Ah Lee, a financial manager at a US based mid-sized manufacturing firm, has been caught off-guard before. To earn the most on excess cash, Ah Lee once bought five-year coupon Treasury bonds (a maturity longer than the firms liabilities) only to see interest rates rise. The loss when the Treasury bonds were sold did not make Ah Lees supervisor, Carlo, Chief Financial Officer, very happy.

In estimating the future dollars from a bond investment, Ah Lee needs a forecast of the direction and level of future interest rates in order to calculate the RCY. At yesterdays investment meeting, Carlo stated his view that interest rates would remain unchanged for the next three years because of an unchanging expected inflation rate. Ah Cheung, another financial manager at the firm and someone that has earned Carlos respect for his reasoned judgment, suggests Ah Lee use the current term structure to gauge interest rate expectations. He uses the following table from Federal Reserve Statistical Release H.15 to get current spot rates on one-, two-, three- and four-year constant maturity Treasury securities. (See table below).

Treasury constant maturities	Spot Rate Today
1-month	1.58%
3-month	1.57%
6-month	1.58%
1-year	1.54%
2-year	1.61%
3-year	1.61%
4-year	1.63%
5-year	1.65%
7-year	1.75%
10-year	1.84%
20-year	2.16%
30-year	2.31%

"Carlo will accept a recommendation different than his own only if it is justified by analysis," advises Ah Cheung. "Well-reasoned analysis is an opportunity to gain back some of Carlo trust, which was lost after your last bond investment." Ah Cheung also adds, If you follow Carols view, he also wants to see the reasons behind your agreement.

Ah Lees problem is to recommend the best investment strategy among the four different US Treasury bonds. The $10 million investment will be liquidated in three years to help repay a bank loan charging a fixed rate interest at 8.50% per year. The bonds, each with a $1,000 par value and annual convention, are described as following:

Note: This is an important recommendation for Ah Lee that can affect his career. Although no one knows the future course of interest rates (not even Carlo), Ah Lee knows it is essential to consider the impact of an unexpected change in interest rates on each of the bonds. To Ah Lee, it is probably least risky to assume Carlos forecast is the best because hell have no one to blame but himself if Ah Lee makes a recommendation based on the forecast.

Bond	Annual Coupon	Current Price	Maturity (yrs)
Bond 1	0%	$882.50	5
Bond 2	11.625%	$1403.39	5
Bond 3	5.5%	$1107.59	3
Bond 4	3.5%	$905.25	4

Q1: explain your recommendation on the investment of $10 million. You need to consider the funding cost the company currently paying for its current liability.