The monitor discovers the bad project 2 (the one yielding private benefit B) with probability x, and learns nothing with probability 1x. The probability x of effective monitoring (=monitoring level) depends on the effort cost or disutility of effort c(x) incurred by the monitor. We assume that this disutility of effort is increasing c 0 () > 0 and convex c 00() > 0. Also we assume that c 0 (0) = 0 and c 0 (1) = . Lets assume that the borrowers reward Rb, in the case of success, is smaller than B p , and larger than b p (i.e. b p < Rb < B p ). Also, letting Rm denote the monitors payoff in the case of success.

(1) Show the NPV of the project for a monitoring level x. Hint: what is the return and cost of the project?

(2) Show the first order condition which determine the optimal level of monitoring x for the maximization problem of NPV. (3) Show the expected return for a monitor.

(4) Show the first order condition which determine the optimal level of monitoring x for the monitors maximization problem.