Consider a firm that gets the single unit of capital needed to implement a project. Suppose that the owner might substitute a bad project for a good one unless the financier takes steps to prevent it. The payoff distributions of the good project and the bad project are shown in the following table.
|
Payoff($) |
Probability |
|
|
Good Project |
2 |
¾ |
|
0 |
¼ |
|
|
Bad Project |
3 |
1/6 |
|
0 |
5/6 |
- If the financier sets the loan payment as $2, what is the expected payoff to the owner after taking the size of the loan payment into account when selecting the good and bad project, respectively? Which project would the owner choose?
- Consider the situation when the financier sets the loan payment as $1.5. Answer the same questions raised in (a).
- What range should the financier set the loan payment so that the owner does not have an incentive to substitute the bad project for the good one?