Question

Suppose that you are running a business, and you need some extra space for one year. Your bank offers you a loan of $200,000 at 0% interest. You consider borrowing this amount to buy the building, use it for one year, and then sell the building to pay back the loan. Unfortunately, the economy in which you are operating is experiencing deflation at the rate of 10% per year. After one year, you should be able to sell the building for____.
Suppose that owning the building for a year would earn you $12,000. To decide whether you will be better off by owning it for one year and then selling it, you seek advice from three different people: (1) Your brother says that you should not buy the building because in one year it will cost you $200,000. (2) Your accountant says that you should definitely buy the building because you can borrow $200,000 at zero interest while the building will generate $12,000 in extra income. Then when you sell it, you will be $12,000 richer. (3) Your bookkeeper says that if you sell the building in a year, you will have to come up with more money to pay off the loan than you will make in extra income.
Keeping in mind that the economy experiences deflation at the rate of 10%, who is right?
A. Your bookkeeper is right, because the extra income you will earn will be less than the cost of owning the building for the year.
B. Your brother is correct, because when the nominal interest rate is zero, the cost of a building is its full purchase price.
C. Your accountant is right, because when the nominal interest rate is zero, you do not incur any cost when you take out a loan.
Now, suppose you inherited $200,000 in cash from your uncle who had kept it hidden in his mattress. Assuming the nominal interest rate is -1%, which of the following options will maximize the amount of cash that you have in one year?
A. Holding onto your $200,000 in cash.
B. Buying the building, because you can earn an additional $12,000 in income if you own the building for one year and then sell it.
C. Depositing the cash in the bank, because the 10% rate of deflation makes the value of your dollars fall even more rapidly than 1% per year.
A high real interest rate will keep firms from borrowing to finance investment in capital, but it will not keep firms with cash from investing in capital.
A. False
B. True

Answer 1

Answer:

Question 1

The building will depreciate by 10% in one year so in one year you will only be able to sell it for:

= 200,000 * ( 1 - 10%)

= $180,000

Question 2.

A. Your bookkeeper is right, because the extra income you will earn will be less than the cost of owning the building for the year.

If you buy the building, you will have to pay back $200,000 in a year.

However, you will only be able to sell the building for $180,000 and you will receive an income of $12,000 for a total of:

= 180,000 + 18,000

= $192,000

This is $8,000 less than the $200,000 you borrowed so you will pay back more than you borrowed.

Question 3

A. Holding onto your $200,000 in cash.

Holding your cash is the best option because investing in the building would lead to a loss of $8,000 after a year.

The bank would also reduce your balance by 1%. It is therefore best to hold the money.

Question 4

A. False

Companies with cash still have to make decisions based on gains and they will stand to gain more if they deposited their money because this would give them more interest profits.