Which investment would the stockholders prefer

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Reference no: EM13199434

An S& L can make one of two types of loans. It can lend money on home mort-gages, where it has a 75% probability of earning $ 100 million and a 25% probability of earning $ 80 million. Alternatively, it can lend money to oil speculators, where it has a 25% probability of earning $ 400 million and a 75% probability of losing $ 160 million (due to loan defaults by the speculators). Bernie, the manager of the S& L who will make the lending decision, receives 1% of the firm's earnings. He believes that if the S& L loses money, he can walk away from his job without repercussions, although without compensation. Bernie and the share-holders of the company are risk neutral.

a. Determine the S& L's expected return on the two investments.

b. Compare the S& L manager's expected profits on the two investments.

c. Compare the shareholders' expected profits on the two investments.

d. Which decision would Bernie make if all he cares about is maximizing his personal expected earnings? Which investment would the stockholders prefer?

e. How would your answer to d. change if Bernie cannot walk away in case of losses, so he would be paid 1% of the firm's earnings regardless of their positive or negative sign?

Reference no: EM13199434

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