Suppose We are going to make $70,0000 with our business activities under good conditions and $500,000 under bad conditions in this year. If we change the risk profile, we then will make $800,000 under good conditions and make $100,000 under bad conditions. Also, assume bad and good conditions are equally likely, meaning that the probabilities of good conditions and bad conditions are 50% and 50% respectively. We will wrap up our business activity after this year.

QUESTION:

1) Shall we change the risk profile of our business activities? Support the answer by showing calculations.

2) If we need to pay the bank $500,000 ($5,0000 being interest) at the end of this year. Is it still considered to be beneficial to change the risk profile of our business activities? Show calculations.

3) Please calculate the break-even interest rate that is to be charged by the bank that makes us indifferent as to change the risk profile of our business activities or not.

4) There’s an agency issue introduced in question (2) might urge us to alter the capital structure of our business activities. Please discuss two other factors that can do the same.