Sep 19, 2017

(LONG-TERM CONTRACT AND LOAN COMMITMENT). CONSIDER THE TWO-PROJECT, TWO-PERIOD VERSION OF THE…

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(long-term contract and loan commitment). Consider the two-project, two-period version of the fixed-investment model of Section 3.2 and a unit discount factor. Assume, say, that the borrower initially has no equity (A = 0). Show the following

then the optimal long-term contract specifies a loan commitment in which the second-period project is financed at least if the first-period project is successful. Showhen the optimal long-term contract specifies that the second-period project is implemented with probability 1 in the case of first-period success, and with probability ξ ∈ (0, 1) in the case of failure. (ii) In question (i), look at how ξ varies with various parameters. (iii) Is the contract “renegotiation proof,” that is, given the first-period outcome, would the partieswant to modify the contract to their mutual advantage? (iv) Investigate whether the long-term contract outcome can be implemented through a sequence of short-term contracts where the first-period contract specifies that the borrower receives A = I − pH(R − B/∆p) with probability 1 in the case of success and with probability ξ in the case of failure


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