This exercise illustrates the case of Lemma 5.2.2 in the model of Diamond (1991). Keep everything from the previous exercise except that here \(X=1.4\) and \(C=0.35\). Show that in this case, if the project is financed with short-term debt, it will be liquidated in the case of a downgrade at \(t=1\). Show also that this leads the entrepreneur of a good project to prefer long-term to short-term debt. Finally, show that this conclusion is reversed if the initial credit rating is \(f=\frac{3}{4}\) instead of the initial \(\frac{1}{2}\).

Data From Lemma 5.2.2:-

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Lemma 5.2.2 (Diamond, 1991). Consider a debt structure that does not imply liquidation and leads to a value of debt V", given a downgrade. Compare it with an alternative structure that implies liquidation. Entrepreneurs of good projects prefer the latter if and only if the control rent C < C, where the upper bound is given by C = LR fa X- - RVd - > 0. qd