This exercise studies the relationship between monitoring costs and the cost of broken con- tracts. Consider a 200 AUD investment in a local bakery for one year. Without monitoring, the baker might be lazy and the probability of a failure of the bakery and no repayment is 20%. With monitoring, the baker is working hard and the probability of a failure of the bakery and no repayment is 10%. Without a failure the repayment is 250 AUD.

The cost of monitoring is 13. The interest rate for one year is 5%

a) Should the investor monitor the bakery?

b) Does the investment in the bakery (given optimal choice in a)) have a positive NPV?

Now the investment is split into two different individuals investing in the local bakery, each of the 100 AUD. There is no exchange of information.

c) Should one investor monitor the bakery? d) Does the investment in the bakery (given optimal choice in c)) have a positive NPV? e) Interpret your findings in the context of the lecture content.