There is no tax (corporate tax rate = 0%). Everyone is risk-neutral, and the risk-free rate is 3%.

Firm F has a project that costs $5 Mns at time 0. Cash-flows at time 1 are equal to $10 Mns in case of success, $0 in the case of failure. The probability of success is 0.7 (failure: 0.3) if the entrepreneur works. The probability of success is 0.3 (failure: 0.7) if the entrepreneur shirks. The private benefits of shirking are equal to $1.5 Mns.

Some countries use policies that limit maximum interest rates that lenders are allowed to charge to small firms. To model this, we assume in this exercise that the interest rate is necessarily equal to 5%. In this type of scenario, lenders cannot adjust interest rates to be compensated in expectation and have instead to adjust the amount of lending. Accordingly, let's call D the face value of debt.

You can check that the project is only NPV-positive if the entrepreneur works. The lender will therefore only finance the project if she believes the entrepreneur will work, and if she makes a positive profit on the loan.

What is the largest face value of debt D truth such that the entrepreneur can credibly claim that he will work?

Answer rating: 100% (QA)

In this scenario we need to determine the largest face value of debt D that the entrepreneur can credibly claim they will work to secure financing for ... View the full answer