ECON RMI 4150 Final exam – Theory of Risk, Firms and risk

ECON RMI 4150 Final exam – Theory of Risk, Firms and risk

Subject: Economics / General Economics
Question
ECON/RMI 4150: Theory of Risk
Spring 2017
3rd Problem Set,
(Questions are from the Fall 2012 Final exam.)

1. Firms and risk.
a. Please explain briefly explain (using ideas discussed in class) why a firm
should NOT care about risk. (2-3 sentences)
b. Please explain briefly (using ideas discussed in class) two reasons given in
class why a firm SHOULD care about risk. (2-3 sentences) 2. Index vs indemnity triggers.
a. Please explain briefly what an index trigger is and how it is different from
an indemnity trigger. (1-2 sentences)
b. What are two key advantages discussed in class of using index triggers
instead of indemnity triggers? (1-2 sentences)
c. What is one key advantage discussed in class of using indemnity triggers
instead of index triggers? (1 sentence per advantage) 3. Consider an entrepreneur with no wealth but a great idea. The entrepreneur wants to raise $1 million needed to start a business. The entrepreneur is rational, maximizes expected utility and is risk neutral. There is a 75 percent chance that the business will go well and make
money, in which case the business will generate $1.5 million; there is a 25
percent chance that the business will go badly and lose money, in which
case it will generate only $0.5 million. The entrepreneur can raise money from
o a bank loan (in which case the entrepreneur receives $x million
from the bank promises to pay the bank a fixed dollar amount out
of the proceeds from the business) and/or from
o issuing stock (in which case the entrepreneur receives $x million
from stock investors and promises to pay them a percent of what is
left over after the bank loan has been repaid). Both the bank and the stock investors would be willing to accept an
expected return of zero, so that they would be willing to put in $1 million
for the promise of getting $1 million back on average. There are no taxes. In the event of bankruptcy, legal fees will total $100,000.
a. Imagine that the entrepreneur funds the project by raising $700,000 from a
bank loan and $300,000 from issuing stock.
i. What amount must the entrepreneur promise to repay the bank
(except in bankruptcy, when the bank will only get the remaining
proceeds after legal fees) to make them willing to lend?
ii. What proportion of the company (the proportion of the proceeds
after the bank has been repaid) must the entrepreneur give to the
stock investors?
iii. Please fill in the following amounts that will be received by each
party if the project goes well, if it goes badly, and on average
Project goes well Project goes badly Expected outcome
Bank
Stock investors
Entrepreneur
Lawyers
Total
b. Imagine that the entrepreneur funds the project by raising $500,000 from a
bank loan and $500,000 from issuing stock. i. ii. iii. What amount must the entrepreneur promise to repay the bank
(except in bankruptcy, when the bank will only get the remaining
proceeds after legal fees)?
What proportion of the company (the proportion of the proceeds
after the bank has been repaid) must the entrepreneur give to the
stock investors?
Please fill in the following amounts that will be received by each
party if the project goes well, if it goes badly, and on average.
Project goes well Project goes badly Expected outcome Bank
Stock investors
Entrepreneur
Lawyers
Total
c. Which financing approach (a) or (b) makes more sense for the
entrepreneur? Please explain briefly and quantify the size of the benefit of
using the better approach.
d. How much would the entrepreneur be willing to pay for full insurance (if
he could precommit to buy this insurance before raising money for his
project) in case (a) and in case (b)?