Nu-Mode Fashions, Inc. manufactures quality women's wear and needs to borrow money to through a brief cash shortage. Unfortunately, sales are down, and lenders consider the firm risky.
a. The CFO has asked you to estimate the interest rate Nu-Mode should pay on a 1 year loan. He's told you to assume a 3% default risk premium, even though the loan period is relatively short, and to assume the liquidity and maturity risk premiums are each 1/2%. Inflation is expected to be 4% over the next 12 months. Economists believe the pure the pure interest rate is currently about 3 1/2%.
b. Calculate the rate Nu-Mode should expect to pay on a two-year loan. Assume a 4% default risk premium and liquidity and maturity risk premiums of 3/4% each, due to the longer term. Inflation is expected to be 5% in the loans 2nd year.