Bill Guerin, an entrepreneur, has a project available for investment with two pro-duction techniques, Safe and Risky, both requiring an initial investment of $100. Next year, the Safe technique provides a payoff of $120 with certainty, and the Risky technique pays $124 if successful, but only $94 if unsuccessful, where the risk-neutral probability of success is ½. The risk-free rate is 5%.
Can Guerin obtain a $100 loan to be repaid next year to finance the project at the risk-free rate?
What is the NPV for the bank if it charges 15% interest on the loan?
What is the NPV for the bank if it charges 17% interest on the loan?
Suppose the bank has a monopoly on providing financing. Discuss how parts b) and c) relate to the bank’s decision about what interest rate to charge.