**Question 155** inflation, real and nominal returns and cash flows, Loan, effective rate conversion

You are a banker about to grant a 2 year loan to a customer. The loan's principal and interest will be repaid in a single payment at maturity, sometimes called a zero-coupon loan, discount loan or bullet loan.

You require a **real** return of **6**% pa over the two years, given as an effective annual rate. Inflation is expected to be **2**% this year and **4**% next year, both given as effective annual rates.

You judge that the customer can afford to pay back $**1,000,000** in **2** years, given as a **nominal** cash flow. How much should you lend to her right now?

Your neighbour asks you for a loan of $100 and offers to pay you back $120 in one year.

You don't actually have any money right now, but you can borrow and lend from the bank at a rate of 10% pa. Rates are given as effective annual rates.

Assume that your neighbour will definitely pay you back. Ignore interest tax shields and transaction costs.

The Net Present Value (NPV) of lending to your neighbour is $9.09. Describe what you would do to actually receive a $9.09 cash flow right now with zero net cash flows in the future.