Question

Consider the model of Monitoring and Capital based on Holmstrom and Tirole (1997) where firms can choose either a good project with a probability of success πG​. or a bad project with probability of success πB​ with πG​>πB​. Both projects need I units of investment and yield the same return, y, if successful and zero if unsuccessful but the bad project yields an additional private return to the investor of B. Banks can monitor firms at a cost of C and this reduces the private return of the bad project to b(1+r)I>πB​y+B. Uninformed risk neutral investors require an expected rate of return of (1+r). Suppose that parameters are such that πG​=3/4​,y=20,I=6,πB​=1/4​,B=5,b=1,C= 2 and r=1 i.e. 1+r=2, that the asset distribution of firms is uniformly distributed on the interval [0,10] and that the total mass of firms is 10 . What is the minimum amount of assets that a firm needs to be able to borrow directly from the market without also borrowing from banks?

Answer 1

The question examines the minimum asset requirement for a firm to borrow directly from the market in a model of Monitoring and Capital by Holmstrom and Tirole, involving financial decision-making factors like monitoring costs, private returns, and expected rates of return.

Step-by-step explanation:

The question relates to a model from Holmstrom and Tirole (1997) concerning financial markets, where firms can choose between good and bad projects, each requiring the same investment but with different probabilities of success and returns. The question asks what the minimum amount of assets a firm needs to borrow directly from the market without relying on banks, given the parameters of the model. This scenario revolves around the concepts of monitoring cost, private return, and expected rate of return, which are crucial to determining the financial decisions that firms make.

The expected rate of return plays a significant role in a firm's decision to select a particular project, as it represents the average potential return on investment, factoring in both interest payments and capital gains. The model indicates that there is a threshold of assets above which a firm can avoid the cost of bank monitoring and borrow directly from the market, underlining the interplay of various factors that include asset distribution, project viability, and the costs of monitoring.