Suppose you are now working. You ask your boss for a raise and he says “I can’t

Question

Suppose you are now working. You ask your boss for a raise and he says “I can’t give you a raise, but I could give you a $3,000 bonus if you complete an online course that would help you in the job”. Suppose the course costs $2,000 (the costs have to be paid now) and lasts for two years. Suppose that you don’t have money available to pay the costs but ask the bank for a loan. (a) What would the interest rate have to be such that you were indifferent between taking the course and not taking it? [Hint: assume you want to maximize the present value of your lifetime income and ignore any other costs of taking the course - e.g., it takes time away from other activities]. [2 points] (b) In general, why would a bank be reluctant to give you this type of loan? [2 points] [Hint: think about why, in general, it will be difficult to get a loan to fund a human capital investment]

Explanation / Answer

a.

If present value of future bonus $3000 becomes equal to the initial cost of the course that is $2000 at a particular interest rate R. Then, it will make me indifferent to go or not to go for the course.

Interest rate = R

Time = n = 2 years

Thus,

2000=3000/(1+R)^n

(1+R)^2 = 1.5

(1+R)^2 =1.2247^2

R = 1.2247 – 1

R = 22.47%

b.

Bank will be reluctant to issues such loans on following grounds.

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