Universal Savings & Loan (USL) has $1,000 to lend. Risk-free loans will be paid back in full next year with 4% interest. Risky loans will be paid back in full next year with 30% interest unless they are defaulted. The probability of risky loan default (a borrower does not pay back anything) is 80%.

(a) (3 points) How much profit can USL expect to earn? Find the expected profits for each loan type.

(b) (5 points) Now suppose that USL knows that the government will bail it out if there is a default. What type of loans will USL choose to make? What is the expected cost of bail out to the government?

(c) (6 points) Suppose that USL doesnt know for sure that the government will bail it out, but estimates the bail out will occur with probability p. For what values of p will USL make risky loans?