Suppose Pompeia wants to finance her education, plus buy a home. She needs to borrow $400,000, and the risk free rate is 5%. She can try to obtain financing by issuing either debt or equity. Pompeias job pays a salary of $60,000 per year. If she works hard, she has a 50 percent chance of getting a promotion and an increase in her salary to $140,000. If Pompeia devotes minimal effort to her job, her salary will remain at $60,000. Pompeias disutility of working hard is $36,000. Everyone is risk neutral. Assume asymmetric information.

a. How much is Pompeias annual cost of funds?

b. Hard work generates how much surplus? Explain.

c. In an equity sale, Pompeia must try to sell at least a 1/5 share. Why?

d. If savers were to accept a 1/5 share, would Pompeia work hard? Show your

computations. How big a share do savers require?

e. In equilibrium, does she obtain financing by using debt or by using equity? Show your

computations. Is the equilibrium efficient?

f. Describe the asymmetric information problem: Who cant observe what?

g. Would savers accept a 1/5 share if information were symmetric? Explain.