(a) Your firm has identified a project which meets the payback requirement and has a strong net present value. You are now deciding on the funding of the project which should begin in a years time. The cost of capital should be no more that 1.75% above the Government bond rates. The one-year government bond rate is 7.25% and the two-year bond rate is 8.55 The liquidity premium is forecasted to be 0.85%. [5 marks]

Assume that the expectations theory is true and that you can buy a three-year bond with an interest rate of 6.25% or three consecutive one-year bonds with interest rates of 5%, 6% and 7%. Which option would you choose to undertake? [3 marks]

The 1-year T-bill rates are expected to steadily increase by 150 basis points per year over the next 5 years. Determine the required interest rate on a 3-year T-bond if the current 1-year interest rate is 6.75%. Assume that the Pure Expectations Hypothesis for interest rates holds. [4 marks]

What is the effect of inflation on interest rates? [2 marks]

Total 15 marks