Toni Difelice is contemplating lending $10,000 to Tech Enterprises Ltd. Tech offers her 8%

interest with the principal to be repaid at the end of the year. Toni carefully examines the financial statements of Tech Enterprises and is concerned about its interest coverage ratio,

which is currently at 1.

8:1. She feels that there is a 5% chance that Tech will go bankrupt, in which case she would only recover $2,000 of her principal and no interest. She suggests a debt covenant in the lending contract, whereby Tech promises not to issue any more debt beyond what Toni invests if its interest coverage ratio falls below1.

6:1. With such covenant protection, Toni assesses only a 1% probability of bankruptcy and subsequent recovery of only $2,000.

The manager of Tech Enterprises agrees to this request, providing that Toni reduces her interest rate to 5%.

Toni is risk-averse, with a mean-variance utility function:

where a is her investment act, x_a is the expected return on

a, and σ_∂²? is the variance of the return of a.
Required

a. Which act should Toni take?
a1 : 8% interest, no debt covenant a2 : 5% interest, debt covenant

b. Explain why the manager of Tech Enterprises would be concerned about new accounting standards that may come into effect after the lending contract with Toni is concluded.
Consider both standards that will tend to lower reported net income and standards that will increase its volatility.

Transcribed Image Text:

U(a) = 2x - 2