CHAPTER 5

PROBLEMS

CORPORATE FINANCE

5-10 Last year the Fed took action to maintain inflation at a 2 percent level. But, now the economy is starting to grow too quickly, and reports indicate that inflation is expected to increase during the next five years. Assume that the rate of inflation expected for this coming year (Year 1) is 4 percent; for the following year (Year 2), it is expected to be 5 percent; for the year after (Year 3), it is expected to be 7 percent; and, for Year 4 and every year thereafter, it is expected to settle at 4 percent.

What was the average expected inflation rate over the next five years (Year 1 through Year 5)?

Over the five-year period, what average nominal interest rate would be expected to produce a 2 percent real risk-free rate of return on five-year Treasury securities?