You have been assigned to estimate the interest rates that your company may have

Question

You have been assigned to estimate the interest rates that your company may have to pay when borrowing money in the near future. The following information is available.
kPR = 2%
MR = .1% for a 1 year loan increasing by .1% for each additional year
LR = .05% for a 1 year loan increasing by .05% for each additional year
DR = 0 for a 1 year loan, .2% for a 2 year loan, increasing.1% for each additional year
Expected Inflation Rates
Year 1 = 7%
Year 2 = 5%
Year 3 and thereafter = 3%

a. Calculate the inflation adjustment (INFL) for a 5-year loan.
b. Calculate the appropriate interest rate for a 5-year loan.
show your work

Explanation / Answer

a.) INFL = (7%+5%+3*3%)/5 = 4.20% b.) r = r* + IP + DRP + LP + MRP Where r = required interest rate r* =2% IP = 4.20% (as above) DRP = 0.1%*5 = 0.5% for 5 yr loan LP = 0.5%*5 yrs = 2.5% MRP = =0.1%*5 = 0.5% r = 2% + 4.2% +0.5%+2.5%+0.5% = 9.70% So ppropriate interest rate for a 5-year loan is 9.70%

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