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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

EXPECTED INTEREST RATE The real risk-free rate is 3%. Inflation is expected to be 3% this year, 4% next year, and 3.5% thereafter. The maturity risk premium is estimated to be 0.05 × (t − 1)%, where t = number of years to maturity. What is the yield on a year Treasury note?

Summary Introduction

To identify: The yield on the 7 year treasury notes.

Yield: Yield is that percentage of the securities at which the return is provided by the company to its investors. Yield can be in the form of dividend and interest.

Explanation

Solution:

The items required for the calculation of actual yield on 7 year Treasury notes are real risk-free rate, maturity risk premium and inflation premium.

Compute the inflation premium

Given,

The inflation of current year is 3%.

Inflation of the next year is 4%.

Further inflation is 3.5%.

Formula to calculate the inflation premium for the 7 year,

InflationPremium=(InflationfortheCurrentYear+InflationfortheNextYear+5(InflationfortheFurtherYears))7

Substitute 3% for inflation for current year, 4% for inflation for the next year and 3.5% inflation for the further years.

InflationPremium=(3%+4%+5(3.5%))7=3%+4%+17.5%7=24.5%7=3

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