iPad 9:15 @ 99%-. Problem Set 1 ps1_2018.pdf 3. Many firms issue low-quality debt (junk bonds) instead of getting banks loans. We examine the trade-offs involved. Consider an a risk-neutral entrepreneur protected by limited liability. She has assets A and must finance an investment of fixed size I > A. The project yields R in the case of success and 0 in the case of failure. The probability of success is PH if the entrepreneur behaves (no private benefit) and pL if she misbehaves (get private benefit B). Investors are risk-neutral and demand a 0 net rate of retur. Assume that: PHR> P,R+B>I Suppose further that there is a competitive supply of monitors (e.g. banks) and abundant monitoring capital. At private cost c, a monitor can reduce the entrepreneur's private benefit of misbehaving from B to b. Assume that PH PL and (PH PL)R> c+ B Show that there exist thresholds Ai A A2, the firn borrows froin a monitor (and from uninformed investors) (c) (10 Marks) if A2 A A1, the firm issues junk bonds (public debt that has a low probability of success) (d(5 Marks) if A >A, the firm does not invest. Hint: for each case above examine when the entrepreneur has incentives iPad 9:15 @ 99%-. Problem Set 1 ps1_2018.pdf 3. Many firms issue low-quality debt (junk bonds) instead of getting banks loans. We examine the trade-offs involved. Consider an a risk-neutral entrepreneur protected by limited liability. She has assets A and must finance an investment of fixed size I > A. The project yields R in the case of success and 0 in the case of failure. The probability of success is PH if the entrepreneur behaves (no private benefit) and pL if she misbehaves (get private benefit B). Investors are risk-neutral and demand a 0 net rate of retur. Assume that: PHR> P,R+B>I Suppose further that there is a competitive supply of monitors (e.g. banks) and abundant monitoring capital. At private cost c, a monitor can reduce the entrepreneur's private benefit of misbehaving from B to b. Assume that PH PL and (PH PL)R> c+ B Show that there exist thresholds Ai A A2, the firn borrows froin a monitor (and from uninformed investors) (c) (10 Marks) if A2 A A1, the firm issues junk bonds (public debt that has a low probability of success) (d(5 Marks) if A >A, the firm does not invest. Hint: for each case above examine when the entrepreneur has incentives