Question 1

(a) A firm wants to undertake an investment project which costs N$25,000, which it wants to finance through a bank loan. The project has an 80 percent probability of success. If the project succeeds the firm will make a cash flow of N$75,000 after a year. If it fails the firm will get a cash flow of N$0 and will not be required to pay anything to the bank. The bank has a required rate return of 25%.

(a) Calculate the projects expected cash flow. (2 marks)

(b) Briefly explain the concept of individual rationality constraint. (2 marks)

(c) What will be the banks loan rate? Will the bank be willing to lend at this rate? Explain. (4 marks)

(d) How much will be the banks safe income? (2 marks)

(e) How is the banks lending rate related to the probability of failure? Explain why it is the case. (2 marks)

(f) What will be the firms expected profit at the rate in (c)? Will the firm be willing to participate in the contract at that rate? (3 marks)

(g) How much will be the firms uncertain incomes? What will be the expected value of these incomes? (3 marks)

Question 2 (7 marks)

Now suppose that the firm in question (1) above, if the project fails, will get cash flow of N$10,000 and will be required to pay an amount of only N$8,000 to the bank. All the other things remain as in question (1)

(a) What will be the banks loan rate? Will the bank be willing to lend at this rate? (2 marks)

(b) Will the firm be willing to participate in this contract? Explain. (3 marks)

(c) How much will be the banks uncertain incomes? What will be the expected value of these incomes? (2 marks)