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Context Suppose we have an imaginary economy with a lot of entrepreneurs. Each entrepreneur needs external funding of IDR 1 0 0 million for a
Context
Suppose we have an imaginary economy with a lot of entrepreneurs. Each entrepreneur needs
external funding of IDR million for a project. There are two risk categories for the project:
highrisk and lowrisk. The cash flow returns of a highrisk project equals IDR million
probability and IDR probability On the other hand, the lowrisk project
generates cash flows IDR million, always probability By assuming riskneutrality
universal and the riskfree rate is zero no discounting each project creates IDR million on
average. The entrepreneurs have positive NPV since
However, the bank does not know the probability to generate the cash flow for each project,
but the entrepreneur knows. Suppose the bank cant find a way to know the riskiness of a project
by screening the project. The bank only knows the estimated probability for lowrisk projects,
which equals to of all cases. The entrepreneur takes his project only if he has a strictly positive
expected payoff, by taking into account what he has to pay back to the bank. We may assume that
the economy has perfect competition in the credit market.
Quesons
Suppose that the bank has following statement: With probability the project is a highrisk,
the project fails to generate cash flow with probability and with probability the project is
a lowrisk project. So to create a break even condition, the bank needs to charge an interest rate r
by using: times times rtimes r Is there any creditworthy entrepreneur who
would accept the interest rate? What is wrong with this statement?
By assuming debt financing, what interest rate the bank will charge in the equilibrium condition?
and what kind of projects are financed by the bank? Who is credit rationed?
By using equity financing, the bank holds some share a a of the firm, which implies the
bank will receive share of a from the firms cash flows. Proof that the bank would finance both
high and low risk projects. In addition, both high and low risk project holders pay the fair capital
cost Explain.
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