Assume an entrepreneur has two projects to choose from. Both require a $100 investment. Assume the entrepreneur is risk-neutral.

Safe project: returns $140 for sure

Risky project: Returns $ 200 with a 50% chance and $50 with a 50% chance.

A. Calculate the total Expected return on each project for the entrepreneur

B. What is his net return (i.e. his profit = Expected return minus his investment) if he had his own money to invest in a project? Which project will he choose?

C. What is his net return if he borrows from a bank with limited liability at a 10% interest rate? (in this example in the low payoff state he will pay $50 to the bank as his liability is limited to what he has in his business)? Which project will he choose?

D. What is Bank’s expected return in each case (assume a 10% interest rate)? Which project will the bank prefer?

E. What is social net return on each project (i.e. entrepreneur’s return and bank return)? Which project is optimal from societal point of view?

F. If bank required collateral of $100, what would be entrepreneur’s return in each case? Which project will entrepreneur choose?

G. If 50% of all borrowers are safe and 50% are risky, what interest rate bank will need to charge to break even if no collateral is required?

Answer rating: 100% (QA)

A Safe project Total Expected return 140 Risky project Total Expected return 125 05 200 05 50 B Safe ... View the full answer