LOAN COMMITMENTS. Chara&McAvoy Inc., can choose one of two projects: safe and risky. The safe project yields $139 with probability .95 and zero with probability .05, whereas the risky project yields $160 with probability .60 and zero with probability .40. Each project requires an investment of $100, which Chara&McAvoy must borrow. The bank can make only an unsecured loan, and cannot observe the firm’s choice of project. Everyone is risk neutral, and the risk-free rate is zero.

Now suppose the bank has made a long-term relationship with Chara&McAvoy. The firm seeks two successive $100 loans to finance projects in periods 1 and 2. The bank promises to extend credit in period 2, at interest rate i2, on the condition that Chara&McAvoy repay its loan from period 1.

d. Given that the bank commits to lending in period 2, which rate i2 does it prefer?

e. Suppose the bank in period 2 charges its preferred rate. Given i2, find the maximum interest rate in period 1 for which Chara&McAvoy prefers the safe project.

f. What is the first period rate at which the bank breaks even on the two-period contract? Explain why this breakeven rate differs from the breakeven rate in part c.

g. Does the bank still offer the contract if it expects to incur a loss on the period 2 loan? Why?

h. Assuming the loan market is competitive, what is the equilibrium rate on the period 1 loan?

i. In this model, does the resolution of the Moral Hazard depend on the reputation of the lender or of the borrower?

j. Suppose Chara&McAvoy does not believe the bank will honor its promise to make the second loan. Since one loan is better than none, can Chara&McAvoy still enter a loan commitment with the bank?

k. If Chara&McAvoy defaults on its first loan, can the firm obtain a loan in period 2 by going to a different bank?