An entrepreneur has to finance a project of fixed size I. The entrepreneur has cash-on-hand A, where A < I. To implement the project, the entrepreneur (that is, the borrower) must borrow I A from lenders. If undertaken, the project either succeeds, in which case it yields a return R > 0, or fails, in which case it delivers a zero return. The probability of success depends on the effort exerted by the borrower: if the borrower exerts effort, the probability of success is equal to pH; if the borrower exerts no effort, the probability of success is equal to pL, where p = pH pL > 0. If the borrower exerts no effort, he also obtains a private benefit B > 0, while there is no private benefit when the borrower exerts effort. Define as Rb the amount of profit going to the borrower, and as Rl the amount of profit going to the lenders in case of success, where R = Rb + Rl . All the players are risk neutral. Lenders behave competitively, and both borrower and lenders receive zero if the project fails.

(a) Write down the Net Present Value (NP V ) of the project when the borrower exerts i) effort and ii) no effort.

(b) Let us assume that NPV is positive only when the borrower exerts effort. Write down the break-even constraint for the lenders (IRl) assuming that the borrower exerts effort.