1. Nu-Mode Fashions Inc. manufactures quality women’s wear and needs to borrow money to get through a brief cash shortage. Unfortunately, sales are down, and lenders consider the firm risky. The CFO has asked you to estimate the interest rate Nu-Mode should expect to pay on a one-year loan. She’s told you to assume a 3% default risk premium, even though the loan is relatively short, and to assume the liquidity and maturity risk premiums are each 1/2%. Inflation is expected to be 4% over the next 12 months. Economists believe the pure interest rate is currently about 31/2%.
2. Calculate the rate Nu-Mode in the last problem should expect to pay on a two-year loan. Assume a 4% default risk premium and liquidity and maturity risk premiums of 3/4% due to the longer term. Inflation is expected to be 5% in the loan’s second year.