3. Cost of money Four fundamental factors affect the cost of money: 1. The return that borrowers expect to earn on their investments 2. The preference of savers to spend their income in the current period rather than delay their consumption until some future period 3. The risks associated with the investment 4. Expected inflation Consider the following statements that address these factors, and indicate if you think each statement is true or false. Statement True False The actual relationship between the risk-free rate of return (1) and the expected future inflation rate or inflation premium (IP) is actually multiplicative-that is, [(1 + TRF) x (1 + IP)] - 1-but it is often simplified to reflect an additive relationship. o o O Projects Z10 and A20 are otherwise identical investments except for one important difference: The cash flows expected from Project A20 are twice as likely to be realized as those expected from Project Z10. This means that Project Z10 is more risky than Project A20. o O All else being equal, the more highly that savers and investors prefer immediate spending to deferred consumption, the lower the compensation that savers and investors will require to induce them to make an investment that will necessitate postponed spending. O o On average and everything else held constant, an investment that can provide a 4% return should attract more investment capital from savers/investors than an otherwise identical investment that can generate a 12% return. O o The inflation premium used to calculate the nominal interest rate on a five-year security should be equal to the rate of inflation expected in year 5 of the investment. O 0 3. Cost of money Four fundamental factors affect the cost of money: 1. The return that borrowers expect to earn on their investments 2. The preference of savers to spend their income in the current period rather than delay their consumption until some future period 3. The risks associated with the investment 4. Expected inflation Consider the following statements that address these factors, and indicate if you think each statement is true or false. Statement True False The actual relationship between the risk-free rate of return (1) and the expected future inflation rate or inflation premium (IP) is actually multiplicative-that is, [(1 + TRF) x (1 + IP)] - 1-but it is often simplified to reflect an additive relationship. o o O Projects Z10 and A20 are otherwise identical investments except for one important difference: The cash flows expected from Project A20 are twice as likely to be realized as those expected from Project Z10. This means that Project Z10 is more risky than Project A20. o O All else being equal, the more highly that savers and investors prefer immediate spending to deferred consumption, the lower the compensation that savers and investors will require to induce them to make an investment that will necessitate postponed spending. O o On average and everything else held constant, an investment that can provide a 4% return should attract more investment capital from savers/investors than an otherwise identical investment that can generate a 12% return. O o The inflation premium used to calculate the nominal interest rate on a five-year security should be equal to the rate of inflation expected in year 5 of the investment. O 0