Exercise Assumptions: everybody is risk neutral, the interest rate is 0 and investors (lenders) are competitive. One entrepreneur needs to borrow money for her project. The initial cost of the project is K. The entrepreneur has a quantity of cash of her own equal to E. Assume K>E, so if the entrepreneur wants to start the project, she will need to borrow KE from investors. The project, after one period, can be either a success and pay off Y, or a failure and pay off 0 . The probability for the project to be a success depends on the entrepreneurs behavior: if she behaves the probability of success will be equal to pH, if she shirks the probability will be equal to pL0 that can be summed to her monetary payoff. Assume the following: pHY>pLY+B,pHYK>0 and 0>pLY+BK. Before the project is undertaken and before the entrepreneur makes the choice between behaving and shirking, the entrepreneur and the investors can enter a debt contract. The entrepreneur cannot commit to behave and she enjoys limited liability. The sequence of actions is the following: 1. Loan agreement is signed (one period zero coupon bond) 2. The investment is made 3. The entrepreneur decides whether to shirk or behave 4. Payoff is realized Back to the case E