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1. Virgil can choose either a safe or a risky project. To keep things simple, lets say either project costs $100. A safe project yields $114 with certainty, while a risky project is equally likely to yield $208 or zero. Virgil needs financing for 50 percent of the cost of his project. Lenders cannot observe his choice of project. Everyone is risk neutral, and the risk-free rate is 6%.

1. If Virgil were to sell $50 worth of bonds with face value equal to $53, in which project would he invest? Justify your answer. How much would bondholders get paid, on average?

2. How much face value would Virgil need to offer lenders in order to sell $50 worth of bonds?

3. Is Virgil willing to offer the face value required to sell bonds? Explain.

4. Is Virgil willing to finance a project by selling shares? Are savers willing to purchase his shares? Does financing with equity yield an efficient equilibrium?

2. Calpurnia wants to finance her education, plus buy a home. She needs to borrow $500,000, and the risk free rate is 5%. She can try to obtain financing by selling either debt or equity. Calpurnias job pays a salary of $75,000 per year. If she works hard, she has a 50 percent chance of getting a promotion and an increase in her salary to $125,000. If Calpurnia devotes minimal effort to her job, her salary will remain at $75,000. Calpurnias disutility of working hard is $20,000. Everyone is risk neutral, and all the surplus goes to Calpurnia. Assume asymmetric information.

1. How much is Calpurnias annual cost of funds?

2. Hard work generates how much surplus? Explain.

3. In an equity sale, Calpurnia must try to sell at least a 1/4 share. Why?

4. If savers were to accept a 1/4 share, would Calpurnia work hard? Show your computations. How big a share do savers require?

5. In equilibrium, does she obtain financing by using debt or by using equity? Show your computations. Is the equilibrium efficient?

6. Describe the asymmetric information problem: Who cant observe what?

7. Would savers accept a 1/4 share if information were symmetric? Explain.

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