Question III: The Diamond Model (35 points) 

Vandelay Industries would like to fund a new project in importing and exporting goods. To do this, they will need funding to cover various startup costs. Assume the following:

• The probability that the project is successful is 75%, and the probability of failure is 25%.

• The company needs to raise $100,000 to start its operation, and in a successful state, the project will be worth $150,000, while it will be worth its initial $100,000 if it fails.

  H.E. Pennypacker, a wealthy American industrialist also wants to fund a new project in clothing retail. He also decides to pursue funding for various startup costs. Assume the following:

  • The probability that the project is successful is 75%, and the probability of failure is thus 25%.

  • The company needs to raise $100,000 to start its operation, and in a successful state, the project will be worth $150,000, while it will be worth its initial $100,000 if it fails.

    Assumptions for both projects: 

    • Bankruptcy costs are 50%.

    • Potential lenders require a rate of return of 5%.

    • Monitoring Costs are $100 per each $25,000 that the bank funds

    • The projects are independent of one another

    1. Assume Vandelay Industries pursues direct financing. To what should a potential lender set the face value of a loan to Vandelay Industries? Now assume that the bankruptcy costs increase to 75%. What should the face value of the loan be? (7 points)

    2. Return to the original assumption that bankruptcy costs are 50%. Vandelay Industries receives news that the project is successful. What return does the firm receive? What return does the lender receive? (7 points)

    3. Vandelay Industries offers to pay back the (direct financing) lender less than the face value you calculated above, claiming that a series of unfortunate events made the project a failure. What should the lender do? (3 points)

    4. Calculate the following probabilities: (3 points) a. Vandelay Industries and Pennypackers projects both succeed b. One of the two projects fails c. Both Vandelay Industries and Pennypackers projects fail

5. If a bank were only to finance Pennypackers project, what would its probability of default be? What is the banks probability of default be if it funds both projects? (3 points)

6. What rate should the bank promise to repay its depositors if it decides to fund both projects? (4 points)

7. For what face value is monitoring feasible for the bank? (3 points)

8. What are the expected profits for the bank? (5 points)