Question
The interest rate outlook for Montrose, Inc., a large, financially sound company, is reflected in the following information: - The pure rate of interest is
The interest rate outlook for Montrose, Inc., a large, financially sound company, is reflected in the following information: - The pure rate of interest is 4% - Inflation is expected to increase in the future from its current low level of 2%. Predicted annual inflation rates follow: Year 1: Inflation rate 2% Year 2: Inflation rate 3% Year 3: Inflation rate 4% Year 4: Inflation rate 5% Years 5-20: Inflation rate 6% - The default risk premium will be 0.1% for one year debt, but will increase by 0.1% for each additional year of term to a maximum of 1.0%. - The liquidity premium is zero for one-and-two-year debt, 0.5% for three, four and five year terms, and 1% for longer issues. - The maturity risk premium is zero for a one-year term and increases by 0.2% for each additional year of term to a maximum of 2%. a. Use the interest rate model to estimate market rates on the firm's debt securities of the following terms: 1 to 5 years, 10 years, and 20 years. b. Plot a yield curve for the firm's debt. c. Using different colors on the same graph, sketch yield curves for: 1. Federal Government debt and 2. Shaky, Inc. a firm in financial difficulty d. Explain the pattern of deviation from Montrose's yield curve for each of the others.
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