Question

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A single firm has the option of pursuing either a safe project or a risky project. Assume that the two investment projects cost $100 each; one produces revenue of $125 for sure, and one produces revenue of $160 with a 50% probability. Assume the firm can sell a bond for $100 if the expected payment is at least $110 (that is, the saver/investor expects a 10% return). If the firm could guarantee that it will pursue the safe project, then the expected payment would equal the promised payment. In that case, the firm [could, could not] sell a bond promising $110. It would undertake the project, earn $125, and make a profit of $_ _ _ - $_ _ _ = $_ _.

Unfortunately, this won't happen if information is [asymmetric, symmetric]. Suppose the firm sells a bond that promises $110. At that point, whatever the firm has promised, it can pursue either project. Bondholders can't control the firm's decision because they don't see what it does.

The firm will consider its options. As stated above, the safe project yields a certain profit of $15. The risky project produces $160 but only if it succeeds. In this case, the firm pays off the bond and its profit is $_ _ _ - $_ _ _ = $_ _.  If the risky project fails, the firm defaults on the $100 bond and earns nothing. Because the risky project succeeds 1/2 of the time, the expected profit is (1/2) X ($_ _) = $_ _. This [exceeds, falls below] the profit from the safe project, so the firm chooses the [risky, safe] project. Thus, the bond market unravels. Savers know the firm will choose the [risky, safe] project, so they [will, won't] buy bonds promising $110. With a 1/2 chance of success, they need a promised payment of $_ _ _ to get an expected payment of $110 ($_ _ _ times .50). But the firm can't profit from either project if it promises $_ _ _. So the bond [is, is not] sold and [both, neither] of the projects are funded.

Answer 1

A single firm has the option of pursuing either a safe project or a risky project. Assume that the two investment projects cost $100 each; one produces revenue of $125 for sure, and one produces revenue of $160 with a 50% probability. Assume the firm can sell a bond for $100 if the expected payment is at least $110 (that is, the saver/investor expects a 10% return). If the firm could guarantee that it will pursue the safe project, then the expected payment would equal the promised payment. In that case, the firm [could] sell a bond promising $110. It would undertake the project, earn $125, and make a profit of $125 - $110 = $15.

Unfortunately, this won't happen if information is [asymmetric]. Suppose the firm sells a bond that promises $110. At that point, whatever the firm has promised, it can pursue either project. Bondholders can't control the firm's decision because they don't see what it does.

The firm will consider its options. As stated above, the safe project yields a certain profit of $15. The risky project produces $160 but only if it succeeds. In this case, the firm pays off the bond and its profit is $160 - $110 = $50. If the risky project fails, the firm defaults on the $100 bond and earns nothing. Because the risky project succeeds 1/2 of the time, the expected profit is (1/2) X ($50) = $25. This [exceeds] the profit from the safe project, so the firm chooses the [risky] project. Thus, the bond market unravels. Savers know the firm will choose the [risky] project, so they [won't] buy bonds promising $110. With a 1/2 chance of success, they need a promised payment of $220 to get an expected payment of $110 ($220 times .50). But the firm can't profit from either project if it promises $220. So the bond [is not] sold and [neither] of the projects are funded.

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