Consider the example of moral hazard problem when a rm issues bonds/takes loans
ID: 1109127 • Letter: C
Question
Consider the example of moral hazard problem when a rm issues bonds/takes loans (in lecture note 9). We have shown that if the a sufciently large fraction of the project is nanced by the rm’s internal funds (in our example, 25%), the rm will choose Project S (the project with higher expected return and lower risk). Suppose now only 10% of the project is nanced by the rm’s internal funds, and the remaining 90% is nanced by bonds/loans. Will the rm still choose Project S?
Consider a firm, who decides in which project it should invest. Amount for investment $100, time horizon 1 year. 2 possible projects: Project S with probability 1/2 pays: $105 with probability 1/2 pays: $115 * Therefore, the expected return is $110, the standard deviation is $5. Project R with probability 1/2 pays: $60 with probability 1/2 pays: $130 * Therefore, the expected return is $95, the standard deviation is $35 From the efficiency point of view, the firm should invest in Project S, which pays a higher expected return and has a lower risk.Explanation / Answer
Moral harzard is a situation when one party includes in the risky events because of higher returns and knowing that it is protected against the risk and the other party will incur the cost.
As it is mentioned that if the a sufciently large fraction of the project is nanced by the rm’s internal funds (in our example, 25%), the rm will choose Project S (the project with higher expected return and lower risk). But if little fraction of the project is financed by the firm's internal funds in our case 10% then one can shift to higher risk project if and only if the net expected profit of other project 'x' is greater than the net expected profit of Project S.
net expected profit for project S = expected return - 75% * (loanable amount + interest amount) - internal funds
net expected profit for project x = expected return - 90% * (loanable amount + interest amount) - internal funds
otherwise, firm will stick to project 'S.'