Question 1

Nominal and real ratesTyra loves to shop at her favoritestore, DollarBarrel, where she can find hundreds of items priced at exactly$1. Tyra has $200 to spend and is thinking of going on a shopping spree at DollarBarrel, but she is also thinking of investing her money.(Ignore all sales and incometaxes.)

a. Suppose the expected rate of inflation is 1% (so nextyear, everything at Dollar Barrel will cost $1.01) and Tyra can earn 5% on money that she invests. Approximately what real rate of interest could Tyra earn if she invests hermoney? How many items can she buy at Dollar Barreltoday, and how many can she buy a year from now if she invests her money and goes shoppinglater? What is the percentage increase inTyra's purchasing power if she waits a year to goshopping? Compare your answer to the approximate real rate of interest onTyra's investment.

b. Now suppose that the expected inflation rate is 10% and Tyra can earn 20% on money that she invests over the year. What is the approximate real rate of interest that Tyra willearn? Calculate the number of items that Tyra could buy next year from Dollar Barrel if she invests her money. What is the percentage increase in her purchasing power if she waits a year to goshopping? Relate your answer back toTyra's real rate of return.

Question 2

Before-tax cost of debt andafter-tax cost of debtDavid Abbot is buying a newhouse, and he is taking out a 30-year mortgage. David will borrow $204,000 from abank, and to repay the loan he will make 360 monthly payments(principal andinterest) of $1,232.54 per month over the next 30 years. David can deduct interest payments on his mortgage from his taxableincome, and based on hisincome, David is in the 30% tax bracket.

a. What is thebefore-tax interest rate(per year) onDavid's loan?

b. What is theafter-tax interest rate that David ispaying?

Question 3

NPVCalculate the net present value (NPV) for a 15-year project with an initial investment of $1,000,000 and a cash inflow of $150,000 per year. Assume that the firm has an opportunity cost of 9%. Comment on the acceptability of the project.