Homework SourseProduceCom and MakeItCom are two companies of identical size
ProduceCom and MakeItCom are two companies of identical size in two different countries, one with a high inflation rate and one with a low inflation rate. ProduceCom is in a country where the inflation rate is 12% and it needs to pay an interest rate of 17% when it borrows. MakeItCom is in a country where the inflation rate is 3%, but it needs to pay a rate of 9% when it borrows. If the time value of money is the same in both economies, which company is being charged a higher risk premium?
C h a p te r
ProduceCom and MakeItCom are two companies of identical size in two different countries, one with a high inflation rate and one with a low inflation rate. ProduceCom is in a country where the inflation rate is 12% and it needs to pay an interest rate of 17% when it borrows. MakeItCom is in a country where the inflation rate is 3%, but it needs to pay a rate of 9% when it borrows. If the time value of money is the same in both economies, which company is being charged a higher risk premium?
C h a p te r
ProduceCom and MakeItCom are two companies of identical size in two different countries, one with a high inflation rate and one with a low inflation rate. ProduceCom is in a country where the inflation rate is 12% and it needs to pay an interest rate of 17% when it borrows. MakeItCom is in a country where the inflation rate is 3%, but it needs to pay a rate of 9% when it borrows. If the time value of money is the same in both economies, which company is being charged a higher risk premium?
C h a p te r
Solution
A risk premium can be defined as the rate of return that is provided in excess to that of a risk-free rate
of return which is provided by an investment. Here lenders are providing funds to ProduceCom at a
rate of 17 percent while the risk free interest rate is 17 - 12 = 5%. Lenders allow MakeItCom to borrow
at 9 percent when the risk free interest rate is 9 - 3 = 6%. Since MakeItCom is paying a higher real
interest rate, it is being charged a higher risk premium.
