Consider a risk neutral entrepreneur i endowed with a business project that requires investment of I...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
Consider a risk neutral entrepreneur i endowed with a business project that requires investment of I and will generate stochastic revenue equal R with probability p; and 0 with probability 1-p₁. If the business is managed efficiently p₁ = PH. If inefficiently, p; = PL.where PL < pH. Inefficient management generates private benefit B for the entrepreneur. The parameters satisfy the following inequality: PHR>I>PLR+ B The entrepreneur is endowed with assets A < I and needs to borrow I- A from a risk neutral, competitive lender. The lender being competitive means that the lender makes zero expected profit on any loan. A contract between lender and borrower specifies amount loaned (I-A) and repayment in case project succeeds, RL. a. For a given repayment rate R₁, write down the condition under which borrower "behaves," or operates the business in the efficient mode (with success probability pH and no side benefit) b. What is the maximum amount that the borrower may pledge to repay if project succeeds that's consistent with "behaving". c. What's the maximum size of a loan that may be extended by a risk neutral competitive lender? What is the minimum necessary amount of self-invested assets, A*? d. If assets A exceed A*, what is the repayment rate RL. Now assume that in addition to mode of operation (which is under entrepreneur's discretion), there is an additional action where decision right may be allocated to either entrepreneur or lender. The action increases probability of success by and involves private cost to the entrepreneur J. T The actions precedes the choice over of management mode. That is, after I is invested in project, the action is taken (or not) and then the entrepreneurs decides to "behave" (or not). In such environment, financial contract has two dimensions: repayment RL in case of success as well as allocation of the decision right regarding action to either borrower or lender. e. Show that the action, or allocation of the decision right, has no effect on which mode of management will be chosen by the entrepreneur. Assume TR < J. (that is, assume the action is inefficient). f. Solve for the optimal contract. What is the size of loan? What is the repayment? Under what conditions will the action be taken in equilibrium (Hint: work backwards. For a given equilibrium decision regarding action, what should be the equilibrium repayment rate? For a given financial contract, determine whether action is taken and whether borrower "behaves" in equilibrium. The optimal contract is then one that maximizes value of entrepreneur, subject to three constraints: (i) the lender breaks even, (ii) the entrepreneur be- haves in equilibrum, (iii) decision right is exercised in an incentive-compatible way) g. Consider a version of the above model in which there are two actions whose decision rights may be allocated to either investor or entrepreneur. Action one costs entrepreneur J₁ and increases success probability by 71,. Action two is similarly characterized by parameters J2, 72. Characterize the equilibrium control rights allocation in this case. Consider a risk neutral entrepreneur i endowed with a business project that requires investment of I and will generate stochastic revenue equal R with probability p; and 0 with probability 1-p₁. If the business is managed efficiently p₁ = PH. If inefficiently, p; = PL.where PL < pH. Inefficient management generates private benefit B for the entrepreneur. The parameters satisfy the following inequality: PHR>I>PLR+ B The entrepreneur is endowed with assets A < I and needs to borrow I- A from a risk neutral, competitive lender. The lender being competitive means that the lender makes zero expected profit on any loan. A contract between lender and borrower specifies amount loaned (I-A) and repayment in case project succeeds, RL. a. For a given repayment rate R₁, write down the condition under which borrower "behaves," or operates the business in the efficient mode (with success probability pH and no side benefit) b. What is the maximum amount that the borrower may pledge to repay if project succeeds that's consistent with "behaving". c. What's the maximum size of a loan that may be extended by a risk neutral competitive lender? What is the minimum necessary amount of self-invested assets, A*? d. If assets A exceed A*, what is the repayment rate RL. Now assume that in addition to mode of operation (which is under entrepreneur's discretion), there is an additional action where decision right may be allocated to either entrepreneur or lender. The action increases probability of success by and involves private cost to the entrepreneur J. T The actions precedes the choice over of management mode. That is, after I is invested in project, the action is taken (or not) and then the entrepreneurs decides to "behave" (or not). In such environment, financial contract has two dimensions: repayment RL in case of success as well as allocation of the decision right regarding action to either borrower or lender. e. Show that the action, or allocation of the decision right, has no effect on which mode of management will be chosen by the entrepreneur. Assume TR < J. (that is, assume the action is inefficient). f. Solve for the optimal contract. What is the size of loan? What is the repayment? Under what conditions will the action be taken in equilibrium (Hint: work backwards. For a given equilibrium decision regarding action, what should be the equilibrium repayment rate? For a given financial contract, determine whether action is taken and whether borrower "behaves" in equilibrium. The optimal contract is then one that maximizes value of entrepreneur, subject to three constraints: (i) the lender breaks even, (ii) the entrepreneur be- haves in equilibrum, (iii) decision right is exercised in an incentive-compatible way) g. Consider a version of the above model in which there are two actions whose decision rights may be allocated to either investor or entrepreneur. Action one costs entrepreneur J₁ and increases success probability by 71,. Action two is similarly characterized by parameters J2, 72. Characterize the equilibrium control rights allocation in this case.
