Answer to Question #208813 in Finance for Syed Eassa

Question

Assume that you have two investment alternatives: the first project produces $125 for sure, and the second project produces $150 with probability 2/5. You can borrow $110 from your financial institution for one project (investment) if you show an asset as a collateral. Suppose that you maximize your expected profit, what would be the minimum level of collateral that make you select the safe project?

Answer 1

Solution

Expected profit is the profit expected

by the investor on the investment made. This expected profit is computed based on past trends ans various variables and probabilities.

Collateral is a security which is submitted by the debtor to the creditor as a security against loan. In case the debtor fails pay the loan the collateral acts as a compensation for the unpaid loan.

Step 2

It is given that first project's return is 100% sure. Therefore

Expected profit out of first project is

=$\frac{100}{100}\times125$

= $125

It is given that second project produces a return of $\frac{2}{5}$ . Therefore,

Expected profit out of second project is

= $\frac{2}{5}\times150$

= $60.

It is evidently seen that the first projects yields 100% profit and the expected profit $125 of the first project is more than the second project's expected return of $60.

Therefore the first project is chose to loaned against a loan amount of $110.

Step 3

It is seen that since the expected probability of the return produced is 100%, the minimum collateral to be presented against should not be more than the 50% of the expected profit of the project.

The minimum collateral to be placed is

Expected profit $\times\frac{50}{100}$

= $125 $\times\frac{50}{100}$

= $62.50.

It can also be seen that collateral to be placed is well within the loan borrowing limits.