Consider the model of Credit Risk and Dilution Costs in Freixas and Rochet 2.5.5 based on Bolton and Freixas (2000) where firms have to choose between Bond financing, Equity if suc- Issue and Bank debt. Firms live for two periods and in each period will obtain, y, cessful and zero if unsuccessful. The probability of success in period 2 is 1 for good firms and 0 for bad firms, where each firms knows its own type but lenders cannnot see this type, where the proportion of good firms in period 2 is v. The probability of success in period 1 is uniformly distributed independently of type over the interval [plow, 1]. This probability is observable and represents a frim's credit rating. Under bond financing the firm is liquidated for value A if unsuccessful in period 1. Under equity issue a share ac[0, 1] of any cash flow is given to the investors and under bank debt, if the firms defaults in period 1 then bank will claim all revenues in period 2 at a cost of C for monitoring and renegotiation costs Uninformed risk neutral investors require an expected rate of return of (1+r). = 1, y = 2, C = 1, A=1 and r=0 i.e. 1+r=1. Suppose V= What is the expected profit of a firm with p = if it chooses Bond Finance
Consider the model of Credit Risk and Dilution Costs in Freixas and Rochet 2.5.5 based on Bolton and Freixas (2000) where firms have to choose between Bond financing, Equity if suc- Issue and Bank debt. Firms live for two periods and in each period will obtain, y, cessful and zero if unsuccessful. The probability of success in period 2 is 1 for good firms and 0 for bad firms, where each firms knows its own type but lenders cannnot see this type, where the proportion of good firms in period 2 is v. The probability of success in period 1 is uniformly distributed independently of type over the interval [plow, 1]. This probability is observable and represents a frim's credit rating. Under bond financing the firm is liquidated for value A if unsuccessful in period 1. Under equity issue a share ac[0, 1] of any cash flow is given to the investors and under bank debt, if the firms defaults in period 1 then bank will claim all revenues in period 2 at a cost of C for monitoring and renegotiation costs Uninformed risk neutral investors require an expected rate of return of (1+r). = 1, y = 2, C = 1, A=1 and r=0 i.e. 1+r=1. Suppose V= What is the expected profit of a firm with p = if it chooses Bond Finance
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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![3. Consider the model of Credit Risk and Dilution Costs in Freixas and Rochet 2.5.5 based
on Bolton and Freixas (2000) where firms have to choose between Bond financing, Equity
Issue and Bank debt. Firms live for two periods and in each period will obtain, y, if suc-
cessful and zero if unsuccessful. The probability of success in period 2 is 1 for good firms
and O for bad firms, where each firms knows its own type but lenders cannnot see this type,
where the proportion of good firms in period 2 is v. The probability of success in period 1
is uniformly distributed independently of type over the interval [plow, 1]. This probability is
observable and represents a frim's credit rating. Under bond financing,the firm is liquidated
for value A if unsuccessful in period 1. Under equity issue a share ac 0, 1] of any cash flow
is given to the investors and under bank debt, if the firms defaults in period 1 then bank
will claim all revenues in period 2 at a cost of C for monitoring and renegotiation costs
Uninformed risk neutral investors require an expected rate of return of (1+r).
0 i.e. 1+r =1.
Suppose v =
v= 2, C = , A = } and r =
if it chooses Bond Finance
What is the expected profit of a firm with p =
В.
C.
D.
E. None of A-D
A.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Fbf3eed26-39d7-4ca5-8429-d7ea4f37886d%2Fc3953aa8-e0ac-4463-b81f-f78f43e930bc%2F0mhajwk_processed.jpeg&w=3840&q=75)
Transcribed Image Text:3. Consider the model of Credit Risk and Dilution Costs in Freixas and Rochet 2.5.5 based
on Bolton and Freixas (2000) where firms have to choose between Bond financing, Equity
Issue and Bank debt. Firms live for two periods and in each period will obtain, y, if suc-
cessful and zero if unsuccessful. The probability of success in period 2 is 1 for good firms
and O for bad firms, where each firms knows its own type but lenders cannnot see this type,
where the proportion of good firms in period 2 is v. The probability of success in period 1
is uniformly distributed independently of type over the interval [plow, 1]. This probability is
observable and represents a frim's credit rating. Under bond financing,the firm is liquidated
for value A if unsuccessful in period 1. Under equity issue a share ac 0, 1] of any cash flow
is given to the investors and under bank debt, if the firms defaults in period 1 then bank
will claim all revenues in period 2 at a cost of C for monitoring and renegotiation costs
Uninformed risk neutral investors require an expected rate of return of (1+r).
0 i.e. 1+r =1.
Suppose v =
v= 2, C = , A = } and r =
if it chooses Bond Finance
What is the expected profit of a firm with p =
В.
C.
D.
E. None of A-D
A.
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