Chapter 2 Homework Pg. 69 2-6 Pg. 72 2-4 Pg. 72 2-5 Pg. 74 2-10

Pg. 69 2-6 Q. Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term basis or a short-term basis? Why? A. It depends on the use of the capital being raised. Generally, the firm would want to use short-term financing during a recession, since interest rates will be dropping. This is especially the case if the funds will be used for current assets (easily converted to cash), since short-term financing would allow the firm to take advantage of lower interest rates. This does make an assumption that the firm is able to accurately predict interest rate movements. If the capital being used is for a fixed asset, like a new operating plant, then long-term financing should be considered, since during periods of recession a firm may not want to commit to short-term financing during which time adverse business conditions may prevent it from being able to meet its interest obligations. Ideally, the firm would want to convert from l-t to s-t when the rates have reached their lowest point. Besley Ch. 2

Pg. 72 2-4 Q. The Angell Company has made $150,000 before taxes during each each of the past 15 years, and it expects to make $150,000 a year before taxes in the future.. However, in 2000 the firm incurred a loss of $650,000. The firm will claim a tax credit at the time it files its 2000 income tax return, and it will receive a check from the US Treasury. Show how it calculates this credit, and then indicate the firm’s tax liability for each of the next five year. Assume a 30% tax rate on all income to ease the calculations. Besley Ch. 2

Pg. 72 2-4 A. Besley Ch. 2

Pg. 72 2-5 Q. The projected taxable income of the Glasgo Corporation, formed in 1999, is indicated in the following table. What is the corporate tax liability for each year? Use tax rates as shown in the appendix. A. Besley Ch. 2

Pg. 74 2-10 x = k* + I2 à 15% = 4% + I2 à I2 = 11% k2 = Q. Assume that the real risk-free rate is 4% and that the maturity risk premium is zero. If the nominal rate of interest on one-year bonds is 11% and that on comparable-risk two-year bonds is 13%, what is the one-year interest rate that is expected for Year 2? What inflation rate is expected during Year 2? Comment on why the average interest rate during the two year period differs from the one-year interest rate expected for Year 2? Given: k* = 4%; MRP = 0%; k1 = 11%; k2 = 13% 13% = [11% + x]/2; x = 15% x = k* + I2 à 15% = 4% + I2 à I2 = 11% k2 = k1 + k1 in Year 2 2 Besley Ch. 2

Pg. 74 2-10 Q. Comment on why the average interest rate during the two year period differs from the one-year interest rate expected for Year 2? Average interest Rate during 2 year period [13%] One-Year Interest Rate for Year 2 [15%] Difference is due to the the fact that the IP for Year 1 is 7% (11%-4%); while the IP for Year 2 is 11% (15%-4%) The inflation rate reflected in the interest rate on any security is the average rate of inflation expected over the securities life. Besley Ch. 2

Pg. 74 2-15 The rate of inflation for the coming ear is expected to be 3%, and the rate of inflation in Year 2 and thereafter is expected to be constant at some level above 3%. Assume that the real risk-free rate is k* = 2% for all maturities and the expectations theory fully explains the yield curve, so there are no maturity premiums. If three-year T-bonds yield 2% points more than one-year bonds, what rate of inflation is expected after year 1? Kt = k* + IPt + DRPt + MRPt + LPt But here IP is the only premium, so kt = k* + IPt IPt = Average inflation = (I1 + I2 + ….In)/n Given: I1 = IP1 = 3%; k* = 2% k1 = 2% + 3% = 5% k3 = k1 + 2% = 5% + 2% = 7%, and k3 = k* + IP3 = 2% + IP3 = 7%, so IP3 = 7% - 2% = 5% We also know that It = constant after t=1  Avg. I = IP3 = (3%+2I)/3 = 5% 2I = 12% I = 6% Besley Ch. 2