Question 1. It is sometime in the far, far distance future (that is, sometime after you have graduated from the WM MBA Program.) have become finance VPs at a large aircraft leasing company, JLease.
JLease is expanding and needs to borrow in order to finance a fleet of new luxury small jet aircraft that it then will lease to various corporations and organizations that really need them, like the Federal Reserve and the Mason School at W&M. The planned borrowing has a nominal value of $100M. Based on forecasts of net-cash flow the company feels that it can repay the loan principal (the $100M) in 5 years. Until then, the bank will require an end-of-year annual interest payment. So for example if the first year interest rate were 8%, the company will make an $8M loan service payment at the one-year anniversary of the loan, and so on.
Ashley and George have spent the afternoon with the bank and have brought back borrowing options A and B. These are:
Option A. A 5-year variable rate loan with the interest rate reset annually to equal the one-year T-bill rate plus a 4% markup. The starting rate would be current one-year T-bill rate + 4 % = 2% + 4% = 6%. Future one-year rates are set at the anniversary of the loan.
Option B. A 5-year fixed rate loan with the interest rate set equal to the five-year Treasury bond rate + 4.25%. At the moment this rate would work out to be the current 5-year T-bond rate + 4.25% = 2.5% + 4.25% = 6.75%.
That night at a cocktail party for visiting company directors, an impromptu discussion takes place with one of the directors argues that "Sure, the one-year rate is low, but borrowing long term with an incredibly low 2.5 percent base rate for 5 years is an historic opportunity! Interest rates are sure to rise and with the variable rate loan we'll get hurt." Recalling their MBA training, and particularly their Global Economics class, Ashley and George reply that while it is possible that Option B is the right one, but the issue is complicated because it involves the term structure of interest rates as well as differential risk factors to be considered. In fact, they point out that Option B is likely to be the right choice.
a. Show how the one-year and five-year T-Bill rates are related through the term structure.
b. Estimate the total cost of borrowing over entire five years under options A and B.
c. What criteria would ultimately decide which option you should?
Question 2. Your company is planning a chain of restaurants aimed at middle income clientele in emerging economies.
But which country presents the best long-run prospects for initial success?
Management has culled the list of possibilities to three countries, code named X1, X2 and X3. Each country is about the same size in terms of GDP and population. Governmental structures are also similar. Management is finding it hard to choose a single country since X1, X2, and X3 also have roughly similar numbers for recent economic growth. Further, in each country the share of total GDP going to capital, denoted as α in growth models, is .4 (40%) for all countries.
To provide management with a better grasp of long-term growth prospects for X1, X2 and X3, your staff downloaded the open source data below from the World Bank, the IMF and the Penn World Tables.
|
Year |
%AL |
%AK |
%AY |
| Country X1 |
2013 |
3 |
2 |
3 |
|
2014 |
2.5 |
2.2 |
2.8 |
|
2015 |
2.8 |
2.5 |
3.1 |
| Country X2 |
2013 |
2.5 |
1.8 |
3.1 |
|
2014 |
2.2 |
1.9 |
2.9 |
|
2015 |
2.4 |
2 |
3 |
| Country X3 |
2013 |
3.8 |
2.4 |
3.3 |
|
2014 |
3.4 |
2.3 |
3 |
|
2015 |
3.6 |
2.4 |
3.2 |
%?L≡ annual percent growth in total labor hours worked; %?K≡ annual percent growth in the nonresidential capital stock; %?Y≡ annual percent growth in GDP.
(a) Using this data and your understanding of the causes of sustainable long-run economic growth, which of these countries looks most likely to provide a long-term sustainable growth in which to embed your company's business?
Specifically draw on the ideas in the Paul Krugman article, "The Myth of the Asian Miracle" and the Growth Accounting Framework from class, to write a one-page summary report to management explaining your analytical method, your calculations and your conclusions in clear and precise terms.
Question 3. The famous economist, Milton Friedman once said " Inflation is anywhere and everywhere a monetary phenomenon" . Explain carefully what did he mean by that?