Credit Problem 1 Imagine that loans are forthcoming at an interest rate of 10% and that a risk neutral (what does that mean?) farmer can invest in one of two alternative projects, each requiring a startup cost of 100,000 pesos. Project A has a certain rate of return of 15% (gross revenue of 115,000) and project B has a certain rate of return of 20% (gross revenue of 120,000). Assume that the farmer wants to make as much money as he can. a. Calculate the gross return for each project and briefly discuss which project the farmer would chose. Now let's change the scenario. Suppose that the return of project A is uncertain, but keep project B the same as before. For project A, there is a 50% chance that the project pays off 230,000 pesos and 50% change that the farmer gets nothing. Note that the expected revenue is the same as above: (0.5)230,000+ (0.5)0 = 115,000. If the project fails, the borrower declares bankruptcy (pays nothing). b. Show what is the borrower's expected return under each project now? Which project will the farmer chose? C. Discuss what the bank can do to prevent the risky activity to be taken.
Credit Problem 1 Imagine that loans are forthcoming at an interest rate of 10% and that a risk neutral (what does that mean?) farmer can invest in one of two alternative projects, each requiring a startup cost of 100,000 pesos. Project A has a certain rate of return of 15% (gross revenue of 115,000) and project B has a certain rate of return of 20% (gross revenue of 120,000). Assume that the farmer wants to make as much money as he can. a. Calculate the gross return for each project and briefly discuss which project the farmer would chose. Now let's change the scenario. Suppose that the return of project A is uncertain, but keep project B the same as before. For project A, there is a 50% chance that the project pays off 230,000 pesos and 50% change that the farmer gets nothing. Note that the expected revenue is the same as above: (0.5)230,000+ (0.5)0 = 115,000. If the project fails, the borrower declares bankruptcy (pays nothing). b. Show what is the borrower's expected return under each project now? Which project will the farmer chose? C. Discuss what the bank can do to prevent the risky activity to be taken.
Chapter1: Making Economics Decisions
Section: Chapter Questions
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Transcribed Image Text:Credit
Problem 1
Imagine that loans are forthcoming at an interest rate of 10% and that a risk neutral (what
does that mean?) farmer can invest in one of two alternative projects, each requiring a
startup cost of 100,000 pesos. Project A has a certain rate of return of 15% (gross revenue
of 115,000) and project B has a certain rate of return of 20% (gross revenue of 120,000).
Assume that the farmer wants to make as much money as he can.
a.
Calculate the gross return for each project and briefly discuss which project the farmer
would chose.
Now let's change the scenario. Suppose that the return of project A is uncertain, but keep
project B the same as before. For project A, there is a 50% chance that the project pays
off 230,000 pesos and 50% change that the farmer gets nothing. Note that the expected
revenue is the same as above: (0.5)230,000+ (0.5)0 = 115,000. If the project fails, the
borrower declares bankruptcy (pays nothing).
b. Show what is the borrower's expected return under each project now? Which project
will the farmer chose?
C. Discuss what the bank can do to prevent the risky activity to be taken.
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