Global Economics Assignment

Q1. JLease, an aircraft leasing company, is expanding and needs to borrow in order to finance a fleet of new luxury small jet aircraft that it then will lease to various corporations and organizations that really need them - like the Federal Reserve and the Mason School of Business W&M.  The planned borrowing has a nominal value of $100M.  Based on forecasts of net-cash flow the company feels that it can repay the loan principal (the $100M) in 5 years.   Until then, the bank will require an end-of-year annual interest payment.  So for example if the first year interest rate were 8%, the company will make an $8M loan service payment at the one-year anniversary of the loan, and so on.

Ken and Jennifer, both senior VPs at the company, have spent the afternoon with the company's bank and have brought back borrowing options A and B.  These are:

Option A. A 5-year variable rate loan with the interest rate reset annually to equal the one-year T-bill rate plus a 4% markup. The starting rate would be current one-year T-bill rate + 4 % = 2% + 4% = 6%.  Future one-year rates are set at the anniversary of the loan.

Option B. A 5-year fixed rate loan with the interest rate set equal to the five-year Treasury bond rate plus a 4.25% markup   At the moment this rate would work out to be the current 5-year T-bond rate + 4.25% = 2.5% + 4.25% = 6.75%.

That night at a cocktail party for visiting company directors, an impromptu discussion takes place with one of the directors argues that "Sure, the one-year rate is low, but borrowing long term with an incredibly low 2.5 percent base rate for five years is an historic opportunity!  Interest rates are sure to rise and with the variable rate loan we'll get hurt."  Recalling their MBA training, and particularly their Global Economics class, Ken and Jennifer reply that while it is possible that Option B is the right one, the issue is more complicated because it involves the term structure of interest rates as well as risk factors to be considered.  In fact, they point out that Option A is quite possibly the right choice. 

a. Show how the one-year and five-year T-Bill rates are related through the term structure.

b. Estimate the expected total cost of borrowing over entire five years under options A and B.

c. What criteria would ultimately decide which option you should?     

Q2. Kathy and Steve work for a firm that has developed a micro, high-efficiency, natural gas generator to generate household-level electricity. The company plans to build its first plant in a large developing economy and sell the produced generators in-country.  They have narrowed the choices in terms of country size (roughly the same) GDP per capita (similar), rule-of-law and corruption (not great, but acceptable).  They must select the country (referenced as countries A, B and C) that they feel has the most sustainable future economic growth. They have the following data on labor force growth (%?L), growth in the capital stock (%?K) and real GDP growth ((%?Y) for each country since 2011.  This is all the data that is available.

Given these data. Which country should Kathy and Steve choose and why?