QP 12.23 of Fundamentals of Corporate Finance: Nominal vs Real cash flows You ar

Question

QP 12.23 of Fundamentals of Corporate Finance: Nominal vs Real cash flows

You are graduating in two years. You want to invest your current savings of $5,000 in bonds and use the proceeds to purchase a new car when you graduate and start to work. You can invest the money in either bond A, a two-year bond with a 3% annual interest rate, or bond B, an inflation-indexed two-year bond paying 1% real interest above the inflation rate (assume this bond makes annual interest payments). The inflation rate over the next 2 years is expected to be 1.5%. Assume that both bonds are default free and have the same market price. Which bond would you invest in? Please show complete solutions.

Explanation / Answer

Alternative 1 :Future value at end of year 2 = 5000 (1+.03)(1+.03)

                                                               = 5000*1.03 *1.03

                                                                 = $ 5304.5

Alternative 2 )Future value = 5000 [(1+.01)(1+.015)] [(1.01)(1+.015)]

                                 = 5000 [1.01*1.015] [1.01*1.015]

                                    = 5000 * 1.02515* 1.02515

                                    = 5000 * 1.05093

                                     = $ 5254.66

Bond A as the future value is higher under that alternative .

Related Questions

Navigate

• Browse (All)
• Browse Q
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.