Answer Key Chapter 5 Homework (These Are 5Th Edition Problem Numbers)

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Answer key Chapter 5 homework (these are 5th edition problem numbers)

4.Nu-Mode Fashions Inc. manufactures quality women’s wear, and needs to borrow money to get through a brief cash shortage. Unfortunately, sales are down, and lenders consider the firm risky. The CFO has asked you to estimate the interest rate Nu-Mode should expect to pay on a one year loan. She’s told you to assume a 3% default risk premium even though the loan is relatively short, and to assume the liquidity and maturity risk premiums are each ½%. Inflation is expected to be 4% over the next twelve months. Economists believe the pure interest rate is currently about 3½%.

Solution: Write the interest rate model and substitute. Since the loan is for one year, the inflation adjustment is simply the expected inflation rate for the year.

k = kpr + INFL + DR + LR + MR

k = 3.5 + 4.0+ 3.0 + .5 + .5

k = 11.5%

5. Calculate the rate Nu-Mode in the last problem should expect to pay on a two year loan. Assume a 4% default risk premium and liquidity and maturity risk premiums of ¾% due to the longer term. Inflation is expected to be 5% in the loan’s second year.

Solution: First calculate the inflation premium as the average inflation rate over the life of the loan.

INFL = (4 + 5)/2 = 4.5%

Then write the interest rate model and substitute.

k = kpr + INFL + DR + LR + MR

k = 3.5 + 4.5+ 4.0 + .75 + .75

k = 13.5%

7.Adams Inc. recently borrowed money for one year at 9%. The pure rate is 3%, and Adams’ financial condition warrants a default risk premium of 2% and a liquidity risk premium of 1%. There is little or no maturity risk in one-year loans. What inflation rate do lenders expect next year?

Solution: Use the interest rate model to calculate the inflation adjustment.

k = kpr + INFL + DR + LR + MR

9 = 3 + INFL + 2 + 1 + 0

INFL = 3%

Since the loan is for one year, the inflation adjustment equals the expected inflation rate for the year.

12. Inflation is expected to be 5% next year and a steady 7% each year thereafter. Maturity risk premiums are zero for one year debt but have an increasing value for longer debt. One-year government debt yields 9% whereas two-year debt yields 11%.

a. What is the real risk-free rate and the maturity risk premium for two-year debt?

b. Forecast the nominal yield on one- and two-year government debt issued at the beginning of the second year.

SOLUTION:

a. For one-year government debt

k1 = kPR + I1 + MR1

9% = kPR + 5% + 0%

kPR = 4%

Then for two-year government debt

k2 = kPR + (I1+I2)/2 + MR2

11% = 4% + 6% + MR2

MR2 = 1%

b. k1 = kPR + I2

= 4% + 7% = 11%

k2 = kPR + (I2 + I3)/2 + MR2

= 4% + 7% +1%

= 12%