Consider the example in Figure 7.2. Assume that neither firm knows whether its project is safe or risky. For each firm, there is a 1/2 chance that the project is safe, producing $125 for sure. There is a 1/2 chance the project is risky, producing $150 with probability 2/3 and zero with probability 1/3. This means that, overall, each firm has a 1/2 chance of earning $125, a 1/3 chance of earning $150, and a 1/6 chance of earning zero. Otherwise, make the same assumptions as before. Will the firms be able to sell bonds? Show your reasoning.
In Figure 7.2

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(A) ASSUMPTIONS Savers . Firm must sell bond Firm must sell bond toWill buy bonds for $100 to finance project that costs S100. Project earns $125 forProject earns $150 finance project that costs $100. if expected payment is at least $110. with 2/3 probability $0 with 1/3 probability. sure. -Firm defaults on bond if So earnings. Expected payment on bond is thus 2/3 of promised payment. (B) WITH SYMMETRIC INFORMATION (C) WITH ASYMMETRIC INFORMATION Savers .Sells bond that eSavers require e If both firms issue bonds, average promised payment of $165 to get expected payment of $110 probability of payment is 5/6 (average of 1 and 2/3). pays $110. Earns profit of $125-$110 $15. (2/3 x $165 $110) Savers require promised payment of $132 to get expected payment of $110 (5/6 x $132 $110). .$165 exceeds highest possible earnings of $150, so firm abandons project. Savers buy bond Safe Firm Risky Firm $132 exceeds earnings of $125, so firm abandons project Will issue bond: has 2/3 chance of earning $150 for profit of $150--$132 No bond issued $18. Savers No bond issued Require promised payment of $165 because probability of payment is 2/3. No bond issued