5) You and your colleagues, Elmo and Ronald, are working as summer interns at the treasury department of Pepsi Co. The company wants to raise $1bn via a bond issuance at t = 0 to finance a project that will generate a large cash flow at t = 2. The CFO has asked you and the other interns for your thoughts on the following 3 options:

i) issue a 2-year 0-cp bond at t = 0

ii) issue a 1-year 0-cp bond at t = 0, with the intention of paying off that bonds face value at t = 1 with the proceeds from another 1-year 0-cp bond issuance at t = 1

iii) issue a 1-year 0-cp bond at t = 0, and also lock in the forward interest rate f1,1, for borrowing $1.05bn at t = 1 for 1 year. Given: r0,1 = 5%, r0,2 = 6%. f1,1 is set such that there is no arbitrage in the market. Pepsi only cares about minimizing the expected total repayment at t = 2. Elmo responded with: Based on current labour market conditions, and its impact on inflation, and based on what the Federal Reserve has said, I believe the 1-year rate at t = 1 will be 6.5%. As such, it would be wise to issue the 2-year bond, which has a 6% yield. Ronald responded with: We should go with option iii) as this would save us a lot of money compared to option i). a) Explain the flaw in Elmos logic. b) Is Ronald right? c) Suppose your own personal view is that r1,1 will equal 6.8%. What option would you recommend to the CFO. Justify by showing how much money you would expect to save compared to the other options in terms of total repayment at t = 2. (Assume that the CFO trusts your expected forecast of r1,1.)