Capital injection as a screening device. Suppose we have a firm that needs $200 to invest in a project that will yield a random payoff one period hence and that the lender will require 10% loan rate. The firm knows the probability distribution of the projects cash flow, but no one else does. All that others know is that the project can be type C or type D. If it is type C, then it will yield a cash flow of $300 with probability 0.9 and zero with probability of 0.1. If it is type D, the project will yield a cash flow of $600 with probability 0.5 and zero with probability 0.5.

The corporate tax rate is now 20%. Now though bank cannot tell whether the borrower has a type C or a type D project, the bank wish to separate out each type of borrower correctly. The key to resolving this informational asymmetry is to use capital from the borrower as a signal. As a banker, how would you deal with those borrowers, assuming that the borrower type is either project C or project D?