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.

1- On average and everything else held constant, rational savers and investors prefer to invest $1,500 to acquire an asset that will pay annual cash flows of $300 per year rather than an otherwise identical asset that will pay $500 per year.

2- An investment that can provide a 10% return should attract more investment capital than an otherwise identical investment that can only provide a 6% return.

3- 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.

4- 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.

5- The actual relationship between the risk-free rate of return (r*) and the expected future inflation rate or inflation premium (IP) is actually multiplicativethat is, [(1 + rRF) x (1 + IP)] 1but it is often simplified to reflect an additive relationship.