5310]

($6000 x 100 / 103.1), (5819 x 100 / 103.1), (5644.6 x 100 / 103.1), (5474.7 x 100 / 103.1 -> 5310)

*****

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