Introduction to Finance HW#2

(Interest Rate Fundamentals; 10 points) You read in Businessweek that a panel of economists has estimated that the long-run real growth rate of US economy over the next five-year period will average 3 percent. In addition, a bank newsletter estimates that the average annual rate of inflation during the five-year period will be about 4 percent. What nominal rate of return would you expect on US government T-bills during this period.?

(Interest Rate Fundamentals; 16 points) What would your required rate of return be on common stocks if you wanted a 5 percent risk premium to own common stocks given what you know from problem #1? If common stock investors became more risk averse, what would happen to the required rate of return on common stocks? What would be the impact on stock prices?

(Internet Activity; Interest Rate Fundamentals; 20 points) Go to http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/. Based on the most recently released daily data (i.e., the data released on the day when you work on this assignment), complete parts a and b below:
(5 points) Bank prime loan charges 4.25% currently. Find yield for 12-month Treasury bills from the Bloomberg website and indicate the size of current default risk premiums for bank prime loans.
(15 points) Prepare a yield curve or term structure of interest rates based on today’s yields on U.S. Treasury securities. Briefly comment on the shape of current yield curve (i.e., is it normal or inverted? Steep or flat? What does it tell you about the current status of the US economy?)

(24 points) Solve the following problems using both formulas and Excel spreadsheet.

1. You have just made your first $2,000 contribution to your individual retirement account. Assuming you earn a 10 percent rate of return and make no additional contributions, what will your account be worth when you retire in 45 years? (5 points)

1. You have just received notification that you have won the $1 million first prize in the Centennial Lottery. However, the prize will be awarded on your 100^th birthday (assuming you’re around to collect), 80 years from now. What is the present value of your windfall if the appropriate discount rate is 10 percent? (5 points)

1. Assume the total cost of a college education will be $250,000 when your child enters college in 18 years. You presently have $43,000 to invest. What annual rate of interest must you earn on your investment to cover the cost of your child’s college education? (5 points)

1. You’re trying to save to buy a new $150,000 Ferrari. You have $40,000 today that can be invested at your bank. The bank pays 5.5 percent annual interest on its accounts. How long will it be before you have enough to buy the car? (5 points)

(30 points) Complete “Homework #2: 30%” on MyFinanceLab under the “Assignments” tab. Please use either math approach or Excel approach to solve the problems. You may try each question up to three times as a maximum.