Question

5. Suppose a bank had lent Moe $50,000 at 8% for 1 year to fund a project (Project A) that will pay $60,000 with certainty. Having received the funds, Moe hears about another (risky) project (Project B) that pays $80,000 with 50% probability and $20,000 with 50% probability. Assume Moe is risk neutral, has pledged no collateral, has no net worth, and has no reputational capital to lose. (This means Moe will not be able to pay in full if he pursues Project B and it doesn't work out as hoped and has nothing else to lose if he defaults.) a. b. Which project, A or B, is more attractive to Moe now that Moe has received the funds from the bank? Briefly explain. What is the bank's expected return if Moe pursues Project B? Which project, A or B, is more attractive to Moe if he has a net worth of $100,000 rather than $0? Briefly explain. C.

Answer 1

$54,000 100 Moe is ve with the a Moe borrowed $50,000 for year at 8%, so Moe has to repay $150,000+ $630,000 + *50,000) a) Project A giver $60,000 with certainty rusk noutal, neutral, which means that he will inayperont between the risking projecta whose Expected retuu will we equal to a project. Legrany die gelten. $60,000 Here euxptet return from Project A (soin) expected return from rusky Project B = ' x $20,000 $ (40,000 +10,000) $ 50,000 Here clearly $60,000 (Projiet A) > $50,000 (Project B) Therefore, project A is more b) Bank's expected geeturn if Hoe pursues Progect B is :- X( 8Operosa 54000) + 1x {* (-4000) ) 27000-2000 25000 Hoe will be able able to repay $5.4000 to the bank if he earns $80,000, weet will be able to pay $ 4000 less uns only ig he incurs loss $20000 from Project B. Therefore bank's expected 2 $ 250,00€ 9 Eupected sectura with net worth $1,00,000 and pursuing Projter A is $(1,00,000 + 60,000 - 50,000) $(1,10,000) (Here Hoe will not borrow bow from bank) attractive to Moe XXL 2 a eauro return is Moe

expected section 9 Moe writh net worth $1,00,000 and pursuing broject Bis $(1,00,000 - 50,000 + 50,000 + (x 80000 +4x2000 -$ (1,00,000 -50,000 + 50,000) $(1,00,000) Still Project AC $1,10,000) > Project B returns ($1,00,000) therefore Project A is still A A 10 returns more athrachnie to Hoe