Question

Your borrowing rate is 15% per year. Your lending rate is 10% per year. The project costs $5000 and has a rate of return of 12%.

1. Should you take the project if you have $2000 to invest?

2. Briefly discuss the concept of market imperfections in the context of this question.

Answer 1

1) a) Return on project = Project cost * Rate of return = $5000 * 12% = $600

b) You have $2000 & require to borrow @ 15% additional $3000 to finance new project.

But, when we use $2000 to finance the project then at the same time we will have to sacrifice return on lending @10% ie opportunity costs.

Opportunity cost = $2000 * 10% = $200

Further borrowing cost required to pay for $3000 borrowed ie $3000 * 15% = $450

Total cost of fund = Opportunity cost + Borrowing cost

Total cost of fund = $200 + $450 = $650

c) Now, net loss if project choosen = Return on project - Total cost of fund

Net loss = $600 - $650 = - $50

As there is net loss & hence project should not be accepted.

2) Market imperfections is a situation in which market does not allocate resources efficiently. It may occure due to monopoly, inefficiency as transactions can have externalities and market failure. Market imperfection theory is based on facts that every one does not have the same homogeneous expectations, there are limited buyers & sellers, nor does every one has the same information. It assumes that there is no perfect competition.

As per the question, projects should not be accepted due to it's net loss. It is suggested that investor should invest the fund in other opportunity than this project.