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Suppose a borrower knows at time t = 0 that it will have available at time t = 1 an opportunity to invest $340 in a risky project that will pay off at time t = 2. The borrower knows that it will be able to invest in one of two mutually exclusive projects, S or R, each requiring a $340 investment. If the borrower invests in S at time t = 1, the project will yield a gross payoff of $615 with a probability of 0.8 and $180 with a probability of 0.2 at time t = 2. If the borrower invests in R at time t = 1, the project will yield a gross payoff of $685 with a probability of 0.6 and $100 with a probability of 0.4 at time t = 2. The borrower's project choice is not observable to the bank.
Problem 1: What advice should you give this borrower? Assume a competitive loan market in which each bank is constrained to earn zero expected profit. Determine the NPV of the alternative(s) that you recommend.
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