Suppose that firms and financiers are both risk neutral, that the interest rate is zero, and that firms have no initial resources. In each period a firm adopting an investment project will generate a random income y, and the distribution of y is shown in the following table.
|
Payoff |
Probability |
|
|
y |
yD =4.2 |
PG=3/4 |
|
yB 1.0 |
pB=1/4 |
Now consider a contract in which the lender advances $2 and agrees to renew for a second period whenever the borrower makes a payment of more than yB at the end of the first period. If only yB is paid at the end of the first period, the arrangement will be terminated immediately. Assuming there are only two periods, the firm has no incentive to maintain a good reputation after time 1 has passed. What conditions should the loan repayment at time 1 satisfy so that the lender”s expected profit is positive and the entrepreneur is willing to enter the arrangement?