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.
-Suppose that you assume B will be chosen, and offer an unsecured loan.What project will the firm choose and what is the interest rate?
A)Project A with net expected payoff $4.05 million, interest rate 83.33%
B)Project A with net expected payoff $2.35 million, interest rate 83.33%
C)Project A with net expected payoff $2.07 million, interest rate 120%
D)Project B with net expected payoff $2.35 million, interest rate 120%
E)Project B with net expected payoff $4 million, interest rate 120%

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.
-Suppose that you assume B will be chosen, and offer an unsecured loan.What project will the firm choose and what is the interest rate?
A)Project A with net expected payoff $4.05 million, interest rate 83.33%
B)Project A with net expected payoff $2.35 million, interest rate 83.33%
C)Project A with net expected payoff $2.07 million, interest rate 120%
D)Project B with net expected payoff $2.35 million, interest rate 120%
E)Project B with net expected payoff $4 million, interest rate 120%

Quizplus · Accepted Answer

Project B has a net expected payoff of $4 million (0.5 * $8 million) and not $2.35 million. However, when considering the correct interest rate and the choice made under the assumption of an unsecured loan, the firm is expected to choose Project B due to its higher potential payoff despite the same probability of success as Project A. The interest rate of 120% is calculated based on the need to repay the $1.5 million loan with a 10% interest, which would require a repayment of $1.65 million. However, the question's specifics about the interest rate calculation and the firm's choice seem to have been misunderstood in the provided options. The correct approach to determining the interest rate would involve considering the expected payoffs and the cost of the loan, but the given options do not align with the standard financial calculations for these scenarios.

Use the Following Information for Questions