Moral Hazard Question 1. An entrepreneur has to decide between two projects, a safe project and a risky project. The safe project gives a return of 150 with probability 100%. The risky project gives a return of 240 with probability 50% and a return of zero with probability 50%. The investment required for both projects is 100. Assume risk neutrality (decisions based only on expected returns) and limited liability for the borrower (in bankruptcy, the borrower is not responsible for paying a loan in full). Suppose the entrepreneur did not save and he has to borrow the whole 100 from the bank. The interest rate is 10%
Required:
a. Calculate the expected return to the safe project.
b. Calculate the expected return to the risky project.
c. Which project will the entrepreneur choose?
d. Suppose that a collateral equal to 75 is required of borrowers. The interest rate is still 10%. Calculate the expected return to the safe project with the collateral.
Answers: 2
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