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National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
-Given that a secured loan is offered, what is the borrower's net expected payoff from choosing project A? Project B?
A)Project A = $0.09 million, Project B = $0.58 million
B)Project A = $2.34 million, Project B = $2.34 million
C)Project A = $2.34 million, Project B = $1.68 million
D)Project A = $0.58 million, Project B = $1.68 million
E)Project A = $1.68 million, Project B = $1.68 million

Question

Use the following information for questions 
National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
-Given that a secured loan is offered, what is the borrower's net expected payoff from choosing project A? Project B?
A)Project A = $0.09 million, Project B = $0.58 million
B)Project A = $2.34 million, Project B = $2.34 million
C)Project A = $2.34 million, Project B = $1.68 million
D)Project A = $0.58 million, Project B = $1.68 million
E)Project A = $1.68 million, Project B = $1.68 million

Quizplus · Accepted Answer

The expected payoff for project A is:
Expected Payoff = 0.6($6.75 million) + 0.4($0) = $4.05 million
The net expected payoff for project A given the collateral cost is:
Net Payoff = $4.05 million - ($1.5 million)(0.9) = $2.34 million

The expected payoff for project B is:
Expected Payoff = 0.5($8 million) + 0.5($0) = $4 million
The net expected payoff for project B given the collateral cost is:
Net Payoff = $4 million - ($1.5 million)(0.9) = $2.34 million

Therefore, both projects have the same net expected payoff ($2.34 million), so the borrower is indifferent between them.

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