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As the Assistant Vice President of a manufacturing company you have to evaluate a projectproposal to invest in a new production facility. The expected gross revenue from salesbased onprior market researchis as follows.YearAnnualRevenue (inmillions of 2016real US$)2016Nil201720201840201960202080Each yearfrom 2021100There are two production technologies to choose from;

a basic machinery that costs US$300million in 2016withitsoperationalexpenses (including all costs of production) amounting80million in 2016real US$ during each year beginning 2017or an advanced machinery with anefficiency improvingadd-on which costs an additional US$200 in2016but cuts operationalexpenses by10million US$ (in 2016real US$) from 2017.

Option

A Option 

B Capital cost in 2016(in millionsof 2016realUS$)300500Operational expensesin each yearfrom2017(in millions of 2016real US$)8070a.If therealinterest rate is3% which of the two options are profitable? If both are profitablewhich one is more profitable?

(Hint: Calculate the net cash flowsof each of the twoinvestments and find the Net Present Value when the real interest rate is3%).b.Ifthe real interest rate drops to2.75% which of the two options are profitable? If both areprofitable which one is more profitable?c.Ifthe real interest rate dropsfurtherto2.5% which of the two options are profitable? Ifboth are profitable which one ismore profitable?d.Ifthe real interest rate dropsfurtherto2.25% which of the two options are profitable? Ifboth are profitable which one is more profitable?e.If your company plans to borrow funds for this project show howthedemand for loansduring 2016changeswhen the real interest rate (borrowing rate) changes from3% to2.75%and to2.5%.22.

Term premiums for bonds with different maturities are given below.Bond maturity (years)Term premium (%)1020.2530.340.3550.4a.Current interestrate is 4%. The term structures of bonds maturing in 1-5 years when theexpected interest rate (from next year onwards) changes from 2.5% to 5.5% are shown inthe following diagram. Reproduce the following diagram using Excel.b.Comment on the nature ofthe term structure when the interest rate is expected to be0.25% lower than the current level.c.Comment on the nature of the term structure when the interest rate is expected to be0.75% lower than the current level.33.544.555.5612345Interest rateMaturity (Years)Term Structure when the expected interest rate changesfrom 2.5-5.5%2.533.544.555.5

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