Question
Assume that investors are risk neutral, i.e., in the context of the CAPM model, RM = rF . Consider the following investment problem. Currently, at
Assume that investors are risk neutral, i.e., in the context of the CAPM model, RM = rF . Consider the following investment problem. Currently, at date 0, ABC corporations assets consist entirely of $1000 of cash. The risk-free rate, rF = 0.05 At date 1, the shareholders of ABC are obligated to pay a bank $1000. Date 1 is the last date, After this date, the cash flows of ABC will be distributed to shareholders (as a dividend) and the bank (as debt repayment). ABC has only one investment opportunity, the opportunity requires investing $1000 at date 0, and at date 1, the investment will return $2000 with probability 0.25 and will return $0 with probability 0.75. NPV is negative $523.81.
1.How will accepting this investment affect the value of the banks loan? 2. Is accepting this project an example of risk shifting, underinvestment, both risk shifting and underinvestment, or neither risk shifting or underinvestment. Please briefly explain your answer.
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