Problem 2 Suppose a firm needs $100 to invest in a project. The firm can choose between two projects: S (safe) or R (risky). The bank cannot directly control the choice of project. If it is S, then it will yield a cash flow of $300 with probability 0.8 and zero with probability 0.2. If it is R, the project will yield a cash flow of $423 with probability 0.5 and zero with probability 0.5. Everybody is risk neutral. The riskless interest rate is 20%. The bank would like to induce the choice of project S. Assume that collateral worth $1 to the firm is worth $0.9 to the bank. The banking sector is perfectly competitive. a. Demonstrate that when the bank offers an unsecured loan, project S will never be chosen. b. Calculate the interest rate when the bank offers an unsecured loan. c. What kind of secured contract would the bank offer to induce the choice of project S?

Problem 2 Suppose a firm needs $100 to invest in a project. The firm can choose between two projects: S (safe) or R (risky). The bank cannot directly control the choice of project. If it is S, then it will yield a cash flow of $300 with probability 0.8 and zero with probability 0.2. If it is R, the project will yield a cash flow of $423 with probability 0.5 and zero with probability 0.5. Everybody is risk neutral. The riskless interest rate is 20%. The bank would like to induce the choice of project S. Assume that collateral worth $1 to the firm is worth $0.9 to the bank. The banking sector is perfectly competitive. a. Demonstrate that when the bank offers an unsecured loan, project S will never be chosen. b. Calculate the interest rate when the bank offers an unsecured loan. c. What kind of secured contract would the bank offer to induce the choice of project S?

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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