FIN 361 Fall 2024 Problem Set 1 Question 5 [20 points] Suppose the current one-year interest rate is 6%. One year from now, you believe the economy will start to slow and the one-year interest rate will fall to 5%. In two years, you expect the economy to be in the middle of a recession, causing the Federal Reserve to cut interest rates drastically and the one-year interest rate to fall to 2.5%. The one-year interest rate will then rise to 3.5% the following year and then return to 6% the following year. a) If you were certain regarding these future interest rate changes, what two-year interest rate would be consistent with these expectations? b) What current term structure of interest rates, for terms of 1 to 10 years, would be consistent with these expectations? c) How does the one-year interest rate compare to the five-year interest rate? Plot the yield- curve: how would you call a yield-curve of this shape? d) What does this yield curve imply about the future of the economy? (hint: why does the relation between the 5-year rate and one-year rate described in part c) hold?) FIN 361 Fall 2024 Problem Set Question 8 [10 points] Cheddar Biscuit Corporation has a dividend yield of 2.5%. Cheddar Biscuit's equity cost of capital is 9.0%, and its dividends are expected to grow at a constant rate. (Assume a Gordon Growth model with constant growth). a) What is the expected growth rate of Cheddar Biscuit's dividends? b) What is the expected growth rate of Cheddar Biscuit's share price? FIN 361 Fall 2024 Problem Set 1 Question 1 [10 points] A risk-free security is selling for $80 and will return $84, with certainty, in one year. Consider the following four investment projects: Project Cash flow Cash flow in today ($ million) | one year ($ million) a) What is the risk-free rate? b) Of the four projects listed, which one would you select if you could only invest in one project? Why