A firm with initial equity E has an option to invest in a safe or a...
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A firm with initial equity E has an option to invest in a safe or a risky project, both of which require a loan L from a bank to get off the ground. The posted interest rate for the loan is R. The safe project yields S extra value to the firm for sure. The risky project gives high and low extra values to the firm of G and -G with probability p and 1-p respectively. a) Suppose L.R<S+E. What is the interpretation and importance of this? b) Suppose also that L.R>E-G. What is the interpretation and importance of this? c) If additionally S<p.G-(1-p).G then show (or argue) that the firm will always strongly prefer the risky project. d) Show (or argue) that in this scenario the effective rate of interest the bank earns will always be lower than the posted rate R. e) Can the bank raise it's effective rate of return by raising R? A firm with initial equity E has an option to invest in a safe or a risky project, both of which require a loan L from a bank to get off the ground. The posted interest rate for the loan is R. The safe project yields S extra value to the firm for sure. The risky project gives high and low extra values to the firm of G and -G with probability p and 1-p respectively. a) Suppose L.R<S+E. What is the interpretation and importance of this? b) Suppose also that L.R>E-G. What is the interpretation and importance of this? c) If additionally S<p.G-(1-p).G then show (or argue) that the firm will always strongly prefer the risky project. d) Show (or argue) that in this scenario the effective rate of interest the bank earns will always be lower than the posted rate R. e) Can the bank raise it's effective rate of return by raising R?
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a The inequality LR SE indicates that the cost of the loan LR is lower than the expected value of th... View the full answer
Related Book For
Income Tax Fundamentals 2013
ISBN: 9781285586618
31st Edition
Authors: Gerald E. Whittenburg, Martha Altus Buller, Steven L Gill
Posted Date:
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