The interest rate outlook for Montrose Inc., a large, financially sound company, is reflected in the following information.

• The pure rate of interest is 4%.

• Inflation is expected to increase in the future from its current low level of 2%. Predicted annual inflation rates follow.

Year Inflation Rate

1 ..........2%

2 ..........3

3 ..........4

4 ...........5

5–20 ..........6

• The default risk premium will be .1% for one-year debt, but will increase by .1% for each additional year of term to a maximum of 1%.

• The liquidity premium is zero for one- and two-year debt, .5% for three-, four-, and five-year terms, and 1% for longer issues.

• The maturity risk premium is zero for a one-year term and increases by .2% for each additional year of term to a maximum of 2%.

a. Use the interest rate model to estimate market rates on the firm’s debt securities of the following terms: 1 to 5 years, 10 years, and 20 years.

b. Plot a yield curve for the firm’s debt.

c. Using different colors on the same graph, sketch yield curves for

i. federal government debt and

ii.Shaky Inc., a firm currently in financial difficulty.

d. Explain the pattern of deviation from Montrose’s yield curve for each of the others.