Firm knows the probability distribution of this cash flow

Assignment Help Financial Management

Reference no: EM131047582

Consider a firm that needs $350 to invest in a project that will yield a single cash flow one period hence. The firm knows the probability distribution of this cash flow, but no one else does. As a banker you only know that the firm is either low risk (L) or high risk (H). If it is L, then it will yield $500 with probability 0.8 and nothing with probability 0.2 one period hence. If it is H, it will yield $1500 with probability 0.6 and nothing with probability 0.4 one period hence. The firm itself knows whether it is H or L.

Assume that both the principal and interest repayments on any debt are tax deductible. The corporate tax rate applicable to this firm is 0.2. There is no equity capital on the firm’s books at present, but it would raise equity as needed. The firm is locked into being either L or H, but as a banker you cannot tell which type it is.

Assume everybody is risk neutral and that the discount rate (and the bank’s cost of funds) is zero. Also, your bank is competitive (it prices loans to earn zero expected profit).

Construct a scheme consisting of two different loan contracts (one requiring the borrower to finance the project partly with equity capital and the other requiring no equity) such that the firm will truthfully reveal its private information by its choice of loan contract.

Reference no: EM131047582

Questions Cloud

Compute the book value-liquidation value-replacement value : We know the following about Mansur. Total assets are $ 1000m, E is $700m, cash is $100m and the # of shares is 1m. We estimate that the market value of equity is 2 times the book value of it. Finally, a fire sale of the firm would bring 70percentage ..

Advise about investments : We have two individuals whom we have to advise about investments. The one is a twenty three year old who has gotten a job in investment banking and is receiving 150 k annually. The other is an eighty year old woman, Ms. Brown, who has $10 million in ..

Stock market and bond market in two different cases : Expound on an expansion in GDP and the effects on the stock market and bond market in two different cases. First, the economic growth does not induce inflation. Second, the economic expansion causes substantial increase in inflation. Specifically, th..

What does convexity measure : Assume a two-year Euro-note (pays coupon annually), $100,000 par value, an annual coupon rate of 10 percent and convexity of 2.7. If today’s YTM is 11.6 percent and term structure is flat, a. What does convexity measure? Why does convexity differ amo..

Firm knows the probability distribution of this cash flow : Consider a firm that needs $350 to invest in a project that will yield a single cash flow one period hence. The firm knows the probability distribution of this cash flow, but no one else does. As a banker you only know that the firm is either low ris..

What is the annual worth of pension : Shepherd Book invests $30,000 in a pension. During the first year, the pension will be worth $2,000, the second year $4,000, the third year $2,000, and the fourth year $4,000, and so on. The pension lasts for 12 years. What is the annual worth of thi..

Treasury decides to extend a loan guarantee : Assume that U.S. Treasury decides to extend a loan guarantee (for political reasons) to a country with a B rating. With such a guarantee this country will be able to issue a five-year $2 billion face value zero-coupon bond at a yield of 7.5 percent (..

Determining mortgage qualification : Brenda found out that reputable lenders use the 28/36 rule when determining mortgage qualification. Brenda currently grosses $6,000 per month. From this she pays a $200 car payment; a personal loan of $100 and a student loan payment of $90. Based on ..

Request the up-front cash option : You and 11 coworkers just won $12 million from the state lottery. Assuming you each receive your share over 20 years and that he state lottery earns a 5.5 percent return on its funds, what is the present value of your prize before taxes if you reques..

User Account

All Pages