Question 1 Suppose you are an investor seeking to nd new opportunities to invest. You have identied two rms: L1 Corporation and B T Enterprises. L1 Corporation is debt free, while B T Enterprises is highly leveraged. Each rm is run by a manager/entrepreneur, who can exert two levels of eort: high or low. The project undertaken by the manager of each rm yields either a high return R3 > 0 or a low return RF 2 0, with RF 0 or a low return RF > U, with RF 0 or a low return equal to zero. Does the amount of leverage of each rm affect its market value? If yes, is there an optimal amount of debt to be issued? Explain. (30% of the marks) 2 TURN OVER Question 2 An entrepreneur has to nance a project of xed size I. The entrepreneur has \"cash-inhand\" A, where A 0, or fails, in which case it delivers a zero return. The probability of success depends on the eort exerted by the entrepreneur: if the entrepreneur exerts high effort, the probability of success is equal to 123; if the entrepreneur exerts low effort, the probability of success is equal to p1,, Where Ap = 113 101, > 0. If the entrepreneur exerts low effort, she also obtains a private benet B > 0, while there is no private benet when the entrepreneur exerts high effort. Dene as R5 the amount of prot going to the entrepreneur, and as R; the amount of prot going to the lenders in case of success, Where R = Rb + Rb All the players are risk neutral and there is limited liability for the entrepreneur. Lenders behave competitively, and both entrepreneur and lenders receive zero if the project fails. (3.) Write down the Net Present Value (NPV) of the project when the entrepreneur (i) exerts high effort and (ii) exerts low effort. (10% of the marks) (b) Write down the \"break-even constraint\" for the lenders (IRg) assuming that the en- trepreneur exerts high eort. {10% of the Inarks) ((2) Write down the entrepreneur's \"Incentive Compatibility Constraint\" (10b) and derive the minimum level of R5 such that the entrepreneur exerts high effort. (10% of the marks) (d) Compute the minimum level of cash-inhand Z the entrepreneur must have to be - nanced. Why are entrepreneurs with low cash-inhand likely to be denied nancing? Explain. (10% of the marks) (e) Suppose now there are two variants, 'A' and 'B', of the project. We assume: pgs" = piss, with RA 0. Also, if the new investment is undertaken, the entrepreneur receives a private benet 3" in case she exerts low effort, where B' > B. Let us assume that TR J U, or fails, in which case it delivers a zero return. The entrepreneur (borrower) can be one of two types. A \"good\" borrower has a probability of success equal to 'p. A \"bad\" borrower has a probability of success equal to q, where p > q. Dene as R5 the borrower's level of compensation when the project is nanced and succeeds. All the players are risk neutral and there is limited liability for the borrower. Lenders behave competitively, and both borrower and lenders receive zero if the project fails. Assume pR > I > (1R. (a) Suppose rst that lenders have complete knowledge of the borrower's type. Write down the lenders' break-even constraint when the borrower is (2') \"good\" or (it) \"bad\". (10% of the marks) (b) What is the highest level of compensation each type of borrower can obtain? D0 both types of borrower obtain nancing? {10% of the marks) (c) Suppose now that lenders cannot observe the borrower's type. Lenders believe the borrower is \"good\" with probability on, and \"bad\" with probability 1 or. Comment on the eect of asymmetric information on (i) the availability of credit to both types of borrower, and (ii) if a loan is granted, on the compensation the two types of borrower obtain from undertaking the project. (20% of the marks) ((1) Suppose now that, if nanced, the project yields a high return R3 > 0 in case of success, and a low return RF > 0 in case of failure, with RF I, where m = orp + (1 i (2):]. Also, dene as RE 2 0 and R: 2 0 the borrower's compen- sations in case of success and failure, respectively. Write down the \"break-even constraint\" for the lenders (1R1) in the presence of asym- metric information. (10% of the marks) (e) Let us continue with the framework introduced in point {(21). Write down the utility of the \"good\" borrower. (10% of the marks) (1') In the presence of asymmetric information, determine the compensations R: and R5 that maximize the utility of the \"good\" borrower, subject to the borrower obtaining nancing. (30% of the marks) 5 TURN OVER (g) Does the entrepreneur issue safe debt D? If yes, determine its level. Explain. (10% of the marks) TURN OVER
