Suppose you are a financial manager of Yuen Cheong Manufacturng Company. Due to the rising demand of product X, Yuen CheongManufacturng Company decides to open a new production plant in China, so it needs to take a loan of US$1 million. Bank A offers Yuen Cheong Manufacturing Company the following two choices of loan:
i borrowing cash at 12% per annum, compounded annually
ii borrowing gold at 3% per annum, compounded annually.Assume the risk-free interest rate is 9.5% per annum and storage costs are 0.5% per annum, both are expressed with continuous compounding. Evaluate which loan you should choose from Bank A. Discuss and briefly explain whether the rate of interest on the gold is too high or too low in relation to the rate of interest on the cash loan.