On present-discounted values and investment decisions Jesse and Wally are new business partners who confider building a Brownie factory. The following table 1 2 gives the net profits that they expect to receive at the each of each year with certainty. The yield to maturity of a four-year bond is presently i4t = 3%. Assume that this 3% also corresponds to the one-year expected interest rates over the four years. There is no inflation and the factory becomes obsolete after its fourth year of operation. ? e t ? e t+1 ? e 1,t+2 ? e 1t+3
Expected net profit 100 150 200 200
(a) What is the maximum price that Jesse and Wally are willing to pay in order to build the factory
(b) Suppose that the expected, short-term one year interest rate for the fourth year increases from an initial value of i1t+3 = 3% to a new value of i1t+3 = 5%. All else remains equal. Recalculate the maximum building cost required in order to implement the project. What does this say about the effect of an increase in expected short-term interest rates on the investment levels today?
(c) Suppose that a suddenly gloomier outlook leads Jesse and Wally to revise down their expected profits in the third and fourth year to decrease to ? e 1t+2 = ? e 1t+3 = 150. All else remains equal. Recalculate the maximum building cost required in order to implement the project. What does this say about the effect of a gloomier outlook about the future on the investment levels today?