Doubts

Mock

Mock

by Sofia Lampreia Alves Garcia -
Number of replies: 1

Hi Professor,

I have a quick question about Exercise 3 from the mock, specifically parts (A) and (B).

In the solution, Project B has a higher probability of bankruptcy than Project A, but the interest rate is lower.
Shouldn't a higher probability of bankruptcy lead to a higher interest rate?

Thank you!

Best,

Sofia


In reply to Sofia Lampreia Alves Garcia

Re: Mock

by Julio Crego -
Dear Sofia,

Your intuition is not wrong. In this case, it does not hold because the recovery rate is much higher for project B. The recovery rate is how much the bank recovers when the firm goes bankrupt. With project B, the lowest cashflow that the bank receives is 70 while it is 20 for project A