Question

1. True or false? Briefly explain.

a Suppose that you open The Wall Street Journal and find that the 30-year

Treasury bond has a yield-to- maturity of 7.5%. This is an example of a nominal interest rate.

b. friend asks to borrow $10,000 from you for a year. Inflation is expected to be 2% during the next year, so she offers to repay you $10,200 at the end of the year to compensate for the price increase. Assume that your friend is completely reliable and will repay the money with certainty. The offer is a fair deal (has a zero NPV)

c. Your firm has an opportunity cost of capital of 10%. The firm should accept any project that has an internal rate of return (IRR) greater than 10%

d. Your firm needs to raise $300,000 and has decided to sell corporate bonds. An investment bank advises that you can sell 3-year bonds with a yield-to- maturity of 7% or 8-year bonds with a yield-to-maturity of 8.5%. From the firm’s perspective, the short- term debt is cheaper because it has a lower yield-to-maturity.

e. You expect to earn $50,000 this year and would like to spend $45,000 on current consumption (you plan to save the remaining $5,000). Unexpectedly, you get an opportunity to invest $10,000 in a project that will repay $13,000 in one year. If the current interest rate is 10%, you should take this investment even though you had planned to save only $5,000.

f. If the U.S. government will pay the coupon and principal on Treasury bonds with certainty, then Treasury bonds are a risk free investment.

Answer 1

a) 7.5% is the example of Nominal Interest rate as by buying this bond and holding till maturity will give you 7.5% return. It does not take into consideration the effect of inflation. Your real interest rate (or your real return) will be less which shall depend on the inflation figure. (More the inflation, less the real return)

b) The offer is NOT a fair deal as this does not give you the risk free return. Lets say the risk free return is 5%, then your friend should give you $10,500 to compensate for that. Only giving you inflation rate of return will end up having your NPV become negative.

c. Yes, If the cost of capital is 10% (which means the funds raised by firm needs to be paid back with 10% return on them), then any project which has IRR of more than 10% would result in positive NPV and thus that project should be accepted.

e. Yes. You can borrow the remaining $5000 @10% After a year, get $13,000 out of which you repay $5,500 (to the bank), put the $5000*1.1 = $5,500 (assuming you would have earned $500 interest had you invested the intended $5,000 in the savings account) in your savings account and enjoy the extra $2,000 profit from the opportunity.

f. Yes, if there is a certainty of payment, that makes the bonds as risk free.