Consider an economy where Banks can invest in one of two projects, G and B. Project G pays G if successful and zero if not successful and has a probability of success ag. Project B pays B if successful and zero if not successful and has a probability of success TB. Suppose also that project G requires an additional cost of c. Assume that banks are required to hold an amount of capital k for each unit of investment. Banks are financed by short term investors who are risk neutral and who require an expected rate of return equal to the risk free rate which is zero. Capital is costly because its holders can demand a rate of return of p > 0 and so the profit of a bank is given by either TG(G – (1 – k)R) -C-(1+p)k or ab(B – (1 – k)R) – (1+p)k depending on what project is invested in Suppose that G = 8, B = 14, TG = 5, B = { and c = = 1. If k = 0, i.e. banks are not required and to hold any capital, what is the critical level of interest rates above which the bank will choose to invest in the bad project? Options: A. 3/4 B. 4/5 C. 5/4 D. 4/2 E. None of A-D
