The interest rate outlook for Montrose, Inc., a large, financially sound company

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 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.

Explanation / Answer

Term kpr infl dr lr mr k 1 4 2.0 0.1 0 0.0 6.1% 2 4 2.5 0.2 0 0.2 6.9% 3 4 3.0 0.3 0.5 0.4 8.2% 4 4 3.5 0.4 0.5 0.6 9.0% 5 4 4.0 0.5 0.5 0.8 9.8% 10 4 5.0 1.0 1.0 1.8 12.8% 20 4 5.5 1.0 1.0 2.0 13.5%

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