An owner/investor can invest in either of two projects, each of which costs $1 million. Project...

 

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An owner/investor can invest in either of two projects, each of which costs $1 million. Project 1 has success probability of 1/2 and failure probability of 1/2. In the event of success, it would yield a gross return of $2.2 million. In the event of failure, the gross return would be $0.6 million. Project 2 has success probability of 3/4 with gross return of $1.6 million and failure probability of 1/4 with gross return of $1.2 million. After the outcome of the investment materializes, the owner/investor needs to pay off debt and interest first. If this amount (debt and interest) exceeds the gross return, the owner/investor can file for bankruptcy, in which case the maximum amount repaid is the gross return. (a) Consider a risk-neutral person who has $0.6 million of his own money and can acquire $0.4 million of debt. The market interest rate is 10%. Which project, if either, would this person choose to invest in? Explain. (b) Next, suppose the same person has $0.1 million of his own money and can borrow $0.9 million. This time, which project, if any, would this person choose to invest in? Explain. (c) More generally, suppose the person can finance r out of the $1 million cost through debt. Determine the optimal project choice as a function of r. What is the optimal z for the person? (d) What can you say about moral hazard of debt-financed investment from the above? (e) How would the above change if the investor were risk-averse? An owner/investor can invest in either of two projects, each of which costs $1 million. Project 1 has success probability of 1/2 and failure probability of 1/2. In the event of success, it would yield a gross return of $2.2 million. In the event of failure, the gross return would be $0.6 million. Project 2 has success probability of 3/4 with gross return of $1.6 million and failure probability of 1/4 with gross return of $1.2 million. After the outcome of the investment materializes, the owner/investor needs to pay off debt and interest first. If this amount (debt and interest) exceeds the gross return, the owner/investor can file for bankruptcy, in which case the maximum amount repaid is the gross return. (a) Consider a risk-neutral person who has $0.6 million of his own money and can acquire $0.4 million of debt. The market interest rate is 10%. Which project, if either, would this person choose to invest in? Explain. (b) Next, suppose the same person has $0.1 million of his own money and can borrow $0.9 million. This time, which project, if any, would this person choose to invest in? Explain. (c) More generally, suppose the person can finance r out of the $1 million cost through debt. Determine the optimal project choice as a function of r. What is the optimal z for the person? (d) What can you say about moral hazard of debt-financed investment from the above? (e) How would the above change if the investor were risk-averse?

Answer rating: 100% (QA)

aThe person would choose Project 2 because it has a higher expected return The expected return for Project 1 is 1222 million 1206 million 14 million The expected return for Project 2 is 3416 million 1... View the full answer