Expert Answer:
Answer rating: 100% (QA)
a For the borrower to behave and operate the business efficiently with success probability pH and no ... View the full answer
Related Book For
Posted Date:
Students also viewed these finance questions
-
What recent human rights violation has been in the media? What happened? Whose rights were violated? Why? What should happen next?
-
Managing Scope Changes Case Study Scope changes on a project can occur regardless of how well the project is planned or executed. Scope changes can be the result of something that was omitted during...
-
KYC's stock price can go up by 15 percent every year, or down by 10 percent. Both outcomes are equally likely. The risk free rate is 5 percent, and the current stock price of KYC is 100. (a) Price a...
-
Glencoe First National Bank operated for years under the assumption that profitability can be increased by increasing dollar volumes. Historically, First Nationals efforts were directed toward...
-
The following accounts, with the balances indicated, appear in the ledger of Yukon Kayak Co. on December 1 of the current year: The following transactions relating to payroll, payroll deductions, and...
-
Let \[d S_{t}=S_{t}\left(b d t+\sigma_{t} d B_{t} ight)\] where \(\left(\sigma_{t}, t \geq 0 ight)\) is an adapted process such that for any \(t, 0 \[\forall t, \mathcal{B S}\left(S_{t}, a, t ight)...
-
The assembly consists of three titanium (Ti-6A1-4V) rods and a rigid bar AC. The cross-sectional area of each rod is given in the figure. If a force of 6 kip is applied to the ring F, determine the...
-
Stillwater Designs is a private company and outsources production of its Kicker speaker lines. Suppose that Stillwater Designs provided you the following transactions. a. Sold a warehouse for...
-
Coherent light from a laser diode is emitted through a rectangular area 3.0m x 1.5m (horizontal-by-vertical). If the laser light has a wavelength of 680 nm, determine the angle between the first...
-
Prepare an income statement for Rex Manufacturing for the year ended December 31 using the following information. Hint. Not all information given is needed for the solution. Finished goods inventory,...
-
ust Dew It Corporation reports the following balance sheet information for 2020 and 2021. JUST DEW IT CORPORATION 2020 and 2021 Balance Sheets Assets 2020 2021 Liabilities and Owners Equity 2020 2021...
-
When individuals take up a position in an organization, sometimes the organization does not offer the best induction and training for the role offered. This means that the individual must learn how...
-
Our company is currently facing a crisis over some negative reports appearing in the local press. Our current PR agency seems ill-equipped to handle this crisis and we are currently looking for a...
-
You work for a business with small offices in eight countries around the world. Meetings are usually facilitated via Skype, but other online communication and collaboration is a problem. Three months...
-
You work for a custom travel business that operates across the world. Your clients tend to come from your own country, but you have regular customers from over 40 others. Although you do not offer...
-
What are three techniques for deemphasizing negative news?
-
You are the audit senior of a manufacturing company, Hello Cannot Sdn Bhd. You have noted certain conditions that gives you significant doubt on the company's ability to continue as a going concern....
-
The Cholesterol Level data sets give cholesterol levels of heart attack patients. Cholesterol measures are taken 2, 4, and 14 days aft er a patient has suffered a heart attack. Is there a significant...
-
The figure below shows the one-year return distribution for RCS stock. Calculate a. The expected return. b. The standard deviation of thereturn. 35 30 25 20 15F 2 10 -25% -10% 0% 10% 25% Return
-
Oppenheimer Bank is offering a 30-year mortgage with an APR of 5.25%. With this mortgage your monthly payments would be $2000 per month. In addition, Oppenheimer Bank offers you the following deal:...
-
Find online the annual 10-K report for Peets Coffee and Tea (PEET) for fiscal year 2011 (filed in January 2012). Answer the following questions from the notes to their financial statements: a. What...
-
When and why should exchange rates change under a fixed-exchange-rate system?
-
Using the diagram in exercise 5, illustrate the effect of the change in Japanese tastes if exchange rates are fixed. What will happen to the foreign exchange market equilibrium? Data from in exercise...
-
How does a currency speculator profit from exchange-rate changes? Give an example of a profitable speculation.
Study smarter with the SolutionInn App